Geopolitics

Highlights Provided that the coronavirus outbreak is contained, global growth should accelerate over the course of 2020. Stocks usually rise when the economy is strengthening. But could this time be different? We explore five scenarios in which the stock market could decouple from the economy: 1) The economy holds up, but stretched valuations bring down equities, especially high-flying growth stocks; 2) Bond yields rise in response to faster growth, hurting equities in the process; 3) A strong US economy lifts the value of the dollar, denting multinational profits and tightening financial conditions abroad; 4) Faster wage growth cuts into corporate profits; and 5) Redistributionist politicians seek to shift income from capital to labor. We are not too concerned about the first four scenarios, but we do worry about the fifth, especially now that betting markets are giving Bernie Sanders a nearly 50% chance of becoming the Democratic nominee. Matters should be clearer by mid-March, by which time more than 60% of Democratic delegates will have been awarded. If Bernie Sanders does emerge as the nominee at that point, we will consider trimming back our bullish cyclical bias towards stocks. Coronavirus: A Break In The Clouds? Chart 1Coronavirus Remains Mostly Contained To China Investors continue to grapple with two distinct narratives about how the coronavirus outbreak is unfolding. On the pessimistic side, some contend that the true number of infections in China is much higher than the Chinese authorities are disclosing. How else, they ask, can one explain why the government has taken the extreme step of imposing some form of quarantine on 400 million of its own people? More optimistic observers argue that the Chinese government is simply being proactive. While the number of cases in Hubei province spiked yesterday, this was due to a loosening in the definition for what constitutes a confirmed infection. Whereas previously a positive laboratory test was required, now a positive imaging-based clinical examination will suffice. Under the new definition, the number of newly confirmed cases fell from 6,528 on February 11th to 4,273 on February 12th. Under the old definition, newly diagnosed cases peaked on February 2nd (Chart 1). The revised definition adopted in Hubei brought the mortality rate in the province down to 2.7%. The mortality rate observed in the rest of China is 0.5%. The share of all cases in China originating in Hubei also rose to 81%. Even before the rule change, the share of cases diagnosed in Hubei had risen from 52% on January 26th to 75% on February 11th. This suggests progress in limiting the outbreak to the province. Critically, the number of cases in the rest of the world remains low. In the US, a total of 13 cases have been confirmed as of February 12th, just two more than the 11 reported on February 2nd. The Exception To The Rule? Provided that the coronavirus outbreak is contained, global growth should bounce back forcefully in the second quarter. If that were to occur, history suggests that equities will continue to rally, while bond prices will fall (Chart 2). But could history fail to repeat itself? In this week’s report, we explore five scenarios in which that may happen. Scenario 1: Stretched valuations bring down equities, especially high-flying growth stocks Stocks have moved up considerably since their December 2018 lows. This suggests that investors have become more confident about the economic outlook. Nevertheless, while most investors may no longer be worried about an imminent recession, they do not foresee a sharp acceleration in global growth either. This is evidenced by the fact that cyclical stocks have generally underperformed defensives (Chart 3). Oil prices have also languished, while copper prices are back near a 2.5-year low (Chart 4). Chart 2Stocks Usually Outperform Bonds When Global Growth Is Accelerating Chart 3Cyclicals Have Failed To Outperform Defensives   At the broad index level, global equities trade at 16.7-times forward earnings. Conceptually, the inverse of the PE ratio – the earnings yield – should serve as a reasonable guide for the total real return that equities will deliver over the long haul.1 At 6%, the global earnings yield still points to decent returns for global stocks. Relative to bonds, the case for owning stocks is even more compelling. The equity risk premium, which one can compute as the earnings yield minus the real bond yield, remains well above its historic average (Chart 5). Chart 4Commodity Prices Have Taken It On The Chin Chart 5Relative Valuations Favor Equities   That said, there are pockets where valuations have gotten stretched. US equities trade at 19.5-times forward earnings compared to 14.1-times in the rest of the world. Growth stocks, in particular, have gotten very expensive (Chart 6). The five largest stocks in the S&P 500 (Apple, Microsoft, Amazon, Alphabet, and Facebook) now account for 18% of the index, the same share that the top five stocks (Microsoft, Cisco, GE, Intel, and Exxon) commanded in 2000. The big risk for stocks is that wages go up not because the overall size of the economic pie is growing, but because policies are implemented that shift a bigger share of the pie from capital to labor. Despite the similarities between today and the dotcom era, there are a few critical differences – most of which make us less worried about the current state of affairs. First, while tech valuations are currently stretched, they are not in bubble territory. The NASDAQ Composite trades at 30-times trailing earnings. At its peak in March 2000, the tech-heavy index traded at more than 70-times earnings (Chart 7). Chart 6Growth Stocks Have Become Expensive Relative To Value Stocks Chart 7Not Yet Partying Like 1999   Second, IPO activity has also been more muted today than during the dotcom boom (Chart 8). Only 110 companies went public last year, with the gain on the first day of trading averaging 24%. In 1999, 476 companies went public. The average first day gain was 71%. Meanwhile, companies continue to buy up their shares. The buyback yield stands at 3%, twice as high as in the late 1990s. Third, there is no capex overhang like in the late 1990s (Chart 9). This reduces the odds of a 2001-recession scenario where falling equity prices prompted companies to pare back capital expenditures, leading to rising unemployment and even lower equity prices. Chart 8IPO Activity Is Muted Today Compared To The Late 1990s Chart 9No Capex Boom This Time   Scenario 2: Bond yields rise in response to faster growth, hurting equities in the process The period between November 2018 and September 2019 was an odd one for the stock-to-bond correlation. If one looks at daily data, stocks did best when bond yields were rising. Yet, for the period as a whole, stocks finished higher while bond yields finished lower (Chart 10). Chart 10Daily Changes: S&P 500 Vs. 10-Year Treasury Yield How can one explain this seeming paradox? The answer is that the underlying trend in bond yields was squarely to the downside last year. While yields did rise modestly on days when equities rallied, yields fell sharply on days when equities swooned. If one zooms out, one sees the underlying trend, whereas if one zooms in, one only sees the wiggles around the trend. Bond yields trended lower last year because the Fed and most other central banks were delivering one dose of dovish medicine after another. This year, however, the Fed is on hold, and while a few central banks may still cut rates, global monetary policy is unlikely to become much looser. This means that bond yields are likely to drift higher if economic growth surprises on the upside. Will rising bond yields sabotage the stock market? We do not think so. Stocks crashed in late 2018 because investors became convinced that US monetary policy had turned restrictive after the Fed had raised rates by a cumulative 200 basis points over the prior two years. The fact that the Laubach-Williams model, one of the most widely followed models of the neutral rate, showed that real rates had moved above their equilibrium level did not help sentiment (Chart 11). Chart 11The Fed Will Keep Policy Easy For The Time Being Chart 12Stocks Do Well When Earnings And Growth Surprise On The Upside Today, real rates are about 100 basis points below the Laubach-Williams estimate. This will not change anytime soon, given that the Fed is likely to remain on hold at least until the end of the year. So long as rates stay put, monetary policy will remain accommodative, allowing the economy to grow at a solid pace. Granted, rising long-term bond yields will reduce the present value of future cash flows, thus potentially hurting stocks. However, as we discussed three weeks ago, the discount rate is not the only thing that affects equity valuations.2 The expected growth rate of earnings matters too. As Chart 12 shows, global equity returns are highly sensitive to earning revisions. While earnings may disappoint in the first quarter due to the economic damage from the coronavirus, they should bounce back during the remainder of this year. This should pave the way for higher equity prices. Scenario 3: A strong US economy lifts the value of the dollar, denting multinational profits and tightening financial conditions abroad The US is a fairly closed economy. Imports and exports account for only 14.6% and 11.7% of GDP, respectively. In contrast, the US stock market is very exposed to the rest of the world. S&P 500 companies derive over 40% of their sales from abroad. As such, changes in the value of the dollar tend to have a bigger impact on Wall Street than on Main Street. Estimating the degree to which a stronger dollar reduces S&P 500 profits is no easy task. Direct estimates that measure the currency translation effect on overseas profits from a stronger dollar tend to yield fairly modest results, typically showing that a 10% appreciation in the trade-weighted dollar reduces S&P 500 profits by about 2%. These estimates, however, generally do not take into account feedback loops between a strengthening dollar and global financial conditions (Chart 13). According to the Bank of International Settlements, $12 trillion of dollar-denominated debt has been issued outside the US. A stronger dollar makes it more challenging to service this debt, which can put a significant strain on borrowers. As a result, a vicious cycle can erupt where a stronger dollar leads to tighter financial conditions, which in turn lead to weaker global growth and an even stronger dollar. Chart 13A Strong US Dollar Could Tighten Global Financial Conditions, Leading To Lower Equity Prices, Especially In EM Such an outcome cannot be dismissed, especially if the spread of the coronavirus fuels significant foreign inflows into the safe-haven US Treasury market. Nevertheless, we continue to see it as a low-probability event given the tailwinds to global growth, including the lagged effects of last year’s decline in bond yields, an improvement in the global manufacturing inventory cycle, diminished Brexit and trade war risks, and ongoing policy stimulus out of China. In fact, one can more easily envision the opposite outcome – a virtuous cycle of dollar weakness, leading to easier global financial conditions, stronger growth, and ultimately, an even weaker dollar (Chart 14). In such an environment, earnings growth is likely to accelerate (Chart 15). Chart 14The Dollar Is A Countercyclical Currency Chart 15The Virtuous Cycle Of Dollar Easing     Scenario 4: Faster wage growth cuts into corporate profits Labor compensation is the largest expense for most companies. Thus, it stands to reason that faster wage growth could depress earnings, and by extension, share prices. Although this is possible conceptually, in practice, it happens less often than one might guess. Chart 16 shows that rising wage growth is positively correlated with earnings. The bottom panel of the chart explains why: Wages tend to rise most quickly when sales are growing rapidly. Strong demand growth adds to revenues, while allowing companies to spread fixed costs over a large amount of output. The resulting improvement in “operating leverage” helps buffer profit margins from higher wages. Scenario 5: Redistributionist politicians seek to shift income from capital to labor As long as wages are rising against a backdrop of fast sales growth, equities will fare well. The big risk for stocks is that wages go up not because the overall size of the economic pie is growing, but because policies are implemented that shift a bigger share of the pie from capital to labor. Bernie Sanders has promised to do just that. The S&P 500 has tended to increase when Sanders’ perceived chances of winning the Democrat nomination have risen (Chart 17). Investors have apparently concluded that Trump would clobber Sanders in a presidential race. Hence, the better Sanders performs in the primaries, the more likely Trump is to be re-elected. Chart 16Stocks Tend To Do Best When Wage Growth Is Rising Chart 17The Sanders Effect On Stocks   Is this really a safe assumption? We are not so sure. Sanders has still beaten Trump in 49 of the last 54 head-to-head polls tracked by Realclearpolitics over the past 12 months. Sanders tends to appeal to white working class voters – the same demographic that propelled Trump into office. Sanders is also benefiting from a secular leftward shift in voter attitudes on economic issues. According to a recent Gallup poll, 47% of Americans believe that governments should do more to solve problems, up from 36% in 2010. Almost 40% of Americans have a positive view on socialism (Chart 18). Today’s youth in particular is enamored with left-wing ideology (Chart 19). Chart 18The US Is Moving To The Left Chart 19Woke Millennials Cozying Up To Socialism It’s not just the Democratic voters who are trending left. Some prominent Republicans are having second thoughts too. Tucker Carlson is probably the best leading indicator for where the Republican Party is heading. His attacks on “woke capitalism” have become a staple of his popular evening show.3 It is not surprising why many Republicans are having a change of heart. For decades, the Republican Party has been a cheap date for corporate interests: It has given businesses what they want – lower taxes, less regulation, etc. – without asking for much in return (aside from campaign contributions, of course). This has allowed corporations to focus on appealing to left-wing interests by taking increasingly strident positions on a variety of social issues. The fact that some of these positions – such as support for open-border immigration policies – are a boon for profits has only increased their appeal. The risk for corporations is that they end up with no real political support. If the Democrats move further to the left, “soak the rich” policies will become popular no matter how much virtue signaling corporate leaders deliver. Likewise, if Republicans abandon big businesses, today’s fat profit margins will become a thing of the past. When The Music Ends The current market climate resembles a Parisian ball on the eve of the French Revolution. The music is still playing, but the discontent among the commoners outside is growing. The question is when will this discontent boil over? Trump’s victory in 2016 represented a shot across the bow of the political establishment. Fortunately for corporate interests, aside from his protectionist impulses, Trump has been on their side. Bernie Sanders would not be so friendly. Matters should be clearer by mid-March. Super Tuesday takes place on March 3rd. By March 17th, more than 60% of Democratic delegates will have been awarded. If Bernie Sanders emerges as the likely nominee at that point, we will consider trimming back our bullish cyclical 12-month bias towards stocks. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1  Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. 2  Please see Global investment Strategy Weekly Report, “Bond Yields: How High Is Too High?” dated January 17, 2020. 3  Ian Schwartz, “Tucker Carlson: Elizabeth Warren's "Economic Patriotism" Plan "Sounds Like Donald Trump At His Best," realclearpolitics, June 6, 2019. Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Special Report

Highlights Geopolitical sparks in the Mediterranean point to the revival of realism or realpolitik in places where it has long been dormant. Europe is wary of Russia but will keep buying more of its natural gas. This will be a source of tension with the United States. Turkey is wary of Russia but will continue choosing pragmatic deals with Moscow that fly in the face of Europe and the United States. Turkey’s intervention in Libya is small but symbolic. Increases in foreign policy aggressiveness are negative signs for Turkey as they stem from domestic economic and political instability. Short Turkish currency, equities, and local government bonds. The recent increase in immigration into Europe will fuel another bout of populism if it goes unchecked. Feature “Multipolarity,” or competition among multiple powerful nations, is our overarching geopolitical theme at BCA Research. The collapse of the Soviet Union did not lead to the United States establishing a global empire, which might in theory have provided a stable and predictable trade and investment regime. The United States lashed out when attacked but otherwise became consumed by internal struggles: financial crisis and political polarization. Under two administrations the American public has demanded a reduced commitment to international affairs. Europe is even less likely to project power abroad – particularly after being thrown on the defensive by the Syrian and Libyan revolutions and ineffectual EU responses. Turkey’s aggressive foreign policy is a symptom of global multipolarity – which makes the world less predictable for investors. Emerging markets have risen in economic and military power relative to their developed counterparts. They demand a redistribution of global political power to set aright historical grievances and address immediate concerns, such as supply line insecurities, which increase alongside a rapidly growing economy. Multipolarity is apparent in Russia’s resurgence: pushing back on its borders with Europe and NATO, seeking a greater role in the Middle East and North Africa, interfering in US politics, and cementing its partnership with China. Multipolarity is equally evident when medium-sized powers – especially those that used to take orders from the US and Europe – seek to establish an independent foreign policy and throw off the shackles of the past. Turkey is just such a middle power. Strongman President Recep Tayyip Erdogan initially sought to lead Turkey into a new era of regional ascendancy. The Great Recession and Arab Spring intervened. Domestic economic vulnerabilities and regional instability have driven him to pursue increasingly populist and unorthodox policies that threaten the credit of the nation and security of the currency. A coup attempt in 2016 and domestic political losses in 2019 drove Erdogan further down this path, which includes aggressive foreign policy as well as domestic economic stimulus. The Anatolian peninsula has always stood at the crossroads of Europe and Asia, as well as Russia and Africa. Turkey’s efforts to change the regional status quo to its favor, increase leverage over its neighbors in Europe and the Middle East, and deal with Russia’s Vladimir Putin from a position of strength, are causing the geopolitics of the Mediterranean to heat up. It has now intervened in the Libyan civil war. In this special report, we focus on this trend and ask what it means for global investors. Unfinished Business In Libya Chart 1Haftar Is Weaponizing Libya’s Oil As the Libyan conflict enters its sixth year this spring, the battle for control of the western bastion of Tripoli rages. Multiple efforts to mediate the conflict between Field Marshal Khalifa Haftar of the Libyan National Army (LNA) and Prime Minister Fayez al-Sarraj of the UN-recognized Government of National Accord (GNA) have failed. Ceasefire talks in Moscow, Rome, and Berlin have fizzled. Instead, fighting has finally hit oil production, with the state-run National Oil Corp (NOC) declaring force majeure on supplies on January 18. Tribal leaders who support Haftar have blockaded eastern ports (Chart 1). Previously the mutual dependence of the rival factions on oil revenues ensured production and exports went mostly undisturbed. LNA forces control nearly all key oil pipelines, fields, ports, and terminals in Libya. The exceptions are the Zawiyya and Mellitah terminals and offshore fields (Map 1). However the National Oil Company (NOC), headquartered in the GNA-controlled Tripoli, is the sole entity controlling operations and the sole marketer of Libyan oil. Map 1Libya’s Oil And Natural Gas Infrastructure: Monopolized By Haftar General Haftar’s blockade – which has ground oil production to a halt – displays his ability to weaponize oil to obtain concessions from the Tripoli-based government. Tribal leaders behind the blockade are calling for a larger share of oil revenues, for which they are at the mercy of the LNA and NOC. With little progress in Haftar’s push to gain control of Tripoli, and Libya more generally, the conflict has reached a stalemate. Not one to back down, Haftar’s decision to cut off oil sales from the Tripoli government, which also cuts off revenues to his own parallel administration, is a brute attempt to force a settlement. Haftar’s gambit follows Turkey’s decision to intervene in Libya on behalf of Sarraj and the GNA. Turkey has deployed roughly 2,000 Syrian fighters, as well as 35 Turkish soldiers in an advisory capacity. Turkey apparently feared that Haftar, who has substantial backing from Egypt and the Gulf Arabs as well as Russia and France, was about to triumph, or at least force a settlement detrimental to Turkish interests. Bottom Line: Turkey’s decision to intervene in the Libyan civil war – while limited in magnitude thus far – raises the stakes of the conflict, which involves the EU, Russia, and the Arab states. It is a clear signal of the geopolitical multipolarity in the region – and a political risk that is flying under the radar amid higher profile risks in other parts of the world. Political Interests: Islamist Democracy Versus Arab Dictatorship The Libyan civil war is a proxy war between foreign nations motivated by conflicting economic and strategic interests in North Africa and the Mediterranean. But there is an ideological and political structure to the conflict that explains the alignment of the nations: Turkey is exporting democracy while the Arab states try to preserve their dictatorships. Haftar’s primary supporters include Egypt, the United Arab Emirates (UAE), and Saudi Arabia. These states see monarchy as the way to maintain stability in a region constantly on the edge of chaos. Islamist democracy movements, such as Egypt’s Muslim Brotherhood, pose a threat to their long-term authority and security. They try to suppress these movements and contain regimes that promote them or their militant allies. They are willing to achieve one-man rule by force and thus support military strongmen like Egypt’s Abdel Fattah el-Sisi and Libya’s General Haftar. On the other side of the conflict stand the backers of the GNA – Turkey and Qatar – which support political Islam and party politics (Chart 2). Turkey’s Erdogan and his Justice and Development Party (AKP) are sympathetic to Hamas in the Palestinian territories and Egypt’s Muslim Brotherhood. They want to ensure a lasting role for Islamic parties in the region, which strengthens their legitimacy. They do not want Libya’s Islamists to suffer the same fate as their affiliates in the Muslim Brotherhood – removal via a military coup. Chart 2Turkey Sees A Place For Political Islam Chart 3Turkey Steps In Amid Qatar Embargo The political conflict is mirrored in the Persian Gulf in the form of the air, land, and sea embargo imposed on Qatar in 2017 at the hands of the Saudis, Egyptians, and Emiratis. The Qatar crisis followed a 2014 diplomatic rift and the 2011 Arab Spring, when Qatar supported protesters and democracy movements against neighboring regimes. The embargo strengthened Turkey-Qatar relations, as Turkey stepped in to ensure that Qataris – who are heavily dependent on imports – would continue to receive essentials (Chart 3). Bottom Line: The alliances forged in the Libyan conflict reflect differing responses to powerful forces of change in the region. Established monarchies and dictatorships are struggling to maintain control of large youth populations and rapidly modernizing economies. Their response is to fortify the existing regime, suppress dissent, and launch gradual reforms through the central government. Their fear of Islamist movements makes them suspicious of Tripoli and the various Islamist groups allied with the GNA, and aligns them with Khalifa Haftar’s attempt to impose a new secular dictatorship in Libya. Meanwhile Turkey, with an active Islamist democracy, is seeking to export its political model, and Muslim Brotherhood-esque political participation, to gain influence across the region, including in Libya and North Africa. Economic Interests: The Scramble For Energy Sources Chart 4Europe Addicted To Russian Gas The Libyan proxy war is also about natural resources, for all the powers involved. Turkey’s intervention reflects its supply insecurity and desire to carve a larger role for itself in the east Mediterranean economy. Turkey needs to secure cheap energy supplies, and also wants to make itself central to any emerging east Mediterranean natural gas hub that aims to serve Europe. Europe’s increasing dependency on natural gas imports to meet its energy demand, and Russia’s outsized role – supplying the EU with 40% of its needs – have encouraged a search for alternative suppliers (Chart 4). Israel is attempting to fill that role with resources discovered offshore in the eastern Mediterranean. Given its strategic location, Turkey hopes to become an energy hub. First, it is cooperating with the Russians. Presidents Putin and Erdogan inaugurated the Turkish Stream pipeline (TurkStream) at a ceremony in Istanbul on January 8. The pipeline will transport 15.75 billion cubic meters (Bcm) of Russian natural gas to Europe via Turkey. This is part of Russia’s attempt, along with the Nord Stream 2 pipeline, to bypass Ukraine and increase export capacity, strengthening its dominance over Europe’s natural gas market (Map 2). Map 2Russia’s Latest Pipelines Bypass Ukraine Europe and its allies are wary of Russian influence, but the EU is not really willing to halt business with Russia, which is a low-cost and long-term provider free from the turmoil of the Middle East. Despite the significant growth in US natural gas supplies, the relatively higher cost makes Russian supplies comparatively more attractive (Chart 5). Chart 5Russian Gas Is Competitive In European Markets … Chart 6… As US Attempts To Gain Market Share The result will be tensions with the United States, which expects the Europeans to honor the security relationship by buying American LNG (Chart 6) and will always abhor anything resembling a Russo-European alliance. American legislation signed on December 20 would impose sanctions on firms that lay pipes for Nord Stream 2 and TurkStream. Second, Turkey wants to become central to eastern Mediterranean energy development. A series of offshore discoveries in recent decades has sparked talk of cooperation among potential suppliers (Table 1). There is a huge constraint on developing the fields quickly, as there is no export route currently available for the volumes that will be produced. While the reserves are not significant on a global scale, their location so close to Europe, and growing needs in the Middle East, has generated some interest. Table 1Recent East Mediterranean Discoveries Are Relatively Small, But Geopolitically Attractive However, Europe and Israel – the status quo powers – threaten to marginalize Turkey in this process: A meeting of the energy ministers of Egypt, Cyprus, Greece, Israel, Italy, the Palestinian territories, and Jordan in Cairo last July resulted in the creation of the Eastern Mediterranean Gas Forum to promote regional energy cooperation. Turkey – along with Lebanon and Syria – was excluded. Turkey seeks access to natural resources – and to prevent Israel, Egypt, and Europe from excluding it. The EastMed Pipeline deal – signed by Greece, Cyprus, and Israel on January 2 – envisages a nearly 2,000 km subsea pipeline transporting gas from Israeli and Cypriot offshore fields to Cyprus, Crete and Greece, supplying Europe with 9-12 Bcm per year (Map 3). The project enjoys the support of the European Commission and the US as an attempt to diversify Europe’s gas supplies and boost its energy security.1 But it would also be an alternative to an overland pipeline on Turkish territory. Map 3The Proposed EastMed Pipeline Would Marginalize Turkey Egypt has two underutilized liquefied natural gas plants – in Idku and Damietta – and has benefited from the 2015 discovery of the Zohr gas field. Egypt has recently become a net exporter of natural gas (Chart 7). It signed a deal with Israel to purchase 85.3 Bcm – $19.5 billion – of gas from Leviathan and Tamar fields over 15 years. Egypt sees itself as an energy hub if it can re-export Israeli supplies economically. Note that Russia and Turkey have some overlapping interests here. Russia does not want Europe to diversify, while Turkey does not want to allow alternatives to Russia that exclude Turkey. Thus maintaining the current trajectory of natural gas projects is not only useful for Russia’s economy (Chart 8) but also for Turkey’s strategic ambitions. Chart 7Egypt Also Aims To Become East Mediterranean Gas Hub Of course, while Russian pipes are actually getting built, the EastMed pipeline is not – for economic as well as geopolitical reasons. Europe is currently well supplied and energy prices are low. At an estimated $7 billion, the cost of constructing the EastMed pipeline is exorbitant. Chart 8Maintaining Energy Dominance Advances Russia’s Strategic Ambitions Too Still, Turkey must make its influence known now, as energy development and pipelines are necessarily long-term projects. The chaos in Libya presents an opportunity. Seizing on the Libyan GNA’s weakness, Turkey signed an agreement to provide for offshore maritime boundaries and energy cooperation as well as military aid. The EastMed pipeline, of course, would need to cross through Turkish and Libyan economic zones (see Map 3 above).2 Turkey is incapable of asserting its will militarily in the Mediterranean against powerful western naval forces. But short of war, it is capable of expanding its claims and leverage over regional energy and forcing the Israelis and Europeans to deal with it pragmatically and realistically rather than exclude it from their plans. Part of Turkey’s goal is to cement an alliance with Libya – at least a partitioned western Libyan government in any ceasefire brokered with Haftar and the Russians. Bottom Line: While Turkey and Russia support opposing sides in the Libyan conflict, both benefit from dealing directly with each other – bypassing the western powers, which are frustrated and ineffectual in Libya. Both would gain some direct energy leverage over Europe and both would gain some influence over any future eastern Mediterranean routes to Europe. In Libya, if either side triumphs and unites the country, it will grant its allies oil and gas contracts almost exclusively. But if the different foreign actors can build up leverage on opposing sides, they can hope to secure at least some of their interests in a final settlement. Turkey Needs Foreign Distractions The foregoing would imply that Turkey is playing the game well, except that its foreign adventures are in great part driven by domestic economic and political instability. After all, Turkey’s maritime claims are useless if they cannot be enforced, and offshore development and pipeline-building are at a low level given weak energy prices and slowing global demand. Economically, in true populist fashion, Erdogan has repeatedly employed money creation and fiscal spending to juice nominal GDP growth. The result is a wage-price spiral, currency depreciation, and current account deficits that exacerbate the problem. The poor economy has mobilized political opposition. Over the past year, for the first time since Erdogan rose to power in 2002, his Justice and Development Party is fracturing. Former Turkish deputy prime minister Ali Babacan, a founding member of the AKP, as well as former prime minister Ahmet Davutoglu, have both announced breakaway political parties that threaten to erode support for the AKP. Local elections in 2019 resulted in a popular rebuke in Istanbul. Thus Erdogan is distracting the public with hawkish or nationalist stances abroad that are popular at home. Turkey has taken a strident stance against the US and Europe, symbolized by its threats to loose Syrian refugees into Europe and its purchase of S400 missile defense from Russia despite being a NATO member. Military incursions in Syria aim to relocate refugees back to Syria (Chart 9). Chart 9Erdogan Is Distracting Turks With Popular Foreign Stances Chart 10No Love Lost Toward The West Turkish public opinion encourages close cooperation with Russia and a more aggressive stance against the West (Chart 10). This is a basis for Russia and Turkey to continue cutting transactional deals despite falling on opposite sides of conflicts in Syria, Libya, Iran, and elsewhere. Erdogan’s pretensions of reviving Ottoman grandeur in the Mediterranean fall in this context. Elections are not until 2023, but we expect Erdogan to continue using foreign policy as a distraction. The opposition is trying to unite behind a single candidate, which could jeopardize Erdogan’s grip on power. The insistence on stimulus at all costs means that Erdogan is not allowing the economic reckoning to occur now, three years before the election. He is trying to delay it indefinitely, which may fail. Libya may not get resolved, however. Allies of Haftar’s LNA – specifically Egypt, Saudi Arabia, and the UAE – will be motivated to intensify their support of him for fear that a loss would revive domestic interest in political Islam. Egypt especially fears militant proxies being unleashed from any base of operations there. The LNA currently serves as a buffer between Egypt and the militant actors in Libya. If Haftar is defeated, Egypt’s porous western border would provoke a harsh reaction from Cairo. The threat of a revival of Islamic State in Libya has united the Egyptian people – a critical variable in the administration’s vision of a stable country. That has provided Egypt’s Sisi an excuse to flex his muscles through military exercises. Neither Russia nor NATO will be moved to bring a decisive finish to the conflict, as neither wishes to invest too heavily in it. Bottom Line: Erdogan has doubled down on populism at home and abroad. His assertive foreign policy in Syria and now Libya may end up exacerbating economic and political pressures on the ruling party. What Is The Endgame In Libya? There are three possible scenarios to end the current stalemate between the Haftar’s forces and the internationally recognized GNA: Military: An outright military victory by either Haftar or Sarraj is highly unlikely. While Haftar’s forces enjoy military and financial support from the UAE, he lacks popular support in Tripoli – which has proved to be challenging to takeover. Similarly, Sarraj’s army is not strong enough to confront the eastern forces and reunify the country. The merely limited involvement of foreign actors – including Turkey – makes a military solution all the more elusive. The most likely path to a quick military victory comes if foreign actors disengage. This will only occur if they are punished for their involvement, and thus it requires a major neutral power, perhaps the United States, to change the calculus of countries involved. But the US is eschewing involvement and the Europeans have shown no appetite for a heavy commitment. Diplomatic: A negotiated settlement is eventually likely, given the loss of oil revenues. A ceasefire would assign some autonomy to each side of the country. Given Haftar’s ambitions of conquering the capital and becoming a strongman for the country as a whole, the diplomatic route will be challenging unless his Gulf backers grow tired of subsidizing him. Financial: Haftar could win by breaking the NOC’s monopoly on oil. In the past, the LNA failed at selling the oil extracted from infrastructure under its control. If Haftar manages to market the oil without the aid of the NOC then he will be able to guarantee a stream of revenue for his forces and at the same time starve the Tripoli government of financing. This would pose an existential risk for the GNA. The key challenge in this scenario is to obtain international backing for LNA sales of Libyan crude supplies. Libya’s partition into two de facto states is the likeliest outcome. Bottom Line: Unless one of the constraints on a military, diplomatic, or financial end to the conflict is broken, the current stalemate in the Libyan conflict will endure. A partition of Libya will be the practical consequence. Turkey hopes to boost its regional influence through Tripoli, and thus increase its leverage over Europe, but a heavy investment could result in fiscal losses or spiral into a broader regional confrontation. Investment Implications While it is not clear how long the current blockade on Libyan ports will last – or the associated over 1 million barrels per day loss of production – oil supplies will remain at risk so long as the conflict endures. However, unlike supplies in the Gulf or in Venezuela, Libyan crude is of the light sweet grade. There is enough global spare capacity – from US shales – to make up for the Libyan loss, at least over the short term. The fall in Libyan supplies is occurring against the backdrop of oil markets that have been beaten down by the decline in demand on the back of the coronavirus impact (Chart 11). The OPEC 2.0 technical panel recommended additional output cuts of 600 thousand barrels per day last week, and is waiting on a final decision by Russia. We expect the cartel to tighten supplies to shore up prices. The instability in Libya could also affect Europe through immigration. The conflict re-routes migrants through the western route and thus could result in an increased flow to Spain and Portugal, rather than Italy which was previously their landing pad (Chart 12). A meaningful pick up would have a negative impact on European domestic political stability, especially with Germany in the midst of a succession crisis and incapable of taking a lead role. Chart 11Libyan Blockade Comes Amid Demand Shock Chart 12Refugees Will Favor Western Route Across The Mediterranean Erdogan’s foreign adventurism, and aggression against the West, poses a risk for Turkish markets. We remain underweight Turkish currency and risk assets. Our Emerging Markets strategists expect foreign capital outflows from EM to weigh on Turkey’s currency, local fixed-income and sovereign credit relative to EM benchmarks. Go short the Turkish lira relative to the US dollar. Bottom Line: Historically, the Mediterranean was the world’s most important waterway. It was the “life line” of the British empire. The US succeeded the British as the guarantor of Suez and corralled both Turkey and Greece into a single alliance under the Truman Doctrine. This status quo held until the twenty-first century. Since 2000, Russia has revived, US foreign policy in the Middle East has become erratic, and the Europeans have lost clout. Turkey is seeking to carve a space for itself and challenge the settlements of the past, all the way back to the 1923 Treaty of Lausanne. Yet in the wake of the Great Recession its economy is unstable and its populist leaders are taking greater risks abroad. The result will be greater friction with Europe, or the Arab states, or both. Given Turkey’s mismanagement at home, and limited gains to be made in Syria or Libya, Turkish assets will be the first to suffer from negative surprises.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 The Eastern Mediterranean Security and Energy Partnership Act of 2019 is an American bi-partisan bill the lends full support for the East Med pipelines and greater security cooperation with Israel, Cyprus, and Greece. The US Senate also passed an amendment to the National Defense Authorization Act last June which ended the arms embargo on Cyprus. 2 Turkey has also been engaging in drilling activities in disputed waters near Cyprus – which Ankara argues it is undertaking in order to protect Turkish-Cypriot claims – motivating EU economic sanctions in the form of travel bans and asset freezes on two Turkish nationals.

Highlights The coronavirus is likely to cut global growth in half (from 3.3% to 1.7%) during the first quarter of 2020. Investors should brace for a slew of profit warnings over the coming weeks from companies with significant operations in China. The near-term economic data is also likely to disappoint. Provided the virus is contained (admittedly a big if), economic activity should recover quickly in the second quarter, leaving global growth about 0.3 percentage points lower for the year as a whole. We should have a better sense of who the Democratic presidential candidate will be by mid-March, by which time more than 60% of the delegates will have been awarded. We continue to recommend an overweight stance on global equities over a 12-month horizon, but do not have a strong conviction about the near-term direction of global bourses given the risks around the virus and the Democratic nomination. Green Shoots Delayed Coming into 2020, we expected global growth to accelerate thanks to the lagged effects of last year’s decline in bond yields, an improvement in the global manufacturing inventory cycle, diminished Brexit and trade war risks, and ongoing policy stimulus out of China. Consistent with this prediction, the manufacturing ISM surged this week, with the forward-looking new orders-to-inventories ratio rising to the highest level in 10 months. The non-manufacturing ISM also surprised on the upside, as did factory orders in December. To top it off, ADP employment rose by 291k in January, well above the consensus estimate of 157k. In the euro area, the manufacturing and services PMIs were both revised higher in January. The future output component of the euro area manufacturing PMI rose to 59.8, the highest level since August 2018. The Swedbank Swedish manufacturing PMI jumped to 51.5, easily topping the consensus estimate of 47.6. We have generally found that the Swedish manufacturing PMI leads the global PMI by one or two months. Meanwhile, the UK composite PMI hit a 16-month high. The Coronavirus: Gauging The Economic Impact Unfortunately, the outbreak of the coronavirus is likely to depress global growth over the next couple of months, and possibly longer if the brewing crisis is not contained. During the SARS epidemic in 2003, Chinese growth fell from 10.8% in Q1 to 5.5% in Q2 on a seasonally-adjusted quarter-over-quarter annualized basis – a decline of 5.3 percentage points – only to snap back to 14.7% in Q3. Given that trend growth in China is currently about 5%-to-6%, growth could grind to a halt in the first quarter of this year, if the SARS experience is any guide. This would bring the year-over-year GDP growth rate down to 4%-to-4.5%. While zero growth on a quarter-over-quarter basis in Q1 may sound dire, keep in mind that this would simply leave real output at the same level as in Q4 of last year. Considering the disruptions presently facing the Chinese economy, a prediction of zero quarterly growth could actually prove to be too optimistic. The outbreak of the coronavirus is likely to depress global growth over the next couple of months, and possibly longer if the brewing crisis is not contained. China now accounts for 16% of global GDP on a US dollar basis, compared to 4% in 2003. Thus, a 5.5 percentage-point decline in Chinese growth would arithmetically shave about 0.16*5.5=0.9 percentage points off of global growth. In addition, there will be spillovers from weaker Chinese growth to the rest of the world. Global goods exports to China stand at about 2.5% of world GDP compared to 0.9% of GDP in 2003 (Chart 1). Chinese import growth is about twice as volatile as GDP growth (Chart 2). Thus, a 5.5 percentage-point decline in Chinese GDP in Q1 would reduce global exports to China by 2*0.055*2.5=0.27% of GDP. Chart 1Chinese Demand Has Expanded Over The Years Chart 2Imports Are More Volatile Than Domestic Production China’s service imports will also decline, mainly due to a sharp drop in Chinese tourists travelling abroad. Overseas spending by Chinese residents rose from 0.05% of world GDP in 2007 to 0.33% of GDP in 2018. If tourist arrivals end up falling by 70% during the first quarter, this would shave a further 0.7*0.33=0.23 percentage points from global growth.   On top of all this, there will probably be some multiplier effects from weaker Chinese growth on domestic spending. For example, a decline in Chinese tourism will reduce the income of hotel proprietors and their employees, leading to lower outlays by local residents. For an economy such as Thailand, where Chinese tourist spending accounts for over 3% of GDP, this effect is likely to be substantial. We subjectively pencil in an additional 0.2 percentage-point hit to Q1 global growth from this multiplier effect. As Chart 3 shows, this gives a total hit to growth of 1.6% in Q1. Going into this year, the IMF expected global growth to average 3.3% in 2020. This implies that growth could fall by half the IMF’s projected pace in the first quarter before recovering during the rest of the year. Chart 3Chinese GDP Growth Will Plunge In Q1, But Should Recover In The Remainder Of 2020 Provided The Coronavirus Outbreak Is Contained Uncertainties Abound These estimates are subject to a large margin of error. On the positive side, the impact on global growth might be mitigated by the fact that most of the categories (aside from tourism) in which the Chinese are cutting back spending are in the service sector, and hence have relatively low import content. In addition, China is likely to further bolster policy stimulus in response to the crisis. The People’s Bank of China has injected additional liquidity into money markets, cut the 7-day repo rate, and indicated that it will further lower lending rates. Regulators have delayed the introduction of new rules and regulations in the financial sector. We also expect the authorities to boost fiscal spending, especially on health care, where China lags behind most other countries (Chart 4). Chart 4China: Public Spending On Health Care Has Room To Catch Up On the negative side, the rising share of services in the Chinese economy means that some of the spending lost in Q1 will not be recouped during the rest of the year (unlike in the case of durable goods, there is little pent-up demand for say, restaurant meals). There is also a risk that spending outside China will decline if confidence drops and people begin to hunker down and save more. This is a particular risk in Japan where at least 30 people have contracted the virus (compared to zero during the SARS outbreak) and consumer confidence remains weak following the consumption tax hike. Lastly, global supply chains that rely on Chinese-produced components could be severely disrupted, leading to a downdraft in global manufacturing output. Needless to say, the impact of the outbreak depends critically on how long the epidemic lasts and how broad-based it ends up being. Our baseline assumption is that the outbreak will subside by the end of March. If that happens, growth will rebound in the remainder of the year, as occurred during the SARS episode. This will limit the overall hit to growth in 2020 to about 0.3 percentage points. As of now, the news is mixed. While the total number of new infections has dipped over the past two days in Hubei, where the outbreak originated, the trend in the province still appears to be on the upside. More encouragingly, the number of new infections seems to be stabilizing elsewhere in China and remains at very low levels in the rest of the world (Chart 5). From a markets perspective, tracking the number of new infections is important because it helped mark a bottom in stocks during the SARS outbreak (Chart 6). Chart 5The Number Of New Cases Seems To Be Stabilizing Outside Of The Epicenter Chart 6Stocks Bottomed As The SARS Infection Rate Was Peaking If the coronavirus follows a limited transmission path like MERS did, which did not spread much beyond the Middle East and South Korea, then worries about a pandemic will quickly abate. However, it is too early to make such a confident pronouncement, especially since this particular virus appears to be spreading more easily than either MERS or SARS. As such, we regard the risks to our GDP growth projection as tilted to the downside. Meanwhile, another potential risk is rising to the fore… The Democrats' B-List The Democratic presidential nomination is turning out to be a battle among four B’s: Bernie, Biden, Buttigieg, and Bloomberg. The big story from the Iowa caucus is how well Pete Buttigieg did and how poorly Joe Biden performed. Both Biden and Buttigieg are moderates. However, Biden fares much better in head-to-head polls against Trump than other Democratic challengers, including Buttigieg (Chart 7). Hence, anything that hurts Biden helps Trump. Chart 7For Now, Biden Is Trump’s Biggest Threat The impact on the stock market would be small if either Biden or Buttigieg were to end up in the White House next year. While both of these Democrats have expressed an interest in reversing at least part of the Trump tax cuts, neither would be as hawkish on trade as Trump. For investors, this makes it a bit of a wash. What would clearly hurt the stock market is if Bernie Sanders were to become the next US president. Sanders brings a lot of baggage to the race, including having campaigned for the far-left Socialist Workers Party in the 1980s, while also honeymooning in Moscow at a time when Soviets had thousands of nuclear missiles pointed at the US. Yet, despite his checkered past, the Vermont senator has still beaten Trump in 48 of the last 53 head-to-head polls tracked by Realclearpolitics over the past 12 months. The reality is that the US is moving leftward on a variety of cultural and economic issues (Chart 8). This is unlikely to change anytime soon given the firm grip the left has over academia and most of the media (Charts 9A & B). All this benefits leftist candidates such as Bernie Sanders and Elizabeth Warren. Chart 8The US Is Moving To The Left Chart 9AMany More Democrats Than Republicans In US Colleges Chart 9BThe Vast Majority Of Journalists Are Left-Leaning Battle Of The Billionaires This brings us to Mike Bloomberg. According to PredictIt, Bloomberg is now the second most likely candidate to emerge as the Democratic nominee after Bernie Sanders (Chart 10). Bloomberg’s nationwide polling numbers are quite poor, but unlike the other candidates, he has enough wealth to stay in the race for as long as he wants to. Chart 10Bloomberg As The Dark Horse? Bloomberg can also do something the other candidates cannot: stage an independent bid for the White House. Bloomberg’s allegiance to the Democratic Party is fairly tenuous. He governed New York City as a Republican, after all. If Bernie Sanders emerges as the Democratic nominee, Bloomberg could try to run up the middle as the “moderate choice.” Granted, Bloomberg has promised to support whoever the Democratic nominee ends up being. But here is the irony: the best thing that Bloomberg could do for Sanders is run as an independent. According to BCA’s geopolitical team, Bloomberg would take more voters from Trump than he would from Sanders.1 Whether Bloomberg will try to sabotage Trump in order to help Sanders remains to be seen. Ideologically, Bloomberg is probably closer to Trump than he is to Sanders. However, the two billionaires hate each other, and this could ultimately prove to be the deciding factor. Investment Conclusions The short-term outlook for risk assets remains murky. It is too early to relax about the coronavirus. Even if the outbreak is contained, a lot of economic damage has already been done. Investors should brace for a slew of profit warnings over the coming weeks from companies with significant operations in China. The near-term economic data is also likely to disappoint. Then there are the US elections. We bucked the consensus view in 2015/16 by predicting that Donald Trump would become President. At the moment, however, we do not have a strong feeling about the outcome of this year’s contest. This is in contrast to many market participants who see a Trump victory as a foregone conclusion. At a recent Goldman conference, 87% of attendees expected President Trump to be re-elected.2  Our conversations with clients have revealed a similar bias. The S&P 500 has moved in lockstep with Trump’s chances of being re-elected (Chart 11). If Trump’s prospects begin to fade, while Bernie Sanders wins in New Hampshire and Nevada and outperforms in South Carolina, risk assets could suffer. Chart 11An Uncanny Correlation Why, then, not turn bearish on stocks now? One reason, as noted above, is that global growth should pick up later this year provided the coronavirus is contained. Stocks generally outperform bonds when growth is accelerating (Chart 12). Equity risk premia also remain quite high, which gives stocks a cushion of support (Chart 13). Chart 12Stocks Usually Outperform Bonds When Global Growth Is Accelerating Chart 13Relative Valuations Favor Stocks All this leaves us in the somewhat uncomfortable position of continuing to advocate an overweight stance towards equities over a 12-month horizon, without having a strong view about the short-term direction for global bourses.   Matters should be clearer by mid-March. Super Tuesday takes place on March 3rd. By March 17th, more than 60% of the Democratic delegates will have been awarded (Appendix Table 1). There should also be more clarity on the coronavirus outbreak by then too. At that point, we will reassess both our short-term and medium-term views on equities and other assets. Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Appendix Table 1Next Stops For The Democrat Caravan     Footnotes 1    Please see Geopolitical Strategy Weekly Report, “After Iowa And Impeachment? Questions From The Road,” dated February 7, 2020. 2   Theron Mohamed, “A Goldman Sachs client poll finds 87% expect Trump to win the next election,” Business Insider (January 17, 2020). Global Investment Strategy View Matrix MacroQuant Model And Current Subjective Scores   Strategic Recommendations Closed Trades

Highlights Trump's odds are still only around 55%. Biden remains the frontrunner in the Democratic primary election, albeit a weak one. Sanders brings forward the risk to this view. Evidence does not suggest that Trump would beat Sanders in a landslide. Bloomberg’s “moment” is arriving but Biden and Buttigieg must fall for him to win. The Democrats will likely avoid a contested convention. If they don’t, Trump benefits. Expect equity volatility in the near term. The market must clear the coronavirus and Democratic primary hurdles before it can rally sustainably. Feature Chart 1China: Bad News, Then Stimulus Boost Over the past week we visited clients in New York and Toronto and debated a range of intriguing questions. The coronavirus impact was top of mind. The outbreak will delay the Chinese economic rebound we expected in the first quarter. It also reinforces one of our key geopolitical views on Chinese policy: bad news will be followed by good news in the form of increased stimulus (Chart 1). The problem is that this is good news for the second half of the year at best, while the near term is extremely murky. After the virus, the US election cycle was clearly the greatest source of policy uncertainty. Because clients asked so many questions on this topic, we devote this report to the election. We still expect US equity volatility in the near term. Aren’t Trump’s Odds Of Reelection Better Than 55%? No. Clients hardly raised an eyebrow this time when we argued that President Trump was favored to win reelection – a stark turnaround from just three months ago, when many believed that his goose was cooked. So much has the climate changed that many clients now argue that Trump’s odds have reached 70% and he is likely to win by a landslide. But that is going too far – according to the data. Certainly Trump is coming off a string of successes. So far this year he has deterred Iran, struck trade deals with the US’s top trading partners – China, Canada, and Mexico – and been acquitted of impeachment articles (Chart 2). The Republican-led Senate resisted a last-ditch effort to admit witnesses and prolong the impeachment trial, and few Republicans defected in the final vote.1 Chart 2Trump Acquittal: Political Constraints In Action Chart 3Trade Deals, Impeachment Boosted Trump Approval Trump’s approval rating hit its all-time high just as the Senate voted to acquit (Chart 3). The impeachment process backfired on the Democrats, a point corroborated by the recent shift in the public’s party identification that puts the Republicans right alongside the Democrats after a period in which they trailed (Chart 4). Just before his acquittal, the president delivered a State of the Union Address in which he rattled off a catalogue of record-setting, late-cycle economic statistics. Meanwhile the Democrats suffered a debacle at their first primary election, the Iowa caucus, when a rushed attempt to improve their digital savvy in the electoral process resulted in a software malfunction that delayed the announcement of election tallies. Nevertheless, the ballot is nine months away and the path to reelection is fraught with danger. First, President Trump has not yet proven that he can keep his approval rating in the upper 40s, let alone over 50%. A true game changer would be cracking 50% on a sustainable basis. If Trump slips beneath the 46% of the vote he received in 2016 his odds fall back toward 50%. Assuming the economy rebounds he cannot afford to slip much below his stable range of 43% and still win, according to the model. Second, the manufacturing sector is only just poking its head out of the woods, leaving the critical swing states of Michigan, Pennsylvania, and Wisconsin hanging in the balance, albeit with positive news (Chart 5). Chart 4More Voters Identify As Republican Post-Impeachment Chart 5US Manufacturing Rebounding, But Watch For Virus Hit Our quantitative election model suggests the election is too close to call. Technically the model shows Trump slipping beneath the threshold for victory for the first time since we unveiled it in November (Chart 6). The reason is that the leading economic indicators in Wisconsin and especially Pennsylvania took a turn for the worse in December. These indicators are forward-looking – they predict the 6-month growth rate of the state coincident indexes, which include nonfarm payroll employment, average hours worked in manufacturing by production workers, the unemployment rate, and wage and salary disbursements deflated by the consumer price index. Chart 6Quantitative Election Model Shows Election A Toss Up Chart 7Pennsylvania Job Growth A Risk To Trump Of course, the state leading indicators also tend to be heavily revised in subsequent prints, which can make our model volatile. Month-on-month total employment growth from the Bureau of Labor Statistics corroborates the shaky status of Pennsylvania, but not Wisconsin (Chart 7). This slight shift in our model from a Trump win to a Trump loss does not change our overall election forecast, which has a qualitative overlay. The point is that Trump is still skating on thin ice, the US manufacturing sector.2 Going forward, the US and global economy should continue improving, especially in the second half of the year. The demand shock emanating from the coronavirus outbreak in China should be temporary. The eventual rebound in Chinese demand combined with the lagged effect of China’s new stimulus measures will benefit US manufacturing states. The manufacturing sector’s woes are still a clear and present danger for Trump. Bottom Line: Trump is still favored but his odds of winning are still only 55% qualitatively. The election will remain a major source of uncertainty throughout the year. Investors need to be prepared for either outcome. Volatility is also frontloaded due to the coronavirus shock to the global economy. Is Biden Still The Frontrunner? Yes. Former Vice President Joe Biden bombed in the Iowa caucus, the first of the Democratic Party’s primary elections, coming in fourth place behind South Bend Mayor Pete Buttigieg, Vermont Senator Bernie Sanders, and Massachusetts Senator Elizabeth Warren. He barely beat the sensible but uninspiring Minnesota Senator Amy Klobuchar (Chart 8). Chart 8Iowa: Buttigieg Surged, Biden Slumped Chart 9Biden Still The Democrats’ Frontrunner Traditionally Iowa delivers a polling boost to the victor, since it goes first and attracts attention disproportionate to its size. But this year the first-comer effect is largely moot because of the reporting debacle. Both Buttigieg’s win and Biden’s loss have been drowned out. This is consolation for Biden because he is far more competitive in later states than Buttigieg – he is in fact still the (weak) frontrunner in national polling (Chart 9). Biden also continues to lead our back-of-the-envelope projection of the delegates who will be pledged to candidates at the end of the primary election season on June 6 in Washington, DC. True, Biden is lined up for a plurality at best, not a majority. There are still plenty of “other” delegates to be redistributed, which could leave Biden in the dust if his polling breaks down due to a loss of momentum in the early states (Chart 10A). Nevertheless the centrist “lane” now has a commanding lead over the progressive lane for the first time in the race, creating our base case in which Biden wins a plurality of votes that translates into winning the nomination (Chart 10B). Chart 10ABiden Leads Back-Of-Envelope Delegate Count For Democratic Nomination Chart 10BCentrists Lead Back-Of-Envelope Delegate Count For Democratic Nomination If Biden continues to underperform his polling in New Hampshire and Nevada then he could stumble into a huge disappointment in South Carolina, his bulwark, on February 29 (Chart 11). As the first southern state, South Carolina is the bellwether for Super Tuesday, March 3, when about 35% of the delegates are up for grabs, 54% of which are southern (Chart 12). Anything that shakes Biden’s substantial lead in South Carolina sets him up for failure overall and pushes Sanders into the frontrunner position. Chart 11Biden’s Bulwark Is South Carolina Chart 12Biden’s ‘Southern Strategy’ Should Pay On Super Tuesday Sanders would then face an emerging centrist in the shape of Buttigieg or Bloomberg. (Or Warren will pivot to the center.) Aside from Biden’s lead in the national polling, and many of the southern and Midwestern states, he continues to benefit from a tailwind in that he is the more “electable” or competitive candidate against Trump. Head-to-head polls continue to bear this out (Chart 13). These polls will congeal around almost any candidate once he or she becomes the de facto nominee, but over the past year Biden has performed far better than any of the others. Chart 13Biden Beats Trump Head-To-Head In Every Swing State (So Far) Bottom Line: Anyone who wants to show their electability against Trump must first prove it by dethroning Biden. This could happen in February if Bernie Sanders generates runaway momentum in the early primaries, so the equity market faces major election risk imminently. Is A Sanders Nomination Suicide For The Democrats? Not Necessarily. Chart 14Sanders Generating Momentum In Early Primaries Sanders is only slightly less likely to win the Democratic nomination than Biden. He is clearly capable of doing so – he rivals Biden in the nationwide polling and surpasses him in the early states. Strong finishes in New Hampshire and Nevada are expected and could generate momentum that lasts through Super Tuesday and beyond (Chart 14). Ideologically Sanders is not unthinkable for most Democrats – the average Democrat is shifting to the left of the political spectrum (Chart 15). Most Biden supporters say Sanders is their second choice (Chart 16). Voters are interested in electability, so if Sanders can prove that he is more electable than Biden, voters will flock to him. Chart 15Democrats More Liberal Than In The Past Chart 16Biden Voters Support … Sanders! Thus the question of Sanders is more about the general election than the primary. “Movement candidates” like Alf Landon, Barry Goldwater, and George McGovern have racked up some of the most humiliating defeats in the history of US elections. The self-described democratic socialist Bernie Sanders has some of the defining traits – he has a movement, he is ideologically “pure” and outside the mainstream, and his nomination is a gamble on whether his youthful supporters’ enthusiasm will carry over to the general public. It is plausible that the Democratic Party could choose Sanders out of a desire to fight populist fire with fire, only to find that Trump overwhelmingly benefits from the stigma of socialism in the swing states. Sanders could still win the nomination and even the White House. So far, however, the evidence does not bear out this interpretation. The aforementioned Chart 13 shows that Sanders is second only to Biden against Trump. It is notable that he outperformed Hillary Clinton versus Trump in 2016 (Chart 17). He is specifically competitive against Trump in the Midwest swing states because of his ability to compete for the vote of the blue-collar worker. Thus he has a viable path to winning the Electoral College: the Clinton 2016 states plus Michigan, Pennsylvania, and Wisconsin. Biden’s primary advantage, by this measure, is that he is also competitive in Florida as well as the Midwest, which broadens his Electoral College options. And while Sanders captivates the youth, Biden appeals to African Americans and moderates who turn out to vote more reliably (Chart 18). Chart 17Sanders Outperformed Hillary Versus Trump Chart 18Biden’s Supporters Have Higher Turnout Ultimately presidential elections are referendums on the incumbent party. Since World War II, incumbent parties have lost because of major shifts in the economic, social, or international context that discredit the current administration and drive voters to demand “regime change.” Sitting presidents strengthen the incumbent party and have only lost in a recessionary environment (1980, 1992) or a massive scandal (1976). And Trump’s scandal has been neutralized, for now, due to his acquittal in the Senate. Unless Trump suffers from a faltering economy, a policy humiliation at home or abroad, or a third party candidate who splits the Republican vote, he is unlikely to be discomfited. By the same token, if major changes occur, Sanders will be as good as or even better than Biden at riding the wave of disenchantment with the ruling party and its figurehead. PredictIt, the online betting site, currently puts Sanders at 29% chance of winning the White House, while Biden stands at 7%. Both are underrated given our assessment that Trump’s odds of election still stand at 55% and that he is only likely to fall as a result of economic weakness or an unforeseen policy humiliation. As things stand, either Biden or Sanders would see their chance of winning the White House rise toward 45% if they won the nomination. If Sanders wins the nomination, yet events all play to Trump’s favor such that he wins resoundingly, Sanders will forever after be seen as confirming the curse of the “movement candidate.” Yet under those circumstances Biden would likely have met the same fate. Bottom Line: Investors would be wrong to buy risky assets on a Sanders nomination in the belief that it guarantees Trump’s victory. Clinching the nomination sharply – and mathematically – increases any candidate’s chance of winning the White House. A Sanders White House in turn would be a paradigm shift in US politics: the first left-wing populist president. He would threaten a major increase in economically significant regulation even if no legislation were passed and as such would weigh on corporate profits and animal spirits. As a result, we expect volatility in the near term, since Sanders’s best hope is to build momentum now, unseat Biden, and then fend off Biden’s centrist replacements. Even if Sanders is only successful for a brief period in Q1, the market will have to discount the higher probability of a progressive populist in the Oval Office. What About Mayor Bloomberg? Show Us The Votes, Not Just The Money. Billionaire former New York Mayor Michael Bloomberg is a notable challenger both to other Democrats and to Trump based on the fact that his aggressive advertising campaign is producing some results in opinion polling – as it would for anyone given the volume! He is polling just ahead of Buttigieg and thus is first in line to benefit if Sanders knocks off Biden (Chart 19). Chart 19Bloomberg Benefits If Biden Falls Chart 20Biden Beats Bloomberg In Big Primaries However, Bloomberg’s attempt to pole-vault over the early states and rack up big wins in March is untested. Moreover the data do not yet reflect the elite optimism about Bloomberg’s chances. First, Biden will be harder to knock off than the consensus holds. He has a strong base in the South, he still leads in many Midwestern states, unlike Iowa, while Bloomberg’s base is the Northeast, where he has to split votes with most of the other candidates (including Biden). Looking ahead to March, Biden is beating Bloomberg in all of the key states where Bloomberg’s strategy requires a win (Chart 20). While Biden beats Trump head-to-head in the swing states, Bloomberg loses to Trump in most of them. This reflects Biden’s electability, a tailwind in the primaries (Chart 21). Bloomberg also has the worst favorability among voters – although admittedly Trump once held that distinction (Chart 22). Chart 21Trump Beats Bloomberg In Swing States Chart 22Trump And Biden More Favorable Than Bloomberg Hence Bloomberg can emerge as the leading centrist or establishment candidate if Biden crumbles, and Buttigieg fails to replicate his Iowa success, but not before then. Otherwise his significance lies in that he could become a dark horse candidate at a contested Democratic National Convention in July – say if the leading progressive candidates prove capable of blocking Biden’s nomination but not securing their own. Bloomberg may be waiting in the wings for just such a moment. Bloomberg could also act as the grand spoiler of the election should he decide to run as an independent candidate in November. Ostensibly his candidacy would hurt the Democrats, especially if they choose a candidate who suffers from the taint of socialism. However, contrary to popular wisdom, a strong third party candidate is historically a negative sign for the incumbent.3 Third party candidacies are only strong if the general public is dissatisfied – and when the public is dissatisfied it swings heavily against the incumbent party. Thus on the whole a large third party vote would tend to hurt Trump in 2020, just as it helped him in 2016 (by hurting the incumbent party). The fact that Bloomberg was formerly a Republican reinforces his risk to Trump – like the independently wealthy Ross Perot in 1992, he could produce a Democratic victory by splitting the conservative vote.4 Remember that 9-10% of Republicans believed that Trump should have been removed from office, according to impeachment polls over the past six months. If the economy holds up, this third party challenge is less likely to succeed, but it is still a risk. Such an outcome is far from assured and the Democratic Party would vilify Bloomberg for fear of him stealing votes from the Democratic candidate, especially if the occasion of his independent run were the nomination of a “socialist” like Sanders. Thus far Bloomberg claims he and his billions will support the Democratic Party’s nominee. Bottom Line: If Bloomberg’s intention were solely to unseat Trump, then he should have spent, or will spend, his billions waging a vigorous third party candidacy. On the contrary, by seeking the nomination of one of the two major parties, he apparently seeks to become president of the United States. In doing so he may weaken Biden and thus help Sanders. But we will not know the effect until we can observe his performance in actual elections, which he starts contesting in March. Nevertheless the big surprise of 2020 could well be an independently wealthy candidate capable of stealing enough votes from Trump to erase his very fine margins in the swing states. Bloomberg or someone else could play this role. Will There Be A Contested Convention? Probably Not. A contested convention – or its cousin, the “brokered convention” – is a situation in which the Democratic Party must decide its presidential nominee at its national convention, having failed to do so through the primary elections. Democratic delegates are awarded proportionately to the popular vote, unlike the Republican primary system which features many winner-take-all states. Several candidates each earning less than a third of the popular vote can continue struggling without any one of them hitting the “jackpot” and surging ahead. If none of the candidates has a majority of pledged delegates – or even a strong plurality – at the conclusion of the primaries on June 6 then the candidates will have to negotiate a solution. Otherwise they will show up in Milwaukee on July 13 for a chaotic four days in which the party delegates would have to hold a series of votes, on live television, to determine the nominee. The last time the Democrats had a contested convention was 1952, when they voted for three rounds; the Republicans saw a shorter-lived contest in 1976. In today’s context, in which a left-wing populist could win the nomination, such an unpredictable and arcane process would present a source of uncertainty for investors throughout June and July. A contested convention is more likely than usual because the party has four, possibly five viable candidates if we count Bloomberg. Biden, Bloomberg, and Sanders all have the financial ability to persist over the long haul. Yet with Buttigieg having won in Iowa and polling well in New Hampshire, he remains in the race, as does Warren, assuming they keep meeting the minimum threshold of 15% of the vote needed to receive delegates. So why isn’t a contested convention likely? Because there is a clear constraint: it would be a train wreck for the party. It would prolong divisions over ideology, it would exhaust everyone’s coffers (except Bloomberg’s), it would send a picture of a party in disarray to the general public (much like the Iowa caucus debacle), and it would deprive the party of months in which the de facto nominee could challenge President Trump. The bad press and divisiveness would actually increase Trump’s chances of winning. In the wake of the impeachment backfire, the candidates will be more attuned to these risks. Instead, with a common enemy, it is more likely that candidates will be pressured to drop out of the race once it is clear they cannot win. Democrats will bind together to pick a nominee – a contested convention helps Trump. Chart 23Iowans Want A Winner, Not A Platform Democratic voters are primarily concerned with beating President Trump – this has been confirmed in polling at the Iowa caucus (Chart 23). Therefore several candidates have a basis for sacrificing their own presidential bid. In exchange those who drop out will be offered cabinet positions, which they will sell as a political “dream team” against Trump’s small circle of loyalists and family members. The risk is that insurgent progressive candidates defy the party leadership and refuse to bow out. While Buttigieg is young and can live to fight another day, neither Sanders nor Warren will drop out easily if they think they still have a chance of winning the presidency. These two are also unlikely to cooperate with each other to consolidate the left-wing bloc. Bottom Line: Multiple competitive candidates make it possible that instead of bandwagoning around the candidate with a plurality – likely Biden – no candidate will have a commanding plurality of pledged delegates by June 6. If that is the case then expect the candidates to negotiate a solution prior to the convention. If a solution cannot be found, a contested convention will reflect a deeply divided party and hence imply higher odds of President Trump’s reelection, other things being equal. Investment Conclusions Investors can look at the three options as follows. Biden, Buttigieg, or Bloomberg would be a “known known,” a moderate Democratic whose policies would largely seek to restore and solidify those of the Obama administration. However, we still see this as negative for equities because of the increase in regulation that would ensue plus the high chance that victory would also bring the Senate and thus give rise to a more progressive policy shift than the consensus expects. Chart 24Centrists Outperformed In Iowa Trump is a “known unknown,” an unorthodox and aggressive president whose tactics have become familiar but whose approach is globally disruptive and would be more so in a second term relatively free of electoral constraints. We expect any melt-up in equities before or after a Trump win to be a sell signal given our base case that Trump’s reelection means Trade War II. Sanders or Warren would be an “unknown unknown,” the first-ever left-wing populist to take the White House. Above we show this is not at all improbable if one of them wins the nomination – which itself is about a 35% probability. The same odds apply to the Senate as under Biden, although moderate Democrats there would act as a constraint on a progressive pushing revolutionary legislation. Still, a progressive populist would be a generational paradigm shift in US policy and would justify a bear market. Where is the median voter? In the primary election, the Iowa caucus results reinforce the national trend suggesting that the median voter prefers a centrist or establishment candidate (Chart 24). If Biden falters, either Buttigieg or Bloomberg will take up the slack. Nevertheless the risk of a Sanders success is imminent and therefore we expect volatility to be frontloaded this year, especially in February but also possibly in March if Sanders does a bang-up job on Super Tuesday. In the general election, polling consistently shows that the economy is the most salient issue for voters in 2020. This plays to President Trump’s favor. Health care is usually ranked second, which plays to the Democrats’ favor. However, a recent open-ended poll by Morning Consult suggests that security issues have supplanted health care as the second-highest voter concern, which would reinforce Trump’s position (Chart 25). Further economic deterioration would not only undermine Trump’s approval on his handling of the economy but would also increase concern over health care, since insurance is tied to employers. So this is a critical risk to Trump in wobbly swing states like Pennsylvania. Chart 25Median Voter Focused On Economy, Trump’s Strong Suit We maintain that Trump is slightly favored with 55% odds. But our mathematical model highlights how close of a call the election is, at least until the manufacturing sector and broader economy durably rebound. Investors need to be prepared for either electoral outcome, which means hedging against sectors under bipartisan scrutiny such as Big Pharma and Big Tech. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Senator Mitt Romney of Utah, no fan of President Trump, voted to convict him of the charge of abuse of power but not of obstruction of Congress. 2 This is the second time Wisconsin has switched across the threshold in our model since November – all else equal, a 0.01% increase in the state’s leading index would move it back to the Republicans. 3 See Allan J. Lichtman, Predicting The Next President (New York: Rowman & Littlefield, 2016), 30-31. 4 Alternately he could ensure a Trump victory by producing an Electoral College tie! Demographic projections of the US electorate in 2020 by Robert Griffin, Ruy Teixeira, and William H. Frey show that a 2020 election in which voters behave exactly as they did in 2016, except that the third party vote normalizes from 5.7% (2016) to 1.7% (2012), would produce an Electoral College tie of 269-269 votes. Obviously this would be a Black Swan event. And the fact that electors in the college can be “faithless” to the candidate that their state elected complicates such projections. Nevertheless the result would be an extraordinary House of Representative vote according to state delegations in which Trump would emerge as the victor and the legitimacy of the election would be contested and debated once again. See "America’s Electoral Future: Demographic Shifts and the Future of the Trump Coalition," April 2018, brookings.edu.

Special Report

Highlights Public opinion has a significant impact on labor-management outcomes: Organized labor cannot make any headway unless elected officials and the courts give it a fighting chance. They will only do so if the public desires it. The face of organized labor is changing: Manufacturing’s decline does not ensure the demise of organized labor. Unions have already pivoted to services, just like the overall economy. Elections have consequences: The power to pass legislation, staff departments and agencies, and exert control over judicial appointments can have a tremendous workplace impact. Organized labor isn’t dead: We do not expect a return to unions’ heyday, but we are convinced that labor’s potential to achieve significant incremental progress is much larger than most investors believe. The election could serve as a catalyst for tapping that potential. Feature We have read quite a bit about US labor relations over the last month and a half. Several themes were apparent, but the most basic was a constant from the 1800s to today: For-profit employers will seek the most favorable terms they can get, to the extent that they are socially acceptable. This is not to say that management is out to get labor, or that Marx might have had a point; it simply acknowledges the pre-New Deal and post-Reagan empirical record. Before the legal and social buffers that sheltered labor were put in place, and after they began to be eroded, employees found themselves steadily losing ground. Capturing Hearts And Minds Public opinion has shaped the outcomes of labor-management contests throughout US labor relations history. Labor was continually outgunned before the New Deal, coming up against private security forces, local police and/or the National Guard when they struck. Employers were able to turn to hired muscle, or request the deployment of public resources on their behalf, because the public had few qualms about using force to break strikes. College athletes were even pressed into service as strikebreakers after the turn of the century for what was viewed at the time as good, clean fun.1 Public opinion is not immutable, however, and by the time of the Flint sit-down strike, it had begun to shift in the direction of labor. The widespread misery of the Depression went a long way to overcoming Americans’ deep-seated suspicion of the labor movement and the fringe elements associated with it. Some employers were slow to pick up on the change in the public mood, however, and Ford’s security force thuggishly beat Walter Reuther and other UAW organizers while they oversaw the distribution of union leaflets outside a massive Ford plant just three months after Flint. Ford won the Battle of the Overpass, but its heavy-handed, retrograde tactics helped cost it the war. Reuther, who later led the UAW in its ‘50s and ‘60s golden age, was a master strategist with a knack for public relations. Writing the playbook later used to great effect by civil rights leaders, Reuther invited clergymen, Senate staffers and the press to accompany the largely female team of leafleteers. When the Ford heavies commenced beating the men, and roughly scattering the women, photographers were on hand to document it all.2 The photos helped unions capture public sympathy, just as televised images of dogs and fire hoses would later help secure passage of landmark civil rights legislation. Unions’ Fall From Grace Labor unions enjoyed their greatest public support in the mid-fifties, and largely maintained it well into the sixties (Chart 1), until rampant corruption and ties to organized crime undermined their public appeal. The shoddy quality of American autos further turned opinion against the UAW, the nation’s most prominent union, and a college football star named Brian Bosworth caused a mid-eighties furor by claiming that he had deliberately sought to prank new car buyers during his summer job on a Chevrolet assembly line. Bosworth later retracted the claim that GM workers had shown him how to insert stray bolts in inaccessible parts of car bodies to create a maddening mystery rattling, but the fact that so many Sports Illustrated readers found it credible eloquently testified to the UAW’s image problem. Chart 1Unions' Public Image Has Recovered Nicely Since The Crisis Figure 1Unions' 1980s Public Opinion Vortex President Reagan accelerated the trend when he successfully stood up to the striking air traffic controllers, but his administration could not have taken such a hard line if unions hadn’t already been weakened by declining public support. In the final analysis, it was PATCO’s disastrous misreading of public opinion – fed-up voters supported the White House, and other air travel unions refused to strike in sympathy with the controllers – that led it to spurn the administration’s generous initial offer and brought about its demise. Together, the public’s waning support for unions and the Reagan administration’s antipathy for them were powerfully self-reinforcing, and they fueled a vicious circle that powered four decades of union reversals (Figure 1). Companies will do whatever they perceive to be socially acceptable in conflicts with employees, but no more. As a prescient November 1981 Fortune report put it, “‘Managers are discovering that strikes can be broken, … and that strike-breaking (assuming it to be legal and nonviolent) doesn’t have to be a dirty word. In the long run, this new perception by business could turn out to be big news.’”3 Emboldened by the federal government’s replacement of the controllers, and the growing public perception that unions had devolved into an insular interest group driving the cost of living higher for everyone else, businesses began turning to permanent replacement workers to counter strikes.4 As an attorney that represented management in labor disputes told The New York Times in 1986, “If the President of the United States can replace [strikers], this must be socially acceptable, politically acceptable, and we can do it, also.”5 Labor’s New Face … Polling data indicate that unions have been recovering in the court of public opinion since the crisis, when the public presumably soured on them over the perception that the UAW was selfishly impeding the auto industry bailout. Their image got a boost in 2018 (Chart 2), as striking red-state teachers embodied the shift from unions’ factory past to their service-provider present. “The teachers, many of them women, are redefining attitudes about organized labor, replacing negative stereotypes of overpaid and underperforming blue-collar workers with a more sympathetic face: overworked and underappreciated nurturers who say they’re fighting for their students as much as they’re fighting for themselves.”6 Chart 2Feeling The Bern? Several commentators have heard organized labor’s death knell in US manufacturing’s irreversible decline. Unions gained critical mass on docks, factory floors, steel mills and coal mines, but few of today’s workers make their living there. Those who remain have little recourse other than to accept whatever terms management offers, as their jobs can easily be outsourced to lower-cost jurisdictions. The decline in private-sector union membership has traced the steady diminution of factory workers’ leverage (Chart 3). Chart 3Tracking Manufacturing's Slide Service workers represent unions’ future, and they have two important advantages over their manufacturing counterparts: many of their functions cannot be offshored, and a great deal of them are customer-facing. When MGM’s chairman was ousted from his job after clashing with Las Vegas’ potent UNITE-HERE local over the new MGM Grand Hotel’s nonunion policy, his successor explained why he immediately came to terms with the union. “‘The last thing you want is for people who are coming to enjoy themselves to see pickets and unhappy workers blocking driveways. … When you’re in the service business, the first contact our guests have is with the guest-room attendants or the food and beverage servers, and if that person’s [sic] unhappy, that comes across to the guests very quickly.’”7 … Management’s New Leaf … The Business Roundtable’s latest statement on corporate governance principles laid out a new stakeholder vision, displacing the Milton Friedman view that corporations are solely responsible for maximizing shareholder wealth. The statement itself is pretty bland, but the preamble in the press release accompanying it sounds as if it had been developed with labor advocates’ help (Box 1). It is a stretch to think that the ideals in the Roundtable’s communications will take precedence over investment returns, but they may signal that management fears the labor-management rubber band has been stretched too far.8 Box 1 Farewell, Milton Friedman America’s economic model, which is based on freedom, liberty and other enduring principles of our democracy, has raised standards of living for generations, while promoting competition, consumer choice and innovation. America’s businesses have been a critical engine to its success. Yet we know that many Americans are struggling. Too often hard work is not rewarded, and not enough is being done for workers to adjust to the rapid pace of change in the economy. If companies fail to recognize that the success of our system is dependent on inclusive long-term growth, many will raise legitimate questions about the role of large employers in our society. With these concerns in mind, Business Roundtable is modernizing its principles on the role of a corporation. Since 1978, Business Roundtable has periodically issued Principles of Corporate Governance that include language on the purpose of a corporation. Each version of that document issued since 1997 has stated that corporations exist principally to serve their shareholders. It has become clear that this language on corporate purpose does not accurately describe the ways in which we and our fellow CEOs endeavor every day to create value for all our stakeholders, whose long-term interests are inseparable. We therefore provide the following Statement on the Purpose of a Corporation, which supersedes previous Business Roundtable statements and more accurately reflects our commitment to a free market economy that serves all Americans. This statement represents only one element of Business Roundtable’s work to ensure more inclusive prosperity, and we are continuing to challenge ourselves to do more. Just as we are committed to doing our part as corporate CEOs, we call on others to do their part as well. In particular, we urge leading investors to support companies that build long-term value by investing in their employees and communities. The Environmental, Social and Governance (ESG) movement has the potential to improve rank-and-file workers’ wages and working conditions. ESG proponents have steadily groused about outsized executive pay packages, but if asset owners and institutional investors were to begin pushing for higher entry-level pay to narrow the income-inequality gap, unions could gain some powerful allies. … And The Public’s Left Turn Chart 4Help! As our Geopolitical Strategy colleagues have argued since the 2016 primaries, the median voter in the US has been moving to the left as the financial crisis, the hollowing out of the middle class and the widening wealth gap have dimmed the luster of Reagan-Thatcher free-market policies.9 Globalization has squeezed unskilled labor everywhere in the developed world, and white-collar workers are starting to look over their shoulders at artificial intelligence programs that may render them obsolete as surely as voice mail and word processing decimated secretaries and typists. Banding together hasn’t sounded so good since the Depression, and nearly half of all workers polled in 2017 said they would join a union if they could (Chart 4). Millennials are poised to become the single biggest voting bloc in the country. They were born between 1981 and 1996, and their lives have spanned two equity market crashes, the September 11th attacks, and the financial crisis, instilling them with a keen awareness of the way that remote events can upend the best-laid plans. Many of them emerged from college with sizable debt and dim earnings prospects. They would welcome more government involvement in the economy, and their enthusiastic embrace of Bernie Sanders and Elizabeth Warren (Chart 5) indicates they’re on unions’ side. Chart 5No "Third Way" For Millennials Elections Have (Considerable Regulatory) Consequences Electoral outcomes influence the division of the economic pie between employers and employees. Labor-friendly presidents, governors and legislatures are more likely to expand employee protections, while more vigilantly enforcing the employment laws and regulations that are already on the books. The White House appoints top leadership at the Labor Department, the National Labor Review Board (NLRB), and the Occupational Safety and Health Administration (OSHA), along with the attorney general, who dictates the effort devoted to anti-trust enforcement. It's no surprise that unions have started to look pretty good to workers after a decade of sluggish growth and widening inequality. The differences can be stark. Justice Scalia’s son would no more have led the Obama Department of Labor than Scott Pruitt (EPA), Wilbur Ross (Commerce) or Betsy Devos (Education) would have found employment anywhere in the Obama administration. McDonald’s has good reason to be happy with the outcome of the 2016 election; its business before the NLRB wound up being resolved much more favorably in 2019 than it would have been when it began in 2014 (Box 2). At the state level, Wisconsin public employees suffered a previously unimaginable setback when Scott Walker won the 2010 gubernatorial election, along with sizable legislative majorities (Box 3). Box 2 The Right Referee Makes All The Difference The Fight for $15 movement that began in 2012 aimed to nearly double the median fast-food worker’s wages. A raise of that magnitude would pose an existential threat to fast-food’s business model, and McDonald’s and its franchisees sought to stymie the movement’s momentum. The NLRB opened an investigation in 2014 following allegations that employees were fired for participating in organizing activities. McDonald’s vigorously contested the case in an effort to avoid the joint-employer designation that would open the door for franchise employees to bargain collectively with the parent company. (Absent a joint-employer ruling, a union would have to organize the McDonald’s work force one franchise at a time.) When the case was decided in McDonald’s favor in December, the headline and sub-header on the Bloomberg story reporting the outcome crystallized our elections-matter thesis: McDonald’s Gets Win Under Trump That Proved Elusive With Obama Board led by Trump appointees overrules judge in case that threatened business model Box 3 Wisconsin Guts Public-Sector Unions Soon after Wisconsin Governor Scott Walker took office in January 2011, backed by sizable Republican majorities in both houses of the legislature, he sent a bill to legislators that would cripple the state’s public-sector unions. Protestors swarmed Madison and filled the capitol building every day for a month to contest the bill, and Democratic legislators fled the state to forestall a vote, but it eventually passed nonetheless. The bill struck at a rare union success story; nearly one-third of public-sector employees are union members and that ratio has remained fairly steady over the last 40 years (Chart 6). Wisconsin’s public-sector unions now do little more than advocate for their members in disciplinary and grievance proceedings, and overall union membership in the state has fallen by a whopping 43% since the end of 2009. Chart 6Public-Sector Union Membership Has Held Up Well Judicial appointments make a difference, too. The Supreme Court’s Janus decision in April 2018, banning any requirement that public employees pay dues to the unions that bargain for them on not-so-readily-apparent First Amendment grounds,10 was widely viewed as a body blow to public-sector unions. The 5-4 decision would certainly have gone the other way had President Obama’s nominee to succeed the late Justice Scalia been confirmed by the Senate. Final Takeaways Six weeks of reading about US labor history, considering the game theory underlying employment negotiations, and examining the current landscape for insight into the drivers of management and labor leverage have left us pretty much where we started. We do not anticipate that organized labor will regain the position it enjoyed in the fifties and sixties, when global competition was weak and shareholders and consumers were anything but vigilant about corporate operations. Even a more modest flexing of labor muscle that pushes wages higher across the entire economy has a probability of less than one half. Investors seem to think the probability is negligible, though, and therein lies an opportunity. We stated two major themes at the outset. One, employees have little chance of gaining ground if government is disposed to side with employers, and, two, successful strikes beget strikes. Public opinion is the tissue that connects the two themes. Elected officials deliver what their constituents want, as do the courts, albeit with a longer lag. Society’s view of striking/strikebreaking tactics heavily influences how they’re deployed and whether or not they’ll be successful. If the electorate has had enough of Reagan-Thatcher policies, elected officials will stop implementing them. We believe that public opinion is beginning to coalesce on employees’ side as labor puts on a more appealing face; as businesses increasingly fret about inequality’s consequences; and as millennials swoon over progressives, undeterred by labels that would have left their Cold War ancestors reaching for weapons. The median voter theory has importance beyond predicting future outcomes; it directly influences them. As the center of the electorate leans to the left, elected officials will have to deliver more liberal outcomes if they want to keep their jobs. If the electorate has given up on Reagan-Thatcher principles, organized labor is bound to get a break from the four-decade onslaught that has left it shrunken and feeble. There is one overriding market takeaway from our view that a labor recovery is more likely than investors realize: long-run inflation expectations are way too low. Although we do not expect wage growth to rise enough this year to give rise to sustainable upward inflation pressures that force the Fed to come off of the sidelines, we do think investors are overly complacent about inflation. We continue to advocate for below-benchmark duration positioning over a cyclical timeframe and for owning TIPS in place of longer-maturity Treasury bonds over all timeframes. Watch the election, as it may reveal that labor’s demise has been greatly exaggerated.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Students were excused from classes and exams and sometimes even received academic credit for their work. 2 King, Gilbert, “How The Ford Motor Company Won a Battle and Lost Ground,” Smithsonian.com, April 30, 2013. 3 Greenhouse, Steven, Beaten Down, Worked Up, Alfred A. Knopf: New York (2019), pp. 137-8. 4 High unemployment, in addition to declining respect for unions, helped erase the stigma of crossing picket lines. 5 Serrin, William, “Industries, in Shift, Aren’t Letting Strikes Stop Them,” New York Times, September 30, 1986, p. A18. 6 Emma, Caitlin, “Teachers Are Going on Strike in Trump’s America,” Politico, April 12, 2018. 7 Greenhouse, p. 44. 8 Please see the January 20, 2020 US Investment Strategy Special Report, “Labor Strikes Back, Part 2: Where Strikes Come From And Who Wins Them,” available at usis.bcaresearch.com. 9 Please see the June 8, 2016 Geopolitical Strategy Monthly Report, “Introducing The Median Voter Theory,” available at gps.bcaresearch.com. 10 The Court found for the plaintiff in Janus, who bridled at the closed-shop law that forced him to join the union that bargained on his and his colleagues’ behalf, because the union’s espousal of views with which he disagreed constituted a violation of his free-speech rights as guaranteed by the First Amendment. Bibliography Aamidor, Abe and Evanoff, Ted. At The Crossroads: Middle America and the Battle to Save the Car Industry. Toronto: ECW Press (2010). Allegretto, S.A.; Doussard, M.; Graham-Squire, D.; Jacobs, K.; Thompson, D.; and Thompson, J. Fast Food, Poverty Wages: The Public Cost of Low-Wage Jobs in the Fast-Food Industry. Berkeley, CA. UC-Berkeley Center for Labor Research and Education, October 2013. Bernstein, Irving. The Lean Years: A History of the American Worker, 1920-1933. Boston: Houghton Mifflin (1960). Blanc, Eric. Red State Revolt: The Teachers’ Strike Wave and Working-Class Politics. Brooklyn, NY: Verso (2019). Emma, Caitlin. “Teachers Are Going on Strike in Trump’s America.” Politico, April 12, 2018, accessed January 20, 2020. Finnegan, William. “Dignity: Fast-Food Workers and a New Form of Labor Activism.” The New Yorker, September 15, 2014 Greenhouse, Steven. Beaten Down, Worked Up: The Past, Present and Future of American Labor. New York: Alfred A. Knopf (2019). Greenhouse, Steven. “The Return of the Strike.” The American Prospect, Winter 2019 Ingrassia, Paul. Crash Course: The American Auto Industry’s Road from Glory to Disaster. New York: Random House (2010). King, Gilbert. “How the Ford Motor Company Won a Battle and Lost Ground.” smithsonianmag.com, April 30, 2013, accessed January 24, 2020. Loomis, Erik. A History of America in Ten Strikes. New York: The New Press (2018). Manchester, William. The Glory and the Dream: A Narrative History of America, 1932-1972. New York: Bantam (1974). Norwood, Stephen H. “The Student As Strikebreaker: College Youth and the Crisis of Masculinity in the Early Twentieth Century. Journal of Social History Winter 1994: pp. 331-49. Sears, Stephen W. “Shut the Goddam Plant!” American Heritage Volume 33, Issue 3 (April/May 1982) Serrin, William. “Industries, in Shift, Aren’t Letting Strikes Stop Them.” The New York Times, September 30, 1986 Wolff, Leon. “Battle at Homestead.” American Heritage Volume 16, Issue 3 (April 1965) *Current newspaper and Bloomberg articles omitted.

Highlights China’s economic rebound in Q1 will be delayed due to the coronavirus, which will have a larger negative hit than SARS. New stimulus measures will assist a rebound in demand later this year. Europe remains a geopolitical opportunity rather than a risk. As long as global growth rebounds this year, European equities can outperform their richly valued American counterparts. Emerging markets face a new headwind from the coronavirus. Emerging market performance relative to developed markets will be a key test of whether endogenous growth trends are taking shape. Tactically – over a 12-month horizon – we remain long industrial commodities; long Korean equities versus Taiwanese; and long Malaysian equities relative to emerging markets. Feature Global equities will ultimately push through the coronavirus and the Democratic Party primary election, but risks are elevated and Q1 looks to bring significant volatility. Last week we shifted to a tactically neutral stance on risk assets but we remain cyclically bullish. In this report we update our market-based GeoRisk indicators, which are almost all set to rise from low levels in the coming months as developed market equities and emerging market currencies face higher risk premiums. China: The Year Of The Rat Chart 1Markets Will Rebound Once Toll Of Virus Peaks The ink had hardly dried on our “Black Swan” report for 2020 when Chinese scientists confirmed human-to-human transmission of the Wuhan coronavirus (2019-nCoV), sending a wave of fear over China and the world. The number of new cases and new deaths is rising and economic activity will suffer as the Chinese New Year is extended, shoppers stay home, and international travel is canceled. The virus is likely to prove more troublesome than stock investors want to admit, at least in the short term. Too little is known to make confident assertions about promptly containing the virus or its impact on global economy and markets. The analogy with the SARS outbreak of 2003 is limited: it is not certain that this virus has a lower death rate, but it is certain that the Chinese economy is more vulnerable to disruption today than at that time – and much more influential on the global economy. The SARS episode is useful, however, in suggesting that the market will not rebound until the number of new cases and deaths turn down (Chart 1). Assuming the virus is ultimately contained – both in China and in neighboring Asian countries whose governments may not be as effective at quarantining the problem – regional consumption and production will bounce back. New stimulus measures will also take effect with a lag. Domestic political risk is structurally understated in China. Stimulus will indeed be the answer. First, the negative shock to consumer demand comes at a time when global trade is still relatively weak, thus presenting a two-pronged threat to China’s economy, which was only just stabilizing after the truce in the trade war. Second, China’s hundredth anniversary of the Communist Party, in 2021, will require the government to stabilize the economy now. The important political leadership reshuffle at the twentieth National Party Congress in 2022 is another imperative to avoid a deepening slump today (Chart 2). Chart 2China Will Stimulate To Avoid A Deepening Slump Beyond 2020, the Wuhan virus highlights our theme that domestic political risk is structurally understated in China. At the centennial celebration, China’s leaders aim to show that the country is a “moderately prosperous society in all respects,” emphasis added. For decades China’s leaders have emphasized industrial production to the detriment of other social and economic goals, such as food safety and a clean and safe environment for households to live in. The emergence of the middle class, writ broadly, as a majority of the population is a persistent source of pressure on leaders, as the limited opinion polling available from China demonstrates (Chart 3). In other emerging markets, a large middle class has led to social and political change when the government failed to meet growing middle class demands (Chart 4). Chart 3Chinese Social And Economic Conditions Are Source Of Pressure Chart 4Consumerism Encourages Democracy Chart 5China’s Government Is Behind The Curve Under General Secretary Xi Jinping, the government has cracked down on corruption and pollution as well as poverty, and has attempted to improve consumer safety and the health care system. The party officially aims to shift its policy focus from meeting the basic material needs of the population to improving quality of life. The problem is that China’s government is behind the curve (Chart 5). While it is making rapid progress – for instance, the communicable disease burden has dropped dramatically – and has unique authoritarian tools, acute problems of health, food safety, pollution, and public services will nevertheless persist. The government’s responses will inevitably fall short from time to time and heads will roll. Crisis events create the potential for the market to be surprised by the level of domestic political change or pushback, which will prove disruptive at times. Bottom Line: China’s economic rebound in Q1 will be delayed due to the coronavirus, which will have a larger negative hit than SARS. The SARS episode suggests that Chinese equities will be a tactical buy when the number of new cases and deaths begin falling. New stimulus measures will assist a rebound in demand later this year – underscoring our constructive cyclical view on Chinese and global growth. The episode highlights the challenges China faces in modernizing and improving regulations, health, and safety for the emerging middle class. Domestic political risk is understated. Europe: Political Risks Still Contained China’s near-term hit, and rebound later this year, will echo in Europe, where the economy and equity market are highly reliant on China’s credit cycle and import demand. Politically, however, Europe remains a geopolitical opportunity rather than a risk (Chart 6). Chart 6China's Hit Will Echo In Europe, But Political Risks Are Contained There The final months of last year saw the biggest and most immediate political risk – a disorderly UK exit from the EU – removed. The Trump administration is not likely to slap large-scale tariffs – such as auto tariffs on a national security pretext – because Trump is constrained by the weak manufacturing sector in advance of his election. Meanwhile immigration and terrorism have declined since 2016, draining the fuel of Europe’s anti-establishment parties. Pound weakness during the Brexit transition period is an opportunity for investors to buy. Chart 7Immigration Is Ticking Up, But From Low Levels Chart 8Refugees Will Favor Western Route Across The Mediterranean Chart 9Government Gridlock, Catalonia, And Poor Reform Momentum Will Pull Up Spanish Risk There are some signs of immigration numbers ticking up, but from very low levels (Chart 7). This uptick must be monitored for Spain (and France), as the renewed civil war in Libya is forcing refugees to shift to the western route across the Mediterranean (Chart 8). (Note that even peace in Libya opens the possibility of greater migrant flows as the country then becomes a viable transit route again). Our Spanish risk indicator is already ticking up due to government gridlock, the Catalonian conflict, and a declining commitment to structural economic reform (Chart 9). But this is not a major concern for global investors. The United Kingdom The UK will formally exit the European Union on January 31. The transition period – in which the UK remains fully integrated into the EU single market – expires on December 31, 2020. This is the official deadline for the two sides to negotiate a trade agreement – though it can, and likely will, be delayed. Chart 10British Political Risk Will Revive, But Not Dramatically The trade agreement is intended to minimize the negative economic impact of Brexit while ensuring that the UK reclaims its sovereignty and the EU retains the integrity of the single market. As negotiations get under way, the pound will face a new round of volatility and British political risk will revive somewhat, but we do not expect a dramatic increase (Chart 10). Ultimately we see pound weakness as an opportunity for investors to buy. The twin risks of no-deal Brexit or a socialist Jeremy Corbyn government have been decisively cast off. The end-of-year deadline can be extended and the two sides can find technical ways to compromise over regulations, tariffs, and border checks. Challenges to global growth only make an amicable solution more obtainable. Italy Our Italian GeoRisk indicator is collapsing as political risks proved yet again to be overstated (Chart 11). Chart 11Italian GeoRisk Indicator Is Collapsing The local election in Emilia-Romagna was hyped as a major populist risk, in which the chief anti-establishment players, Matteo Salvini and the League, would take power in a region viewed as the symbolic home of the Italian left wing. Instead, the League lost, the ruling Democratic Party won, and the current government coalition will survive. While the populists prevailed at another election in Calabria, this outcome was fully expected. The trend of recent provincial elections does not suggest a swell of Italian populism (Chart 12). Chart 12Recent Local Elections Do Not Suggest A Swell Of Italian Populism Chart 13The Italian Coalition Will Not Rush To Elections This local election is not the end of the coalition’s troubles. The left-wing, anti-establishment Five Star Movement is suffering in the polls as a result of its uninspiring, politically expedient pairing with the establishment Democrats. The Democrats may receive a boost from Emilia-Romagna but the Five Star’s leadership change – the resignation of party leader Luigi di Maio – will not be enough to revive its fortunes alone. A new Five Star leader will have to decide whether to collaborate more deeply with the Democrats or try to reclaim the party’s anti-establishment credentials. The latter would push the coalition toward an election before too long. But the Five Star’s weak polling – and the League’s persistent 10 percentage point lead over the Democratic Party in nationwide polling – suggests that the coalition will not rush to elections but will try to prepare by passing a new electoral law (Chart 13). What is clear is that the Five Star Movement will not court elections until they improve their polling. France In France, Emmanuel Macron and his ruling En Marche party have seen their popularity drop to new lows amid the historic labor strikes in opposition to Macron’s pension reforms (Chart 14). Macron’s current trajectory is dangerously close to that of his predecessor, Francois Hollande, and threatens to turn him into a lame duck. We doubt this is the case. Chart 14Macron’s Popularity Is On A Dangerous Trajectory Diagram 1The ‘J-Curve’ Of Structural Reform We view Macron’s decline as another example of the “J-Curve of Structural Reform,” in which a leader’s political capital drops amid controversial reforms (Diagram 1). If the leader avoids an election during the trough of the curve, the danger zone, then his or her political capital may well revive after the benefits of the structural reform are recognized. In this case, the reform is neutral for France’s budget deficit – a cyclical positive – but it encourages an improvement in pension sustainability by incentivizing workers to work longer and postpone retirement – a structural positive. Chart 15France's Economy Is Holding Up Chart 16A Relatively Strong Economy Will Buffer Against Political Risk In France Municipal elections in March will not go Macron’s way, but the presidential and legislative elections are not until 2022. France’s GDP growth is holding up better than that of its neighbors, wages are rising, and confidence did not collapse amid the Christmas labor strike (Chart 15). Hence we expect the increase in political risk to be manageable (Chart 16), a boon for French equities. Germany German political risk is set to rise from today’s depths (Chart 17). The country faces a major shift: globalization is structurally declining and Chancellor Angela Merkel is stepping down. Merkel’s heir-apparent, Annegret Kramp-Karrenbauer (AKK), is floundering in the opinion polls (Chart 18). Chart 17German Political Risk Will Rise Chart 18Merkel's Heir-Apparent Is Floundering In The Opinion Polls Thus intra-party struggle, and conceivably even a rare early election, could emerge. But the US-China trade ceasefire offers a temporary reprieve. Next year will be different, with elections looming in the fall and the potential for a Trump reelection to trigger a second round of the US-China trade war or to shift to trade war with the EU and tariffs on German cars. The overall political trend in Germany is centrist and pro-Europe, and most of the parties are becoming more willing to upgrade fiscal policy over time. South Korea’s economic problems are priced in, while the market is dismissing Taiwan’s immense political risk. Bottom Line: The US election cycle is the chief source of policy risk and geopolitical risk in 2020, a stark contrast with the EU. European political risk will spike with a full-fledged recession, but for now it is contained. In fact the risks are largely to the upside in the short term as the countries turn slightly more fiscally accommodative. As long as global growth rebounds this year, European equities can outperform their richly valued American counterparts. Emerging Markets: Can They Outperform? With volatility likely in the near-term, Arthur Budaghyan of BCA Research’s Emerging Markets Strategy argues that the key test for emerging markets equities is whether they outperform their developed market counterparts. If they do not, then it suggests that investors still do not see endogenous growth, capital spending and profitability in emerging markets and therefore that they will lag their DM counterparts in the eventual equity upswing. Our long Korea / short Taiwan trade exploded out of the gate but has since fallen back in the face of the new headwind from the coronavirus. We have a high conviction in this trade because the difference in equity valuations faces a looming catalyst in the market’s mispricing of relative geopolitical risk: South Korea’s risk indicator is in a broad upswing while Taiwan’s has collapsed, despite the persistence of the diplomatic track with North Korea and Taiwan’s resounding reelection of both a pro-independence president and legislature (Chart 19). Mainland China will send both risk indicators upward in the near term, but South Korea’s economic problems are priced in and Trump’s diplomacy with North Korea is grounded in well-established constraints on Washington, Beijing, Pyongyang, and Seoul. By contrast the market is entirely dismissing Taiwan’s immense political risk, which does not depend on the outcome of the US election. In the coming 1-3 years, Beijing, Taipei, and Washington are all more likely to take self-interested actions that test the constraints in the Taiwan Strait, upsetting the market, before those constraints are reconfirmed (assuming they are). Beijing is likely to impose economic sanctions as Taipei’s demand for greater freedom and alliance with the US will agitate Chinese leaders who will seek to get the Kuomintang back into power. Brazilian political risk has failed to reach new highs, as anticipated, suggesting that President Jair Bolsonaro’s many problems are not driving investors to sell the real amid underlying indications of rebounding global growth and at least attempts at pro-market reform (Chart 20). Chart 19Markets Are Mispricing Geopolitical Risks In South Korea And Taiwan Chart 20Political Risks Remain Contained In Brazil Turkey’s military intervention into Libya’s civil war is another example of the foreign adventurism that we see as an outgrowth of populism and the need to distract the public’s attention from domestic mismanagement. We expect the risk indicator to rise or be flat and would remain short Turkish currency and risk assets. Bottom Line: Emerging markets face a new headwind from the coronavirus. Not only will China’s growth rebound sputter but Asian EMs will be exposed to the virus and may be less capable than China of dealing with it rapidly and effectively. With volatility looming, emerging market performance relative to developed markets will be a key test of whether endogenous growth trends are taking shape. Investment Conclusions Tactically we are closing our long GBP/JPY trade and UK curve steepener for negligible gains. We are also closing our long Egyptian sovereign bond trade for a gain of 5.59%. We remain long industrial commodities; long Korean equities versus Taiwanese; and long Malaysian equities relative to emerging markets. We expect these trades to perform well over a 12-month horizon. Strategically several of our recommendations will benefit from heightened volatility in the near term but face challenges later in the year as growth rebounds and risk sentiment revives. Nevertheless our time horizon is three-to-five years. In that span we remain long gold, long euro, long defense, short US tech, and short CNY-USD.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Germany: GeoRisk Indicator France: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator UK: GeoRisk Indicator Canada: GeoRisk Indicator China: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: GeoRisk Indicator Russia: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey: GeoRisk Indicator Section III: Geopolitical Calendar

Special Report

Our top five geopolitical “Black Swans” are risks that the market is seriously underpricing. With the “phase one” trade deal signed, Chinese policy could become less accommodative, resulting in a negative economic surprise. The trade deal may fall victim to domestic politics, raising the risk of a US-China military skirmish. A Biden victory at the Democratic National Convention or a Democratic takeover of the White House could trigger social unrest and violence in the US. A pickup in the flow of migrants to Europe would fundamentally undermine political stability there. Russia’s weak economy will add fuel to domestic unrest, risking an escalation beyond the point of containment. Over the past four years, BCA’s Geopolitical Strategy service has started off each year with their top five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s perennial list of market surprises, we do not assign these events a “better than 50% likelihood of happening.” We offer risks that the market is seriously underpricing by assigning them only single-digit probabilities when we think the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Some of our risks below are so obscure that it is not clear how exactly to price them. We exclude issues that are fairly probable, such as flare-ups in Indo-Pakistani conflict. The two major risks of the year – discussed in our Geopolitical Strategy’s annual outlook – are that either US President Donald Trump or Chinese President Xi Jinping overreaches in a major way. But what would truly surprise the market would be a policy-induced relapse in Chinese growth or a direct military clash between the two great powers. That is how we begin. Other risks stem from domestic affairs in the US, Europe, and Russia. Black Swan 1: China’s Financial Crisis Begins Chart II-1A Crackdown On Financial Risk Could Cause China's Economy To Derail The risk of Xi Jinping’s concentration of power in his own person is that individuals can easily make mistakes, especially if unchecked by advisors or institutions. Lower officials will fear correcting or admonishing an all-powerful leader. Inconvenient information may not be relayed up the hierarchy. Such behavior was rampant in Chairman Mao Zedong’s time, leading to famine among other ills. Insofar as President Xi’s cult of personality successfully imitates Mao’s, it will be subject to similar errors. If President Xi overreaches and makes a policy mistake this year, it could occur in economic policy or other policies. We begin with economic policy, as we have charted the risks of Xi’s crackdown on the financial system since early 2017 (Chart II-1). This year is supposed to be the third and final year of Xi Jinping’s “three battles” against systemic risk, pollution, and poverty. The first battle actually focuses on financial risk, i.e. China’s money and credit bubble. The regime has compromised on this goal since mid-2018, allowing monetary easing to stabilize the economy amid the trade war. But with a “phase one” trade deal having been signed, there is an underrated risk that economic policy will return to its prior setting, i.e. become less accommodative (Chart II-2). When Xi launched the “deleveraging campaign” in 2017, we posited that the authorities would be willing to tolerate an annual GDP growth rate below 6%. This would not only cull excesses in the economy but also demonstrate that the administration means business when it says that China must prioritize quality rather than quantity of growth. While Chinese authorities are most likely targeting “around 6%” in 2020, it is entirely possible that the authorities will allow an undershoot in the 5.5%-5.9% range. They will argue that the GDP target for 2020 has already been met on a compound growth rate basis (Chart II-3), as astute clients have pointed out. They may see less need for stimulus than the market expects. Chart II-2Easing Of Trade Tensions May Re-Incentivize Tighter Policy Chart II-3Chinese Authorities Might Tolerate A Growth Undershoot In 2020   Similarly, while urban disposable income is ostensibly lagging its target of doubling 2010 levels by 2020, China’s 13th Five Year Plan, which concludes in 2020, conspicuously avoided treating urban and rural income targets separately. If the authorities focus only on general disposable income, then they are on track to meet their target (Chart II-4). This would reduce the impetus for greater economic support. The Xi administration may aim only for stability, not acceleration, in the economy. There are already tentative signs that Chinese authorities are “satisfied” with the amount of stimulus they have injected: some indicators of money and credit have already peaked (Chart II-5). The crackdown on shadow banking has eased, but informal lending is still contracting. The regime is still pushing reforms that shake up state-owned enterprises. Chart II-4Lower Impetus For Economic Support Due To Improvements In National Income? Chart II-5Has China's Stimulus Peaked?   An added headwind for the Chinese economy stems from the currency. The currency should track interest rate differentials. Beijing’s incremental monetary stimulus, in the form of cuts to bank reserve requirement ratios (RRRs), should also push the renminbi down over time (Chart II-6). However, an essential aspect of any trade deal with the Trump administration is the need to demonstrate that China is not competitively devaluing. Hence the CNY-USD could overshoot in the first half of the year. This is positive for global exports to China, but it tightens Chinese financial conditions at home. A stronger than otherwise justified renminbi would add to any negative economic surprises from less accommodative monetary and fiscal policy. Conventional wisdom says China will stimulate the economy ahead of two major political events: the centenary of the Communist Party in 2021 and the twentieth National Party Congress in 2022. The former is a highly symbolic anniversary, as Xi has reasserted the supremacy of the party in all things, while the latter is more significant for policy, as it is a leadership reshuffle that will usher in the sixth generation of China’s political elite. But conventional wisdom may be wrong – the Xi administration may aim only for stability, not acceleration, in the economy. It would make sense to save dry powder for the next US or global recession. The obvious implication is that China’s economic rebound may lose steam as early as H2 – but the black swan risk is that negative surprises could cause a vicious spiral inside of China. This is a country with massive financial and economic imbalances, a declining potential growth profile, and persistent political obstacles to growth both at home and abroad. Corporate defaults have spiked sharply. While the default rate is lower than elsewhere, the market may be sniffing out a bigger problem as it charges a much higher premium for onshore Chinese bonds (Chart II-7). Chart II-6CNY/USD Overshoot Would Tighten Chinese Financial Conditions Chart II-7Is China's Bond Market Sniffing Out A Problem?   Bottom Line: Our view is that China’s authorities will remain accommodative in 2020 in order to ensure that growth bottoms and the labor market continues to improve. But Beijing has compromised its domestic economic discipline since 2018 in order to fight trade war. The risk now, with a “phase one” deal in hand, is that Xi Jinping returns to his three-year battle plan and underestimates the downward pressures on the economy. The result would be a huge negative surprise for the Chinese and global economy in 2020. Black Swan 2: The US And China Go To War In 2013, we predicted that US-China conflict was “more likely than you think.” This was not just an argument for trade conflict or general enmity that raises the temperature in the Asia-Pacific region – we included military conflict. At the time, the notion that a Sino-American armed conflict was the world’s greatest geopolitical threat seemed ludicrous to many of our clients. We published this analysis in October of that year, months after the Islamic State “Soldier’s Harvest” offensive into Iraq. Trying to direct investors to the budding rivalry between American and Chinese naval forces in the South China Sea amidst the Islamic State hysteria was challenging, to say the least. Chart II-8Americans’ Attitudes Toward China Plunged… The suggestion that an accidental skirmish between the US and China could descend into a full-blown conflict involved a stretch of the imagination because China was not yet perceived by the American public as a major threat. In 2014, only 19%of the US public saw China as the “greatest threat to the US in the future.” This came between Russia, at 23%, and Iran, at 16%. Today, China and Russia share the top spot with 24%. Furthermore, the share of Americans with an unfavorable view of China has increased from 52% to 60% in the six intervening years (Chart II-8). The level of enmity expressed by the US public toward China is still lower than that toward the Soviet Union at the onset of the Cold War in the 1950s (Chart II-9). However, the trajectory of distrust is clearly mounting. We expect this trend to continue: anti-China sentiment is one of the few sources of bipartisan agreement remaining in Washington, DC (Chart II-10). Chinese sentiment toward the United States has also darkened dramatically. The geopolitical rivalry is deepening for structural reasons: as China advances in size and sophistication, it seeks to alter the regional status quo in its favor, while the US grows fearful and seeks to contain China. Chart II-9…But Not Yet To War-Inducing Levels Chart II-10Distrust Of China Is Bipartisan Chart II-11Newfound American Concern For China’s Repression One example of rising enmity is the US public’s newfound concern for China’s domestic policies and human rights, specifically Beijing’s treatment of its Uyghur minority in Xinjiang. A Google Trends analysis of the term “Uyghur” or “Uyghur camps” shows a dramatic rise in mentions since Q2 of 2018, around the same time the trade war ramped up in a major way (Chart II-11). While startling revelations of re-education camps in Xinjiang emerged in recent years, the reality is that Beijing has used heavy-handed tactics against both militant groups and the wider Uyghur minority since at least 2008 – and much earlier than that. As such, the surge of interest by the general American public and legislators – culminating in the Uyghur Human Rights Policy Act of 2019 – is a product of the renewed strategic tension between the two countries. The same can be said for Hong Kong: the US did not pass a Hong Kong Human Rights and Democracy Act in 2014, during the first round of mass protests, which prompted Beijing to take heavy-handed legal, legislative, and censorship actions. It passed the bill in 2019, after the climate in Washington had changed. Why does this matter for investors? There are two general risks that come with a greater public engagement in foreign policy. First, the “phase one” trade deal between China and the US could fall victim to domestic politics. This deal envisions a large step up in Sino-American economic cooperation. But if China is to import around $200 billion of additional US goods and services over the next two years – an almost inconceivable figure – the US and China will have to tamp down on public vitriol. This is notably the case if the Democratic Party takes over the White House, given its likely greater focus on liberal concerns such as human rights. And yet the latest bills became law under President Trump and a Republican Senate, and we fully expect a second Trump term to involve a re-escalation of trade tensions to ensure compliance with phase one and to try to gain greater structural concessions in phase two. Second, mounting nationalist sentiment will make it more difficult for US and Chinese policymakers to reduce tensions following a potential future military skirmish, accidental or otherwise. While our scenario of a military conflict in 2013 was cogent, the public backlash in the United States was probably manageable.1 Today we can no longer guarantee that this is the case. The “phase one” trade deal risks falling victim to domestic politics due to greater public engagement in foreign policy. China has greater control over the domestic narrative and public discourse, but the rise of the middle class and the government’s efforts to rebuild support for the single-party regime have combined to create an increase in nationalism. Thus it is also more difficult for Chinese policymakers to contain the popular backlash if conflict erupts. In short, the probability of a quick tamping down of public enmity is actively being reduced as American public vilification of China is closing the gap with China’s burgeoning nationalism at an alarming pace. Another of our black swan risks – Taiwan island – is inextricably bound up in this dangerous US-China dynamic. To be clear, Washington will tread carefully, as a conflict over Taiwan could become a major war. Nevertheless Taiwan’s election, as we expected, has injected new vitality into this already underrated geopolitical risk. It is not only that a high-turnout election (Chart II-12) gave President Tsai Ing-wen a greater mandate (Chart II-13), or that her Democratic Progressive Party retained its legislative majority (Chart II-14). It is not only that the trigger for this resounding victory was the revolt in Hong Kong and the Taiwanese people’s rejection of the “one country, two systems” formula for Taiwan. It is also that Tsai followed up with a repudiation of the mainland by declaring, “We don’t have a need to declare ourselves an independent state. We are an independent country already and we call ourselves the Republic of China, Taiwan.” Chart II-12Tsai Ing-Wen Enjoys A Greater Mandate On Higher Turnout… Chart II-13…Popular Support… Chart II-14…And A Legislative Majority This statement is not a minor rhetorical flourish but will be received as a major provocation in Beijing: the crystallization of a long-brewing clash between Beijing and Taipei. Additional punitive economic measures against Taiwan are now guaranteed. Saber-rattling could easily ignite in the coming year and beyond. Taiwan is the epicenter of the US-China strategic conflict. First, Beijing cannot compromise on its security or its political legitimacy and considers the “one China principle” to be inviolable. Second, the US maintains defense relations with Taiwan (and is in the process of delivering on a relatively large new package of arms). Third, the US’s true willingness to fight a war on Taiwan’s behalf is in doubt, which means that deterrence has eroded and there is greater room for miscalculation. Bottom Line: A US-China military skirmish has been our biggest black swan risk since we began writing the BCA Geopolitical Strategy. The difference between then and now, however, is that the American public is actually paying attention. Political ideology – the question of democracy and human rights – is clearly merging with trade, security, and other differences to provoke Americans of all stripes. This makes any skirmish more than just a temporary risk-off event, as it could lead to a string of incidents or even protracted military conflict. Black Swan 3: Social Unrest Erupts In America There are numerous lessons that one can learn from the ongoing unrest in Hong Kong, but perhaps the most cogent one is that Millennials and Generation Z are not as docile and feckless as their elders think. Images of university students and even teenagers throwing flying kicks and Molotov cocktails while clad in black body armor have shocked the world. Perhaps all those violent video games did have a lasting impact on the youth! What is surprising is that so few commentators have made the cognitive leap from the ultra-first world streets of Hong Kong to other developed economies. Perhaps what is clouding analysts’ minds is the idiosyncratic nature of the dispute in Hong Kong, the “one China” angle. However, Hong Kong youth are confronted with similar socio-economic challenges that their peers in other advanced economies face: overpriced real estate and a bifurcated service-sector labor market with few mid-tier jobs that pay a decent wage. There is a risk of rebellion from Trump’s most ardent supporters if he loses the White House. In the US, Millennials and Gen Z are also facing challenges unique to the US. First, their debt burden is much more toxic than that of the older cohorts, given that it is made up of student loans and credit card debt (Chart II-15). Second, they find themselves at odds – demographically and ideologically – with the older cohorts (Chart II-16). Chart II-15Younger American Cohorts Plagued By Toxic Debt Chart II-16Younger And Older Cohorts At Odds Demographically Chart II-17Massive Turnout To The 2016 Referendum On Trump The adage that the youth are apolitical and do not turn out to vote may have ended thanks to President Trump. The 2018 midterm election, which the Democratic Party successfully turned into a referendum on the president, saw the youth (18-29) turnout nearly double from 20% to 36% (the 30-44 year-old cohort also saw a jump in turnout from 35.6% to 48.8%). The election saw one of the highest turnouts in recent memory, with a 53.4% figure, just two points off the 2016 general election figure (Chart II-17). Despite the high turnout in 2018, the-most-definitely-not-Millennial Vice President Joe Biden continues to lead the Democratic Party in the polls. His probability of winning the nomination is not overwhelming, but it is the highest of any contender. In recent polls, Biden comes third place in Millennial/Gen-Z vote preferences (Chart II-18). Yet he is hardly out of contention, especially for the 30-44 year-old cohort. The view that “Uncle Joe” does not fit the Democratic Party zeitgeist has become so entrenched in the Democratic Party narrative that it became conventional wisdom last year, pulling oddsmakers and betting markets away from the clear frontrunner (Chart II-19). Chart II-18Biden Unpopular Among Young American Voters Chart II-19Bookies Pulled Down 'Uncle Joe’s' Odds, Capturing Democratic Party Zeitgeist     As such, a Biden victory at the Democratic National Convention in Milwaukee, Wisconsin on July 13-16 may come as an affront to the left-wing activists who will surely descend on the convention. This will particularly be the case if Biden wins despite the progressive candidates amassing a majority of overall delegates, which is possible judging by the combined progressive vote share in current polling (Chart II-20). He would arrive in Milwaukee without clearing the 1990 delegate count required to win on the first ballot. On the second ballot, his presidency would then receive a boost from “superdelegates” and those progressives who are unwilling to “rock the boat,” i.e. unify against an establishment candidate with the largest share of votes. This is also how Mayor Michael Bloomberg could pull off a surprise win. Chart II-20Progressives Come Closest To Victory Such a “brokered” – or contested – convention has not occurred since 1952. However, several Democratic Party conventions came close, including 1968, 1972, and 1984. The 1968 one in Chicago was notable for considerable violence and unrest. Even if the Milwaukee Democratic Party convention does not produce unrest, it could sow the seeds for unrest later in the year. First, a breakout Biden performance in the primaries is unlikely. As such, he will likely need to pledge a shift to the left at the convention, including by accepting a progressive vice-presidential candidate. Second, an actual progressive may win the primary. Chart II-21Zealots In Both Parties Perceive Each Other As A National Threat It is likely that either of the two options would be seen as an existential threat to many of Trump’s loyal supporters across the United States. President Trump’s rhetoric often paints the scenario of a Democratic takeover of the White House in apocalyptic terms. And data suggests that the zealots in both parties perceive each other as a “threat to the nation’s wellbeing” (Chart II-21). The American Civil War in the nineteenth century began with the election of a president. This is not just because Abraham Lincoln was a particularly reviled figure in the South, but because the states that ultimately formed the Confederacy saw in his election the demographic writing-on-the-wall. The election was an expression of a general will that, from that point onwards, was irreversible. Given demographic trends in the US today, it is possible that many would see in Trump’s loss a similar fait accompli. If one perceives progressive Democrats as an existential threat to the US constitution, rebellion is the obvious and rational response. Bottom Line: Year 2020 may be a particularly violent one for the US. First, left wing activists may be shocked and angered to learn that Joe Biden (or Bloomberg) is the nominee of the Democratic Party come July. With so much hype behind the progressive candidates throughout the campaign, Biden’s nomination could be seen as an affront to what was supposed to be “the big year” for left-wing candidates. Second, investors have to start thinking about what happens if Biden – or a progressive candidate – goes on to defeat President Trump in the general election. While liberal America took Trump’s election badly, it has demographics – and thus time – on its side. Trump’s most ardent supporters may conclude that his defeat means the end of America as they know it. Black Swan 4: Europe’s Migration Crisis Restarts It is a testament to Europe’s resilience that we do not have a Black Swan scenario based on an election or a political crisis set on the continent in 2020. Support for the common currency and the EU as a whole has rebounded to its highest since 2013. Even early elections in Germany and Italy are unlikely to produce geopolitical risk. The populists in the former are in no danger of outperforming whereas the populists in the latter barely deserve the designation. But what if one of the reasons for the surge in populism – unchecked illegal immigration – were to return in 2020? Chart II-22Decline In Illegal Immigration Dampened European Populism The data suggests that the risk of migrant flows has massively subsided. From its peak of over a million arrivals in 2015, the data shows that only 125,472 migrants crossed into Europe via land and sea routes in the Mediterranean last year (Chart II-22). Why? There are five reasons that we believe have checked the flow of migrants: Supply: The civil wars in Syria, Iraq, and Libya have largely subsided. Heterogenous regions, cities, and neighborhoods have been ethnically cleansed and internal boundaries have largely ossified. It is unlikely that any future conflict will produce massive outflows of refugees as the displacement has already taken place. These countries are now largely divided into armed, ethnically homogenous, camps. Enforcement: The EU has stepped up border enforcement since 2015, pouring resources into the land border with Turkey and naval patrols across the Mediterranean. Individual member states – particularly Italy and Hungary – have also stepped up border enforcement policy. While most EU member states have publicly chided both for “draconian” policies, there is no impetus to force Rome and Budapest to change policy. Libyan Imbroglio: Conflict in Libya has flared up in 2019 with military warlord Khalifa Haftar looking to wrest control from the UN-backed Government of National Accord led by Fayez al-Serraj. The Islamic State has regrouped in the country as well. Ironically, the conflict is helping stem the flow of migrants as African migrants from sub-Saharan countries dare not cross into Libya as they did in 2015 when there was a brief lull in fighting. Turkish benevolence: Ankara is quick to point out that it is the only thing standing between Europe and a massive deluge of migrants. Turkey is said to host somewhere between two and four million refugees from various conflicts in the Middle East. Fear of the crossing: If crossing the Mediterranean was easy, Europe would have experienced a massive influx of migrants throughout the twentieth century. Not only is it not easy, it is costly and quite deadly, with thousands lost each year. Furthermore, most migrants are not welcomed when they arrive to Europe, many are held in terrible conditions in holding camps in Italy and Greece. Over time, migrants who made it into Europe have reported these dangers and conditions, reducing the overall demand for illegal migration. We do not foresee these five factors changing, at least not all at once. However, there are several reasons to worry about the flow of migrants in 2020. US-Iran tensions have sparked outright military action, while unrest is flaring up across Iran’s sphere of influence. Going forward, Iran could destabilize Iraq or fuel Shia unrest against US-backed regimes. Second, Afghanistan has been the source of most migrants to Europe via sea and land Mediterranean routes – 19.2%. The conflict in the country continues and may flare up with President Trump’s decision to formally withdraw most US troops from the country in 2020. Third, a break in fighting in Libya may encourage sub-Saharan migrants to revisit routes to Europe. Migrants from Guinea, Cote d’Ivoire, and the Democratic Republic of Congo make up over 10% of migrants to Europe. Finally, Turkish relationship with the West could break up further in 2020, causing Ankara to ship migrants northward. We highly doubt that President Erdogan will risk such a break, given that 50% of Turkish exports go to Europe. A European embargo on Turkish exports – which would be a highly likely response to such an act – would crush the already decimated Turkish economy. Bottom Line: While we do not see a return to the 2015 level of migration in 2020, we flag this risk because it would fundamentally undermine political stability in Europe. Black Swan 5: Russia Faces A “Peasant Revolt” Our fifth and final black swan risk for the year stems from Russia. This risk may seem obvious, since the US election creates a dynamic that revives the inherent conflict in US-Russian relations. Russia could seek to accomplish foreign policy objectives – interfering in US elections, punishing regional adversaries. The Trump administration may be friendly toward Russia but Trump is unlikely to veto any sanctions passed by the House and Senate in an election year, should an occasion for new sanctions arise. Conversely Russia could anticipate greater US pressure if the Democrats win in November. Yet it is Russia’s domestic affairs that represent the real underrated risk. Putin’s fourth term as president has been characterized by increased focus on domestic political control and stability as opposed to foreign adventurism. The creation of a special National Guard in 2016, reporting directly to Putin and responsible for quelling domestic unrest, symbolizes the shift in focus. So too does Russia’s adherence to the OPEC 2.0 regime of production control to keep oil prices above their budget breakeven level. Meanwhile Putin’s courting of Europe for the Nordstream II pipeline, and his slight peacemaking efforts with Ukraine, has suggested a slightly more restrained international posture. Strategically it makes little sense for Russia to court negative attention at a time when the US and Europe are at odds over trade and the Middle East, the US is preoccupied with China and Iran, and Russia itself faces mounting domestic problems. The domestic problems are long in coming. The central bank has maintained a stringent monetary policy for the better part of the decade. Despite cutting interest rates recently, monetary and credit conditions are still tight, hurting domestic demand. Moscow has also imposed fiscal austerity, namely by cutting back on state pensions and hiking the value added tax. Real wage growth is weak (Chart II-23), retail sales are falling, and domestic demand looks to weaken further, as Andrija Vesic of BCA Emerging Markets Strategy observes in a recent Special Report. The effect of Russia’s policy austerity has been a drop in public approval of the administration (Chart II-24). Protests erupted in 2019 but were largely drowned out by the larger and more globally significant protests in Hong Kong. These were met by police suppression that has not removed their underlying cause. Putin’s first major decision of the new year was to reshuffle the government, entailing Prime Minister Dmitri Medvedev’s transfer to a new post and the appointment of a new cabinet. This move reveals the need to show some accountability to reduce popular pressure. While Moscow now has room to cut interest rates and ease fiscal policy, it is behind the curve and the weak economy will add fuel to domestic unrest. Chart II-23Sluggish Wage Growth Threatens Russian Stability Chart II-24Austerity Weighed On The Administration's Popularity In Russia   Meanwhile Putin’s efforts to alter the Russian constitution so he can stay in power beyond current term limits, effectively becoming emperor for life, like Xi Jinping, should not be dismissed merely because they are expected. They reflect a need to take advantage of Putin’s popular standing to consolidate domestic political power at a time when the ruling United Russia party and the federal government face discontent. They also ensure that strategic conflict with the United States will take on an ideological dimension. Russia's recent cabinet shakeup is positive from the point of view of economic reform. And the country's monetary and fiscal room provide a basis for remaining overweight equities within EM, as our Emerging Markets Strategy recommends. However, Russian equities have rallied hard and the political risk is understated. Chart II-25Russian Political Risk Is Unsustainably Low Bottom Line: It is never easy predicting Putin’s next international move. Our market-based indicators of Russian political risk have hit multi-year lows, but both the domestic and international context suggest that these lows will not be sustained (Chart II-25). A new bout of risk can emanate from Putin, or from changes in Washington, or from the Russian people themselves. What would take the world by surprise would be domestic unrest on a larger scale than Russia can easily suppress through the police force. Housekeeping We are closing our long European Union / short Chinese equities strategic trade with a 1.61% loss since inception on May 10, 2019. Dhaval Joshi of BCA’s European Investment Strategy downgraded the Eurostoxx 50 to underweight versus the S&P 500 and the Nikkei 225 this week. He makes the point that the Euro Area bond yield 6-month impulse hit 100 bps – a critical technical level – and will be a strong headwind to growth. We will look to reopen this trade at a later date when the euphoria over the “phase one” trade deal subsides, as we still favor European equities and DM bourses over EM. We will reinstitute our long Brent crude H2 2020 versus H2 2021 tactical position, which was stopped out on January 9, 2020. We remain bullish on oil fundamentals and expect Middle East instability to add a political risk premium. China's stimulus and the oil view also give reason for us to reinitiate our long Malaysian equities relative to EM as a tactical position. The Malaysian ringgit will benefit as oil prices move higher, helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power. Higher oil prices also correlate with higher equity prices, while China's stimulus and the US trade ceasefire will push the US dollar lower and help trade revive in the region. Marko Papic Chief Strategist, Clocktower Group Matt Gertken Geopolitical Strategist Footnotes 1 Observe how little attention the public paid to US-China saber-rattling around China’s announcement of an Air Defense Identification Zone in the East China Sea that year.