Geopolitical Regions
Highlights The U.S. midterm elections are far less investment-relevant than consensus holds; Trump will increase the pressure on China and Iran regardless of the likely negative election results for the GOP; The Iranian sanctions, civil conflict in Iraq, and other oil supply issues are the real geopolitical risk; Despite the tentative good news on Brexit, political uncertainty in the U.K. makes now a bad time to buy the pound; Go long Brent crude / short S&P 500; long U.S. energy / tech equities; long JPY / short GBP. Feature The U.S. political cycle begins in earnest after Labor Day. Understandably, we have noticed an uptick in client interest, with a steady stream of questions and conference call requests about U.S. politics. Generally, our forecast remains unchanged since our April net assessment of the upcoming midterm election.1 Democrats have a slightly better than 60% probability of winning the House of Representatives, with a solid 45% probability of taking the Senate, and rising. The latter is astounding, given that the "math" of the Senate rotation is against the Democrats. Our bias toward a Democratic victory is based on current polling (Chart 1) and President Trump's woeful approval rating (Chart 2). There are a lot of other moving parts, however, and we will update them next week in detail. Chart 1GOP Trails In Polls, But It Is Still Close Chart 2Trump's Approval Rating Lines The GOP Up For Steep Losses But why, dear client, should you care? Do the midterms really matter for investors? History suggests that they tend to be a bullish catalyst for the stock market (Chart 3). Will this time be any different? The two bearish narratives hanging over markets have to do with the Democrats foiling President Trump's pro-business policy and impeaching him. The former would purportedly have a direct impact on earnings by stymieing Trump's pluto-populist agenda, while the latter would presumably force Trump to seek relevance abroad - through an aggressive foreign policy or trade policy. We think both concerns are without merit. First, by taking over the House of Representatives, the Democrats will not be able to stop or reverse the president's economic agenda. Trump's deregulation will continue, given that regulatory affairs are the sole prerogative of the executive branch of government. Tax cuts will not be reversed, given that Democrats have no chance of gaining a 60-seat, filibuster-proof, majority in the Senate, and would not have a two-thirds majority in each chamber to override Trump's veto. As for fiscal stimulus, it is highly unlikely that the party of the $15 minimum wage and "Medicare for all" would seek to impose fiscal discipline on the nation. As far as the market is concerned, President Trump has accomplished all he needed to accomplish. Gridlock is perfectly fine, which is why a divided Congress has not stopped bull markets in the past (Chart 4). And should the Republicans somehow retain Congress, the result would be a "more of the same" rally. Chart 3Midterm U.S. Elections Tend To Be Bullish... Chart 4... Even Those That Produce Gridlock What about impeachment? Well, what about it? As we have illustrated in our net assessment of the impeachment risk, the Senate is not likely to convict Trump, so markets can look through it, albeit with bouts of volatility (Chart 5A & 5B).2 Chart 5AMarkets Can Rally Through Impeachment... Chart 5B...Despite Volatility To this our clients counter: "But Trump is different!" According to this theory, President Trump would respond to the threat of impeachment by becoming unhinged and seeking relevance abroad through an aggressive foreign and trade policy. But can he be more aggressive than ... Threatening nuclear war with North Korea; Re-imposing an oil embargo against Iran - and thus unraveling the already shaky equilibrium in the Middle East; Imposing tariffs on half, possibly all, U.S. imports from China; Threatening additional tariffs on U.S. allies like Canada, the EU, and Japan? More aggressive than that? We are agnostic towards the upcoming midterm elections. We already have a deeply alarmist view towards U.S. foreign policy posture vis-à-vis Iran3 and U.S. trade policy vis-à-vis China,4 both of which we have articulated at length. The midterm elections factor very little in our analysis of either. As such, they are a non-diagnostic variable. The outcome of the vote is a red herring. President Trump will seek relevance abroad whether or not his Republican Party holds the House and Senate. In fact, we believe that the midterms are a distraction. Investors have already forgotten about Iran (Chart 6), at a time when global oil spare capacity is falling (Chart 7). BCA's Commodity & Energy Strategy is forecasting Brent to average $80/bbl in 2019, but prices would easily reach $120/bbl in a case where all three pernicious scenarios occur (shale production bottlenecks, Venezuela export collapse, and Iran sanctions).5 Chart 6Nobody Is Paying Attention To Iranian Supply Risk! Chart 7Global Spare Capacity Stretched Thin These figures are alarming. But they could become even worse if our Q4 Black Swan - a Shia-on-Shia civil war in Iraq - manifests. The end of the U.S.-Iran détente has put the tenuous geopolitical equilibrium in Iraq on thin ice.6 Since our missive on this topic last week, the violence in Basra has intensified, with rioters setting the Iranian consulate alight. Investors were largely able to ignore the Islamic State insurgency in Iraq because it occurred in areas of the country that do not produce oil. A Shia-on-Shia conflict, however, would take place in Basra. This vital port exports 3.5 bpd. Any damage to its facilities, which is highly likely if Iran gets involved in the conflict, would instantly become the world's largest supply loss since the first Gulf War (Chart 8). Bottom Line: Our message to clients is that midterm elections are far less investment-relevant than is assumed. President Trump has already initiated aggressive foreign and trade policy. We expect the White House to intensify the pressure on Iran and China regardless of the outcome of the midterm election. And we also expect the Democratic Party to be unable to stop President Trump on either front, should it gain a majority in the House of Representatives. The truly underappreciated risk for investors is a massive oil supply shock in 2019 that comes from a combination of instability in Venezuela, aggressive U.S. enforcement of the oil embargo against Iran, and Iran's retaliation against such sanctions via chaos in Iraq. We are initializing a long Brent / short S&P 500 trade, as well as a long energy stocks / short tech trade, as hedges against this risk (Chart 9). Chart 8Civil Unrest In Basra Would Be Big Chart 9Two Hedges We Recommend Government Shutdown Is The One True Midterm-Related Risk There is a declining possibility of a government shutdown before the midterm - and a much larger possibility afterwards. It is well known that the election odds favor the Democrats, but if there were ever a president who would do something drastic to try to turn the tables, it would be Trump. A majority in the House gives Democrats the ability to impeach. While we think the Senate would acquit Trump of any impeachment articles, this view is based on stout Republican support. A "smoking gun" from Special Counsel Robert Mueller - comparable to Nixon's Watergate tapes - could still change things. Trump would rather avoid impeachment altogether. Trump could still conceivably try to upset the election by insisting on funding his promised "Wall" on the border. The Republicans want to delay the appropriations bill for the Department of Homeland Security, which would include any border security funding increases, until after the election (but before the new House sits in January). Trump has repeatedly threatened to reject his own party's plan, though he has recently backed off these threats. A shutdown ahead of an election would conventionally be political suicide - especially given the likely need for a federal response to Hurricane Florence. Moreover Trump's border wall is opposed by over half the populace. But Trump could reason that the greatest game changer would be a spike in turnout when his supporters hear that he is willing to stake the entire election on this key issue. Turnout is everything. The success of such a kamikaze run would hinge on the Senate. Assuming that Trump retained full Republican support to push through wall funding, as GOP incumbents frantically sought to end the shutdown, there would be 12 Democratic senators, in the broadest measure, who could conceivably be intimidated into voting with them (Table 1). These senators would have to decide on the spot whether they are safer running for office during a government shutdown or after having given Trump his wall. They may decide on the latter. Table 1A Government Shutdown Could Conceivably Intimidate Trump-State Democrats This would total 63 votes in the Senate, enough to invoke "cloture," ending debate, and hence break any Democratic filibuster against proposed wall funding. But this calculation is also extremely generous to Trump. More likely, at least four of the twelve senators would refuse to break rank: Debbie Stabenow of Michigan, Robert Menéndez of New Jersey, Sherrod Brown of Ohio, and Bob Casey of Pennsylvania. They would be averse to defecting from their party on such a consequential vote, even if eight of their colleagues were willing to do so.7 This is presumably why Mick Mulvaney, Trump's budget director, has already gone to Capitol Hill and "personally assured" the leading Republicans that Trump is not going to pursue a government shutdown.8 The legislative math doesn't really work. Nevertheless, there is still some chance that Trump - as opposed to any other president - will try this gambit. Especially as the loss of the House and potentially the Senate begins to appear "inevitable." After the midterm, of course, all bets are off. A lame duck Congress, or worse a Democratic Congress, will give President Trump all the reason he needs to grind things to a halt over his wall, with a view to 2020. The odds of a shutdown will shoot up. Do shutdowns matter for investors? Not really. S&P 500 returns tend to be flat for the first two weeks after a shutdown. Looking at eight past shutdowns, the average return was 1% fifteen days later, and 4.5% two months later. Bottom Line: We give a pre-election shutdown 10% odds due to Trump's unorthodoxy and desperate need to boost turnout among his voter base. Post-midterm election, a government shutdown is inevitable, unless congressional Republicans manage to convince President Trump to sign long-term appropriation bills before the election. Brexit: Is The Pound Pricing In Uncertainty? The U.K.-EU negotiations are entering their final, and thus most uncertain, phase. Our Brexit decision-tree looks messy and complicated (Diagram 1). While we believe that Prime Minister Theresa May has increased the probability of the sanguine "soft Brexit" outcome, there are plenty of pathways that lead to risk-off events. Diagram 1Brexit: Decision Tree And Conditional Probabilities Is the pound sufficiently pricing in this uncertainty? According to BCA's Foreign Exchange Strategy, which recently penned a special report on the subject, the answer is no.9 According to their long-term fair value model, the trade-weighted pound exhibits only a 3% discount - well within its historical norm (Chart 10). Chart 10Pound: A Much Smaller Discount On A Trade-Weighted Basis In order to assess the degree of political risk priced into the pound, one needs to isolate the risk of the U.K. leaving the EU. This is because all fair value models - including that of our FX team - are based on a potentially unrepresentative sample, one where the U.K. is part of the EU! The problem is that the traditional variables used to explain exchange rate movements were also greatly affected by the shock following the Brexit vote in June 2016. For example, looking at the behavior of British gilts, the FTSE, consumer confidence, and business confidence, one can see very abnormal moves occurring in conjunction with large fluctuations in the pound during the summer of 2016 (Chart 11A & 11B). Thus, if one were to regress the pound on these variables, one would not have observed a risk premium, even though the market was clearly very concerned with the geopolitical outlook for the U.K. Chart 11AAbnormal Moves Around The Brexit Vote... Chart 11B...Make It Hard To Spot Geopolitical Risk Our FX team therefore decided to try to explain the pound's normal behavior using variables that did not experience large abnormal moves in the direct aftermath of the British referendum. For GBP/USD (cable), the currency pair was regressed versus the dollar index and the British leading economic indicator (LEI). For EUR/USD, the currency pair was regressed against the trade-weighted euro and U.K. LEI. The reason for using the trade-weighted dollar and euro as explanatory variables is simple: it helps isolate the pound's movements from the impact of fluctuations in the other leg of the pair. Using the U.K. LEI helps incorporate the immediate outlook for U.K. growth and U.K. monetary policy into the pound's movement. The remaining error term was mostly a reflection of geopolitical risk.10 The results of the models are shown in Chart 12A & 12B. While the pound did show a geopolitical discount in the second half of 2016 (as evidenced by the abnormally large discount from the fundamental-based model), today the pound's pricing shows no geopolitical risk premium, whether against the dollar or the euro. This corroborates the message from the economic policy uncertainty index computed by Baker, Bloom, and Davis, which shows a very low level of economic policy uncertainty based on news articles (Chart 13). Chart 12ANo Geopolitical Risk Embedded... Chart 12B...In Today's Pound Sterling Chart 13Policy Uncertainty Index Muted Considering the thin risk premium embedded in the pound against both the dollar and the euro, GBP does not have much maneuvering room through the upcoming busy calendar. The problem for the pound is that the 5% net disapproval of Brexit among the British public remains smaller than the cohort of British voters who remain undecided (Chart 14). This means that domestic politics in the U.K. could remain a source of surprise, especially as Prime Minister Theresa May's polling remains tenuous (Chart 15). This raises the risk that Hard Brexiters end up controlling 10 Downing Street - despite their status as a minority within the ranks of Conservative MPs (Chart 16). Chart 14A Liability For Sterling Chart 15Theresa May's Tenuous Grip Chart 16Hard Brexiters Are A Minority With the global economic outlook already justifying a lower pound, especially versus the dollar, the pound seems to be too risky of an investment at this moment. It is true that positioning and sentiment towards cable are currently very depressed, raising the risk of a short-term rebound (Chart 17). This could particularly occur if the EU meeting in Salzburg in two weeks results in some breakthrough. Such an event would still not resolve May's domestic conundrum, which is why we would be inclined to fade any such rebound. Bottom Line: On a six-to-nine-month basis, it makes sense to short the pound against the dollar and the yen. Slowing global growth hurts the pound but also hurts the euro while benefiting the greenback and the yen. The political environment in Japan, in particular, supports this reasoning. As we have maintained, Shinzo Abe is not going to lose the September 20 leadership election for the ruling party (Chart 18).11 And the Trump administration is not going to wage a full-scale trade war against Japan. However, after the leadership poll, Abe will press ahead with his agenda to revise the constitution, which will initiate a controversial process and stake his fate on a popular referendum that is likely to be held next year. Chart 17Fade Any Short-Term Rebound Chart 18Abe Lives, But Yen Will Rise At the same time, Trump might try throwing some threats or jabs against Japan before his defense secretary and admirals are able to convince him that such actions subvert U.S. strategy against China. Therefore Japan-specific political risks are on the horizon, in addition to the ongoing trade war with China, which is already a boon for the yen. We are therefore initiating a long yen / short pound tactical trade. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Juan Manuel Correa, Senior Analyst juanc@bcaresearch.com Ekaterina Shtrevensky, Research Associate ekaterinas@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "The U.S. And China: Sizing Up The Crisis," dated July 11, 2018, available at gps.bcaresearch.com. 5 Please see BCA Commodity & Energy Strategy Weekly Report, "Trade, Dollars, Oil & Metals ... Assessing Downside Risk," dated August 23, 2018, available at ces.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "Iraq: The Fulcrum Of Middle East Geopolitics And Global Oil Supply," dated September 5, 2018, available at gps.bcaresearch.com. 7 Please see Burgess Everett, "Key red-state Democrat sides with Trump on wall funding," Politico, August 8, 2018, available at www.politico.com, and Ali Vitali, "Vulnerable Senate Democrats embrace Trump's wall," NBC News, August 13, 2018, available at www.nbcnews.com. 8 Please see Niv Elis and Scott Wong, "Trump again threatens shutdown," The Hill, September 5, 2018, available at thehill.com. 9 Please see BCA Foreign Exchange Strategy Special Report, "Assessing The Geopolitical Risk Premium In The Pound," dated September 7, 2018, available at fes.bcaresearch.com. 10 To make sure the exercise was robust, Foreign Exchange Strategy tested the out-of-sample performance of the model. Reassuringly, the GBP/USD and EUR/GBP models showed great predictive power out-of-sample (see Appendix), while remaining significant and explaining 80% and 65% of the pairs' variations respectively. 11 Please see BCA Geopolitical Strategy Special Report, "Japan: Kuroda Or No Kuroda, Reflation Ahead," dated February 7, 2018, available at gps.bcaresearch.com. Appendix: Traditional Variables Are Of Little Use To Isolate A Geopolitical Risk Premium Chart 19 Chart 20 Geopolitical Calendar
Highlights President Trump has little to do with the ongoing EM selloff; The macro backdrop is the real culprit behind Turkey's woes, particularly the strong dollar... ... Which is a product of global policy divergence, with the U.S. stimulating while China pursues growth-constraining reforms; Chinese stimulus is important to watch, as it could change the game, but we do not expect China to save EM as it did in 2015; Turkey's troubles are a product of its late-stage populist cycle and will not end with Trump's magnanimity; The positive spin on the EM bloodbath is that it may force the Fed to slow its rate hikes, prolonging the business cycle. Feature Chart 1EM: Bloodbath Markets are selling off in Turkey and the wider EM economies (Chart 1), with the financial media focusing on the actions taken by the U.S. President Donald Trump in the escalating diplomatic spat between the two countries. Investors should be very clear what it means to ascribe the ongoing selloff to President Trump's aggressive posture with Ankara in particular and trade in general. If President Trump started EM's troubles with his tweets, he can then end them with another late-night missive. This is not our view. Turkey is enveloped in a deep morass of populism and weak fundamentals since at least 2013. What is worse, the ongoing selloff is likely going to ensnare at least the other fragile EM economies and potentially take down EM as an asset class. In this Report, we recount the pernicious macro backdrop - both geopolitical and economic - that EM economies face today. We then focus on Turkey itself and show that President Trump has little to do with the current selloff. The Bloodbath Is Afoot, Again Every financial bubble, and every financial bust, begins with a compelling story grounded in solid fundamentals. The now by-gone EM "Goldilocks Era" (2001-2011) was primarily driven by exogenous factors: a generational debt-fueled consumption binge in DM; an investment-fueled double-digit growth rate in China that kicked off a structural commodity bull market; and the unleashing of pent-up EM consumption/credit demand (Chart 2).1 These EM tailwinds petered out by 2011. Subsequently, China and EM economies entered a major downtrend that culminated in a massive commodity rout that began in 2014. But before the bloodbath could motivate policymakers to initiate painful structural reforms, Chinese policymakers stimulated in earnest. In the second half of 2015, Beijing became unnerved and injected enormous amount of credit and fiscal stimulus into the mainland economy (Chart 3). The intervention, however, did not change the pernicious fundamentals driving EM economies but merely caused "a mid-cycle recovery, or hiatus, in an unfinished downtrend," as our EM strategists have recently pointed out (Chart 4).2 Chart 2Goldilocks Era##BR##Is Over For EM Chart 3Is China About To Cause Another##BR##EM Mid-Cycle Recovery? Take Brazil, for example. Instead of using the 2014-2015 generational downturn to double-down on painful fiscal and pension reforms, the country's politicians declared President Dilma Rousseff to be the root-cause of all evil that befell the nation, impeached her in April 2016, and then proceeded to unceremoniously punt all painful reforms until after this year's election (if ever). They were enabled to do so by the "mid-cycle recovery" spurred by Chinese stimulus. In other words, Brazil's policymakers did nothing to actually deserve the recovery in asset prices but got one anyway. The country now will experience "faceoff time" with the markets, with no public support for painful reforms (Chart 5) and hardly an orthodox candidate in sight ahead of the October general election.3 Chart 4Where Are China/EM In The Cycle? Chart 5Brazil's Population Is Not Open To Fiscal Austerity Could Brazilian and Turkish policymakers be in luck, as Chinese policymakers have blinked again?4 Our assessment is that the coming stimulus will not be as stimulative as in 2015. First, President Xi's monetary and fiscal policy, since coming into office in 2012, has been biased towards tightening (Chart 6). Second, Chinese leverage has plateaued (Chart 7). In fact, "debt servicing" is now the third-fastest category of fiscal spending growth since Xi came to power (Table 1). Third, the July 31 Politburo statement pledged to make fiscal policy "more proactive" and "supportive," but also reaffirmed the commitment to continue the campaign against systemic risk. Chart 6Xi Jinping Caps##BR##Government Spending And Credit Chart 7The Rise And Plateau##BR##Of Macro Leverage Whether China's mid-year stimulus will be globally stimulative is now the question for global investors. The key data to watch out of China will be August credit numbers, to be released September 9th through 15th. Is President Trump not to be blamed at all for the EM selloff? What about the trade war against China? If anything, tariffs against China have caused Beijing to "blink" and implement some stimulative measures this summer. If one must find fault in U.S. policy, it is the double dose of fiscal stimulus that has endangered EM economies. A key theme for BCA's Geopolitical Strategy this year has been the idea that global policy divergence would replace the global growth convergence.5 Populist economic stimulus in the U.S. and structural reforms in China would imperil growth in the latter and accelerate it in the former, forming a bullish environment for the U.S. dollar (Chart 8). Table 1Total Government Spending Preferences (Under Leader's General Control) Chart 8U.S. Outperformance Should Be Bullish USD As such, the White House is partly responsible for the EM selloff, but not in any way that can be changed with a tweet or a handshake. Furthermore, we do not see the upcoming U.S. midterm election as somehow capable of altering the global growth dynamics.6 It is highly unlikely that Democrats will seek to spend less, and they cannot raise taxes under Trump. Bottom Line: EM economies have never adjusted to the end of their Goldilocks era. A surge in global liquidity pushed investors further down the risk-curve, propping up EM assets despite poor macro fundamentals. China's massive 2015-2016 stimulus arrested the bear market, giving investors a perception that EM economies had recovered. This mid-cycle hiatus, however, has now been overtaken by the global policy divergence between Washington and Beijing, which is bullish USD. President Trump's trade tariffs and aggressive pressure on Turkey do not help. However, they are merely the catalyst, not the cause, of the selloff. As such, investors should not "buy" EM on a resolution of China-U.S. trade tensions or of the Washington-Ankara diplomatic dispute. Contagion Risk BCA's Emerging Market Strategy is clear: in all episodes of a major EM selloff, the de-coupling between different regions proved to be unsustainable, and the markets that showed initial resilience eventually re-coupled to the downside (Chart 9).7 One reason to expect contagion risk among all EM markets is that the primary export market for China and other East Asian exporters are other EM economies, particularly the commodity producers (Chart 10). As such, it is highly unlikely that East Asian EM economies will be able to avoid a downturn. In fact, leading indicators of exports and manufacturing, such as Korea's manufacturing shipments-to-inventory ratio and Taiwan's semiconductor shipments-to-inventory ratio herald further deceleration in their respective export sectors (Chart 11). Chart 9Asian And Latin American Equities:##BR##Unsustainable Divergences Chart 10EM Trades##BR##With EM Chart 11Asia Export##BR##Slowdown Is Afoot In respect of foreign funding requirements of EM economies, our EM strategists have pointed out that there is a substantive amount of foreign currency debt coming due in 2018 (Table 2), with majority EM economies facing much higher foreign debt burdens than in 1996 (Table 3).8 Investors should not, however, rely merely on debt as percent of GDP ratios for their vulnerability assessment. For example, Malaysia's private sector FX debt load stands at 63.7% of GDP, the second highest level after Turkey. But relative to total exports (a source of revenue for its indebted corporates) and FX reserves (which the central bank can use to plug the gap in the balance of payments), Malaysia actually scores fairly well. Table 2EM: Short-Term (Due In 2018) FX Debt Table 3EM Private Sector FX Debt: 1996 Versus Today Chart 12 shows the most vulnerable EM economies in terms of foreign currency private sector debt exposure relative to FX reserves and total exports. Unsurprisingly, Turkey stands as the most vulnerable economy, along with Argentina, Brazil, Indonesia, Chile, and Colombia. Chart 12BCA's Emerging Markets Strategy Has Already Pinned Turkey As The Most Vulnerable EM Economy Will the EM selloff eventually ensnare DM economies as well, particularly the U.S.? We think yes. The drawdown in EM will bid up safe-haven assets like the U.S. dollar. The dollar can be thought of as America's second central bank, along with the Fed. If both the greenback and the Fed are tightening monetary conditions, eventually the U.S. economy will feel the burn. As such, it is dangerous to dismiss the ongoing crisis in Turkey as a merely localized problem that could, at its worst, spread to other EM economies. In 1997, Thailand played a similar role to that of Turkey. The Fed tightened rates in early 1997 and largely remained aloof of the developing East Asia crisis that eventually spread to Brazil and Russia, ignoring the tumult abroad until September 1998 when it finally cut rates three times. Fed policy easing at the end of 1998 ushered in the stock market overshoot and dot-com bubble, whose burst caused the end of the economic cycle. The same playbook may be occurring today. The Fed, motivated by the strong U.S. economy and fears of being too close to the zero-bound ahead of the next recession, is proceeding apace with its tightening cycle. It is likely to ignore troubles in the rest of the world until the USD overshoots or U.S. equities are impacted directly. At that point, perhaps later this year or early next year, the Fed will back off from tightening, ushering the one last overshoot phase ahead of the recession in 2020 - or beyond. Bottom Line: Research by BCA's EM strategists shows that EM contagion is almost never contained in just a few vulnerable economies. For investors who have to remain invested in EM economies, we would recommend that they go long Chinese equities relative to EM, given that Beijing policymakers are stimulating the economy to ensure that Chinese growth is stabilized. While this will be positive for China, it is likely to fall short of the 2015 stimulus that also stimulated non-China EM. An alternative play is to go long energy producers vs. the rest of EM - given our fundamentally bullish oil view combined with rising geopolitical risks regarding sanctions against Iran.9 We eventually expect EM risks to spur an appreciation in the USD that the Fed has to lean against by either pausing its tightening cycle, or eventually reversing it as it did in the 1997-1998 scenario. This decision will usher in the final blow-off stage in U.S. equities that investors will not want to miss. What About Turkey? Chart 13Turkey: Volatile Politics, Volatile Stocks In 2013, we called Turkey a "canary in the EM coal mine" arguing that its historically volatile financial markets would mean-revert as domestic politics became turbulent (Chart 13).10 Turkey is a deeply divided society equally split between the secularist cities, which are primarily located on the Mediterranean (Istanbul, Izmir, Bursa, Adana, etc.), and the religiously conservative Anatolian interior. This split dates back to the founding of the modern Turkish Republic in the post-World War I era (and in truth, even before that). The ruling Justice and Development Party (AKP), a religiously conservative but initially pro-free-market party, managed to appeal to the conservative Anatolia while neutering the most powerful secularist institution in Turkey, its military. Investors hailed AKP's dominance because it reduced political volatility and initially promised both pro-market policies and even accession to the EU. However, the AKP has struggled to win more than 50% of the popular vote in a slew of elections and referendums since coming to power (Chart 14), a fact that belies its supposed iron-grip hold on Turkish politics since it came to power in 2002. The vulnerability behind AKP's hold on office has largely motivated President Recep Tayyip Erdogan's attempt to consolidate political power. While we disagree with the consensus view that Erdogan's constitutional changes have turned Turkey into a dictatorship, some of his actions do suggest a deep fear of losing power.11 Populist leadership is characterized by a strategy of "giving people what they want" so that the policymakers in charge remain in office. Erdogan's perpetually slim hold on power has motivated several populist policy decisions that have stretched Turkey's macro fundamentals. First, Turkey's central bank has essentially been conducting quantitative easing since 2013 via net liquidity injections into the banking system (Chart 15). Notably, these injections began at the same time as the May 2013 Gezi Park protests, which saw a huge outpouring of anti-government sentiment across Turkey's large cities. Essentially, politics has been motivating Ankara's monetary policy over the past five years. Chart 14AKP's Stranglehold On Power Is Overstated Chart 15Turkey's Populist Policies Began##BR##With Gezi Park Protests Second, Turkey's current account balance has suffered under the weight of rising energy costs, with no attempt to improve the fiscal balance (Chart 16). The government has done little in terms of structural reforms or fiscal austerity, instead President Erdogan has continued to challenge central bank independence on interest rates, despite a clear sign that the country is experiencing a genuine inflationary breakout (Chart 17). Chart 16Populism Means No Austerity Is In Sight Chart 17Genuine Inflation Breakout Overall, Turkey is a classic example of how populism in a highly divided and polarized country can get out of control. Foreign investors have long assumed that Erdogan's populism was benign, if not even positive, given the presumably ample political capital at the president's disposal. However, with every election or referendum, the government did not double-down on pro-market structural reforms. Instead, the pressure on the central bank only increased while Turkey's expensive and extravagant geopolitical adventures in neighboring Syria accelerated. In this pernicious macro context, it has not taken much to knock Turkey's assets off balance. President Trump's threats to expand sanctions to Turkish trade are largely irrelevant, given that the vast majority of Turkey's exports and FDI sources are non-American (Chart 18). However, given past behavior - such as after the shadowy Gülen "plot" to take over power or the 2016 coup d'état - markets are by now conditioned to expect that Turkish policymakers will double-down on populist policies in the face of renewed pressure. Chart 18Turkey-U.S. Relationship Is Not Economic What of Turkey's membership in NATO? Should investors fear broader geopolitical instability due to the domestic crisis? No. Ankara has used its membership in NATO, and particularly the U.S. reliance on its Incirlik air base in southern Turkey, as levers in previous negotiations and diplomatic spats with Europe and the U.S. If Ankara were to renege on its commitments to the Western military alliance, it would likely face a united front from Europe and the U.S. As such, we would expect Turkey neither to threaten exit from NATO, which it has not done in the past, nor even to threaten U.S. operations in Incirlik, which Erdogan's government has threatened before. The most likely outcome of the ongoing diplomatic spat, in fact, would be to see Ankara give in to U.S. demands, given the accelerating financial and economic crisis. Such an outcome, however, will not arrest the downturn. Turkey's economy and assets are fundamentally under pressure due to the realization by investors that this year's main macro theme is not the resynchronized global growth recovery, but rather the global policy divergence between the U.S. and China, which has appreciated the U.S. dollar. No amount of kowtowing by Ankara will change this macro trend. Bottom Line: The list of Turkish policy sins is long. Erdogan's reign has been characterized by deep polarization and populism, leading to suboptimal policy choices since at least 2013. The latest U.S.-Turkey spat is therefore merely one of many problems plaguing the country. As such, its resolution will not be a buying opportunity for investors. Investment Implications Our main investment theme in 2018 was that the global policy divergence between the U.S. and China - emblematized by fiscal stimulus in the U.S. and structural reforms in China - would end the global growth resynchronization. As the U.S. economy outperformed the rest of the world, the U.S. greenback would appreciate, imperiling EM economies. The best cognitive roadmap for today is the late 1990s, when the U.S. economy continued to grow apace as the rest of the world suffered from an EM crisis. The problems eventually washed onto American shores in the form of a stronger dollar, forcing the Fed to back off from tightening in mid-1998. Policy easing then led to the overshoot phase in U.S. equities in 1999. Investors should prepare for a similar roadmap by being long DXY relative to EM currencies, long DM equities (particularly U.S.) relative to EM equities, and tactically cautious on all global risk assets. Strategically, however, it makes sense to remain overweight equities as a Fed capitulation would be a boon for risk assets. If the current selloff in EM gets worse, we would expect that the Fed would again back off from tightening as it did in 1998, ushering in a blow-off stage in equities ahead of the next recession. Once the dollar peaks and EM assets bottom, U.S. equities will become the laggard, with global cyclicals outperforming. A secondary conclusion is that President Trump's trade rhetoric in general, and aggressive policies towards Turkey in particular, are merely a catalyst for the selloff. As such, if President Trump changes his mind, we would fade any rally in EM assets. The fundamental policy decisions that have led to the greenback rally have already been taken in 2017 and early 2018. The profligate tax cuts and the two-year stimulative appropriations bill, combined with Chinese policymakers' focus on controlling financial leverage, are the seeds of the current EM imbroglio. Finally, a small bit of housekeeping. We are booking gains on our long Malaysian ringgit / short Turkish lira trade for a gain of 51.2% since May. We are also closing our speculative long Russian equities relative to EM trade for a loss of -0.9% as a result of the persistent headwind from U.S. sanctions. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 2 Please see BCA Emerging Markets Strategy Weekly Report, "Understanding The EM/China Cycles," dated July 19, 2018, available at ems.bcaresearch.com. 3 Please see BCA Emerging Markets Special Report, "Brazil: Faceoff Time," dated July 27, 2018, available at ems.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "China: How Stimulating Is The Stimulus?" dated August 8, 2018, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, and Weekly Report, "Upside Risks In U.S., Downside Risks In China," dated January 17, 2018, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Weekly Report, "Will Trump Fail The Midterm?" dated April 18, 2018, available at gps.bcaresearch.com. 7 Please see BCA Emerging Markets Strategy Weekly Report, "EM: Sustained Decoupling, Or Domino Effect?" dated June 14, 2018, available at ems.bcaresearch.com. 8 Please see BCA Emerging Markets Strategy Special Report, "A Primer On EM External Debt," dated June 7, 2018, available at ems.bcaresearch.com. 9 Please see BCA Geopolitical Strategy and Commodity & Energy Strategy Special Report, "U.S., OPEC Talk Oil Prices Down; Gulf Tensions Could Become Kinetic," dated July 19, 2018, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Monthly Report, "Turkey: Canary In The EM Coal Mine?" in "The Coming Political Recapitalization Rally," dated June 13, 2013, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy and Emerging Markets Strategy Weekly Report, "Turkey: Deceitful Stability," in "EM: The Beginning Of The End," dated April 19, 2017, available at ems.bcaresearch.com.
Highlights Our forecast of higher geopolitical risk in 2018 is coming to fruition; President Trump's two key policies, economic populism (fiscal stimulus) and mercantilism (trade tariffs), will counteract each other; Stimulus is leading to trade deficits and a stronger dollar, while a stronger dollar encourages trade deficits. This is a problem for Trump in 2020; The administration will seek coordinated international currency moves, but the U.S. has less influence today than it did at the time of key 1971 and 1985 precedents; Favor DM over EM assets; favor U.S. over DM stocks; and expect Trump to threaten tariffs against currency manipulation. Feature "China, the European Union and others have been manipulating their currencies and interest rates lower, while the U.S. is raising rates while the dollars [sic] gets stronger and stronger with each passing day - taking away our big competitive edge. As usual, not a level playing field... The United States should not be penalized because we are doing so well. Tightening now hurts all that we have done. The U.S. should be allowed to recapture what was lost due to illegal currency manipulation and BAD Trade Deals. Debt coming due & we are raising rates - Really?" - President Donald Trump, tweet, July 20, 2018 "The dollar may be our currency, but it is your problem." - Treasury Secretary John Connally, 1971, speaking to a group of European officials Chart 1A Fiscal Boost Will Accelerate Inflation In April 2017, BCA's Geopolitical Strategy concluded that "Political Risks Are Overstated In 2017," but also "Understated In 2018."1 At the heart of our forecast was the interplay between three factors: "Domestic Policy Is Bullish USD:" We argued in early 2017 that the political "path of least resistance" would lead to "tax cuts in 2017" and that President Trump's economic policies "will involve greater budget deficits than the current budget law augurs." The conclusion was that "even a modest boost to government spending will motivate the Fed to accelerate its tightening cycle at a time when the output gap is nearly closed and unemployment is plumbing decade lows" (Chart 1). "Chinese Growth Scare Is Bullish USD:" We also correctly predicted that "Chinese data is likely to decelerate and induce a growth scare." Even though Chinese data was peachy in early 2017, we pointed out that "Chinese policymakers have gone forward with property market curbs and begun to tighten liquidity marginally in the interbank system." We would go on to produce several in-depth research reports throughout the year that outlined these reform efforts and linked them to President Xi Jinping's reduced political constraints following the nineteenth National Party Congress in October.2 "European Political Risks Are Bullish USD:" Finally, we argued that a combination of political risks - e.g., the 2018 Italian election - and the slowdown in China would reverberate in Europe, forcing "the ECB to be a lot more dovish than the market expects." Our conclusion in April 2017 - quoted verbatim below - was that these three factors would combine to force President Trump to try to talk down the greenback: The combination of Trump's domestic policy agenda and these global macro-economic factors will drive the dollar up. At some point in 2018, we assume that USD strength will begin to irk Donald Trump and his cabinet, particularly as it prevents them from delivering on their promise of shrinking trade deficits. We suspect that President Trump will eventually reach for the "currency manipulation" playbook of the 1970s-80s. On July 20, President Trump put a big red bow on our forecast by doing precisely what we expected: talking down the USD by charging the rest of the world with currency manipulation. Speaking with CNBC, Trump pointed out that "in China, their currency is dropping like a rock and our currency is going up, and I have to tell you it puts us at a disadvantage." President Trump is correct: Beijing is definitely manipulating the currency, as we pointed out last week (Chart 2).3 Chart 2The CNY Is Much Weaker Than The DXY Implies Chart 3U.S. Outperformance Should Be Bullish USD But President Trump wants to have his cake and eat it too. His economic stimulus is inevitably leading to a widening trade deficit. With tax cuts and increased capital spending, U.S. demand is growing faster than demand in the rest of the world. This economic outperformance in the context of stalling global growth is leading to the greenback rally that we forecast (Chart 3). When the U.S. economy outperforms the rest of the world, the Fed tends to be in the lead of tightening policy among G10 economies, spurring a rally in the trade-weighted dollar index (Chart 4).4 A rising currency then reinforces the trade deficit. Chart 42018 Rally Is Not Over There is much uncertainty regarding President Trump's true preferences, but we know two things: he is an economic populist and a mercantilist. He has been clear on both fronts throughout his campaign. The problem for President Trump is that the two policies are working against one another. His stimulus has spurred a USD rally that will likely offset the impact of his tariffs, particularly the more modest 10% variety he has said he will impose on all Chinese imports (Chart 5). Chart 5Trump Threatens Tariffs On All ##br##Chinese Imports (And Then Some) The Trump administration is therefore facing a choice: triple-down on tariffs, potentially causing a market and economic calamity in the process; or, use protectionism as a bargaining chip in a bout of orchestrated and negotiated, global, currency manipulation. As we pointed out last April, President Trump would not be the first to face this choice: 1971 Smithsonian Agreement President Richard Nixon famously closed the gold window on August 15, 1971 in what came to be known as the "Nixon shock."5 Less understood, but also part of the "shock," was a 10% surcharge on all imported goods, the purpose of which was to force U.S. trade partners to appreciate their currencies against the USD. Much like Trump, Nixon had campaigned on a mercantilist platform in 1968, promising southern voters that he would limit imports of Japanese textiles. As president, he staffed his cabinet with trade hawks, including Treasury Secretary John Connally who was in favor of threatening reduced U.S. military presence in Europe and Japan to force Berlin and Tokyo to the negotiating table. Connally also gave us the colorful quote for the title of this report and also famously quipped that "foreigners are out to screw us, our job is to screw them first." The economists in the Nixon cabinet - including Paul Volcker, then the Undersecretary of the Treasury under Connally - opposed the surcharge, fearing retaliation from trade partners, but policymakers like Connally favored brinkmanship. The U.S. ultimately got other currencies to appreciate, mostly the deutschmark and yen, but not by as much as it wanted. Critics in the administration - particularly the powerful National Security Advisor Henry Kissinger - feared that brinkmanship would hurt Trans-Atlantic relations and thus impede Cold War coordination. As such, the U.S. removed the surcharge merely four months later without meeting most of its objectives, including increasing allied defense-spending and reducing trade barriers to U.S. exports. Even the currency effects dissipated within two years. 1985 Plaza Accord The U.S. reached for the mercantilist playbook once again in the early 1980s as the USD rallied on the back of Volcker's dramatic interest rate hikes. The subsequent dollar bull market hurt U.S. exports and widened the current account deficit (Chart 6). U.S. negotiators benefited from the 1971 Nixon surcharge because European and Japanese policymakers knew that the U.S. was serious about tariffs and had no problem with protectionism. The result was coordinated currency manipulation to drive down the dollar and self-imposed export limits by Japan, both of which had an almost instantaneous effect on the Japanese share of American imports (Chart 7). Chart 6Dollar Bull Market And Current Account Balance In 1980s-90s Chart 7The U.S. Got What It Wanted From Plaza Accord The Smithsonian and Plaza examples are important for two reasons. First, they show that Trump's mercantilism is neither novel nor somehow "un-American." It especially is not anti-Republican, with both Nixon and Reagan having used overt protectionism and currency manipulation in recent history. Second, the experience of both negotiations in bringing about a shift in the U.S. trade imbalance will motivate the Trump administration to reach for the same "coordinated currency manipulation" playbook. In fact, Trump's Trade Representative, Robert Lighthizer, is a veteran of the 1985 agreement, having negotiated it for President Ronald Reagan. Should investors get ahead of the Plaza Accord 2.0 by shorting the greenback? The knee-jerk reactions of the market suggest that this is the thinking of the median investor. For instance, the DXY fell by 0.7% on the day of Trump's tweet. We disagree, however, and are sticking with our long DXY position, initiated on January 31, 2018, and up 6.17% since then.6 Why? Because 2018 is neither 1985 nor 1971. President Trump, and America more broadly, is facing several constraints today. As such, we do not expect that he will find eager partners in negotiating a coordinated currency manipulation. Chart 8Globalization Has Reached Its Apex Chart 9Global Protectionism Has Bottomed Economy: Europe and Japan were booming economies in the early 1970s and mid-1980s, and had the luxury of appreciating their currencies at the U.S.'s behest. Today, it is difficult to see how either Europe or China (now in Japan's place) can afford significant monetary policy tightening that would engineer structural bull markets in their currencies. For Europe, the risk is that the peripheral economies may not survive a back-up in yields. For China, if the PBOC engineered a persistently strong CNY/USD, it would tighten financial conditions and hurt the export sector. Apex of Globalization: U.S. policymakers were able to negotiate the 1971 and 1985 currency agreements in part because of the underlying promise of growing trade. Europe and Japan agreed to a tactical retreat to get a strategic victory: ongoing trade liberalization. In 2017-18, however, this promise has been muted. Global trade has peaked as a percent of GDP (Chart 8), average tariffs have bottomed (Chart 9), and the number of preferential trade agreements signed each year has collapsed (Chart 10). Temporary trade barriers have ticked up since 2008 (Chart 11). To be clear, these signs are not necessarily proof that globalization is reversing, but merely that it has reached its apex. Nonetheless, America's trade partners will be far less willing to agree to coordinated currency manipulation in an era where the global trade pie is no longer growing. Chart 10Low-Hanging Fruit Of Globalization Already Picked Chart 11Temporary Trade Barriers Ticking Up Multipolarity: The U.S. is simply not as powerful - relatively speaking - as it was at the height of the Cold War (Chart 12). As such, it is difficult to see how President Trump can successfully bully major economies into self-defeating currency manipulation. The Cold War gave the U.S. far greater leverage, particularly vis-à-vis Europe and Japan. Today, Trump's threats of pulling out of NATO are merely spurring Europeans to integrate further as Russia is no longer the threat it once was. There are no Soviet tank divisions arrayed across the Fulda Gap in Eastern Germany. In fact, Russia is cutting defense spending and further integrating into the European economy with new pipeline infrastructure (which Trump has pointedly criticized). And China is overtly hostile to the U.S. and thus completely unlike Japan, which huddled under the American nuclear umbrella during the U.S.-Japan trade war. Chart 12The U.S. Has Less Weight To Throw Around Is the Trump administration ignoring these major differences? No. There may be a much simpler explanation for President Trump's dollar bearishness: domestic politics. We only see a probability of around 20% that the U.S. trade deficit will shrink during the course of Trump's first term in office. Most likely, the trade deficit will widen as domestic stimulus supercharges the U.S. economy relative to the rest of the world and the greenback rallies. Economic slowdown in China and EM will likely further expand the U.S. trade deficit as these economies cut interest rates and allow their exchange rates to drop. President Trump therefore has a problem. The only way the trade deficit will shrink by 2020 is if the U.S. enters a recession and domestic demand shrinks - but presidents do not survive re-election during recessions. If a recession does not develop, he will have to explain to voters in early 2020 why the trade deficit actually surged, despite all his tough rhetoric, tariffs, and trade negotiations. The charge of currency manipulation could therefore do the trick, blaming the rest of the world for the USD rally that was largely caused by U.S. stimulus. Bottom Line: We do not expect the Fed to respond to President Trump's rhetoric. The current Powell Fed is not the 1970s Burns Fed. As such, we would fade any upcoming weakness in the USD. We expect the dollar bull market to carry on in 2018 and to continue weighing on global risk assets, namely EM equities and currencies. Investors should remain overweight DM assets relative to EM in terms of broad global asset allocation, and overweight U.S. equities in particular relative to other DM equities. The major risk to our bullish USD view is not a compliant Fed but rather a China that "blinks." Beijing has begun some modest stimulus in the face of the economic slowdown produced by the Xi administration's aforementioned efforts to contain systemic financial risk. Over the next month, we will dive deep into Chinese politics to see if the trade conflict will prompt Xi to reverse his attempt to tighten policy and once again embrace a resurgence in credit growth. In the long term, however, we expect that the Trump administration will grow frustrated with the fact that its two main policies - economic populism at home and mercantilism abroad - will offset each other and that the U.S. trade imbalance will continue to grow apace. At that point, President Trump may decide to reach for two levers: staffing the Fed with über doves and/or ratcheting up tariffs to much higher levels. We expect the latter to be the more likely outcome than the former, and either would result in a serious blowback from the rest of the world that would unsettle markets. More importantly, it would be the death knell of globalization, stranding trillions of dollars of capex behind suddenly very relevant national borders. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017, and "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy, "China Down, India Up," dated March 15, 2017, "China: Looking Beyond The Party Congress," dated July 19, 2017, "China's Nineteenth Party Congress: A Primer," dated September 13, 2017, "China: Party Congress Ends... So What?" dated November 1, 2017, "A Long View Of China," dated December 28, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Weekly Report, "Whoever Said Anything About Bluffing?" dated July 18, 2018, available at gps.bcaresearch.com. 4 Please see BCA Foreign Exchange Strategy Weekly Report, "The S&P Doesn't Abhor A Strong Dollar," dated July 20, 2018, available at fes.bcaresearch.com. 5 Please see Douglas A. Irwin, "The Nixon shock after forty years: the import surcharge revisited," World Trade Review 12:01 (January 2013), pp. 29-56, available at www.nber.org; and Barry Eichengreen, "Before the Plaza: The Exchange Rate Stabilization Attempts of 1925, 1933, 1936, and 1971," Behl Working Paper Series 11 (2015). 6 Please see BCA Geopolitical Strategy Weekly Report, "America Is Roaring Back! (But Why Is King Dollar Whispering?)," dated January 31, 2018, available at gps.bcaresearch.com.
Highlights President Trump is a prisoner of his own mercantilist rhetoric - there is more trade tension and volatility to come; China's depreciation of the RMB can go further - and will elicit more punitive measures from Trump; Gasoline prices are a constraint on Trump's Maximum Pressure campaign against Iran, but only until midterm elections are done; Brexit woes are keeping us short GBP/USD, but Theresa May has discovered the credible threat of new elections - we are putting a trailing stop on this trade at 2%; The EU migration "crisis" is neither a real crisis nor investment relevant. Feature General Hummel: I'm not about to kill 80,000 innocent people! We bluffed, they called it. The mission is over. Captain Frye: Whoever said anything about bluffing, General? The Rock, 1996 As BCA's Geopolitical Strategy has expected since November 2016, the risk of trade war poses a clear and present danger for investors.1 The U.S. imposed tariffs of 25% on $34 billion of Chinese goods on July 6, with tariffs on another $16 billion going into effect on July 20. President Trump announced on July 10 that he would levy a 10% tariff on an additional $200 billion of Chinese imports by August 31 and then on another $300 billion if China still refused to back down. That would add up to $550 billion in Chinese goods and services that could be subject to tariffs, more than China exported to the U.S. last year (Chart 1)! Chart 1President Trump Magically Threatens ##br##Even Non-Existent China Imports Table 1Market's Couldn't Care##br## Less About Tariffs The S&P 500 couldn't care less. Trade-related events - and other geopolitical crises - have thus far had a negligible impact on U.S. equities (Table 1). If anything, stocks appear to be slowly climbing the geopolitical wall of worry since plunging to a low of 2,581 on February 8, which was before any trade tensions emerged in full focus (Chart 2A and Chart 2B).2 Chart 2AStocks Climbing The 'Wall Of Worry' On Trade Tensions... Chart 2B...And On Military Tensions Speaking with clients, the consensus appears to be that President Trump is "bluffing." After all, did he not successfully create a "credible threat" amidst the tensions with North Korea, thus forcing Pyongyang to stand down, change its bellicose rhetoric, free U.S. prisoners, and freeze its nuclear device and ballistic tests? This was a genuinely successful application of his "Maximum Pressure" tactic and he did not have to fire a shot!3 Yes, but the Washington-Pyongyang 2017 brinkmanship caused 10-year Treasuries to plunge 35bps from their July 7 peak to their September 7 low.4 Our colleague Rob Robis - BCA's Chief Fixed Income Strategist - assures us that this move in Treasuries last summer was purely North Korea-related, which suggests that not all investors were relaxed and expecting tensions to resolve themselves.5 President Trump may be bluffing on protectionism, on Iran, and on the U.S.'s trade and geopolitical relationship with its G7 allies. However, we should consider two risks. The first is that his opponents might not back down. Yes, we agree with the consensus that China will ultimately lose a trade war with the U.S. It is a trade surplus country fighting a trade war with its chief source of final export demand (Chart 3). Chart 3China Has More To Lose Than The U.S. Forecasting when China backs down, however, is difficult. If Beijing backs down in 2018, investors betting on stocks ignoring trade risks will be proven correct. We do not see this happening. Instead, we expect Beijing to continue using CNY depreciation to offset the impact of tariffs, likely exacerbating the ongoing USD rally in the process, and eventually putting pressure on U.S. corporate earnings in Q3 and Q4. China does not appear to be panicking about the threat of a 10% tariff. In fact, Beijing may decide to double-down on its structural reform efforts, which have negatively impacted growth in the country thus far, blaming President Trump's protectionist policies for the pain. The other question is whether the U.S. political context will allow President Trump to end the trade war. Our clients, colleagues, and friends in the financial industry seem to have collective amnesia about the "trade truce" orchestrated by Treasury Secretary Steven Mnuchin on May 20. The truce lasted merely a couple of days, with the U.S. ultimately announcing on May 29 that the tariffs on $50 billion of Chinese imports would go forward. President Trump may have wanted to present the Mnuchin truce as a big victory ahead of the midterm elections. His tweets the next day were triumphant.6 However, once the collective American establishment (Congress, pundits, and even Trump's ardent supporters in the conservative media) got hold of the details of the deal, they were shocked and disappointed.7 Why? The American "median voter" is far more protectionist than the political establishment has wanted to admit. Now that this public preference has been elucidated, President Trump himself cannot move against it. He is a prisoner of his own mercantilist rhetoric. President Trump may be dealing with a situation similar to the one General Hummel faced in the iconic mid-1990s action thriller The Rock. Hummel, played by the steely Ed Harris, holed up in Alcatraz with VX gas-armed M55 rockets, threatening to take out tens of thousands in San Francisco unless a ransom was paid by the Washington establishment. Unfortunately for Hummel, the psychotic marines he brought to "The Rock" turned against him when he suggested that the entire operation was in fact a bluff. As such, we reiterate: Whoever said anything about bluffing? China: Beware Beijing's Retaliation Since 2017, we have cautioned investors that Beijing was likely to retaliate to the imposition of tariffs by weakening the CNY/USD.8 June was the largest one-month decline in CNY/USD since the massive devaluation in 1994 (Chart 4). BCA's China Investment Strategy has shown that the PBOC is indeed allowing China's currency to depreciate against the U.S. dollar.9 Chart 5 shows the actual CNY/USD exchange rate alongside the value that would be predicted based on its relationship with the dollar over the year prior to its early-April peak. The chart suggests that the decline in CNY/USD appears to have reflected the strength in the U.S. dollar until very recently. However, CNY/USD has fallen over the past few days by a magnitude in excess of what would be expected given movements in the greenback, implying that the very recent weakness is likely policy-driven. Chart 4The Biggest One-Month Yuan Drop Since 1994 Chart 5The CNY Is Much Weaker Than The DXY Implies BCA's Foreign Exchange Strategy has pointed out that currency depreciation is also a way to stimulate the economy in the face of the central government's ongoing deleveraging policy.10 Not only does a weaker CNY dull the impact of Trump's tariffs, it also insulates China against a slowdown in global trade volumes (Chart 6). Moreover, China's current account fell into deficit last quarter (Chart 7). A weaker RMB helps deal with this issue, but the PBoC may be forced to cut Reserve Requirement Ratios (RRRs) further if the deficit remains in place, forcing the currency even lower. Chart 6China Needs A Buffer Against Slowing Trade Chart 7Supportive Conditions For A Lower CNY There is no silver lining in this move by Beijing. Evidence that China is manipulating its currency would be a clear sign of an outright, full-scale trade war between the U.S. and China. On one hand, a falling RMB will improve the financial position of China's exporters. On the other hand, it may invite further protectionist action from the U.S., including a threat by the White House to increase the tariff levels on the additional $500 billion of imports from the current 10% rate, or to enhance export restrictions on critical technologies, or to add new investment restrictions. Several of our clients have pointed out that China does not want a trade war, that it cannot win a trade war, and that it is therefore likely to offer concessions ahead of the U.S. midterm election. We agree that China is at a disadvantage.11 But we also reiterate that the concessions have already been offered, in mid-May following the Mnuchin negotiations with Chinese Vice Premier Liu He. China and the U.S. may of course resume negotiations at any time, but it will likely take months, at best, to arrange a deal that reverses this month's actual implementation of tariffs. We think that the obsession with "who will win the trade war" is misplaced. Of course, the U.S. will "win." The problem is that what the Trump administration and what investors consider a "victory" may be starkly different: victory may not include a rip-roaring stock market. In fact, President Trump may require a stock market correction precisely to convince his audience, including those in Beijing, that his threats are indeed credible. Bottom Line: President Trump's promise of a 10% tariff on $500 billion of Chinese imports can easily be assuaged by a CNY/USD depreciation. If we know that Beijing is depreciating its currency, so does the White House. The charge against Beijing for currency manipulation could occur as late as the Treasury Department's semiannual Report to Congress in October, or informally via a presidential tweet at any time before then. While the formal remedies against a country deemed to be officially engaged in currency manipulation are relatively benign in the context of the ongoing trade war, we would expect President Trump to up the pressure on China regardless. Iran: Can Midterm Election Stay President Trump's Hand? We identified U.S.-Iran tensions in our annual Strategic Outlook as the premier geopolitical risk in 2018 aside from trade concerns.12 We subsequently argued that President Trump's application of "Maximum Pressure" against Iran would likely exacerbate tensions in the Middle East, add a geopolitical risk premium to oil prices, and potentially lead to a military conflict in 2019 (Diagram 1).13 Diagram 1Iran-U.S. Tension Decision Tree The Brent crude oil price has come off its highs just below $80/bbl in late May and appears to be holding at $75/bbl. Is the market once again ignoring bubbling U.S.-Iran tensions or is there another factor at play? We suspect that investors are placing their hopes on White House pressure on producers to bring massive amounts of crude online to offset the impact of "Maximum Pressure" on Iran. First, Trump tweeted in April that "OPEC is at it again," keeping oil prices artificially high. He followed this with another tweet at the end of June, directly requesting that Saudi Arabia increase oil production by up to 2 million b/d so that he may continue to play brinkmanship with Tehran. Second, the Libyan media leaked that President Trump sent letters to the representatives of Libya's warring factions, imploring them to restart oil exports or face international prosecution and potential U.S. military intervention.14 The pressure on the Libyan authorities appears to have worked, with the Tripoli-based National Oil Corporation (NOC) ending its force majeure, a legal waiver on contractual obligations, on the ports of Ras Lanuf, Es Sider, Zueitina, and Hariga. Third, Secretary of State Mike Pompeo signaled on July 10 that the U.S. would consider granting waivers to countries seeking to avoid being sanctioned for buying oil from Iran. On July 15, however, the administration clarified the comment by stating that it would only grant limited exceptions based on national security or humanitarian efforts. The White House is realizing that, unlike its brinkmanship with North Korea, "Maximum Pressure" on Iran comes with immediate domestic costs: higher gasoline prices (Chart 8). The last thing President Trump wants to see is his household tax cut trumped by the higher cost of gasoline. Chart 8How Badly Do Americans Want A New Iran Deal? Chart 9Iran Is Not Yet At Peak North Korean Levels Of Threat Applying Maximum Pressure on Iran is tricky. Politically, the upside is limited for President Trump. First, a majority of Americans (62%) do not want to see the U.S. withdraw from the deal, and do not consider Iran to be as critical of a threat as North Korea (Chart 9). That said, 40% believe that Iran is a "very serious" threat - up from just 30% in October, 2017 - and 62% of Americans believe that "Iran has violated the terms" of the nuclear agreement. These are numbers that President Trump can "work with," but not if gasoline prices rise to consumer-pinching levels. As such, the question is whether we should stand down from our bullish oil outlook given President Trump's active role in eking out new supply. We should, if there were supply to be eked out. BCA's Commodity & Energy Strategy believes that global supply capacity will not be sufficient to keep prices below $80/bbl in the event that Venezuela collapses in 2019 or that Iranian export losses are greater than the 500,000 b/d we are currently projecting.15 The U.S. EIA estimates there is only 1.8mm b/d of spare capacity available worldwide this year, to fall to just over 1 mm b/d next year (Chart 10). Our commodity strategists believe that the idle and spare capacity of KSA, Russia, and other core OPEC 2.0 states that can actually increase production would be taxed to the extreme to cover losses of Iranian exports, especially if the losses reached 1 mm b/d. In fact, many secondary OPEC 2.0 producers are struggling to produce at their 2017-2018 production quota, suggesting that lack of investment and natural depletion have already taken their toll (Chart 11). Chart 10Global Spare Capacity##br## Stretched Thin Chart 11OPEC 2.0's Core Producers Would##br## Struggle To Replace Lost Exports Could President Trump back off from the threat of brinkmanship with Iran due to the risk of rising oil prices? Yes, absolutely. We have argued in the past that President Trump appears to be an intensely domestically-focused president. We also see little logic, from the perspective of U.S. interests broadly defined or President Trump's "America First" strategy specifically, in undermining the Obama-era nuclear agreement. As such, domestic constraints could stay President Trump's hand. On the other hand, these constraints would have the greatest force ahead of the November 2018 midterm and the 2020 general elections. This gives President Trump a window between November 2018 and at least the early summer of 2020 to put Maximum Pressure on Iran. As such, we think that investors should fade White House attempts to shore up global supply. Once the midterm election is over, the pressure will fall back on Iran. What about Iran's calculus? Tehran has an interest in dampening tensions ahead of the midterms as well. However, if the U.S. actually enforces sanctions, as we expect it will, we are certain that Iran will begin to ponder the retaliatory action we describe in Diagram 1. In fact, Iran's population appears to be itching for a confrontation, with an ever-increasing majority supporting the restart of Iranian nuclear facilities in response to U.S. withdrawal from the JCPOA nuclear agreement (Chart 12). Iranian officials have also already threatened to close the Straits of Hormuz as we expected they would. Chart 12Iranians Supported Ending Nuclear Deal If The U.S. Did (And It Did!) Bottom Line: Between now and November, U.S. policy towards Iran may be much ado about nothing. However, we expect the pressure to rise by the end of the year and especially in 2019. Our subjective probability of armed conflict remains at an elevated 20%, by the end of 2019. This is four times greater than our probability of kinetic action amidst the tensions between the U.S. and North Korea. Brexit: Has Theresa May Figured Out How Credible Threats Work? We have long argued that a soft Brexit is incompatible with Euroskeptic demands for increased sovereignty (Diagram 2). And, indeed, sovereignty was one of the main demands - if not the main demand - of Brexit voters ahead of the referendum. A large percent, 32% of "leave" voters, said they would be willing to vote "stay" if a deal with the EU gave "more power to the U.K. parliament," an even greater share than those focused on migration (Chart 13). As such, since March 2016, we have expected the U.K. Conservative Party to split into factions regardless of the outcome of the vote on EU membership.16 Diagram 2The Illogic Of ##br##Soft Brexit Chart 13Sovereignty Topped The##br## List Of Brexit Voter Concerns U.K. Prime Minister Theresa May has fought against the inevitable by inviting notable Euroskeptics into her cabinet and by trying to pursue a hard Brexit in practice. The problem with this strategy is that it won't work in Westminster, where a whopping 74% of all members of parliament, and 55% of all Tory MPs, declared themselves as "remain" supporters ahead of the 2016 referendum (Chart 14). Given that the House of Commons has to approve the ultimate U.K.-EU deal, a hard-Brexit deal is likely to fail in Parliament. While such a defeat would not automatically bring up an election, May would be essentially left without any political capital with which to continue EU negotiations and would either have to resign or call a new election. Chart 14Westminster MPs Support Bremain! Theresa May therefore has two options. The first is to trust the political instincts of David Davis and Boris Johnson and try to push a hard Brexit through the House of Commons. But with a slim majority of just one MP, how would she accomplish such a feat? Nobody knows, ourselves included, which is why we shorted the GBP as long as May stubbornly listened to the Euroskeptics in her cabinet. However, it appears that May has finally decided to ditch her Euroskeptic cabinet members and establish the "credible threat" of a new election. While May has not uttered the phrase directly, she hinted at a new election when she suggested that "there may be no Brexit at all." The message to hard-Brexit Tory rebels is clear: back my version of Brexit or risk new elections. From an economic perspective, retaining some semblance of Common Market membership is obviously superior to the hard-Brexit alternative. It is so superior, in fact, that Boris Johnson himself called for it immediately following the referendum!17 From a political perspective, it is also much easier to persuade less than two-dozen committed Tory Euroskeptics that a new election would be folly than it is to convince half of the party that the economic risks of a hard-Brexit are inconsequential. The switch in May's tactic therefore warrants a cautionary approach to our current GBP/USD short. The recommendation is up 5.55% since February 14. However, the GBP could be given a tailwind if investors sniff out fear amongst hard Brexit Tories. We still believe that downside risks exist in the short term. First, there is no telling if the EU will accept the particularities of May's Brexit strategy. In fact, the EU may want to make May's life even more difficult by asking for more concessions. Second, Euroskeptic Tories in the House of Commons may be willing martyrs, rebelling against May regardless of the economic and political consequences. Bottom Line: We are keeping our short GBP/USD on for now, which has returned 5.55% since February 14, but we will tighten the stop to just 2%. We think that Theresa May has finally figured out how to use "credible threats" to cajole her party into a soft Brexit. The problem, however, is that she still needs Brussels to play ball and her Euroskeptic MPs to act against their ideology. Europe: Will The Immigration Crisis End The EU? Chart 15European Migration Crisis Is Over No. There is no migration crisis in the EU (Chart 15). Despite the posturing in Europe over the past several months, the migration crisis ended in October 2015. As we forecast at the time, Europe has since taken several steps ovet the succeeding years to increase the enforcement of its external borders, including illiberal methods that many investors thought beyond European sensibilities.18 Today, EU member states are openly interdicting ships carrying asylum seekers and turning them away in international waters. Chancellor Angela Merkel has become just the latest in a long line of policymakers to succumb to her political constraints - and abandon her preferences - by agreeing to end the standoff with her conservative Bavarian allies. Merkel has agreed to set up transit centers on the border of Austria from where migrants will be returned to the EU country where they were originally registered, or simply sent across the border to Austria. The idea behind the move is to end the "pull" that Merkel inadvertently created by openly declaring that Germany was open to migrants regardless of where they came from. Why wouldn't migrants keep coming to Europe regardless? Because if the promise of a job and a legal status in Germany or other EU member states is no longer available, the cost - in treasure, limb, and life - of the journey through the Sahara and unstable states like Libya, and the Mediterranean Sea will no longer make sense. As Chart 15 shows, potential migrants are capable of making the cost-benefit calculation and are electing to stay put. Bottom Line: The EU migration crisis is not investment-relevant. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 Please see the Appendices for the detailed description of events. 3 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," June 8, 2018, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 5 BCA Global Fixed Income Strategy Weekly Report, "Have Bond Yields Peaked For The Cycle? No," dated September 12, 2017, available at gfis.bcaresearch.com. 6 His tweets in the immediacy of the deal suggest that this was the case. He tweeted, immediately following Mnuchin's Fox News appearance, "China has agreed to buy massive amounts of ADDITIONAL Farm/Agricultural Products - would be one of the best things to happen to our farmers in many years!" He then tweeted again, suggesting that his deal was superior to anything President Obama got, "I ask Senator Chuck Schumer, why didn't President Obama & the Democrats do something about Trade with China, including Theft of Intellectual Property etc.? They did NOTHING! With that being said, Chuck & I have long agreed on this issue! Trade, plus, with China will happen!" His third tweet suggested that the deal being negotiated was indeed a big compromise, "On China, Barriers and Tariffs to come down for first time." All random capitalizations are President Trump's originals. 7 We reacted to the truce by arguing that it would not "last long." It lasted merely three days! Please see BCA Geopolitical Strategy Weekly Report, "Some Good News (Trade), Some Bad News (Italy)," dated May 23, 2018, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, and "Are You 'Sick Of Winning' Yet?" dated June 20, 2018, available at gps.bcaresearch.com. 9 Please see BCA China Investment Strategy Weekly Report, "Now What?" dated June 27, 2018, available at cis.bcaresearch.com. 10 Please see BCA Foreign Exchange Strategy Weekly Report, "What Is Good For China Doesn't Always Help The World," dated June 29, 2018, available at fes.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Year Two: Let The Trade War Begin," dated March 14, 2018, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Strategic Outlook, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Why Conflict With Iran Is A Big Deal - And Why Iraq Is The Prize," dated May 30, 2018, available at gps.bcaresearch.com. 14 Please see "Trump's letter to rivals allegedly results in resumption of oil exports in Libya," Libyan Express, dated July 11, 2018, available at libyanexpress.com. 15 Please see BCA Commodity & Energy Strategy Weekly Report, "Brinkmanship Fuels Chaos In Oil Markets, And Raises The Odds Of Conflict In The Gulf," dated July 5, 2018, available at ces.bcaresearch.com. 16 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 17 Johnson stated right after the referendum that "there will continue to be free trade and access to the single market." Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. 18 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. Appendix Appendix 2A Appendix 2B Appendix 2B (Cont.) Geopolitical Calendar
Highlights BCA's Geopolitical Power Index (GPI) confirms that we live in a multipolar world; Most of President Trump's policies are designed to strike out against this structural reality; Trade war with China is real and presents the premier geopolitical risk in 2018; President Trump's aggression towards G7 allies boils down to greater NAFTA risk; We remain bullish USD, bearish EM, maintain our short U.S. China-exposed equities and closing all our "bullish" NAFTA trades; Remain short GBP/USD, Theresa May's days appear numbered. Feature "We're going to win so much, you're going to be so sick and tired of winning." Candidate Donald Trump, May 26, 2016 In 2013, BCA's Geopolitical Strategy introduced the concept of multipolarity into our financial lexicon.1 Multipolarity is a term in political science that denotes when the number of states powerful enough to pursue an independent and globally relevant foreign policy is greater than one (unipolarity) or two (bipolarity). At the time, the evidence that U.S. global hegemony was in retreat was plentiful, but the idea of a U.S. decline was still far from consensus. By late 2016, however, President Donald Trump was overtly campaigning on it. His campaign slogan, "Make America Great Again," promised to reverse the process by striking out at the perceived causes of the decline: globalization, unchecked illegal immigration, and the ineffective foreign policy of the D.C. establishment. How can we quantitatively prove that the world is multipolar? We recently enhanced the classic National Capability Index (NCI) with our own measure, the Geopolitical Power Index (GPI). The original index, created for the Correlates of War project in 1963, had grown outdated. Its reliance on "military personnel" and "iron and steel production" harkened back to the late nineteenth century and overstated the power of China (Chart 1). Chart 1The National Capability Index Overstates China's Power Our own index avoids these pitfalls, while retaining the parsimony of the NCI, by focusing on six key factors: Population: We adapted the original population measure by penalizing countries with large dependency ratios. Yes, having a vast population matters, but having too many dependents (the elderly and youth) can strain resources otherwise available for global power projection. Global Economic Relevance: The original index failed to capture a country's relevance for the global economy. Designed at the height of the Cold War, the NCI did not foresee today's globalized future. As such, we modified the original index by introducing a measure that captures a country's contribution to global final demand. The more an economy imports, the greater its bargaining power in terms of trade and vis-à-vis its geopolitical rivals. Arms Exports: Having a large army is no longer as relevant now that wars have become a high-tech affair. To capture that reality, we replaced the NCI's focus on the number of soldiers with arms exports as a share of the global defense industry. We retained the original three variables that measure primary energy consumption, GDP, and overall military expenditure. Chart 2 shows the updated data. As expected, the U.S. is in decline, having lost nearly a third of its quantitatively measured geopolitical power since 1998. Over the same period, China has gone from having just 30% of U.S. geopolitical power to over 80%. Other countries, like Russia, India, Turkey, Iran, and Pakistan, have also seen an increase in geopolitical power over the same period, confirming their roles as regional powers (Chart 3). Chart 2BCA's Geopolitical Power Index Illustrates A Multipolar World Chart 3China Was Not The Only EM To Rise President Trump was elected with the mandate of changing the trajectory of American power and getting the country back on a "winning" path. Investors can perceive nearly all the moves by the administration - from protectionist actions against China and traditional allies, to applying a "Maximum Pressure" doctrine against North Korea and Iran - as a fight against the structural decline of U.S. power. Isn't President Trump "tilting at windmills"? Fighting a vain battle against imaginary adversaries? Yes. The decline of the U.S. is a product of classic imperial overstretch combined with the natural lifecycle of any global hegemon. U.S. policymakers have made decisions that have hastened the decline, but the overarching American geopolitical trajectory would have been negative regardless: Global peace brought prosperity which strengthened Emerging Markets (EM), particularly China, relative to the U.S. That said, Trump is not as crazy as the media often imply. Chaos is not necessarily bad for a domestically driven economy secured by two oceans. The U.S. tends to outperform the rest of the world - economically, financially, and geopolitically - amid turbulence. Our own updated GPI shows that both World Wars were massively favorable for U.S. hegemony (Chart 4), although this time around the chaos is mostly self-inflicted. Chart 4America Profits From Chaos Similarly, Trump's economic populism at home is buoying sentiment and assuaging the negative consequences - real or imagined - of his protectionism. Meanwhile, the threat of tariffs is souring the mood abroad. This policy mix is causing U.S. assets to outperform (Chart 5). Most importantly, the U.S. dollar is now up 2.7% since the beginning of the year, putting pressure on EM assets. When combined with continued counter-cyclical structural reforms in China, we maintain that the overall macro and geopolitical context remains bearish for global risk assets. This is not the first time that an American president has deployed both an aggressive trade policy and an aggressive foreign policy. The difference, this time around, is that the world is multipolar. A defining feature of multipolarity is that it is less predictable and more likely to produce inter-state conflict (Chart 6). As more countries matter - geopolitically, economically, financially - the number of "veto players" rises, making stable equilibria more difficult to produce. As such, bullying as a negotiating tactic worked when used by Presidents Nixon, Reagan, Bush Jr., and Clinton, but may not work today. Investors should therefore prepare for a long period of uncertainty this summer as the world responds to a U.S. administration focused on "winning." Chart 5U.S. Assets Outperform Chart 6Multipolarity Produces Uncertainty Bottom Line: There is a clear logic behind President Trump's foreign and trade policy. He is trying to reverse a decline in U.S. hegemony. The problem is that his policy decisions are unlikely to address the structural causes of America's decline. What is much more likely is that his policy will cause the rest of the world to react in unpredictable ways. The U.S. may benefit, but that is not a forgone conclusion. Investors should position themselves for a volatile summer. Below we review three key issues, two negative and one positive. The U.S. Vs. China: The Trade War Is Real The Trump administration has announced that it will go ahead with tariffs on $50 billion worth of Chinese imports in retaliation for forced technology transfer and intellectual property theft under Section 301 of the 1974 Trade Act. The tariffs will come in two tranches beginning on July 6. China will respond proportionately, based on both its statements and its response to the steel and aluminum tariffs (Chart 7). If the two sides stop here, then perhaps the trade war can be delayed. But Trump is already saying he will impose tariffs on a further $200 billion worth of goods. At that point, if Beijing re-retaliates, China's proportionate response will cover more goods than the entire range of U.S. imports (Chart 8). Retaliation will have to occur elsewhere. Chart 7Trump's Steel/Aluminum Tariffs Chart 8Trump's Tariffs On China We would expect the CNY/USD to weaken as negotiations fail. We would also expect tensions to continue spilling over into the South China Sea and other areas of strategic disagreement.2 The South China Sea or Taiwan could produce market-moving "black swan" geopolitical events this year or next.3 Chart 9Downside Risks Continue It is critical to distinguish between the U.S. trade conflict with China and the one with the G7. In the latter case, the U.S. political establishment will push against the Trump administration, encouraging him to compromise. With China, however, Congress is becoming the aggressor and we certainly do not expect the Defense Department or the intelligence community to play the peacemaker with Beijing. In particular, members of Congress are trying to cancel Trump's ZTE deal while expanding the powers of the Committee on Foreign Investment in the United States (CFIUS) to restrict Chinese investments.4 These congressional factors underscore our theme that U.S.-China tensions are structural and secular.5 Would China stimulate its economy to negate the effects of tariffs? We see nothing yet on the policy side to warrant a change in our fundamental view, which holds that any stimulus will be limited due to the agenda of containing systemic financial risk. Credit growth remains weak and fiscal spending has not yet perked up (Chart 9), portending weak Chinese imports and negative outcomes for EM. The risk to Chinese growth remains to the downside this year (and likely next year) as the government continues with the reforms. Critically, stimulus is not the only possible Chinese response to trade war. A trade war with the United States will provide Xi with a "foreign devil" on whom he can blame the pain of structural reforms. As such, it is entirely possible that Beijing doubles-down on reforms in light of an aggressive U.S. Bottom Line: The U.S.-China trade war is beginning and will cause additional market volatility and, potentially, a "black swan" event, especially ahead of the U.S. midterm elections. We do not expect 2015-style economic stimulus from Beijing. Stay long U.S. small caps relative to large caps; short U.S. China-exposed equities; and remain short EM equities relative to DM. The U.S. Vs. The G6: This Is About NAFTA There was little rhyme or reason to President Trump's smackdown of traditional U.S. allies at the G7 summit in Quebec. As our colleague Peter Berezin recently pointed out, the U.S. is throwing stones while living in a glass house.6 While the overall level of tariff barriers within developed countries is low, the U.S. actually stands at the top end of the spectrum (Chart 10). The decision to launch an investigation into whether automobile imports "threaten to impair the national security" of the U.S. - under Section 232 of the Trade Expansion Act of 1962 - falls into the same rubric of empty threats. The U.S. has had a 25% tariff on imported light trucks since 1964, a decision that likely caused its car companies to become addicted to domestic pickup truck demand to the detriment of global competitiveness. Meanwhile, only 15% of U.S. autos shipped to the EU were subject to the infamous European 10% surcharge on auto imports. This is because U.S. autos containing European parts are exempt from the tariff. Many foreign auto manufacturers have already adjusted to the U.S. market, setting up manufacturing inside the country (Chart 11). Tariffs would hurt luxury brands like BMW, Daimler, Volvo, and Jaguar.7 As such, we doubt the investment-relevance of Trump's threat against autos. Either way, the investigation is unlikely to be completed until the tail-end of Q1 2019. Chart 10Tariffs: Who Is Robbing The U.S.? Chart 11Car Imports? What Imports? Instead, investors should take Trump's aggressive comments from the G7 in the context of the ongoing NAFTA negotiations and the closing window for a deal. President Trump wants to get a NAFTA deal ahead of the U.S. midterms in November and prior to the new Mexican Congress being inaugurated on September 1.8 This means that a deal has to be concluded by late July, or early August, giving the "old" Mexican Congress enough time to ratify it before the new president - likely Andrés Manuel López Obrador - comes to power on December 1. This would conceivably give the U.S. Congress enough time to ratify a deal by December, assuming Republicans can remove some procedural hurdles before then. The rising probability of no resolution before the U.S. midterm election will increase the risk that Trump will trigger Article 2205 and announce the U.S.'s withdrawal. Trump has always had the option of triggering the six-month withdrawal period as a negotiating tactic to increase the pressure on Canada and Mexico. Withdrawing might fire up the base, while major concessions from Canada or Mexico might be presented as "victories" to voters. Anything short of these binary outcomes is useless to Trump on November 6. Therefore, if Canada and Mexico do not relent in the next month or two, the odds of Trump triggering Article 2205 will shoot up. The key is that Trump faces limited legal or economic constraints in withdrawing: Legal Constraints: Not only can Trump unilaterally withdraw from the agreement, triggering the six-month exit period, but Congress is unlikely to stop him. Announcing withdrawal automatically nullifies much of the 1993 NAFTA Implementation Act.9 Some provisions of NAFTA under this act may continue to be implemented, but the bulk would cease to have effect, and the White House could refuse to enforce the rest. Economic Constraints: The U.S. economy has far less exposure to Canada and Mexico than vice- versa (Chart 12). Certain states and industries would be heavily affected - ironically, the U.S. auto industry would be most severely impacted (Chart 13) - and they would lobby aggressively to save the agreement. But with the American economy hyper-charged with stimulus, the drag from leaving NAFTA is not prohibitive to Trump. Voters will feel any pocketbook consequences about three months late i.e., after the election. Chart 12U.S. Economy:##br## Largely Unaffected By NAFTA Chart 13NAFTA Has Made U.S. Auto ##br##Manufacturing More Competitive The potential saving grace for Canada is the Canada-U.S. Free Trade Agreement (CUSFTA), which took effect in 1989 and was incorporated into NAFTA. The U.S. and Canada agreed through an exchange of letters to suspend CUSFTA's operation when NAFTA took effect, but the suspension only lasts as long as NAFTA is in effect. However, reinstating CUSFTA is not straightforward. The NAFTA Implementation Act suspends some aspects of the CUSFTA and amends others (for instance, on customs fees), so there will not be an easy transition from NAFTA to a fully operational CUSFTA.10 Trump may well walk away from both CUSFTA and NAFTA in the same proclamation, or he could walk away from NAFTA while leaving CUSFTA in limbo. The latter would mitigate the negative impact on Canada, but it would still see rising tariffs, customs fees, and rising policy uncertainty. Bottom Line: We originally assigned a high probability to the abrogation of NAFTA.11 Subsequently, we lowered the probability due to positive comments from the White House and Trump's negotiating team. This was a mistake. As we initially posited, there are few constraints to abrogating NAFTA, particularly if President Trump intends to renegotiate the deal later, or conclude two separate bilateral deals that effectively maintain the same trade relationship. We are closing our trade favoring an equally-weighted basket of CAD/EUR and MXN/EUR. We are also closing our trade favoring Mexican local government bonds relative to EM. North Korea: A Geopolitical Opportunity, Not A Risk Not every move by the Trump administration is increasing geopolitical volatility. Trump's Maximum Pressure doctrine may have elevated risks on the Korean Peninsula in 2017, but it ultimately worked. The media is missing the big picture on the Singapore Summit. Diplomacy is on track and geopolitical risk - namely the risk of war on the peninsula - is fading. It is false to claim that President Trump got nothing in return for the summit. Since November 28, North Korea has moderated its belligerent threats, ceased conducting missile tests, released three U.S. political prisoners, and largely blocked off access to the Punggye-ri nuclear testing site. Now, North Korean leader Kim Jong-un has held the summit with Trump, reaffirmed his longstanding promise of "complete denuclearization," reaffirmed the peace-seeking April 2018 Panmunjom Declaration with South Korea, and pledged to dismantle a ballistic missile testing site and continue negotiations. In response, President Trump has given security guarantees to the North Korean regime and has pledged to discontinue U.S.-South Korea military drills for the duration of the negotiations. Trump has not yet eased economic sanctions and his administration has ruled out troop withdrawals from South Korea for now. There is much diplomatic work to be done. But the summit was undoubtedly a positive sign, dialogue is continuing at lower levels, and Kim is expected to visit the White House in the near future. Table 1 shows that the Singapore Summit is substantial when compared with major U.S.-North Korea agreements and inter-Korean summits - and it is unprecedented in that it was agreed between American and North Korean leaders. Table 1How The Singapore Summit Stacks Up To Previous Pacts With North Korea Because Trump demonstrated a credible military threat, and China enforced sanctions, the foundation is firmer than that of President Barack Obama's April 2012 agreement to provide food aid in payment for a cessation of nuclear and missile activity. It is much more similar to that of President Clinton and the "Agreed Framework" of 1994, which lasted until 2002, despite many serious failures on both the U.S. and North Korean sides. We should also bear in mind that it was originally U.S. Congress, not North Korea, which undermined the 1994 agreement. Aside from removing war risk, Korean diplomacy is of limited global significance. It marginally improves the outlook for South Korean industrials, energy, telecoms, and consumer staples relative to their EM peers (Chart 14). In the long run it should also be positive for the KRW. Chart 14Winners And Losers Of Inter-Korean Engagement We maintain that a U.S.-China trade war will not be prevented because of a Korean deal. But we do not expect China to spoil the negotiations. Geopolitically, China benefits from reducing the basis for U.S. forces to be stationed in South Korea. Bottom Line: Go long a "peace dividend" basket of South Korean equity sectors (industrials, energy, consumer staples, and telecoms) and short South Korean "loser" sectors (financials, IT, consumer discretionary, and health care), both relative to their EM peers. Stick to our Korean 2-year/10-year sovereign bond curve steepener trade. Brexit Update: A New Election Is Now In Play Prime Minister Theresa May is fending off a revolt within her Conservative Party this week that could set the course for a new election this year. May reneged on a "compromise" with soft-Brexit/Bremain Tory backbenchers on an amendment that would have given the House of Commons a meaningful vote on the final U.K.-EU Brexit deal. According to the press, the compromise was killed by her own Brexit Secretary, David Davis. There is a fundamental problem with Brexit. The current path towards a hard Brexit, pushed on May by hard-Brexit members of her cabinet and articulated in her January 2017 speech, is incompatible with her party's preferences. According to their pre-referendum preferences, a majority of Tory MPs identified with the Bremain campaign ahead of the referendum (Chart 15). That would suggest that a vast majority prefer a soft Brexit today, if not staying in the EU. We would go further. The current trajectory is incompatible with the democratic preferences of the U.K. public. First, polls are showing rising opposition to Brexit (Chart 16). Second, most voters who chose to vote for Brexit in 2016 did so under the assumption that the Conservative Party would pursue a soft Brexit, including continued membership in the Common Market. Boris Johnson, the most prominent supporter of Brexit ahead of the vote and now the foreign minister, famously stated right after the referendum that "there will continue to be free trade and access to the single market."12 Chart 15Westminster MPs Support Bremain! Chart 16Bremain On The Rise So what happens now? We expect the government to be defeated on the crucial amendment giving Westminster the right to vote on the final EU-U.K. deal. If that happens, PM May could be replaced by a hard-Brexit prime minister, most likely Davis. Given the lack of support for an actual hard-Brexit outcome - both in Westminster and among the public - we believe that a new election remains likely by March 2019. Bottom Line: Political risk remains elevated in the U.K. A new election could resolve this risk, but the potential for a Jeremy Corbyn-led Labour Party to win the election could add additional political risk to U.K. assets. We remain short GBP/USD. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013; and "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Pyongyang's Pivot To America," dated June 8, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taiwan Is A Potential Black Swan," dated March 30, 2018, available at gps.bcaresearch.com. 4 The Senate has passed a version of the National Defense Authorization Act with a rider that would boost CFIUS and maintain stringent restrictions on ZTE's business with the U.S. These restrictions have crippled the company but would have been removed under the Trump administration's snap deal in June. The White House claims it will remove the rider when the House and Senate hold a conference to resolve differences between their versions of the defense bill, but it is not clear that the White House will succeed. Congress could test Trump's veto. If Trump does not veto he will break a personal promise to Xi Jinping and escalate the trade war further than perhaps even he intended. 5 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 6 Please see BCA Global Investment Strategy Weekly Report, "Piggy Bank No More? Trump And The Dollar's Reserve Currency Status," dated June 15, 2018, available at gis.bcaresearch.com. 7 We do not include Porsche in this list as we would gladly pay the 25% tariff on top of its current price. 8 Mexican elections for both president and Congress will take place on July 1, but the new Congress will sit on September 1 while the new president will take office on December 1. 9 Please see Lori Wallach, "Presidential Authority to Terminate NAFTA Without Congressional Approval," Public Citizen's Global Trade Watch, November 13, 2017, available at www.citizen.org. 10 The National Customs Brokers and Forwarders Association of America, "Issues Surrounding US Withdrawal From NAFTA," available from GHY International at www.ghy.com. See also Dan Ciuriak, "What if the United States Walks Away From NAFTA?" C. D. Howe Institute Intelligence Memos, dated November 27, 2017, available at www.cdhowe.org. 11 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 12 Please see "U.K. will retain access to the EU single market: Brexit leader Johnson," Reuters, dated June 26, 2016, available at uk.reuters.com. Geopolitical Calendar