Geopolitical Regions
Highlights China and India periodically fight each other on their fuzzy Himalayan border with zero market consequences. A major conflict is possible in the current environment – but it would present a buying opportunity. Chinese escalation with India would not have a negative impact on global trade and economy, unlike escalation with the US or its East Asian allies. If China gets into a major conflict with India, it is less likely to stage major military actions in the South China Sea or Taiwan Strait. It would reduce much more significant geopolitical risks. Go strategically long Indian pharmaceuticals. Feature India and China have engaged in their first deadly military clash since 1967. An Indian colonel and at least 20 troops died in fighting on June 15 in the Galwan Valley, Ladakh, where territorial disputes have heated up over the past month.At least 50 Chinese troops are estimated dead.1 Chart 1Regional Equities May Not Shrug Off War In Himalayas ... At First It was a minor incident. No shots were fired. Combatants used stones and knives and threw each other off cliffs. However, the occasion of the battle was a negotiation to de-escalate tensions, and talks have gone on since June 3. So that bodes ill. Prime Minister Narendra Modi’s government has not responded but China’s foreign ministry is making conciliatory remarks. Normally India-China border clashes occur during the summer, when weather permits, and do not last long and do not impact the rest of the world, either politically or financially. However, the structural and cyclical drivers of the conflict suggest it could escalate over the summer. A major escalation between nuclear powers is unlikely but could conceivably cause volatility in global financial markets. Global equity investors are focused on other things (COVID-19, global stimulus), but recent volatility suggests that Chinese, Indian, and Pakistani bourses could be vulnerable to any major military escalation (Chart 1). However, a Himalayan-inspired selloff would be short-lived and would present a buying opportunity. India-China tensions are far less relevant to global financial markets than China’s disputes with the United States in East Asia. If the US uses India as a pretext for tougher actions on China, then that is a different story. But it is unlikely for reasons explained below. Our base case strategic assessment of India remains the same: Chinese expansionism will pressure India to speed up economic development to gain greater influence in South Asia. India will also pursue better trade and defense relations with the United States and its allies in East Asia and the Pacific. We are tactically cautious on global equities, but strategically we expect equities to beat bonds and cyclicals to beat defensives. Selloffs stemming from Himalayan conflict will create buying opportunities for emerging market equities, especially India. The Drivers Of The Ladakh Skirmish India and China have a 2,170-mile border in the Himalayan mountains that is disputed in India’s northwest (Aksai Chin) and northeast (Sikkim; Arunachal Pradesh). These border disputes have simmered for decades and occasionally flare into violent incidents, usually meaningless. An India-China border war could occur, but is unlikely. Today’s clashes are mostly taking place in eastern Ladakh, as with disputes in 2013-14. Minor incidents have also occurred in India’s northeast (Naku La, Sikkim). These may be unrelated, but they may also suggest a broad India-China border conflict is in the works (Map 1). Map 1India And China Often Fight Over Undefined Himalayan Border When Ice Melts There is always a local spark for clashes along the Line of Actual Control. These tend to be triggered by infrastructure construction or military patrols that cross the countries’ various border claims. Typically China triggers the incident as it is always pouring more money and concrete into new structures to solidify its territorial claims, whereas India’s resources are more limited. However, in recent years India has grown more capable. Both sides may also be surging infrastructure spending amid the recession (Chart 2). Chart 2China No Longer Alone In Nation-Building In Himalayas Chart 3China's Slower Growth Jeopardizes Communist Party Legitimacy In the current dispute both sides claim the other broke the peace. Indian builders supposedly violated China’s space while working on the Darbuk-Shayok-DBO road which connects to an airfield near Galwan Valley, the site of the clash. But the Indian side argues that Chinese military forces have ventured several miles from their usual outposts and amassed major forces on their side suggesting they are preparing for a bigger effort to expand their control of territory. 2 We may never know who “started” it. There is no clear border and even the Line of Actual Control is hard to define.3 Investors should not confuse the proximate cause of this conflict for the underlying cause. There are structural and cyclical factors at work on both sides: 1. China’s declining domestic stability and rising international assertiveness. The crises of 2008, 2015, 2018-19, and 2020 have caused a hard break in China’s economic model. Slower trend growth jeopardizes the Communist Party’s long-term monopoly on power (Chart 3). The Xi Jinping administration has responded to each crisis by tightening the party’s grip and reasserting central Beijing control. This is true at home, in peripheral territories like Xinjiang and Hong Kong, and abroad, as in the South China Sea and the Belt and Road Initiative. Territorial disputes have flared up across China’s borders. India is no exception, with incidents in 2013, 2014, 2017, and now 2020 marking the change (Table 1). Table 1China’s Territorial Assertiveness Triggers Clashes With India The China-Pakistan Economic Corridor strengthens the alliance between these two countries and deepens India’s insecurities. India perceives China’s Belt and Road Initiative as a threat of economic and eventually military encirclement. In 2017, the Doklam dispute between China, Bhutan, and India – which lasted over two months – served to distract the Chinese populace from a major increase in US pressure on China’s periphery. That was President Trump’s “fire and fury” campaign to intimidate North Korea into entering nuclear negotiations (Chart 4). In 2020, China faces its first recessionary environment since the mid-1970s as well as rocky relations with the United States over trade, technology, Hong Kong, North Korea again, and possibly even the Taiwan Strait. It is a convenient time to turn the public’s attention to the Himalayas. Chart 4China's Last Dispute With India Occurred During US-North Korea Tensions 2. India’s emerging national consensus and international coming-of-age. India’s rise as a global power has accelerated since the Great Recession, especially after oil prices fell in 2014. Prime Minister Modi has won two smashing general elections with single-party majorities, in 2014 and 2019. His movement also maintains the upper hand in state legislatures, which is important given that India’s weak federal government cannot simply force structural reforms onto the country (Map 2). Modi’s electoral success reflects a deeper national consensus on the need for stronger central leadership, faster economic development, deeper international trade and investment ties, and pro-efficiency reforms such as the creation of a single market. The policy retreat from globalization benefits insular and service-oriented economies like India at the expense of mercantilist trading powers such as China. America’s pivot to Asia and “Indo-Pacific” strategy create a chance for India to attract investment as multinational corporations diversify away from China (Chart 5). Map 2Modi’s Political Capital At State-Level Chart 5India Attracts Investment As Supply Chains Diversify From China Chart 6US And India Fiscal Stimulus Enable Supply Chain Shift Out Of China In August 2019, after Modi’s big election victory, he launched an ambitious agenda of state-building. He converted the autonomous region of Jammu and Kashmir into two union territories under New Delhi: Jammu and Kashmir, and Ladakh. This change of status quo angered China and Pakistan, which felt their own territory threatened. Chinese territorial pressure could be retribution for these administrative reforms. China and Pakistan will also want to undermine Modi’s party in upcoming elections for the state assembly of Jammu and Kashmir. China’s territorial encroachments reflect its desire to gain control of the entire Aksai Chin plateau. India does not want China to gain such a strategic advantage at the head of the Indus River and valley. The global pandemic and recession reinforced these structural and cyclical trends by pushing both India and China to use nationalist devices to divert their populations from domestic ills. The use of fiscal stimulus across the world enables leaders to pursue risky strategic policies (Chart 6). There is also a tactical issue: India took over the chairmanship of the World Health Assembly in May, while the US is lobbying on behalf of Taiwan’s long desire to be represented in the World Health Organization in the wake of COVID-19. China is resisting this call and could be using Ladakh as a pressure tactic.4 How Far Will Sino-Indian Conflict Escalate? Reports suggest that India and China have reinforced troops in and near Ladakh and have brought more firepower and airpower into range.5 Some of this activity, on both sides, consists of seasonal military drills. So it is not certain that a build-up is occurring. China is less constrained and more capable of escalation than India. If China continues pressing its territorial advance, or if India tries to reclaim territory or take other territory in compensation, then the fight will expand. The conflict is taking place in rocky recesses at a far remove from the rest of the world, so there is a temptation to believe that any escalation can be controlled.6 This may be false and lead to tit-for-tat escalation. Table 2Military Balance: India Versus China In Himalayas Which side faces greater constraints? China is least constrained and most capable of escalation. Over the short run, China can utilize improved military command and capabilities in the area and can control the media and political response at home. Besting India would demonstrate that all Asian territorial claimants should defer to China. However, over the long run, aggression would cement the balance-of-power alliance between the US and India. India is more constrained than China, less capable of escalation: Modi has considerable political capital, but his conventional military advantage in this area is eroding and China has the higher ground from which to stage attacks (Table 2). India’s loss in the 1962 Himalayan war with China was a national humiliation. A repeat of such an event could destroy much of Modi’s mystique as a strongman leader and national savior. In the worst-case scenario, China would demonstrate superior military capability while the US and its allies would remain utterly aloof, leaving India looking both weak and isolated. Therefore India will engage in tit-for-tat military response while seeking diplomatic de-escalation. The US lacks interest in the dispute: Trump has already offered to mediate, presumably to demonstrate his deal-making skills again before the election. But the US does not have a compelling interest in this dispute and India does not want US mediation. If Trump takes punitive measures against China it will be for other reasons. Serious punitive measures require the stock market and economy to relapse, since at the moment Trump’s average approval rating is 43% and he hopes financial and economic gains will help him recover (Diagram 1). Diagram 1Odds President Trump Will Hike Tariffs On China Before US Election The above points suggest that China can afford to escalate if it wants to show India and the rest of Asia that the US is toothless and that China’s territorial claims in Asia should not be opposed. Since COVID-19, China has been aggressive in the South China Sea and Taiwan Strait, despite the fact that these areas bring economic risks. The Himalayas do not. The implication is that China’s risk appetite is large, particularly in territorial disputes, and driven by social and economic pressure at home. Investment Takeaways Because India and China (and Pakistan) have nuclear arms, and because the US could get involved, it is possible that a major escalation could occur and cause volatility in global financial markets. But it would not last long and no parties will use nuclear arms over Himalayan territorial disputes. A major conflict that results in a Chinese victory would subtract from Prime Minister Modi’s political capital and hence weigh on Indian equities, which have broken down badly since COVID-19 (Chart 7). The reason is that strong political support for Modi would enable India to continue making structural economic reforms that increase productivity. Chart 7Indian Equities Underperforming Since COVID-19 Chart 8India’s Path To Regional Primacy Lies Through Economic Opening And Reform In the long run, a major conflict, especially a humiliating defeat, would accelerate India’s attempts to improve national economic prowess for the sake of strategic security. Since India cannot achieve its strategic objective of primacy in South Asia merely through military power, it will need to do so through a stronger economic pull (Chart 8). This is an impetus for structural economic reform even beyond Modi. Hence our secularly bullish outlook on India. Indian pharmaceutical equities offer an investment opportunity (Chart 9). In an attempt to address land acquisition, which is one of the biggest constraints faced by companies looking to invest in India, New Delhi has announced that it is developing an area the size of Luxembourg to attract businesses moving out of China. The government reached out to over 1,000 US companies in April with incentives for them to move their facilities to India, with a focus on industries in which India has a comparative advantage, such as medical equipment suppliers, food processing units, textiles, leather, and auto part makers. Chart 9US And Indian Stimulus Policies Will Boost Investment In Indian Pharma While India is not as economically competitive as China, it could be attractive for non-strategic industries that would not want to relocate to the US but are looking to reduce uncertainty from US-China tensions. The next round of US fiscal stimulus is also likely to contain significant provisions that will incentivize companies to relocate from China, particularly in the medical and health care sector. For global investors, while a major Sino-Indian escalation could lead to short-term volatility, it would ultimately be a positive development if Beijing vented its nationalism on a strip of earth that is not globally relevant, rather than on the seas, which are highly relevant. Conflict between the US and China in East Asia is a far greater risk than Sino-Indian conflict. Indeed Chinese and American actions over the Taiwan Strait, North Korea, or the South and East China Seas are still far more likely than Sino-Indian tensions to affect global trade and stability and financial markets this year. The US could impose sanctions on Chinese tech and trade, a military incident could occur in the Taiwan Strait, North Korea could provoke US President Donald Trump into a new round of “fire and fury” that triggers a showdown with China, or the US and China could fight a naval skirmish in the South or East China Sea. None of these options is low probability, especially surrounding the US election. Over the short run, global investors should prepare for greater equity volatility, primarily because of hiccups in delivering new stimulus in the US, EU, and China, plus US domestic political risks and US-China-Asia strategic tensions. Stay long JPY-USD. Over the long run, a global growth rebound driven by massive global fiscal and monetary stimulus will drive the US dollar to weaken, global equities to outperform bonds, and cyclicals to outperform defensives. We remain long China-sensitive plays as well as infrastructure, cyber-security, and defense stocks. Strategically, go long Indian pharmaceuticals relative to the emerging market benchmark. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The Guardian, "Soldiers fell to their deaths as India and China’s troops fought with rocks," June 17, 2020. 2 See Ashley J. Tellis, "Hustling in the Himalayas: The Sino-Indian Border Confrontation," Carnegie Endowment for International Peace, June 4, 2020. See also Mohan Guruswamy, "India-China Border Dispute: Is A Give And Take Possible Now?" South Asia Monitor, June 3, 2020. 3 The Treaty of Tingmosgang (1684) only specifies one checkpost, at the Lhari Stream near Demchok, leaving everything else to disputed Indian and Chinese claims. See Alexander Davis and Ruth Gamble, "The local cost of rising India-China tensions," June 1, 2020. 4 See Nayanima Basu, "India Isn’t Worried About Tension With China, Unlikely To Give In To US Pressure On Taiwan," May 13, 2020. 5 See Ren Feng and He Penglei, "PLA Xizang Military Command holds coordinated exercise in plateau region," China Military Online, June 15, 2020. See also "空降兵某旅积极探索远程兵力投送新模式 空地同步 奔赴高原". 6 The reason escalation is normally limited is because of the extreme difficulty of operating extended military operations and resupply at 13,000-feet altitude. Both sides have the ability to surge reinforcements and equalize the contest. The cost and difficulty of retaking lost territory is often prohibitive. And while India’s conventional military power may overbalance China in this region, China has the uphill advantage and has made leaps and bounds in operational capabilities in recent decades. In short, escalation is normally controllable. See Aidan Milliff, "Tension High, Altitude Higher: Logistical And Physiological Constraints On The Indo-Chinese Border," War On The Rocks, June 8, 2020.
Highlights China is taking advantage of global chaos to solidify its sphere of influence – beginning with Hong Kong. The crisis is also motivating the European Union to link arms more tightly through a symbolic step toward fiscal solidarity and transfers. US, Chinese, and European stimulus measures are cyclically positive but near-term risks abound. Hiccups in stimulus rollout are to be expected – and China’s disappointing stimulus thus far may cause market turmoil before policymakers do what we expect and add greater oomph. US-China relations are breaking down as we outlined, as renminbi depreciation coincides with Trump approval depreciation. The risks of the UK failing to agree to a trade deal with the EU are higher than prior to COVID-19. Stay defensive tactically – the risk-on rally is not yet confirmed by major reflation indicators yet geopolitical risks are spiking. Feature Chart 1Will Geopolitics Stunt The Early Bull's Growth? After wavering at the 2,900 level, the S&P 500 broke above 3,000. As we go to press, it is holding the line, despite a surge in geopolitical risk emanating from the efforts of the Great Powers to consolidate their spheres of influence at the expense of globalization. Key cyclical indicators are on the verge of breaking out. Our “China Play Index,” which consists of the Australian dollar, Swedish equities, Brazilian equities, and iron ore prices, is reviving smartly. The copper-to-gold ratio, however, is not really confirming the rally (Chart 1). Nor are Asian currencies. We recommend a tactically defensive stance. We are not dogmatic, but are not convinced that the rally will overcome near-term risks. We expect explosive political and geopolitical events throughout the summer. Near-Term Geopolitical Risks To The Rally Our reasons for near-term caution are as follows: Global stimulus hiccups: China’s National People’s Congress over the weekend disappointed expectations on the size of economic stimulus. This is a short-term risk, we argue below, but nevertheless a risk. The US Congress may not pass stimulus until July 2 and the final law will fall short of the House bill of $3 trillion. The European “Next Generation EU” recovery fund is only 750 billion euros in size and may not be agreed until July, or even September if the financial market does not impose urgency. We elaborate below. Ultimately policymakers will keep doing “whatever it takes” but there will be hiccups first and they will trouble the market in the near term (Chart 2). Chart 2Stimulus Tsunami Will Peak This Summer Sino-American conflict: The “phase one” trade deal was never going to bring durable comfort to markets about US-China cooperation, and the outbreak of COVID-19 prompted our March 13 argument that US-China tensions would erupt sooner than we thought. So far the market is grinding higher despite the materialization of this risk. Mega-stimulus and the equity rally enable the US and China to clash. At some point escalation will upset the market. Domestic stimulus is substituting for a collapse in globalization and risk markets are cheering. But increased domestic support will enable political leaders to clash with each other and keep upping the ante. The higher the market goes the more willing President Trump will be to expend some ammunition on China and other political targets. But if you play with sticks, somebody always gets hurt. The market is betting that Trump is a typical US president, typically bashing China in an election year. We are arguing that he is atypical, that this is an atypical election year, and that China’s own ambition cannot be left out of the equation. Wild cards: Jokers, one-eyed jacks, suicidal kings, and aces are all wild in this deck. Emerging markets like Russia (Chart 3) – and rogue regimes like Iran – pose non-negligible risks of upsetting the global rebound this year. Chart 3ARussian Risk To Rise Further On Libya, US Tensions Chart 3BRussian Risk To Rise Further On Libya, US Tensions Chart 4Equity Investors Wise To Erdogan's Mischief Investors cannot focus on tail risks all the time, but not all geopolitical risks are tail risks. This is particularly the case because of the US election, which heightens Washington’s willingness to retaliate to any provocations. Geopolitics in the Mediterranean are verifiably unstable, particularly in Libya where Russia looks to make a major intervention yet Turkey is also involved (Chart 4). This affects North African and European security. Iran is under historic stress and will attempt to undermine the Trump administration as it has no downside to Democratic victory in November. In a recent event we hosted with the CFA Institute in India and Asia Pacific, only 4% of participants highlighted Russia and 2% Iran as a significant source of political risk this year, while 93% highlighted the US and China. Clearly the US-China competition is the great game. But other risks are underrated, especially Russia. Stimulus hiccups this summer are likely to be overcome in the US, EU, and China, so perhaps the market will look through this risk while economies reopen and leading indicators inevitably improve. US-China tensions could remain bound within Trump’s desire to keep the stock market up during his election campaign and China’s desire not to incur Trump’s unmitigated wrath if he happens to be reelected. Russian, Iranian, and emerging market risks, if they materialize, may have merely localized and ephemeral market effects. However, Trump’s falling approval rating and executive decree to open the social media companies to litigation supports our thesis that he is not enslaved by the stock market. The market is expecting “the Art of the Deal” to lead to positive outcomes but that assumption is not as reliable in a recessionary context as it is in an economic boom. The Atlanta Fed’s second quarter real GDP growth estimate stands at -40.4%. Any state that provokes the US over the next five months risks a massive or unpredictable retaliation. China will ultimately bring stimulus to 15.5% of GDP. Deflation and unemployment are a massive constraint. We do not mention the well-known risks of weak consumer activity and business investment amid the pandemic, which itself is expected to revive in the fall with no guarantee of a vaccine by then. Bottom Line: In the near term, maintain safe haven trades such as long Japanese yen, US Treasuries, and defensive equity sectors. China Stimulus Hiccups Won’t Last, But Will Sow Doubt The most important question in China is the implication of the National People’s Congress with regard to the size of stimulus. After the stimulus blowout of 2015-16, Xi Jinping consolidated power and launched a deleveraging campaign. His administration is determined to keep a lid on systemic risks, especially the money and credit bubble. Chart 5China's Stimulus Faces Doubts But Will Prove Huge In The End Beijing’s targets for central and local government spending disappointed market observers. In Chart 2 above, we revised Beijing’s fiscal stimulus from 11% of GDP to 4.3% of GDP as a result of lower-than-expected targets for local government special bonds and central government special treasury bonds, as well as a corrected calculation of the fiscal relief for small and-medium-sized enterprises. This 4.3% understates the real size of China’s stimulus because it includes only fiscal elements. Since the Communist Party and state bureaucracy control the banks and many large enterprises, one must also include credit growth – it is a quasi-fiscal factor. Total social financing (total private credit) is usually the biggest element of China’s periodic bouts of stimulus. While Chinese authorities showed restraint in their fiscal measures, they announced that credit growth would “significantly” exceed nominal GDP growth, which has collapsed due to the virus lockdowns. Our Emerging Markets Strategy estimates that credit growth will accelerate to 14% this year, making for an 11.2% of GDP increase in total credit, and a combined fiscal and credit impulse that will reach 15.5% of GDP (Chart 5). The dramatic global economic shock and the hit to China’s labor market ensure that additional stimulus will be applied as needed to plug the output gap. Soaring unemployment is a fundamental risk to social stability and hence to single-party rule. This means that the fiscal impulse will in the end likely exceed 4.3% as new measures are rolled out later this year. It also means that credit growth will surprise to the upside, as the regime loosens the reins on shadow banks as well as state-controlled lenders. Nevertheless, accepting our Emerging Market Strategy’s base case of 15.5% of GDP fiscal and credit impulse, we would note that China’s economy is much larger as a share of the global economy today than it was in previous rounds of stimulus. Thus while the stimulus may be smaller than that in 2008 as a proportion of China’s economy, it is larger as a proportion of the world’s (Table 1). China-linked asset prices, such as industrial metals, will see rising demand over time. Table 1China Fiscal+Credit Impulse Will Be Big Relative To World The Xi administration’s preference is not to overstimulate and exacerbate its problems of imbalanced growth, falling productivity, and excessive indebtedness. But its constraint is deflation, unemployment, and social instability. Insufficiently loose policy in the midst of a very deep global recession could prove to be the biggest policy mistake of all time. To refuse to loosen as needed, or to re-tighten policy too soon, would be to make a cruel joke out of the new policy slogan, “the Six Stabilities and Six Guarantees” and jeopardize Xi Jinping’s ability to reconsolidate power ahead of the twentieth National Party Congress in 2022. Rather the constraint will force policymakers to alter any hawkish preferences if growth looks to relapse. Bottom Line: Doubts about the sufficiency of China’s fiscal and monetary stimulus pose a near-term risk to global risk assets since investors face disappointing stimulus promises on the surface, combined with lack of certainty about Beijing’s willingness to increase stimulus going forward. We are confident that Beijing will ultimately do whatever it takes to stabilize employment and try to ensure social stability. But this implies near-term challenges and possibly a market riot prior to resolution. Before then, many market participants, including in China, will believe that the Xi Jinping administration will be hawkish and resistant to re-leveraging. China’s Sphere Of Influence Global geopolitical risk stems from the Xi Jinping regime at least as much as from the Donald Trump regime, as we have long pointed out. The scenario unfolding as we go to press is precisely the one we outlined back in March in which Beijing depreciates its currency to ease its economic woes while President Trump’s approval rating falls due to his own woes, prompting him to retaliate. The CNY-USD exchange rate is largely pricing out the phase one trade deal, which is marked by the peak in renminbi strength in Chart 6. Chart 6Phase One Trade Deal Priced Out Of Renminbi Already Chart 7China's Warning To Trump Could Scrap Trade Deal This depreciation is not merely the effect of market moves – though weakness in global and Asian trade and manufacturing certainly reinforce it. The People’s Bank of China’s fixing rate has been guiding the currency to its lowest point since 2008 amid the spike in US-China tensions over the past month (Chart 7). China says it will adhere to the phase one deal as long as it is mutual. It is buying more soybeans, cotton, pork, and beef from the United States relative to last year. Demand has collapsed. Unless China decides to dictate purchases as a subsidy to keep the agreement alive, its purchases will fall short of the huge expansion envisioned in the deal. US actions could nullify the deal anyway. President Trump and his Economic Director Larry Kudlow have both suggested that the administration no longer cares about maintaining the deal. China was fast becoming unpopular in the US and this trend has skyrocketed as a result of COVID-19. China’s other notable decision at the National People’s Congress was to state that it would impose a new national security law on Hong Kong SAR, after the autonomous financial center’s long reluctance to do so. Beijing has sought greater direct control of the city since early in Xi’s term, in contravention of the promise of 50 years of substantial autonomy enshrined in the Sino-British Joint Declaration of 1984. Beijing’s action comes after Hong Kong’s widespread civil unrest last year and ahead of the city’s Legislative Council elections in September, which will likely become a major geopolitical flashpoint. The United States is retaliating by removing Hong Kong’s designation as an autonomous region. This entails higher tariffs, tougher export controls, stricter visa requirements, and likely sanctions directed at mainland entities that will enforce the national security law in various ways, including eventually some Chinese banks. The US also accelerated sanctions against China for its civil rights abuses in Xinjiang – sanctions that target tech and security companies – and is moving forward with a bill to threaten Chinese companies that hold American Depository Receipts (ADRs) with delisting from American stock exchanges if they do not meet the same auditing requirements as other foreign companies. This potentially affects $1.8 trillion in market capitalization over a 3-4 year period. China’s power grab in Hong Kong initiates a market-negative Sino-American dynamic that will last all year. It cannot be assumed that Trump will accept Beijing’s implicit offer of swapping phase one trade deal implementation for China’s historic encroachment on Hong Kong’s autonomy. The imposition of legislative dependency on Hong Kong should not have been a surprise to investors given recent trends, but it was, as Hong Kong equities fell by 6% at first blush. There is more downside, judging by our China GeoRisk Indicator, which is in a clear uptrend for all of these reasons and correlates reasonably well with the Hang Seng index (Chart 8). Chart 8Hong Kong Equities Face More Downside From Geopolitics While the US will retaliate over Hong Kong, the question for global investors is whether the conflict spills over into the rest of China’s periphery. This would highlight the systemic nature of the geopolitical risk and make it harder for the market to swallow the new cold war. Our Taiwan Strait GeoRisk Indicator (Chart 9) is pricing zero political risk despite the clear risk that Beijing will eventually resort to economic sanctions to penalize the mainland-skeptic government there; that the US will seek to shore up the diplomatic and defense relationship in significant ways in what may be the final five months of the Trump administration; and that Taiwan may seek to draw the US into granting greater economic and security assurances. Chart 9Taiwan Equities Pricing ZERO Geopolitical Risk ... Huge Mispricing Our Korea GeoRisk Indicator (Chart 10) has also fallen drastically. This risk indicator deviates from Korean equities frequently due to North Korean risks, which equity investors tend (usually correctly) to ignore. This year is different, however, because Kim Jong Un’s decision whether to give Trump a diplomatic win, or frustrate him with the test of a nuclear device or intercontinental ballistic missile, actually has a bearing on Trump’s election odds and the pace of US-China escalation. If Kim humiliates Trump then we expect Trump to make a major show of force in the region that would draw China into a strategic standoff. Chart 10North Korea Is Relevant In 2020 Due To Trump China is attempting to solidify its sphere of influence, first in Hong Kong but later in Taiwan and the Korean peninsula. The United States is pushing back and the US election cycle combined with massive stimulus means that push will come to shove. Bottom Line: Investors should steer clear of Chinese, Taiwanese, and Korean currencies and risk assets in the near term. We recommend playing the cyclical China recovery via Korean equities over the long run. The European Sphere Of Influence The European Union is also attempting to strengthen and expand its sphere of influence – namely with steps in the direction of a fiscal union. Our GeoRisk Indicators are generally flagging a huge drop in political risk for Germany, France, Italy, and Spain (Charts 11A & 11B). The reason is that the economies have collapsed yet the equity market has bounded back on ECB quantitative easing and huge promises of fiscal support. In the coming months these risk indicators will rise even as economies reopen because the debate over fiscal and monetary policies is heating up. Our base case is that both the debate over EU recovery funds and the German constitutional court’s objections to QE will resolve in dovish compromises. Chart 11AEurope’s Not-Quite Hamiltonian Moment Chart 11BEurope’s Not-Quite Hamiltonian Moment At issue on the fiscal front is the EU Commission’s “Next Generation EU” recovery fund. Commission President Ursula von der Leyen is offering to create a 750 billion euro relief fund (500 billion in grants, 250 billion in loans). The decision is contentious because it would entail the EU Commission issuing bonds – essentially joint bonds among the EU states – to raise funds that would then be distributed through the EU Commission seven-year budget (2021-7). Joint issuance would be a symbolic step toward greater solidarity. This proposal began with an agreement between French President Emmanuel Macron and German Chancellor Angela Merkel to launch the 500 billion in grants. Merkel signaled earlier this year that she was prepared to accept joint bond issuance focused on the immediate crisis. When more fiscally hawkish or euroskeptic states objected that loans should be used instead of grants, von der Leyen simply added their proposal to the total, despite the fact that the ECB and European Stability Mechanism (ESM) already offer emergency loans to help states through the global crisis. The proposal marks a victory of the fiscally dovish Mediterranean states (once called “Club Med”) over the frugal Germans, with Macron prevailing on Merkel to foist yet another major compromise onto her conservative German power base in the name of European integration and solidarity before she exits the chancellorship in 2021. But it is not as if German elites like Merkel and von der Leyen are running amok: German public opinion is Europhile and supportive of bolder actions to share burdens, save the union, and shore up the continental economy. The market is not pricing any political risk in Taiwan despite clear dangers. Stay short Taiwanese equities. The recovery fund itself is limited in size, relative to overall stimulus actions thus far. But it would plug an important gap for states like Italy and Spain, which are constrained by large public debt loads and have not provided enough stimulus as yet. The “Frugal Four,” the Netherlands, Austria, Sweden, and Denmark, are leading the opposition to the use of grants rather than loans and any effort to establish a track leading to European fiscal union. But they are also willing to negotiate. Estonia and other nations are also objecting, with the eastern Europeans seeking to ensure that southern Europe does not take the lion’s share of the funds, while the core European states will use the funds to pressure populist and euroskeptic eastern states that have defied the European Court of Justice and other institutions (Chart 12). Chart 12Europe: Distribution Of ‘NextGen EU’ Fund A final decision may not be settled by the time of a special summit in July but some compromise should be expected by the fall or (latest) end of year. The proposal would do the very thing that its opponents resist: pave the way toward jointly issued bonds in future that do not have a time limit or a single purpose (today’s sole purpose being pandemic relief). Hence the negotiations will be intense and it will likely require a return of financial instability to bring them to a conclusion. The global financial crisis and its aftermath provoked a higher degree of integration among the EU member states despite the tendency of the mainstream media to assume that the dissonance between monetary and fiscal policy would create an unbridgeable rupture. COVID-19 is now supporting this pattern of Brussels not letting a good crisis go to waste. Chart 13Europe Fends Off Latest Doubts About Solidarity The reason is that the EU is a geopolitical project. As Russia revived, the US began to act unilaterally and unpredictably, and China emerged as a global heavyweight, European powers were forced to huddle together ever more tightly to create economies of scale and improve their security against various external and unconventional threats. Influential German Finance Minister Olaf Scholz has compared the new recovery fund to the work of American founding father Alexander Hamilton in mutualizing the early American states’ war debt so as to create a tighter fiscal union among the states. For that very reason the more Euroskeptic member states oppose the proposal – long rejecting the idea of a “United States of Europe.” Today’s proposals are more symbolic, less substantial, than Hamilton’s famous Compromise of 1790. Nevertheless we would not underrate them as they highlight the way the European states continually turn crisis moments that worry the markets about European break-up into new opportunities to combine more closely. As such it is fitting that the European break-up risk premium has fallen, signifying a drop in peripheral bond spreads (Chart 13). The battle over debt mutualization is not over yet so spreads could widen again, but the trend will be down as the bloc develops new tools to combat the latest crisis. The United Kingdom obviously marks a major exception to this reinforcement of the European sphere of influence. The Brits are historically and geopolitically opposed to a unified continental political power. Having decided to leave, they lack the ability to obstruct from within. But they are also not necessarily more likely to yield in their trade negotiations. British political risks are understandably low because Prime Minister Boris Johnson and his Conservative Party won a strong mandate in December and technically do not have to face voters again until 2024. The major limitation on a “no trade deal” outcome in talks with Brussels was a recession – yet that has already occurred. London could ultimately bite the bullet and accept that outcome if the trade talks turn acrimonious. The GBP/EUR is not pricing a full “no deal” exit. Stimulus and economic recovery suggest that it is a good time to go long sterling but we will pass on this trade in the short run due to resilient dollar strength and the reduced barrier to exiting without a trade deal (Charts 14A & 14B). Chart 14ABrexit Trade Talks Not Globally Relevant Chart 14BBrexit Trade Talks Not Globally Relevant Bottom Line: We do not yet recommend reinstituting our long EUR/USD trade, which we initiated late last year as part of our annual forecast. The COVID-19 crisis has created such a spike in geopolitical and political risk that we expect the US dollar to remain surprisingly strong throughout the coming months and for US equities to outperform global equities beyond expectation. Nevertheless we will look to reinitiate this long-term trade at an appropriate time, as it fits squarely with our “European Integration” theme since 2012. Investment Takeaways Our contention that “geopolitics is the next shoe to drop” has materialized. This has negative near-term implications for global risk assets. However, thus far, market positives have outweighed negatives for global investors faced with the reopening of economies and wartime-magnitude fiscal and monetary stimulus. Buying risky assets makes sense for investors with a long-term investment horizon – and we recommend cyclical plays like commodities, corporate bonds, infrastructure stocks, and defense stocks in our strategic portfolio. We also recognize that if key cyclical and reflation indicators break out from here, then a cyclical bull market could take shape. Yet our analytical framework reveals that recession and mega-stimulus have diminished the financial and economic constraints that would normally deter geopolitical actors from ambitious actions on the international stage. Most notably, the US election dynamic has turned upside-down. President Trump is the underdog and will need to develop a reelection bid that does not hinge on the economy. Doubling down on “America First” foreign policy and trade policy makes the most sense and the ramifications are negative for the markets over the next five months. This is the key dynamic that makes US-China, US-North Korea, US-Russia, and US-Iran tensions more market-relevant than they would otherwise be. It also will dampen an otherwise positive story for the euro, in the short run. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Section II: Appendix : GeoRisk Indicator China: Russia: UK: Germany: France: Italy: Canada: Spain: Taiwan: Korea: Turkey: Brazil: Section III: Geopolitical Calendar
Highlights Global stimulus efforts are sufficient thus far, but more will need to be done, especially by Europe and emerging markets. Hiccups will not be well-received by financial markets. The net public wealth of countries helps put debt constraints into perspective in a world of zero and negative interest rates. Insufficient fiscal policy is a bigger risk for Europe in the near term than any Germany-mandated withdrawal of ECB quantitative easing. European states remain locked in a geopolitical predicament that prevents them from abandoning each other despite serious differences over fiscal policy, which will persist. We are tactically long defensive plays and safe havens. Stay long JPY-EUR. Feature This week we focus on two questions: Will global stimulus be enough to fill the gap in demand? And will Germany impose a hard limit on European stimulus efforts? Our answers are yes to the first and no to the second. It is impossible for governments to replace private activity indefinitely, but the resumption of private activity is inevitable one way or another. Governments are continuing to provide massive fiscal and monetary support. The near term is cloudy, however, due to the mismatch between uncertain economic reopening and increasing impediments to new stimulus. Weak spots in the global fiscal stimulus efforts arise in Europe and emerging markets excluding China. Europe, at least, is a temporary catch – as Germany has no choice but to help the rest of the EU prop up aggregate demand. But fiscal policy is a greater near-term risk to peripheral European assets than any cessation of monetary support from the ECB. Will Global Stimulus Be Enough? Yes, Eventually Chart 1 shows the latest update of our global fiscal stimulus chart comparing the size of today’s stimulus to the 2008-10 period. Countries that make up 92% of global GDP are providing about 8% of global GDP in fiscal stimulus. Full calculations can be found in the Appendix. Chart 1US Still Leads In Fiscal Stimulus The chief difference between our calculation and that of others is that we include government loans while excluding government loan guarantees. If a government gives a loan to a business or household, funds are transferred to the receiver’s deposits and can be spent to make necessary purchases or pay fixed costs. A loan guarantee, by contrast, is helpful but does not involve a transfer of funds. Our colleague Jonathan LaBerge, has recently written a Special Report analyzing the size of global fiscal stimulus. He provides an alternative calculation in Chart 2, which focuses on “above the line” measures, i.e. only measures affecting government revenues and expenditures. Government loans, guarantees, and other “below the line” measures are left aside in this conservative definition of stimulus. Chart 2Japan Leads In IMF “Above The Line” Account Of Stimulus Chart 3 shows the discrepancies between Jonathan’s version and our own – they are not very large. The major differences are Japan, China, Germany, Italy, and South Africa. Of these only Germany, Japan, and China are significant.1 Chart 3Geopolitical Strategy Estimates Accord Less Stimulus To Japan, More To Germany And China, Than IMF Does In Japan’s case, we include the stimulus measures that Japan passed at the end of 2019 because even though they were not passed in response to the pandemic, they will take affect at the same time as those that were. We do not include private sector complements to government action, which Japan includes in its account, since private responses are hard to predict and we do not include them for other countries. In China’s case, official estimates underrate the easing of credit policy. Credit is a quasi-fiscal function in China since the Communist Party controls the banks. With a large credit expansion the overall stimulus impact will be larger than expected, as long as borrowers still want to borrow. Data thus far this year suggests that they do, if only to cover expenses and debt payments. Our assessment that China’s stimulus will reach about 10% of GDP follows BCA Research’s China Investment Strategy. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts … Is global stimulus “enough” to plug the gap in demand? Chart 4 shows our colleague Jonathan’s narrower definition of stimulus compared with estimates of the drop in demand from social lockdowns and spillover effects. It assumes a fiscal multiplier of 1.1. The result suggests that the US, China, and Australia are clearly doing enough; Germany, Japan, and Canada are arguably doing enough; other countries including Italy, France, and Spain will likely have to do more. Chart 4Which Countries Have Plugged The Gap In Demand So Far? The latest news confirms this assessment. The US Congress is negotiating another phase of stimulus that will provide a second round of direct payments to households, a third infusion of small business loans, and a large bailout of state and local governments. The current total is $2 trillion, and so far this year these totals are only revised upward. This tendency stems from the political setup: Trump needs to stimulate for the election, GOP senators’ fates ultimately hinge on Trump, while the House Democrats cannot withhold stimulus merely to undermine the Republicans. Similarly, there can be little doubt that China and Japan will provide more stimulus to maintain full employment – their different political systems have always demanded it. We are more concerned about Europe. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts, with the last three ranging from 2%-4% of GDP, according to Chart 4 above. They will add more stimulus, but might they still fall short of what is needed? Assuming that the ECB will provide adequate liquidity, and that low bond yields for a long time will enable debts to be serviced, these countries can service their debts for some time. But what then is the constraint? From a long-term point of view, the UK and peripheral European nations have relatively fewer national assets to weigh against their well-known liabilities. They are closer to their constraints in issuing debt, even if those constraints are nearly impossible to establish and years away from being hit. This is apparent from the IMF’s data series on net public wealth, i.e. total public sector assets and liabilities (Chart 5A). These data, from 2016, are a bit stale, but they are still useful because they take account of assets like natural resources, real estate, state-owned companies, and pension plans that retain value over the long run. It does no good to refer to the large debt loads of countries without considering the vast holdings that they command. By the same token, at some point the debt loads look formidable even relative to these huge realms. Chart 5ANet Public Wealth: A Fuller Picture Of The Debt Story These data tend to underrate the sustainability of developed markets, which are highly indebted but have reserve currencies, safe haven status, and large, liquid credit markets. They overrate the sustainability of emerging markets, with large resource wealth and low-debt, but vulnerable currencies and credit markets. This is not only true for emerging markets with the most negative net worth, like Brazil, or with unsustainable fiscal policies, like Turkey and South Africa. China would look a lot worse in net public wealth, if this could be calculated, than it does on the general government ledger (Chart 5B), due to the liabilities of its state-owned enterprises and local governments. It would look more like the US or Japan in net public wealth – yet without a reserve currency. Chart 5BNet Government Debt: Flatters EM, Not DM Nevertheless the European states have a problem that the other developed markets do not have: the Euro Area’s “constitutional” order is still unsettled. Questions are continually arising about whether countries’ liabilities are backstopped by a single currency authority and the entire assets of the Euro Area. These questions will tend to be settled in favor of European integration. But treaty battles in the context of upcoming elections – in the Netherlands, Germany, France, and likely Italy and Spain – will provide persistent volatility. Bottom Line: Fiscal stimulus passed thus far is only “sufficient” in a few economies; it is insufficient in southern Europe and emerging markets. Uncertainty about the pandemic, and the pace of economic reopening and normalization, combined with any hiccups in providing adequate stimulus will create near-term volatility. Will Germany Halt Quantitative Easing? No, Not Ultimately The questions about Europe highlighted above have come to the fore with the reemergence of the “German question,” which in today’s context means Germany’s and northern Europe’s willingness to conduct fiscal policy to help rebalance the Euro Area and monetary policy to ease conditions for heavily indebted, low productivity southern Europe. We have little doubt that Germany will provide more than its current 10.3% of GDP fiscal stimulus given that it has explicitly stated that state lender KfW has no limit on the amount of loans it can provide to small businesses. This accounts for the difference between our fiscal stimulus estimate and the IMF’s, but the fullest count, including “below the line” measures, would amount to nearly 35% of GDP. A sea change in the German attitude toward fiscal policy has occurred, which we have tracked in reports over the years. This shift gives permission for other European states to loosen their belts as well. We also have little doubt that German leaders will ultimately accept the ECB’s need to take desperate measures to backstop the European financial system: The “dirty little secret” of the Euro Area is that debt is already mutualized through the Target 2 banking imbalance, worth 1.5 trillion euros (Chart 6). As our Chief European Investment Strategist Dhaval Joshi has argued, Germany, as the largest shareholder in the ECB, holds a large quantity of Italian bonds, and Italians have deposited the proceeds of these bond purchases in German banks. All of this is denominated in euros. If Italy redenominates into lira, it can make bond payments in lira and the ECB and Germany will suffer capital losses. Germany would then face Italians withdrawing their deposits from German banks that would still be denominated in euros (or the deutschmark). The cause of this predicament is the ECB’s quantitative easing program (Chart 7). Chart 6Europe’s Gordian Knot Thus Chancellor Angela Merkel’s shift in tone to become more supportive of joint debt issuance belies the fact that European debt is already mutualized through the Gordian knot of Target2 imbalances. This is a politically unpalatable reality for Germans, but they generally accept it because it is in Germany’s national interest to maintain the monetary union and broader European integration. Chart 7Quantitative Easing Puts Germans On Hook For Italy However, the market may need reassurances about “the German question” from time to time, as EU institutional evolution is ongoing. Financial markets did not sell off on the German court’s ruling on May 5, which ostensibly gave the Bundesbank three months before withdrawing from the ECB’s quantitative easing program. Since the sovereign debt crisis, investors have come to recognize that there is more undergirding European integration than mere German preference. Namely, geopolitics – which we have outlined many times, originally in a 2011 Special Report. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. Still, there will be more consequences from this week’s ruling. At issue is the budgetary sovereignty of the European member states as well as Article 123 of the Treaty of Europe, which holds that neither the ECB nor the national central banks of member states can directly purchase public debts. The latter is a prohibition on the monetary financing of deficits. It became controversial in the wake of Mario Draghi’s 2012 declaration that the ECB would do “whatever it takes” to preserve the euro and the ECB’s 2015 Public Sector Purchase Program (PSPP) quantitative easing program, which the European Court of Justice deemed legal on December 11, 2018. The controversy is now implicitly shifting to the new Pandemic Emergency Purchase Program. The other principle concerned is that of “proportionality,” which requires that EU entities not take actions beyond what is necessary to achieve treaty objectives. If the ECB acted without regard to the limits of its mandate, the fiscal supremacy of the states, and the broader economic and fiscal consequences of QE, then its actions would violate the principle of proportionality and would require adjustment by EU authorities or non-participation from member state authorities. The German court did not attempt to overrule or invalidate the European court’s decision in favor of QE, or QE as a whole. Rather, it held that this ruling was not “comprehensible,” hence requiring an independent German ruling, and that the larger question of whether QE violates the prohibition against debt monetization is “not ascertainable.” The reason is that the ECB did not explain its actions adequately and the European Court of Justice did not demand an explanation. Presumably once this is done more decisive determinations can be made. Essentially the German court is demanding “documentation” by the ECB Governing Council that it weighed its monetary decisions against larger economic and fiscal consequences. So will the Bundesbank withdraw from the ECB’s QE operations in three months? Highly unlikely! The ECB, whether directly or indirectly, will provide an assessment of the proportionality of its actions to the Bundesbank and the German court will probably conclude, with limitations, that the ECB’s actions were largely within its mandate. If not, however, markets will plunge. Then the Bundestag or the Bundesbank will have to intervene to ensure that Germany does not in fact withdraw support from the ECB. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. How can we be sure? German opinion. Chancellor Merkel and her ruling Christian Democrats have not suffered this year so far from launching a wartime fiscal expansion and backing the ECB and EU institutions in their emergency actions. On the contrary, they have received one of the biggest bounces in popular opinion polls of any western leaders over the course of the global pandemic. While the bounce will deflate once the acute crisis subsides, this polling signals more than the average rally around the flag (Chart 8). Merkel’s approval rating started to rise when her party embraced more expansive fiscal policy in late 2019 in reaction to malaise revealed in the 2017 election. Germany’s handling of today’s crisis, both the pandemic and the expansive fiscal policy, has put the ruling party in the lead for the 2021 elections (Chart 9). Chart 8Germans See Popular Opinion ‘Bounce’ Amid COVID Chart 9Merkel's CDU Revives Amid Global Crisis Chart 10Germans Support Euro, But Lean On ECB Moreover Germans are enthusiastically in support of the euro and the EU relative to their peers – which makes sense because Germany has been the greatest beneficiary of European integration (Chart 10). The ECB, by contrast, does not have strong support – and is losing altitude. But a crisis provoked by the court and centered on the ECB would quickly become a crisis about the euro and European project as a whole. Opinion has broken in this direction despite Merkel’s and Germany’s many compromises over the years. Remember that Merkel’s capitulation to the Mediterranean states on the European Council in June 2011, which paved the way for Draghi’s famous dictum, was initially seen as a failure by her to defend German interests. Merkel and her party have also recovered from the hit they took when she insisted that Germany take in a huge influx of Syrian refugees in 2015. German popular opinion is relevant when discussing the judicial system and rule of law. No court can ignore popular opinion entirely, no matter how independent and austere, because every court ultimately needs public opinion to maintain its credibility. The European Court’s decision is final, as long as Germany remains committed to the EU. Yet German sovereignty still gives German institutions a say. If the German court persists in attempting to block Bundesbank participation in QE, the result will be a bond market riot that pushes up peripheral debt funding costs. This would eventually risk forcing peripheral states out of the Euro Area, which is against German interests. It is very unlikely things will go so far. Rather, the court will back down after receiving due attention and having its legitimate concerns addressed. The imperatives of European integration are as powerful today as they were in 2011. True, other court challenges will open up against the ECB, particularly the PEPP. But bear in mind that it will be even easier to show that ECB actions are proportional – that broader economic consequences have been weighed – in the case of the pandemic relief emergency than with respect to PSPP prior to COVID. Today it is households and small businesses that need protection from an act of God, not banks and bureaucracies that need protection from the consequences of their excesses. As for the size and duration of QE, the court will try to force some limitations to be acknowledged given the risk to fiscal sovereignty. In this sense, the ECB faces a new constraint, albeit one that we doubt will prove relevant in the near term. Ultimately, the consequence of imposing some limits on central bank policy is to restore authority to member state budgets and European fiscal coordination. In the short term, emergency provision can be provided via the European Stability Mechanism (ESM), whose lending conditions can be relaxed, and by the ECB’s Outright Monetary Transactions (OMT), which can buy bonds amid a market riot. But beyond the immediate crisis the clash over fiscal policy will persist because at some point countries will have to climb down from their extraordinary stimulus and the attempt to restore limits will be contentious. Germany has already made a huge shift in a more fiscally accommodative direction. Italy, Spain, and France are currently not providing enough, but they will add more. Future governments might demand more than even today’s more dovish Germany is willing to accept. Down the road, if these states do not provide more stimulus, then their recoveries will be weaker and political malaise will get worse. An anti-establishment outcome is already likely in Italy in the coming year or two, due to the ability of the League to capitalize on post-COVID voter anger. The big question after that is France in 2022. Macron’s approval rating is holding up, we expect him to win, but his bounce amid the pandemic is not remarkable. From our point of view the peripheral states have a license to spend, so spend they will. But then fiscal conflicts will revive later. Bottom Line: The German constitutional court is not going to try to force the Bundesbank to withdraw from QE, but it is attempting to lay a foundation for the imposition of at least some limits on this policy. The risk to European assets in the short run is not on the monetary side but the fiscal side. Over the long run, the “German question” will never be settled. But the imperatives of European integration are as powerful today as they were in 2011. Each new crisis exposes the weakness of the peripheral states, their need for European institutions. It also exposes Germany’s need to accommodate them when they form a united front. Investment Takeaways Financial markets have no clarity on economic reopening in the face of the virus or how governments will respond to resurgent outbreaks or a second wave in the fall. Taking into consideration the initial shock of the lockdowns plus spillover effects, the cumulative impact to annual GDP rises to 6%-8% by the end of this year for major economies. If another lockdown occurs, the level of GDP would be 10-12% lower at the end of the year depending on the region. This bare risk suggests that global equities face a relapse in the near term. Eventually economic reopening will proceed, as the working age population will demand it. But the path between here and there is rocky and any hiccups in providing stimulus will create even more volatility. Globally, we continue to argue that political and geopolitical risks are rising across the board as the pandemic and recession evolve into a struggle among nations to maintain security amid vulnerabilities and distract from their problems at home. Rumors that China is about to declare an air defense identification zone (ADIZ) in the South China Sea are unverified but we have long expected this to occur and tensions and at least some saber-rattling would ensue. We also expect the US to surprise the market with punitive tech and trade measures against China in the near term and to upgrade relations with Taiwan. We remain long JPY-EUR on a tactical 0-3 month horizon. We are converting our tactical long S&P consumer staples, which is up 6%, to a relative trade against the broad market. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Appendix Table 1The Global Fiscal Stimulus Response To COVID-19 Footnotes 1 In the case of Italy, we assume that parliament will pass the latest proposed increase in stimulus from 1.4% to 3.1% of GDP. In the case of South Africa, we expect the IMF to include these measures soon. Germany is discussed below.
Highlights Kim Jong Un’s sickness or death is a matter of speculation and it is best to remain skeptical for now. If Kim dies or is incapacitated, it is a serious concern for North Korean and hence regional stability – and not only in the medium and long term. A North Korean power vacuum could trigger a major relapse in US-China relations. Even if Kim is healthy, his negotiations with President Trump could affect US-China relations or Trump’s reelection chances this year. US-China tensions could also break down separately this year – watch for yuan depreciation or for Trump to lose public approval. The South China Sea and Taiwan Strait are also non-negligible risks that could derail US-China relations before the US election. Feature If North Korean leader Kim Jong Un dies, it is a risk to global stability. We have no insight on Kim’s health or whereabouts but we do know that North Korea is relevant to global investors – it is no longer a joke – because US-China relations are no longer stable. Korean political risk has been on an uptrend since the second summit between Kim and President Trump in Hanoi, Vietnam was cut short without any agreement (Chart 1). Chart 1Korean Political Risk Already On An Uptrend Due To Pandemic, Recession, US-China Tensions A dispute over North Korea could trigger a relapse in US-China relations that threatens the global equity rebound. Remain Skeptical As we go to press it is still unknown whether Kim is sick, well, living, or dying. What is known is that Kim failed to make a public appearance on Kim Il Sung Day, April 15, a noteworthy absence. China has sent a group of officials from the Communist Party’s Liaison Department, including medical doctors, according to Reuters – the most objective sign yet that something in North Korea has gone amiss. Japan’s Shukan Gendai on April 26 quoted an unnamed Chinese official saying that Kim was in a “vegetative state” after having stents put in his arteries after a heart attack. This corroborates (or repeats) the story that originally broke in South Korean newspaper Daily NK on April 21, saying that Kim was in grave condition after complications from heart surgery. Neither the Daily NK nor the Shukan Gendai are premium papers and the Daily NK also had to correct its original story which it attributed to “multiple” North Korean sources when in fact it only had one source. The US think tank 38 North on April 26 identified Kim’s elite passenger train at Wonsan but neither 38 North nor Reuters can confirm that Kim is actually in Wonsan. Kim was last seen in public on April 11 in Pyongyang, the day before Kim’s alleged surgery on April 12, but North Korean state press has reported on him conducting a range of activities since that date, albeit without video footage or anything that would disprove his incapacity. South Korean officials at the highest levels have repeatedly denied that they have intelligence of anything “special” happening in North Korea. South Korean assets are untroubled by the rumors (Chart 2). US President Donald Trump, and Pentagon officials, have also cast doubt on rumors that Kim is sick or dying – although various White House officials and Senator Lindsey Graham of South Carolina have implied something is wrong. Frequently it occurs that a temporary absence of autocratic leaders like Kim or Chinese President Xi Jinping causes the global media to speculate about illness, death, or intrigue. The lack of transparency of such regimes gives rise to a cottage industry of political watchers who interpret a leader’s every movement. Usually these rumor cycles amount to nothing. Absence of evidence (a leader’s failure to appear at an event) is not evidence of absence (the leader’s death). Still, the longer North Korea goes without offering definitive proof that Kim is alive, the greater the concerns will mount. One thing that we find unusual is the positioning of Kim’s sister, Kim Yo Jong. Kim Yo Jong was removed from the Politburo of the Korean Worker’s Party shortly after the failed Hanoi summit last year. She was reinstated as an alternate member on April 11 this year, in what was probably Kim Jong Un’s last credible public appearance. This gave rise to a surge of interest in her as a rising star, reflected in Google searches on April 12. These searches have spiked much more dramatically now that Kim Jong Un’s health is in question (Chart 3). Chart 2Korean Assets Not Responding Much To Kim Rumors Chart 3Why Was Kim Yo-Jong Rehabilitated Just Before Kim’s Alleged Surgery? The timing of her reinstatement, promptly followed by rumors about Kim’s health, is strange. North Korea’s political legitimacy is based on the Kim family dynasty. Her political recovery and promotion would be necessary to prepare her for any heightened role in the event of Kim’s incapacity or death. The purpose of the Politburo meeting was apparently to address the COVID-19 pandemic and delay a meeting of the legislature, the Supreme People’s Assembly. While rumors have focused on Kim’s cardiac event, we would not rule out the possibility that he has contracted COVID-19. Global leaders certainly are not immune to the disease, as evidenced by UK Prime Minister Boris Johnson. Reports also cite Kim's past periods of illness in 2012-14, although it is doubtful that his previous troubles with gout have any connection to a heart attack this month. What Is At Stake If Kim Exits The Scene For investors, the important thing to recognize is that North Korea is no longer irrelevant, no longer a geopolitical “red herring,” as we outlined in a series of reports in 2016 and 2017. Rather it is a critical moving part in a growing strategic conflict between the US and China. North Korea is a nuclear-armed state and a personalized autocracy with no clear succession plan, a stability risk on China’s border, and a national security risk to the United States and its allies Japan and South Korea. Pyongyang is in the midst of a multi-year, high-stakes diplomatic negotiation with its Northeast Asian neighbors and the United States. Diplomacy has not, thus far, gone off the rails. While Pyongyang has pushed the envelope with minor nuclear and missile activities, and by contesting Trump’s claims of exchanging letters, it has not abandoned negotiations with President Trump since 2017 by testing nuclear devices or intercontinental ballistic missiles, or by threatening to attack the US. South Korea’s legislative election on April 15 reinforced the leadership of President Moon Jae In and his left-leaning Democratic Party, marking a rebound for Moon due to his handling of the pandemic. This marks a boost to his “Moonshine” policy of diplomacy and economic integration with the North, another factor conducive to the continuation of diplomacy (Chart 4). However, any instability now would occur at a time of extreme vulnerability both within North Korea and abroad. North Korean growth is already facing a historic downturn unlike anything since the collapse of the Soviet Union (Chart 5). Chart 4Peaceniks Still Winning In South Korea Chart 5North Korean Instability Is Likely Regardless Of Kim's Health President Trump’s policy of “maximum pressure” sanctions has the North’s economy in a vise (Chart 6). For the past few years China has enforced sanctions on the North to cooperate with the United States. Beijing has reduced fuel exports and coal imports, according to official statistics (Chart 7). Chart 6Sanctions Have Damaged The Regime Chart 7China's Sanctions Enforcement Is Critical Even if China were not enforcing sanctions, North Korea’s economic conditions would be drastically deteriorating due to the COVID-19 pandemic, which has pushed China into what may well be the first recession since the 1970s (Chart 8). Thus if North Korea does end up having a leadership problem, investors should not assume that the regime will remain stable, in the near, medium, or long term. A power struggle broke out in China immediately upon Chairman Mao’s death in 1976. And when Kim Jong Un took power in December 2011, he struggled to consolidate power over the party, state, and military at first. He notoriously executed his uncle in December 2013 amid these internal struggles, which may have involved insubordinate military actions. His older brother Kim Jong Chol, or his sister Kim Yo Jong, would have more trouble consolidating power given that they were not Kim Jong Il’s choice for successor and would enter the supreme office in an extremely unstable time both at home and abroad. A succession process could also lead to external risks relatively quickly. North Korea’s historic surprise attack on the South Korean corvette, the Chonan, occurred in March 2010. Kim Jong Il was known to be preparing for his exit and for Kim Jong Un’s succession, so the regime sought to demonstrate strength while the world was distracted with a global financial crisis. If US-China relations were stable, there would be at least one substantial basis for believing that a North Korean crisis could be prevented from causing a crisis in other foreign relations. But US-China relations are not stable – they have deteriorated since the global financial crisis, as symbolized here by China’s diversifying away from US treasury holdings (Chart 9). The average US tariff rate on Chinese imports has risen from 5% to 15% under President Trump, who is threatening to impose additional punitive measures on China, such as export controls, as the two sides quarrel over the pandemic and recession. Chart 8Chinese Slowdown A Threat To Pyongyang President Trump’s signature foreign policy initiative – as opposed to trade initiative – has consisted of negotiations with North Korea over denuclearization and eventual peace. If these negotiations fall apart, President Trump will suffer in a substantial way that will at least marginally harm his reelection chances on November 3. Chart 9US-China Relations Fundamentally Unstable If the negotiations result in a “magnificent” deal this year, they could help those chances. Negotiations could face a test before that time, if either side abandons negotiations or gets cold feet before agreeing to a deal. Chart 10Brinkmanship Results In US Shows Of Force Testing periods in the current relationship involve shows of US military strength, as in the summer of “fire and fury” in 2017, and as the US also showed in a similar summer of fire and fury with Iran in 2019 (Chart 10). Shows of force typically are a source of passing volatility, at best, in global financial markets. But in this year’s context the risk of broader US-China strategic competition would amplify that impact, even if it is transient. Investment Takeaways For global investors, what matters is if a North Korean crisis destabilizes the region and if US-China relations destabilize for this or any other reason. If Kim dies, we expect instability to ensue in North Korea eventually, if not immediately, and this would entail some degree of instability among the major powers. The US and China would seek to shape the outcome on the peninsula – China has already sent a team of officials. Washington and Beijing have a shared interest in preventing regime collapse, but they have a high level of distrust and different aims for the regime that might emerge in the aftermath. Tensions would get extremely high amid a power vacuum in North Korea. To gauge the durability of the US-China détente, the phase one trade deal signed in January, we are monitoring the CNY-USD exchange rate and President Trump’s approval rating (Chart 11). Renminbi depreciation is possible to ease pressure on China’s weak economy, but it would break the deal entirely, given that most other elements of the deal are either interrupted by the recession (goods purchases) or unverifiable (intellectual property protections). Chart 11Yuan Depreciation Or Falling Trump Approval Threaten Global Equities Meanwhile President Trump only has an incentive to refrain from punitive measures as long as he believes his economy and election chances are salvageable. If this changes, and he is stuck in the 42% approval range or below, he may become a “lame duck” and attempt to turn the tables. Aggressive scapegoating of China, which has attracted widespread American disfavor, is a possible tactic for him to outmaneuver his rival, former Vice President Joe Biden, who is allegedly soft on China. We have long argued that US-China tensions would spill over to strategic disputes in China’s periphery and cause a higher risk-premium in global equities and risk assets exposed to this relationship. The current fragile environment of pandemic and recession makes a risk-off more likely by rendering both the US and China more vulnerable. We have held that the Taiwan Strait was more likely than the Korean peninsula to be the site of a crisis this year, but Kim Jong Un’s death would change that calculation. Two final points. First, North Korea has a long and distinguished history of feigning weakness in order to get foreign aid. If the great powers think it is on the verge of collapse then they will offer aid and possibly sanctions relief. With the pandemic and recession, we could eventually learn that Kim is alive and well, but that North Korea wants assistance with the pandemic. As outlined above, it is still possible that Kim’s health is fine, and yet that a failure of diplomacy with President Trump results in significant saber-rattling this year. Second, all of the above demonstrates the seriousness of geopolitical risk in East Asia stemming from US-China competition. Distrust is growing on a secular level and is seeing a near-term spike due to COVID and the US election. As a consequence, we take any North Korean instability seriously. But we also see potential for conflicts to emerge in the Taiwan Strait or the South China Sea, where a standoff between China, its rival territorial claimants, and the US is already underway. We remain tactically defensive and continue to recommend the Japanese yen as a hedge. We are adding JPY-EUR to this mix. On a longer-term horizon we recommend investors remain long selective international equities and commodities. For now we remain overweight Korean equities relative to Taiwanese, but we will close this trade on any confirmation that Kim is dead or incapacitated. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com
Highlights The collapse in oil prices supercharges the geopolitical risks stemming from the global pandemic and recession. Low oil prices should discourage petro-states from waging war, but Iran may be an important exception. Russian instability is one of the most important secular geopolitical consequences of this year’s crisis. President Trump’s precarious status this election year raises the possibility of provocations or reactions on his part. Europe faces instability on its eastern and southern borders in coming years, but integration rather than breakup is the response. Over a strategic time frame, go long AAA-rated municipal bonds, cyber security stocks, infrastructure stocks, and China reflation plays. Feature Chart 1Someone Took Physical Delivery! Oil markets melted this week. Oil volatility measured by the Crude Oil ETF Volatility Index surpassed 300% as WTI futures for May 2020 delivery fell into a black hole, bottoming at -$40.40 per barrel (Chart 1). Our own long Brent trade, initiated on 27 March 2020 at $24.92 per barrel, is down 17.9% as we go to press. Strategically we are putting cash to work acquiring risk assets and we remain long Brent. The forward curve implies that prices will rise to $35 and $31 per barrel for Brent and WTI by April 2021. We initiated this trade because we assessed that: The US and EU would gradually reopen their economies (they are doing so). Oil production would be destroyed (more on this below). Russia and Saudi Arabia would agree to production cuts (they did). Monetary and fiscal stimulus would take effect (the tsunami of stimulus is still growing). Global demand would start the long process of recovery (no turn yet, unknown timing). On a shorter time horizon, we are defensively positioned but things are starting to look up on COVID-19 – New York Governor Andrew Cuomo has released results of a study showing that 15% of New Yorkers have antibodies, implying a death rate of only 0.5%. The US dollar and global policy uncertainty may be peaking as we go to press (Chart 2). However, second-order effects still pose risks that keep us wary. Chart 2Dollar And Policy Uncertainty Roaring Geopolitics is the “next shoe to drop” – and it is already dropping. A host of risks are flying under the radar as the world focuses on the virus. Taken alone, not every risk warrants a risk-off positioning. But combined, these risks reveal extreme global uncertainty which does warrant a risk-off position in the near term. This week’s threats between the US and Iran, in particular, show that the political and geopolitical fallout from COVID-19 begins now, it will not “wait” until the pandemic crisis subsides. In this report we focus on the risks from oil-producing economies, but we first we update our fiscal stimulus tally. Stimulus Tsunami Chart 3Stimulus Tsunami Still Building Policymakers responded to COVID-19 by doing “whatever it takes” to prop up demand (Chart 3). Please see the Appendix for our latest update of our global fiscal stimulus table. The latest fiscal and monetary measures show that countries are still adding stimulus – i.e. there is not yet a substantial shift away from providing stimulus: China has increased its measures to a total of 10% of GDP for the year so far, according to BCA Research China Investment Strategy. This includes a general increase in credit growth, a big increase in government spending (2% of GDP), a bank re-lending scheme (1.5% of GDP), an increase in general purpose local government bonds (2% of GDP), plus special purpose bonds (4% of GDP) and other measures. On the political front, the government has rolled out a new slogan, “the Six Stabilities and the Six Guarantees,” and President Xi Jinping said on an inspection tour to Shaanxi that the state will increase investments to ensure that employment is stabilized. This is the maximum reflationary signal from China that we have long expected. The US agreed to a $484 billion “fourth phase” stimulus package, bringing its total to 13% of GDP. President Trump is already pushing for a fifth phase involving bailouts of state and local governments and infrastructure, which we fully expect to take place even if it takes a bit longer than packages that have been passed so far this year. German Chancellor Angela Merkel has opened the way for the EU to issue Eurobonds, in keeping with our expectations. Germany is spending 12% of GDP in total – which can go much higher depending on how many corporate loans are tapped – while Italy is increasing its stimulus to 3% of GDP. As deficits rise to astronomical sums, and economies gradually reopen, will legislatures balk at passing new stimulus? Yes, eventually. Financial markets will have to put more pressure on policymakers to get them to pass more stimulus. This can lead to volatility. In the US the pandemic is coinciding with “peak polarization” over the 2020 election. Lack of coordination between federal and state governments is increasing uncertainty. Currently disputes center on the timing of economic reopening and the provisioning bailout funds for state and local governments. Senate Majority Leader Mitch McConnell is threatening to deny bailouts for American states with large, unfunded public pension benefits (Chart 4A). He is insisting that the Senate “push the pause button” on coronavirus relief measures; specifically that nothing new be passed until the Senate convenes in Washington on May 4. He may then lead a charge in the Republican Senate to try to require structural reforms from states in exchange for bailouts. Estimates of the total state budget shortfall due to the crisis stand at $500 billion over the next three years, which is almost certainly an understatement (Chart 4B). Chart 4AUS States Have Unfunded Liabilities Chart 4BUS States Face Funding Shortfalls Could a local government or state declare bankruptcy? Not anytime soon. Technically there is no provision for states to declare bankruptcy. A constitutional challenge to such a declaration would go to the Supreme Court. One commonly cited precedent, Arkansas in 1933, ended up with a federal bailout.1 A unilateral declaration could conceivably become a kind of “Lehman moment” in the public sector, but state governors will ask their legislatures to provide more fiscal flexibility and will seek bailouts from the federal government first. The Federal Reserve is already committed to buying state and local bonds and can expand these purchases to keep interest rates low. Washington would be forced to provide at least short-term funding if state workers started getting fired in the midst of the crisis because of straightened state finances – another $500 billion for the states is entirely feasible in today’s climate. Constraints will prevail on the GOP Senate to provide state bailout funds. This conflict over state finances could have a negative impact on US equities in the near term, but it is largely a bluff – McConnell will lose this battle. The fundamental dynamic in Washington is that of populism combined with a pandemic that neutralizes arguments about moral hazard. Big-spending Democrats in the House of Representatives control the purse strings while big-spending President Trump faces an election. Senate Republicans are cornered on all sides – and their fate is tied to the President’s – so they will eventually capitulate. Bottom Line: The global fiscal and monetary policy tsunami is still building. But there are plenty of chances for near-term debacles. Over the long run the gargantuan stimulus is the signal while the rest is noise. Over the long run we expect the reflationary efforts to prevail and therefore we are long Treasury inflation-protected securities and US investment grade corporate bonds. We recommend going strategically long AAA-rated US municipal bonds relative to 10-year Treasuries. Petro-State Meltdown Since March we have highlighted that the collapse in oil prices will destabilize oil producers above and beyond the pandemic and recession. This leaves Iran in danger, but even threatens the stability of great powers like Russia. Normally there is something of a correlation between the global oil price and the willingness of petro-states to engage in war (Chart 5). Chart 5Petro-States Cease Fire When Oil Drops When prices fall, revenues dry up and governments have to prioritize domestic stability. This tends to defer inter-state conflict. We can loosely corroborate this evidence by showing that global defense stocks tend to be correlated with oil prices (Chart 6). Global growth is the obvious driver of both of these indicators. But states whose budgets are closely tied to the commodity cycle are the most likely to cut defense spending. Chart 6Global Growth Drives Oil And Guns Russia is case in point. Revenues from Rostec, one of Russia’s largest arms firms, rise and fall with the Urals crude oil price (Chart 7). The Russians launch into foreign adventures during oil bull markets, when state coffers are flush with cash. They have an uncanny way of calling the top of the cycle by invading countries (Chart 8). Chart 7Oil Correlates With Russian Arms Sales Chart 8Russian Invasions Call Peak In Oil Bull Markets Chart 9Turkish Political Risk On The Rise In the current oil rout, there is already some evidence of hostilities dying down in this way. For instance, after years of dogged fighting in Yemen, Saudi Arabia is finally declaring a ceasefire there. Turkey, which benefits from low oil prices, has temporarily gotten the upper hand in Libya vis-à-vis Khalifa Haftar and the Libyan National Army, which depends on oil revenues and backing from petro-states like Russia and the GCC. Of course, Turkey’s deepening involvement in foreign conflicts is evidence of populism at home so it does not bode well for the lira or Turkish assets (Chart 9). But it does highlight the impact of weak oil on petro-players such as Haftar. However, the tendency of petro-states to cease fire amid low prices is merely a rule of thumb, not a law of physics. Past performance is no guarantee of future results. Already we are seeing that Iran is defying this dynamic by engaging in provocative saber-rattling with the United States. Iran And Iraq The US and Iran are rattling sabers again. One would think that Iran, deep in the throes of recession and COVID-19, would eschew a conflict with the US at a time when a vulnerable and anti-Iranian US president is only seven months away from an election. Chart 10US Maximum Pressure On Iran Iran has survived nearly two years of “maximum pressure” from President Trump (Chart 10), and previous US sanction regimes, and has a fair chance of seeing the Democrats retake Washington. The Democrats would restart negotiations to restore the 2015 nuclear deal, which was favorable to Iran. Therefore risking air strikes from President Trump is counterproductive and potentially disastrous. Yet this logic only holds if the Iranian regime is capable of sustaining the pain of a pandemic and global recession on top of its already collapsing economy. Iran’s ability to circumvent sanctions to acquire funds depended on the economy outside of Iran doing fine. Now Iran’s illicit funds are drying up. This could lead to a pullback in funding for militant proxies across the region as Iran cuts costs. But it also removes the constraint on Iran taking bolder actions. If the economy is collapsing anyway then Iran can take bigger risks. Furthermore if Iran is teetering, there may be an incentive to initiate foreign conflicts to refocus domestic angst. This could be done without crossing Trump’s red lines by attacking Iraq or Saudi Arabia. With weak oil demand, Iran’s leverage declines. But a major attack would reduce oil production and accelerate the global supply-demand rebalance. Iran’s attack on the Saudi Abqaiq refinery last September took six million barrels per day offline briefly, but it was clearly not intended to shut down that production permanently. Threats against shipping in the Persian Gulf bring about 14 million barrels per day into jeopardy (Chart 11). Chart 11Closing Hormuz Would Be The Biggest Oil Shock Ever Iran-backed militias in Iraq have continued to attack American assets and have provoked American air strikes over the past month, despite the near-war scenario that erupted just before COVID. Iranian ships have harassed US naval ships in recent days. President Trump has ordered the navy to destroy ships that threaten it; Iranian commander has warned that Iran will sink US warships that threaten its ships in the Gulf. There is a 20% chance of armed hostilities between the US and Iran. Why would Iran be willing to confront the United States? First, Iran rightly believes that the US is war-weary and that Trump is committed to withdrawing from the Middle East. But this could prompt a fateful mistake. The equation changes if the US public is incensed and Trump’s election campaign could benefit from conflict. Chart 12Youth Pose Stability Risk To Iran Second, the US is never going to engage in a ground invasion of Iran. Airstrikes would not easily dislodge the regime. They could have the opposite effect and convert an entire generation of young, modernizing Iranians into battle-hardened supporters of the Islamic revolution (Chart 12). This is a dire calculation that the Iranian leaders would only make if they believed their regime was about to collapse. But they are quite possibly the closest to collapse that they have been since the 1980s and nobody knows where their pain threshold lies. They are especially vulnerable as the regime approaches the uncharted succession of Supreme Leader Ali Khamanei. Since early 2018 we have argued that there is a 20% chance of armed hostilities between the US and Iran. We upgraded this to 40% in June 2019 and downgraded it back to 20% after the Iranians shied from direct conflict this January. Our position remains the same 20%. This is still a major understated risk at a time when the global focus is entirely elsewhere. It will persist into 2021 if Trump is reelected. If the Democrats win the US election, this war risk will abate. The Iranians will play hard to get but they are politically prohibited from pursuing confrontation with the US when a 2015-type deal is available. This would open up the possibility for greater oil supply to be unlocked in the future, but sanctions are not likely to be lifted till 2022 at earliest. Russia Russia may not be on the verge of invading anyone, but it is internally vulnerable and fully capable of striking out against foreign opponents. Cyberattacks, election interference, or disinformation campaigns would sow confusion or heighten tensions among the great powers. The Russian state is suffering a triple whammy of pandemic, recession, and oil collapse. President Vladimir Putin’s approval rating has fallen this year so far, whereas other leaders in the western world have all seen polling bounces (even President Trump, slightly) (Chart 13). Putin postponed a referendum designed to keep him in office through 2036 due to the COVID crisis. In other words, the pandemic has already disrupted his carefully laid succession plans. While Putin can bypass a referendum, he would have been better off in the long run with the public mandate. Generally it is Putin’s administration, not his personal popularity, that is at risk, but the looming impact on Russian health and livelihoods puts both in jeopardy (Chart 14) and requires larger fiscal outlays to try to stabilize approval (Chart 15). Chart 13Putin Saw No COVID Popularity Bump Chart 14Russian Regime Faces Political Discontent Moreover, regardless of popular opinion, Putin is likely to settle scores with the oligarchs. The fateful decision to clash with the Saudis in March, which led to the oil collapse, will fall on Igor Sechin, Chief Executive of Rosneft, and his faction. An extensive political purge may well ensue that would jeopardize domestic stability (Chart 16). Chart 15Russia To Focus On Domestic Stability Chart 16Russian Political Risk Will Rise Russian tensions with the US will rise over the US election in November. The Democrats would seek to make Russia pay for interfering in US politics to help President Trump win in 2016. But even President Trump may no longer be a reliable “ally” of Putin given that Putin’s oil tactics have bankrupted the US shale industry during Trump’s reelection campaign. The American and Russian air forces are currently sparring in the air space over Syria and the Mediterranean. The US has also warned against a malign actor threatening to hack the health care system of the Czech Republic, which could be Russia or another actor like North Korea or Iran. These issues have taken place off the radar due to the coronavirus but they are no less real for that. Venezuela We have predicted Venezuela’s regime change for several years but the oil meltdown, pandemic, and insufficient Russian and Chinese support should put the final nail in the regime’s coffin. Hugo Chavez’s rise to power, the last “regime change,” occurred as oil prices bottomed in 1998. Historically the Venezuelan armed forces have frequently overthrown civilian authorities, but in several cases not until oil prices recovered (Chart 17). Chart 17Venezuelan Coups Follow Oil Rebounds The US decision to designate Nicolas Maduro as a “narco-terrorist,” to deploy greater naval and coast guard assets around Venezuela, to reassert the Monroe Doctrine and Roosevelt Corollary, and to pull Chevron from the country all suggest that Washington is preparing for regime change. Such a change may or may not involve any American orchestration. Venezuela is an easy punching-bag for President Trump if he seeks to “wag the dog” ahead of the election. Venezuela would be a strategic prize and yet it cannot hurt the US economy or financial markets substantially, giving limited downside to President Trump if he pursues such a strategy. Obviously any conflict with Venezuela this year is far less relevant to global investors than one with Iran, North Korea, China, or Russia. Regime change would be positive for oil supply and negative for prices over the long run. But that is a story for the next cycle of energy development, as it would take years for government and oil industry change in Venezuela to increase production. The US election cycle is a critical aggravating factor for all of these petro-state risks. Shale producers are going bankrupt, putting pressure on the economy and some swing states. The risk of a conflict arises not only from Trump playing “wag the dog” after the crisis abates, but also from other states provoking the president, causing him to react or overreact. The “Other Guys” Oil producers outside the US, Canada, gulf OPEC, and Russia – the “other guys” – are extremely vulnerable to this year’s global crisis and price collapse. Comprising half of global production, they were already seeing production declines and a falling global market share over the past decade when they should have benefited from a global economic expansion. They never recovered from the 2014-15 oil plunge and market share war (Chart 18). Angola (1.4 million barrels per day), Algeria (one million barrels per day), and Nigeria (1.8 million barrels per day) are relatively sizable producers whose domestic stability is in question in the coming years as they cut budgets and deplete limited forex reserves to adjust to the lower oil price. This means fewer fiscal resources to keep political and regional factions cooperating and provide basic services. Algeria is particularly vulnerable. President Abdelaziz Bouteflika, who ruled as a strongman from 1999, was forced out last year, leaving a power vacuum that persists under Prime Minister Abdelaziz Djerad, in the wake of the low-participation elections in December. An active popular protest movement, Hirak, already exists and is under police suppression. Unemployment is high, especially among the youth. Neighboring Libya is in the midst of a war and extremist militants within Libya and North Africa would like to expand their range of operations in a destabilized Algeria. Instability would send immigrants north to Europe. Oil production will be reduced involuntarily as well as voluntarily this year due to regime failures. Brazil is not facing the risk of state failure like Algeria, but it is facing a deteriorating domestic political outlook (Chart 19). President Jair Bolsonaro’s popularity was already low relative to most previous presidents before COVID. His narrow base in the Chamber of Deputies got narrower when he abandoned his political party. He has defied the pandemic, refused to endorse social distancing or lockdown orders by local governments, and fired his Health Minister Luiz Henrique Mandetta. Chart 18Petro-States: 'Other Guys' Face Instability Chart 19Brazilian Political Risk Rising Again Brazil has a high number of coronavirus deaths per million people relative to other emerging markets with similar health capacity and susceptibility to the disease. This, combined with sharply rising unemployment, could prove toxic for Bolsonaro, who has not received a bounce in popular opinion from the crisis like most other world leaders. Thus on balance we expect the October local elections to mark a comeback for the Worker’s Party. The limited fiscal gains of Bolsonaro’s pension reform are already wiped out by the global recession, which will set back the country’s frail recovery from its biggest recession in a century. The country is still on an unsustainable fiscal path. Bolsonaro does not have a strong personal commitment to neoliberal structural reform, which has been put aside anyway due to the need for government fiscal spending amid the crisis. Unless Bolsonaro’s popularity increases in the wake of the crisis – due to backlash against the state-level lockdowns – the economic shock is negative for Brazil’s political stability and economic policy orthodoxy. Bottom Line: Our rule of thumb about petro-states suggests that they will generally act less aggressive amid a historic oil price collapse, but Iran may prove a critical exception. Investors should not underestimate the risk of a US-Iran conflict this year. Beyond that, the US election will have a decisive impact as the Democrats will seek to resume the Iranian nuclear deal and Iran would eventually play ball. Venezuela is less globally relevant this year – although a “wag the dog” scenario is a distinct possibility – but it may well be a major oil supply surprise in the 2020s. More broadly the takeaway is that oil production will be reduced involuntarily as well as voluntarily this year due to regime failures. Investment Takeaways Obviously any conflict with Iran could affect the range of Middle Eastern OPEC supply, not just the portion already shuttered due to sanctions on Iran itself. Any Iran war risk is entirely separate from the risk of supply destruction from more routine state failures in Africa. These shortages have been far less consequential lately and have plenty of room to grow in significance (Chart 20). The extreme lows in oil prices today will create the conditions for higher oil prices later when demand recovers, via supply destruction. Chart 20More Unplanned Outages To Come Chart 21European Political Risk No Longer Underrated An important implication – to be explored in future reports – is that Europe’s neighborhood is about to get a lot more dangerous in the coming years, as the Middle East and Russia will become less stable. Middle East instability will result in new waves of immigration and terrorism after a lull since 2015-16. These waves would fuel right-wing political sentiment in parts of Europe that are the most vulnerable in today’ crisis: Italy, Spain, and France (Chart 21). This should not be equated with the EU breaking apart, however, as the populist parties in these countries are pursuing soft rather than hard Euroskepticism. Unless that changes the risk is to the Euro Area’s policy coherence rather than its existence. Finally Russian domestic instability is one of the major secular consequences of the pandemic and recession and its consequences could be far-reaching, particularly in its great power struggle with the United States. We are reinitiating a strategic long in cyber security stocks, the ISE Cyber Security Index, relative to the S&P500 Info Tech sector. Cyberattacks are a form of asymmetrical warfare that we expect to ramp up with the general increase in global geopolitical tensions. The US’s recent official warning against an unknown actor that apparently intended to attack the health system of the Czech Republic highlights the way in which malign actors could attempt to capitalize on the chaos of the pandemic. We also recommend strategic investors reinitiate our “China Play Index” – commodities and equities sensitive to China’s reflation – and our BCA Infrastructure Basket, which will benefit from Chinese reflation as well as US deficit spending. China’s reflation will help industrial metals more so than oil, but it is positive for the latter as well. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 John Mauldin, "Don't Be So Sure That States Can't Go Bankrupt," Forbes, July 28, 2016, forbes.com. Section II: Appendix : GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Appendix Table 1 The Global Fiscal Stimulus Response To COVID-19 Section III: Geopolitical Calendar
Highlights The near-term is fraught with risk for US equities and global risk assets. Investors concerned over uncertainty, a slow recovery, and economic aftershocks must also guard against geopolitics. COVID-19 is not a victory for dictatorship over democracies. Democracies face voters and will ultimately improve government effectiveness. President Trump is likely to lose the US election. As this becomes increasingly likely, his policy will turn more aggressive, increasing geopolitical risks – particularly in US-China relations. Stay short CNY-USD. Stay long defense stocks. Feature Chart 1Another Downdraft Is Likely US equity prices have risen 26% since their March 23 low point, but our review of systemic global crises suggests that a re-test of the bottom would not be surprising (Chart 1). A range of mitigating health policies – plus still-growing policy stimulus – will most likely prevent a depression. But a longer than expected economic trough, due to some persistent level of social distancing pre-vaccine, and negative second-order effects, such as emerging market crises, could trigger another wave of selling. Moreover we expect another shoe to drop: geopolitics. A Light At The End Of The Tunnel Governments are starting to get a handle on the COVID-19 pandemic. The number of daily new cases in the European Union, which is most clearly correlated with global equities, has subsided (Chart 2). Chart 2Any Setbacks Will Hit Equity Market Hard The US is also seeing new cases crest. To be safe one should count on a subsidiary spike that could easily set back US equities after a notable stock market rally (Chart 2, second panel). But Europe has shown that social distancing works, which US investors will recognize. Italy’s Prime Minister Giuseppe Conte is expected to begin the gradual loosening of social controls to restart the economy. Since Italy is the hardest hit of the western nations (second only to Spain), its leaders will not relax lockdown measures unless they are sure they can do so safely (Chart 2, bottom panel). Still, if governments loosen controls too soon, they may have to tighten them again. Uncertainty will therefore persist regarding the pace of economic normalization, which is bound to be slow due to the fact that discretionary spending will remain suppressed, as it is today in China, and the special precautions that at-risk populations like the elderly will have to take. Economic stimulus measures are still growing in size. Japan’s stimulus, which we count at 16% of GDP, is smaller than the headline 20% but still very large. We have long argued that Japan was on the forefront of the move toward debt monetization among developed markets, but COVID-19 has accelerated the paradigm shift. The United Kingdom has now explicitly stated that the Bank of England will directly finance government debt. The Spanish government is proposing Universal Basic Income (UBI), which it hopes to make permanent, rather than merely for the duration of the pandemic. The jury is still out on whether the weak Pedro Sanchez government will be able to pass it but the current is in favor of “whatever it takes.” Italy’s Five Star Movement has long advocated universal basic income and is part of a ruling coalition that has received a wave of popular support to combat the crisis. At present only a more limited “income of emergency” is being legislated, in keeping with the more centrist Democratic Party, a coalition partner. But Italy’s devastation creates the impetus for bolder moves, either by this government or a subsequent government in 2021 or after. The European institutions are backstopping these states, at least for now, so any deeper disagreements about climbing down from stimulus will have to wait until the coming years. The EU itself is likely to announce additional fiscal measures, via the European Stability Mechanism, whose austerity requirements will be waived, and the European Investment Bank. We can see a token agreement on “coronabonds” (joint debt issuance by the Euro Area), but investors should not fixate on the eurobond debate. These would require a new mechanism, which is inexpedient, whereas the existing mechanisms are already sufficient to bankroll the huge deficit spending plans that the member states are already rolling out. The United States is negotiating an additional “phase four” package that could range between $500 billion and $2 trillion, meaning anywhere from 2.5% to 10% of GDP in new measures (Chart 3). Our estimate would err on the high side because it will largely consist of the same key elements as the “phase three” $2.3 trillion package: unemployment benefits and cash to households, plus a larger dollop for local governments than in the last package. Chart 3Fiscal Tsunami Is Still Building Congress is scheduled to return to vote the week of April 20, but an early return is entirely possible if the pandemic worsens. If the infection curve is flattening, then Republican Senators may hold out longer in negotiations. Squabbling would cause temporary agitation in equity markets. The Democrats and the Republicans still have a mutual interest in spending profusely: the Republicans to try to salvage their seats through economic improvement by November; the Democrats to prove their election proposition that a larger role for government is necessary. Finally, China is preparing to announce more stimulus. So far Chinese measures amount to only 3% of GDP but this is insufficient given the weakness in China’s economic rebound thus far. The expansion in quasi-fiscal spending (government-controlled credit expansion) is an open question, but we would guesstimate a minimum of 3% of GDP. Dramatic measures should be expected because China is undergoing the first recessionary environment since the Cultural Revolution and President Xi Jinping risks a monumental economic destabilization if he hesitates to shore up aggregate demand, which would ultimately threaten single-party rule. We see little chance of him making this mistake. The problem is that animal spirits and external demand will remain weak regardless, an occasion for disappointments among bullish equity investors. Moreover US-China geopolitical risks are rising again, as discussed below. Our updated list of fiscal measures for 25 countries can be found in the Appendix. Bottom Line: The pandemic is peaking in the US and EU, while more stimulus is coming. This is positive for equity investors with a 12-month time frame but the near-term remains vulnerable to another selloff. Democracies Are Not Less Effective Than Dictatorships The pandemic has given rise to wildly misleading narratives in the financial community and mainstream media about the political ramifications for different nations. Getting these narratives right is important for one’s investment strategy. The most popular is that China “won” – is expanding its global influence – while the United States “lost” – is failing at global leadership. More broadly the authoritarian eastern model is said to be triumphing over the western democratic model. The real distinction among states is whether they were familiar with pandemics emanating from China, the unreliability of China’s transparency and communications, and the need to track and trace infections from the beginning. Thus South Korea, Taiwan, Singapore, Vietnam, and Japan have all had relatively benign experiences and all but Vietnam are democracies, with varying degrees of representation and contestation. Nor is COVID-19 an “eastern” versus “western” thing. Germany did an effective job testing, tracking, and tracing infections as well. Germans are relatively law-abiding and trust Chancellor Angela Merkel and the state governments to “do the right thing.” Canada, with its experience of SARS, has also reacted effectively. Denmark, Austria, and the Czech Republic are already tentatively reopening their economies. Yet the number of new confirmed cases per million people shows that Germany is not wildly different from the US and Italy (Chart 4). The truth is that Italy’s bad fortune alerted the US and G7 states to take the threat more seriously – the US has had good outcomes in Washington State but bad outcomes in highly populated New York. Nor is it true that the American health care system is uniquely terrible in treating patients, as is so widely claimed. US deaths per million are worse than Germany but better than Italy (Chart 5) – and Italy’s health system is also not to blame. Failure of ruling parties to spring into decisive action is the main differentiator. Chart 4US In Line With Italy In New Cases … Chart 5… But Better In Limiting Deaths Chart 6Dictatorships Good At Halting Freedoms Dictatorships have had fewer cases and deaths, if their statistics can be trusted – which is a big if.1 This does not suggest that their governance model is better, but rather that they are better at halting freedoms, such as free movement (Chart 6). North Korea has zero cases of COVID-19. People were already under lockdown. Variation within the dictatorships stems from their policy responses and experience fighting pandemics. China, the origin of several recent outbreaks, has extensive experience. It also has a functional health system, fiscal resources, and a heavily centralized power structure. Iran, however, has less experience and capability. The question now is Russia, which was slow to react and has a growing outbreak, yet has a heavily centralized power structure to flatten the curve. Incidentally domestic risk is an important reason for Russia to cooperate with OPEC on oil production cuts, as we have argued. These points can be demonstrated by comparing COVID-19 deaths per million to each nation’s health capabilities and underlying vulnerability to the disease. Note that our intention is to highlight the role of policy in outcomes, not to attempt a full explanation of an epidemiological phenomenon. In Chart 7A, we judge health capacity by health spending per head and life expectancy at the age of 60. Nations that spend a lot per person, and whose people live longer, have better health systems. Yet many of these states are seeing the highest number of deaths because they are European and Europe was the epicenter of the outbreak. Chart 7ARich, Healthy Countries Got Hit Hardest Because Unprepared The US ranks right along with Germany and Sweden.2 Policy responses – early testing, tracking, and tracing – explain why South Korea has far fewer deaths than Italy and Spain on a population-weighted basis. However, the underlying conditions still matter, as the US’s health system, travel bans, and distance from the crisis produced better outcomes than its other policy responses would have implied. These data will be more accurate once the infection curve has flattened across the world. The situation is changing rapidly. If the US rises up in deaths per capita, it will be because of its slow responses, or subsequent policies. The same goes for emerging market economies that are ranking low in deaths but either have not seen the full effect of the pandemic, or had more time to adjust policy due to the crisis in Europe. Emerging market economies have lower health capacity, but also younger and hence healthier populations. The older the society, and the higher proportion of severe illnesses like heart and lung disease, the more susceptible to COVID-19 deaths, as Chart 7B shows. But yet again, the policy response still proves decisive. China has more deaths than some countries that are more vulnerable, because it got hit first. If Brazil and Turkey rise higher and higher above China in deaths, as is likely, it is because of policy failure, not basic vulnerability. Chart 7BEurope And US: Vulnerable Populations, Governments Slow To React Russia stands out as especially vulnerable in this Chart 7B. Here is where authoritarian measures may pay off, as with China, but only in the short term – since Russia will still be left with an elderly population highly prone to severe illness and a creaking health system. As mentioned above, the risk to Russian stability is a factor pushing for geopolitical cooperation in oil market cartel behavior to push prices up and improve the fiscal outlook to enable better domestic stability management. Bottom Line: Government policy, particularly preparedness and rapid action, have been the decisive factors in containing COVID-19, not dictatorial or democratic government types. The richest countries have the most freedoms and the most vulnerable elderly demographics. Within the rich countries, southern Europe reacted slowly and got hit hardest, with some exceptions. The US’s incompetence has been overrated, based on deaths, probably because of President Trump’s general unpopularity. These results are preliminary but they suggest that the US and EU will experience political change to address their lack of rapid action. Non-democracies will still have to deal with the recession and the consequences on social stability. Democracies Face Voter Blowback Democracies will face the wrath of voters once the immediate crisis dies down. The crisis has driven people to rally around the flag, creating polling bounces for national leaders and ruling parties. In some cases the trough-to-peak increase in popular support is remarkable – President Trump's approval reached 10 percentage points briefly, and he rose over 50% approval in some polls for the first time in his presidency (Chart 8A). Yet these initial bounces are already subsiding, as in Trump’s case (Chart 8B). Chart 8ADemocracies Are Accountable To Voters Chart 8BAnd Polling Bounces Are Fading By this measure, the US, Italy, France, and Spain all face serious political reckonings going forward. Trump is the first in the firing line. Our quantitative election model relies on state-level leading economic indicators that are lagging and show him still winning with 273 Electoral College votes (Chart 9A). However, if we introduce a 2008-magnitude economic shock to these indexes, the Democrats flip Michigan, Wisconsin, Pennsylvania, and New Hampshire, yielding 334 Electoral College votes for former Vice President Joe Biden (Chart 9B). This is assuming Trump’s approval rating stays the same, which, at 46%, is strong relative to the whole term in office. Chart 9AOur Quant Election Model Will Turn Against Trump When Data Catches Up Chart 9BA 2008-Style Shock To States Gives Democrats The White House Our qualitative judgement reinforces our election model. Historically, US elections are referendums on the ruling party. An incumbent president helps the party win reelection. But a recession is usually insurmountable. George Bush Sr lost in 1992 despite a shallow recession that ended the year before. While Joe Biden is a flawed candidate in numerous ways, the question voters face in November is whether they are better off than they were four years ago. With thousands of deaths and an unemployment rate at or above 20%, it is hard to see swing state voters answering “yes.” Not impossible, but we subjectively put the odds at 35%, and that could easily be revised downward if Trump’s polling falls back down to the 42% range. Trump will also be responsible for the handling of the pandemic itself. His administration obviously made several policy mistakes. A paper trail will highlight intelligence warnings as early as November, and warnings from his inner circle as early as January, that will hurt him.3 Objectively, the Republican Party’s greatest policy flaw, prior to COVID-19, was health care – and this will connect with COVID-19 even if the Affordable Care Act (Obamacare) has little to do with crisis response. Bottom Line: The first and most important political casualty of the pandemic will be Trump’s presidency. Not because the US is uniquely incompetent in the face of the pandemic – although it obviously could have done better, judging by several of the other democracies – but because this year happens to be an election year and democracies hold governments accountable. Major Risk Of Clash With China Chart 10China Likely To Depreciate The Renminbi There are two downside geopolitical risks that follow directly from the above. First, while the Democratic candidate Joe Biden is a “centrist,” his position will move to the left of the political spectrum. This is to energize the progressive faction of the party – which is already energized. The market will be taken aback if Biden produces major leftward shifts, in the direction of Senator Bernie Sanders, on taxes, regulation, health care, pharmaceuticals, banks, energy, or tech. This is not a problem when the market is down 36%, but as the market rallies, it becomes more relevant. While US taxes and regulation will go up, Biden will still have to win over the Midwestern Rust Belt voter through trade protectionism, a la Trump and Bernie. This will be exacerbated by the pandemic, which has supercharged American popular enmity toward China and fear of supply chain vulnerability toward China. When Biden reveals that he is protectionist too, US equities will react negatively. Second, more immediately, the clash with China may happen much sooner. As President Trump comes to realize he is losing his grip on power, he will have an incentive to retaliate against China for its mishandling of the pandemic, shift the blame, and achieve long-term strategic objectives as well. This makes Trump’s approval rating a critical indicator – not only of his reelection odds, but of whether he determines he has lost and therefore adopts more belligerent foreign or trade policy. We view the danger zone as anything less than 43%. If Trump becomes a lame duck, he could target China, or other countries, such as Venezuela. The advantage of the latter is that it could have the desired political effect without threatening the economic restart. A conflict with Iran would have bigger consequences – particularly negative for Europe. But in the COVID-19 context, Venezuela and Iran are not relevant to American voters. A conflict with North Korea, however, is part of the strategic conflict with China and would be hard to keep separate from broader tensions. This is only likely if Kim Jong Un stages a major provocation. At present, Washington and Beijing are keeping a lid on tensions. Presidents Trump and Xi are in communication. Beijing has rebuked the foreign minister who accused the US military of bringing COVID-19 to Wuhan. Trump has stopped using inflammatory rhetoric about the “Chinese virus.” China is not depreciating the renminbi, it is upholding other aspects of the trade deal, and it is sending face masks and ventilators to assist the US with the health crisis. But this could change. With its economy under extreme pressure, Beijing must take greater moves to stimulate. An obvious victim will be the renminbi, which is arguably stronger than it should be, especially if China cuts interest rates further, no doubt in great part because of the “phase one” trade deal with the United States (Chart 10). If and when Beijing decides that it must ease the downward pressure on exports and the economy, the renminbi will slide. This will provoke Trump. If he is convinced he cannot salvage the economy anyway, then he has an incentive to channel American anger toward China into new punitive measures over currency manipulation. Finally, the ingredients for our “Taiwan black swan” scenario are falling into place. Taiwan has long attempted to gain representation in the World Health Organization but has been blocked by Beijing’s assertion of the One China principle. However, Taiwan is now caught in an escalating tussle with the WHO leadership that involves both Washington and Beijing. Taipei warned the WHO as early as December that COVID-19 could be transmitted by humans and that the pandemic risk was high.4 Both China and the WHO leadership are simultaneously under pressure from the Trump administration for failing to share information and sound the alarm to prepare other nations. Bottom Line: If President Trump decides to prosecute China for its handling of the virus, and/or promote US-Taiwan relations in a way that aggravates China, then the trigger for a major geopolitical incident will have arrived. Investment Implications It is impossible to predict the precise catalyst or timing of such a crisis. We observe that the US and China are each experiencing historic economic dislocation, their strategic relationship has broken down over the past decade, and their populations are incensed at each other over grievances relating to the trade war, COVID-19, and various disinformation campaigns. Taiwan is at the epicenter of this conflict, due to its defense relationship with the United States and renewed political tensions with China under Xi Jinping. But the Chinese tech sector, North Korea, the South and East China Seas, Xinjiang, and Iran are also potential catalysts. Geopolitics is the other shoe to drop in the wake of COVID-19. Presidents Trump and Xi Jinping are the biggest sources of geopolitical risk, as we outlined in our 2020 forecast. They are cooperating in the immediate crisis, but in the aftermath there will be recriminations. A worsening domestic situation, a loss of prestige for either leader, or a foreign policy provocation could trigger punitive measures, saber rattling, or even military incidents. Risk assets are rallying on the light at the end of the tunnel. We are reaching and in some countries passing the peak intensity of the (first wave of the) pandemic. But the economic aftermath is extremely uncertain and the political fallout has hardly begun. In the US, the implication is clearly negative for Trump. But if that implication is realized, it points to much higher geopolitical risks within 2020 than are currently being considered as the world focuses on the virus. If President Trump chooses to wag the dog with Venezuela, that is obviously a much more positive outcome for global risk assets than if he attempts to achieve American strategic objectives of curbing China’s global assertiveness. Tactically, we remain defensive and recommend defensive US equity sectors and the Japanese yen. On a 12-month and beyond time frame we are more bullish on global growth and are long gold and oil. We remain strategically short CNY-USD and short Taiwanese equities relative to Korean. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Appendix TableThe Global Fiscal Stimulus Response To COVID-19 Footnotes 1 Given that one of Iran’s top health officials has criticized China for its questionable data and lack of transparency, one does not need to trust the US Intelligence Community’s assessment that China misled the world in the early days of the outbreak. See Matthew Petti, "Even Iran Doesn't Believe China's Coronavirus Stats," April 6, 2020. 2 Readers accustomed to the apocalyptic view of the US health system may wonder that the US comes out looking very well on health capacity. This is because we combine and standardize the scores for per capita spending and longevity. However our data also show that the US is inefficient on health: its life expectancy scores are slightly lower than those of the Europeans, yet it spends more per head. 3 See Josh Margolin and James Gordon Meek, "Intelligence report warned of coronavirus crisis as early as November: Sources," ABC News, April 8, 2020, and Maggie Haberman, "Trade Adviser Warned White House in January of Risks of a Pandemic," New York Times, April 6, 2020. 4 See "Taiwan says WHO failed to act on coronavirus transmission warning," Financial Times, March 19, 2020.
Highlights The pandemic has a negative impact on households and has not peaked in the US. But a depression is likely to be averted. Our market-based geopolitical risk indicators point toward a period of rising political turbulence across the world. We are selectively adding risk to our strategic portfolio, but remain tactically defensive. Stay long gold on a strategic time horizon. Feature I'm going where there's no depression, To the lovely land that's free from care. I'll leave this world of toil and trouble My home's in Heaven, I'm going there. - “No Depression In Heaven,” The Carter Family (1936) Chart 1The Pandemic Stimulus Versus The Great Recession Stimulus Markets bounced this week on the back of a gargantuan rollout of government spending that is the long-awaited counterpart to the already ultra-dovish monetary policy of global central banks (Chart 1). Just when the investment community began to worry about a full-fledged economic depression and the prospect for bank runs, food shortages, and martial law in the United States, the market rallied. Yet extreme uncertainty persists over how long one third of the world’s population will remain hidden away in their homes for fear of a dangerous virus (Chart 2). Chart 2Crisis Has Not Verifiably Peaked, Uncertainty Over Timing Of Lockdowns Chart 3The Pandemic Shock To The Labor Market While an important and growing trickle of expert opinion suggests that COVID-19 is not as deadly as once thought, especially for those under the age of 50, consumer activity will not return to normal anytime soon.1 Moreover political and geopolitical risks are skyrocketing and have yet to register in investors’ psyche. Consider: American initial unemployment claims came in at a record-breaking 3.3 million (Chart 3), while China International Capital Corporation estimates that China’s GDP will grow by 2.6% for the year. These are powerful blows against global political as well as economic stability. This should convince investors to exercise caution even as they re-enter the equity market. We are selectively putting some cash to work on a strategic time frame (12 months and beyond) to take advantage of some extraordinary opportunities in equities and commodities. But we maintain the cautious and defensive tactical posture that we initiated on January 24. No Depression In Heaven The US Congress agreed with the White House on an eye-popping $2.2 trillion or 10% of GDP fiscal stimulus. At least 46% of the package consists of direct funds for households and small businesses (Chart 4). This includes $290 billion in direct cash handouts to every middle-class household – essentially “helicopter money,” as it is financed by bonds purchased by the central bank (Table 1). The purpose is to plug the gap left by the near complete halt to daily life and business as isolation measures are taken. A depression is averted, but we still have a recession. Go long consumer staples. Chart 4The US Stimulus Package Breakdown Table 1Distribution Of Cash Handouts Under US Coronavirus Response Act China, the origin of the virus that triggered the global pandemic and recession, is resorting to its time-tried playbook of infrastructure spending, with 3% of GDP in new spending projected. This number is probably heavily understated. It does not include the increase in new credit that will accompany official fiscal measures, which could easily amount to 3% of GDP or more, putting the total new spending at 6%. Germany and the EU have also launched a total fiscal response. The traditionally tight-fisted Berlin has launched an 11% of GDP stimulus, opening the way for other member states to surge their own spending. The EU Commission has announced it will suspend deficit restrictions for all member states. The ECB’s Pandemic Emergency Purchase Program (PEPP) enables direct lending without having to tap the European Stability Mechanism (ESM) or negotiate the loosening of its requirements. It also enables the ECB to bypass the debate over issuing Eurobonds (though incidentally Germany is softening its stance on the latter idea). The cumulative impact of all this fiscal stimulus is 5% of global GDP – and rising (Table 2). Governments will be forced to provide more cash on a rolling basis to households and businesses as long as the pandemic is raging and isolation measures are in place. Table 2The Global Fiscal Stimulus In Response To COVID-19 President Trump has signaled that he wants economic life to begin resuming after Easter Sunday, April 12. But he also said that he will listen to the advice of the White House’s public health advisors. State governors are the ones who implement tough “shelter in place” orders and other restrictions, so the hardest hit states will not resume activity until their governors believe that the impact on their medical systems can be managed. Authorities will likely extend the social distancing measures in April until they have a better handle on the best ways to enable economic activity while preserving the health system. Needless to say, economic activity will have to resume gradually as the government cannot replace activity forever and the working age population can operate even with the threat of contracting the disease (social distancing policies would become more fine-tuned for types of activity, age groups, and health risk profiles). The tipping point from recession to depression would be the point at which the government’s promises of total fiscal and monetary support for households and businesses become incapable of reassuring either the financial markets or citizens. The largest deficit the US government has ever run was 30% of GDP during World War II (Chart 5). Today’s deficit is likely to go well beyond 15% (5% existing plus 10% stimulus package plus falling revenue). If authorities were forced to triple the lockdown period and hence the fiscal response the country would be in uncharted territory. But this is unlikely as the incubation period of the virus is two weeks and China has already shown that a total lockdown can sharply reduce transmission. Chart 5The US's Largest Peacetime Budget Deficit Any tipping point into depression would become evident in behavior: e.g. a return to panic selling, followed by the closure of financial market trading by authorities, bank runs, shortages of staples across regions, and possibly the use of martial law and curfews. While near-term selloffs can occur, the rest seems very unlikely – if only because, again, the much simpler solution is to reduce the restrictions on economic activity gradually for the low-risk, healthy, working age population. Bottom Line: Granting that the healthy working age population can and will eventually return to work due to its lower risk profile, unlimited policy support suggests that a depression or “L-shaped” recovery is unlikely. The Dark Hour Of Midnight Nearing While the US looks to avoid a depression, there will still be a recession with an unprecedented Q2 contraction. The recovery could be a lot slower than bullish investors expect. Global manufacturing was contracting well before households got hit with a sickness that will suppress consumption for the rest of the year. There is another disease to worry about: the dollar disease. The world is heavily indebted and holds $12 trillion in US dollar-denominated debt. Yet the dollar is hitting the highest levels in years and global dollar liquidity is drying up. The greenback has rallied even against major safe haven currencies like the Japanese yen and Swiss franc (Chart 6). Of course, the Fed is intervening to ensure highly indebted US corporates have access to loans and extending emergency dollar swap lines to a total of 14 central banks. But in the near term global growth is collapsing and the dollar is overshooting. This can create a self-reinforcing dynamic. The same goes for any relapse in Chinese growth. Unlike in 2008 – but like 2015 – China is the epicenter of the global slowdown. China has much larger economic and financial imbalances today than it did in 2003 when the SARS outbreak occurred, and it will increase these imbalances going forward as it abandons its attempt to deleverage the corporate sector (Chart 7). Chart 6The Greenback Surge Deprives The World Of Liquidity Chart 7China's Financial Imbalances Are A Worry The rest of emerging markets face their own problems, including poor governance and productivity, as well as the dollar disease and the China fallout. They are unlikely to lift themselves out of this crisis, but they could become the source for credit events and market riots that prolong the global risk-off phase. Bottom Line: It is too soon to sound the all-clear. If the dollar continues on its rampage, then the gigantic stimulus will not be enough, markets will relapse, and fears of deflation will grow. World Of Toil And Trouble Political risk is the next shoe to drop. The pandemic and recession are setting in motion a political earthquake that will unfold over the next decade. Almost all of our 12 market-based geopolitical risk indicators have exploded upward since the beginning of the year. Chart 8China's Political Risk Is Rising These indicators show that developed market equities and emerging market currencies are collapsing far more than is justified by underlying fundamentals. This risk premium reflects the uncertainty of the pandemic, but the recession will destabilize regimes and fuel fears about national security. So the risk premium will not immediately decline in several important cases. China’s political risk is shooting up, as one would expect given that the pandemic began in Hubei (Chart 8). The stress within the Communist Party can be measured by the shrill tone of the Chinese propaganda machine, which is firing on all cylinders to convince the world that Chinese President Xi Jinping did a great job handling the virus while the western nations are failing states that cannot handle it. The western nations are indeed mishandling it, but that does not solve China’s domestic economic and social troubles, which will grow from here. Of course, our political risk indicator will fall if Chinese equities rally more enthusiastically than Chinese state banks expand credit as the economy normalizes. But this would suggest that markets have gotten ahead of themselves. By contrast, if China surges credit, yet equity investors are unenthusiastic, then the market will be correctly responding to the fact that a credit surge will increase economic imbalances and intensify the tug-of-war between authorities and the financial system, particularly over the effort to prevent the property sector bubble from ballooning. China needs to stimulate to recover from the downturn. Obviously it does not want instability for the 100th birthday of the Communist Party in 2021. An even more important reason for stimulus is the 2022 leadership reshuffle – the twentieth National Party Congress. This is the date when Xi Jinping would originally have stepped down and the leading member of the rival faction (Hu Chunhua?) would have taken over the party, the presidency, and the military commission. Today Xi is not at risk of losing power, but with a trade war and recession to his name, he will have to work hard to tighten control over the party and secure his ability to stay in power. An ongoing domestic political crackdown will frighten local governments and private businesses, who are already scarred by the past decade and whose animal spirits are important to the overall economic rebound. It is still possible that Beijing will have to depreciate the renminbi against the dollar. This is the linchpin of the trade deal with President Trump – especially since other aspects of the deal will be set back by the recession. As long as Trump’s approval rating continues to benefit from his crisis response and stimulus deals, he is more likely to cut tariffs on China than to reignite the trade war. This approach will be reinforced by the bump in his approval rating upon signing the $2 trillion Families First Coronavirus Response Act into law (Chart 9). He will try to salvage the economy and his displays of strength will be reserved for market-irrelevant players like Venezuela. But if the virus outbreak and the surge in unemployment turn him into a “lame duck” later this year, then he may adopt aggressive trade policy and seek the domestic political upside of confronting China. He may need to look tough on trade on the campaign trail. Diplomacy with North Korea could also break down. This is not our base case, but we note that investors are pricing crisis levels into the South Korean won despite its successful handling of the coronavirus (Chart 10). Pyongyang has an incentive to play nice to assist the government in the South while avoiding antagonizing President Trump. But Kim Jong Un may also feel that he has an opportunity to demonstrate strength. This would be relevant not because of North Korea’s bad behavior but because a lame duck President Trump could respond belligerently. Chart 9Trump’s Approval Gets Bump From Crisis Response And Stimulus Chart 10South Korean Political Risk Rising We highlighted Russia as a “black swan” candidate for 2020. This view stemmed from President Vladimir Putin’s domestic machinations to stay in power and tamp down on domestic instability in the wake of domestic economic austerity policies. For the same reason we did not expect Moscow to engage in a market share war with Saudi Arabia that devastated oil prices, the Russian ruble, and economy. At any rate, Russia will remain a source of political surprises going forward (Chart 11). Go long oil. Putin cannot add an oil collapse to a plague and recession and expect a popular referendum to keep him in power till 2036. The coronavirus is hitting Russia, forcing Putin to delay the April 22 nationwide referendum that would allow him to rule until 2036. It is also likely forcing a rethink on a budget-busting oil market share war, since more than the $4 billion anti-crisis fund (0.2% of GDP) will be needed to stimulate the economy and boost the health system. Russia faces a budget shortfall of 3 trillion rubles ($39 billion) this year from the oil price collapse. It is no good compounding the economic shock if one intends to hold a popular referendum – even if one is Putin. For all these reasons we agree with BCA Research Commodity & Energy Strategy that a return to negotiations is likely sooner rather than later. Chart 11Russia: A Lake Of Black Swans However, we would not recommend buying the ruble, as tensions with the US are set to escalate. Instead we recommend going long Brent crude oil. Political risk in the European states is hitting highs unseen since the peak of the European sovereign debt crisis (Chart 12). Some of this risk will subside as the European authorities did not delay this time around in instituting dramatic emergency measures. Chart 12Europe: No Delay In Offering 'Whatever It Takes' Chart 13Political Risk Understated In Taiwan And Turkey However, we do not expect political risk to fall back to the low levels seen at the end of last year because the recession will affect important elections between now and 2022 in Italy, the Netherlands, Germany, and France. Only the UK has the advantage of a single-party parliamentary majority with a five-year term in office – this implies policy coherence, notwithstanding the fact that Prime Minister Boris Johnson has contracted the coronavirus. The revolution in German and EU fiscal policy is an essential step in cementing the peripheral countries’ adherence to the monetary union over the long run. But it may not prevent a clash in the coming years between Italy and Germany and Brussels. Italy is one of the countries most likely to see a change in government as a result of the pandemic. It is hard to see voters rewarding this government, ultimately, for its handling of the crisis, even though at the moment popular opinion is tentatively having that effect. The Italian opposition consists of the most popular party, the right-wing League, and the party with the fastest rising popular support, which is the right-wing Brothers of Italy. So the likely anti-incumbent effect stemming from large unemployment would favor the rise of an anti-establishment government over the next year or two. The result would be a clash with Brussels even in the context of Brussels taking on a more permissive attitude toward budget deficits. This will be all the worse if Brussels tries to climb down from stimulus too abruptly. Our political risk indicators have fallen for two countries over the past month: Taiwan and Turkey (Chart 13). This is not because political risk is falling in reality, but because these two markets have not seen their currencies depreciate as much as one would expect relative to underlying drivers of their economy: In Taiwan’s case the reason is the US dollar’s unusual strength relative to the Japanese yen amidst the crisis. Ultimately the yen is a safe-haven currency and it will eventually strengthen if global growth continues to weaken. Moreover we continue to believe that real world politics will lead to a higher risk premium in the Taiwanese dollar and equities. Taiwan faces conflicts with mainland China that will increase with China’s recession and domestic instability. In Turkey’s case, the Turkish lira has depreciated but not as much as one would expect relative to European equities, which have utterly collapsed. Therefore Turkey’s risk indicator shows its domestic political risk falling rather than rising. Turkey’s populist mismanagement will ensure that the lira continues depreciating after European equities recover, and then our risk indicator will shoot up. Chart 14Brazilian Political Risk Is No Longer Contained Prior to the pandemic, Brazilian political risk had remained contained, despite Brazilian President Jair Bolsonaro’s extreme and unorthodox leadership. Since the outbreak, however, this indicator has skyrocketed as the currency has collapsed (Chart 14). To make matters worse, Bolsonaro is taking a page from President Trump and diminishing the danger of the coronavirus in his public comments to try to prevent a sharp economic slowdown. This lackadaisical attitude will backfire since, unlike the US, Brazil does not have anywhere near the capacity to manage a major outbreak, as government ministers have warned. This autumn’s local elections present an opportunity for the opposition to stage a comeback. Brazilian stocks won’t be driven by politics in the near term – the effectiveness of China’s stimulus is critical for Brazil and other emerging markets – but political risk will remain elevated for the foreseeable future. Bottom Line: Geopolitical risk is exploding everywhere. This marks the beginning of a period of political turbulence for most of the major nation-states. Domestic economic stresses can be dealt with in various ways but in the event that China’s instability conflicts with President Trump’s election, the result could be a historic geopolitical incident and more downside in equity markets. In Russia’s case this has already occurred, via the oil shock’s effect on US shale producers, so there is potential for relations to heat up – and that is even more true if Joe Biden wins the presidency and initiates Democratic Party revenge for Russian election meddling. The confluence of volatile political elements informs our cautious tactical positioning. Investment Conclusions If the historic, worldwide monetary and fiscal stimulus taking place today is successful in rebooting global growth, then there will be “no depression.” The world will learn to cope with COVID-19 while the “dollar disease” will subside on the back of massive injections of liquidity from central banks and governments. Gold: The above is ultimately inflationary and therefore our strategic long gold trade will be reinforced. The geopolitical instability we expect to emerge from the pandemic and recession will add to the demand for gold in such a reflationary environment. No depression means stay long gold! US Equities: Equities will ultimately outperform government bonds in this environment as well. Our chief US equity strategist Anastasios Avgeriou has tallied up the reasons to go long US stocks in an excellent recent report, “20 Reasons To Buy Equities.” We agree with this view assuming investors are thinking in terms of 12 months and beyond. Chart 15Oil/Gold Ratio Extreme But Wait To Go Long Tactically, however, we maintain the cautious positioning that we adopted on January 24. We have misgivings about the past week’s equity rally. Investors need a clear sense of when the US and European households will start resuming activity. The COVID-19 outbreak is still capable of bringing negative surprises, extending lockdowns, and frightening consumers. Hence we recommend defensive plays that have suffered from indiscriminate selling, rather than cyclical sectors. Go tactically long S&P consumer staples. US Bonds: Over the long run, the Fed’s decision to backstop investment grade corporate bonds also presents a major opportunity to go long on a strategic basis relative to long-dated Treasuries, following our US bond strategists. Global Equities: We prefer global ex-US equities on the basis of relative valuations and US election uncertainty. Shifting policy winds in the United States favor higher taxes and regulation in the coming years. This is true unless President Trump is reelected, which we assess as a 35% chance. Emerging Markets: We are booking gains on our short TRY-USD trade for a gain of 6%. This is a tactical trade that remains fundamentally supported. Book 6% gain on short TRY-USD. Oil: For a more contrarian trade, we recommend going long oil. Our tactical long oil / short gold trade was stopped out at 5% last week. While we expect mean reversion in this relationship, the basis for gold to rally is strong. Therefore we are going long Brent crude spot prices on Russia’s and Saudi Arabia’s political constraints and global stimulus (Chart 15). We will reconsider the oil/gold ratio at a later date. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Joseph T. Wu et al, "Estimating clinical severity of COVID-19 from the transmission dynamics in Wuhan, China," Nature Medicine, March 19, 2020, and Wei-jie Guan et al, "Clinical Characteristics of Coronavirus Disease 2019 in China," The New England Journal Of Medicine, February 28, 2020. Section II: Appendix : GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Section III: Geopolitical Calendar