Geopolitics
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 Editor's Note: I am pleased to return to U.S. Investment Strategy (USIS). I worked with the service when I joined BCA in 2010, and previously led it from August 2013 through September 2014. Sara Porrello, who has been with the team for over 20 years, and I look forward to re-aligning USIS with its original mandate. We hope you will find it consistently insightful. Best regards, Doug Peta U.S. Investment Strategy is getting back to basics: Today's report, plainly stating our position on the near-term direction of interest rates, is the first in an ongoing series meant to stake out our views on the macro issues that are most important to investors. Rates are headed higher, consistent with a booming economy that may well overheat, ... : Assuming trade tensions don't short-circuit the expansion, the U.S. economy is poised to grow above trend well into 2019. ...thanks to a tightening labor market and dubious fiscal spending, ... : Employers will be forced to bid up wages as the pool of idled and under-utilized workers dries up, and the fiscal stimulus package is all but certain to goose inflation pressures. ... and neither tweets nor testy interviews nor other expressions of presidential pique are likely to stay the Fed from its appointed rounds: The Federal Reserve cherishes its independence, and it is extremely unlikely to bow to presidential pressure. Feature U.S. Investment Strategy is meant to provide analyses of the U.S. economy and its future direction for the purpose of helping our clients make asset-allocation decisions. Starting with this report, we are going back to the basics of meeting that mandate. Over the rest of the summer, we intend to outline our positions on the key macro drivers of financial markets: rates, credit, the business cycle, and the state of monetary policy. Laying out our big-picture views, and the rationale underpinning them, will establish a framework for evaluating incoming data. The goal is to allow our clients to think along with us as new information is disseminated, and to distinguish signals from noise. We also want to make it easier for clients to anticipate the evolution of our views. To that end, will make frequent use of checklists highlighting the specific elements that might lead us to change our take on the evolution of the key cycles. The ultimate goal is to stay on top of cyclical inflection points, and to use them to inform asset-allocation decisions. The Fed Gets Its Way On Rates Monetary policy is a blunt instrument that works with indeterminate lags, and its effect has been roundly questioned. At the ends of the armchair-quarterback continuum, the Fed is mocked as a clueless bumbler, turning dials at random like a fumbling Mr. Magoo, or bemoaned as an omnipotent manipulator of financial markets and real-world activity. Strictly speaking, it controls nothing more than short rates. As its post-crisis communications strategy has shown, however, its reach extends well beyond its official policy-rate dominion. Talk of last decade's "conundrum" aside, changes in the fed funds rate reverberate along the entire yield curve. As the Chart Of The Week demonstrates, the aggregate yield on all outstanding Treasury issues is joined at the hip, directionally, with the fed funds rate. Aggregate weighted-average Treasury duration sits squarely in the belly of the curve, and it is a not-quite-perfect proxy for the long end, where the Fed's gravitational pull wanes (Table 1). Its pull is still powerful, though; the 90% correlation between the fed funds rate and the 30-year bond testifies eloquently to the Fed's significant influence at all points of the curve (Chart 2). Chart of the WeekThe Fed Gets Its Way The investment takeaway is that the Fed gets what it wants across the full spectrum of rates the vast majority of the time. Given the FOMC's repeatedly expressed intention to continue on its normalization course, the path of least resistance for rates at all maturities is higher. Despite the money markets' resistance to extrapolate the 25-bps-a-quarter "gradual pace" across the rest of this year and next (Chart 3), six more quarters of that pace is our baseline expectation provided an economic shock does not occur. Investors should be prepared for a higher peak in the fed funds rate than the consensus expects. Table 1Correlation With The Fed Funds##BR##Rate By Bond Maturity Chart 2The Long Arm##BR##Of The Fed Chart 3Rates Have Room To##BR##Surprise To The Upside Bottom Line: The Treasury curve faithfully reflects changes in the fed funds rate. In the absence of a shock that would cause the FOMC's repeatedly expressed plans to change, monetary policy is a catalyst for higher rates. But What About An Inverted Yield Curve? The yield curve typically inverts in the latter stages of a rate-hiking campaign, so it is more correct to say a higher fed funds rate implies higher Treasury yields until the yield curve inverts. An inverted yield curve is a classic recession indicator, albeit often a very early one (Table 2), and it should not be taken as a signal to immediately de-risk portfolios. The yield curve may be prone to invert even earlier than it otherwise would this time around, given that QE1, QE2, and QE3 may well have depressed the term premium on long-term bonds,1 as The Bank Credit Analyst noted in its August edition. The question of how much the Fed's asset purchases have affected the term premium, if at all, is far from settled within either the Fed or BCA, but its potential to impact the signal from the yield curve reinforces our conviction to look to other indicators to confirm its recession message before declaring the end of the bull markets in equities and spread product. Table 2The Yield Curve Is Early The Inflation Outlook As the tepid post-crisis expansion has stretched on and on, investors have grown accustomed to sleepy inflation readings and begun to regard the prospects for a pickup in inflation with skepticism, if not outright disdain. Even within BCA, there has been spirited debate about the relevance of the Phillips Curve - the formalization of the idea that there is an inverse relationship between wage growth and the unemployment rate. Despite the stagflation of the 1970s and the lengthy post-crisis dry spell that have undermined the Phillips Curve's credibility with the rigorously empirically-minded, we do not find it controversial. The relationship between unemployment and compensation may not be perfectly linear, but the Phillips Curve is nothing more than an extension of the laws of supply and demand to wage negotiations. We can accept that the Phillips Curve is kinked - that compensation growth is utterly indifferent to changes in the unemployment rate when labor supply is glutted (as can be seen in Chart 4 when covering all of the observations below 7%), but rather sensitive to its moves when it is in the neighborhood of full employment (as can be seen when covering all of the observations above 5%). We believe the U.S. labor market has reached the point at which employers will have to compete fiercely to attract new talent. After nine years, the economy has finally worked down nearly all of the hidden slack that had padded the broader U-6 unemployment rate.2 The pool of discouraged workers - those who are not counted as officially unemployed because they're not actively looking for a job, but would start tomorrow if offered one - has shrunk below its 2000 and 2007 levels (Chart 5, top panel). Similarly, the share of the labor force that is working part time but would prefer to be working full time is approaching its pre-crisis bottom (Chart 5, bottom panel). The prospects for inflation gained another boost last December upon the passage of the spending package on the coattails of the tax-cut bill. The U.S. economy is poised to receive a substantial dose of fiscal stimulus this year and next (Chart 6). Mainstream macroeconomic thought holds that stimulus injected into an economy that is already operating at full capacity is prone to kindle inflation.3 Chart 4The Phillips Curve Can't Handle Copious Slack ... Chart 5... But Almost All Of It Has Been Worked Off Chart 6Goosing Inflation Along With Output Bottom Line: The U.S. labor market has tightened considerably and competition between employers to attract scarce talent should soon translate to a pickup in wage growth. Unneeded fiscal stimulus is also likely to push prices higher. There are plenty more inflation green shoots behind the ones that have already begun to emerge. White House-Fed Tension Is Nothing New It is not beyond the realm of possibility that presidential pressure could deter the Fed from following through on its intentions and present a risk to our above-consensus terminal rate estimate. The bond market immediately discounted the potential of a less independent Fed by selling off at the long end after the president stated he was "not thrilled" with ongoing rate hikes in an interview with CNBC. There would seem to be little doubt that a captive Fed would be more reluctant to remove the punch bowl than a Fed which was free to pursue its inflation mandate without outside interference. After all, elected officials would be happy to trade long-term pain for near-term gain (at least through the next campaign). The president may have upended convention by publicly airing his displeasure, but there is a natural tension between the White House and the Fed. There have been dust-ups in the past, and there will be dust-ups in the future for as long as elected officials shudder at the thought of an economic downturn. Alan Greenspan wrote frankly in his memoir about friction with the first Bush administration, which included public criticism from the sitting president. "I do not want to see us move so strongly against inflation that we impede growth," President Bush told the press at the beginning of his term, in response to hawkish congressional testimony from Greenspan.4 By all accounts, however, the conflict between Bush père and Greenspan was of a lower-pressure variety than the conflicts between LBJ and William McChesney Martin, and Nixon and Arthur Burns. The legendarily intimidating LBJ summoned Martin to his ranch following an unwelcome rate hike. According to several accounts (and consistent with his longstanding negotiating practices in the Senate), LBJ backed the smaller Martin up against a wall before giving full voice to his complaints. Martin did not budge, pointing out that the Fed had acted in accordance with the legislation governing its actions.5 If Martin represents the heroic Fed chief, standing his ground in the face of heavy pressure from a larger-than-life figure, Arthur Burns is the poster child for folding like a cheap lawn chair. The Nixon tapes capture Nixon and his proxies repeatedly pressuring Burns to prime the pump ahead of the 1972 election, which Burns ultimately did.6 Our view is that Fed Chair Powell is more likely to follow Martin than Burns. The Fed is more transparent today, and its independence is more firmly established than it was in the 1970s. Even if Powell were amenable to doing the president's bidding, he would be held back by the realization that it would ultimately be self-defeating: any hint of political manipulation in the rate-setting process would risk a bond market riot that would blast rates far beyond the levels where a 3.5% fed funds rate would take them. Bottom Line: We are not concerned that the FOMC will yield to pressure from the White House to back away from their rate hike plans. Attempted influence of the Fed is nothing new, and investors need not worry about it now. Investment Implications If we are correct in our view that rates have not yet peaked, the bond market is likely to face continued headwinds. Long-dated Treasuries will come under more pressure than shorter-maturity issues. Thanks to positive carry, spread product will be less vulnerable to higher rates, but our bond strategists are lukewarm on the risk-reward offered by investment-grade and high-yield bonds given the late stage of the cycle and historically tight spreads. We acknowledge the potential seriousness of the current spate of geopolitical risks, headlined by trade tensions, and advocate temporarily de-risking portfolios in line with the BCA house view (equal weight equities, underweight bonds, overweight cash). We are more constructive than the BCA consensus, however, because we remain constructive on the business cycle, the monetary policy cycle, and the credit cycle. If the key cycles aren't over, the equity bull market probably isn't over, and neither spread widening nor a pickup in defaults is likely to wipe out spread product's excess returns. We will express all of our calls in a basket of ETF recommendations once we have completed our review of the most impactful macro questions, but for now we recommend maintaining below-benchmark positioning in Treasury portfolios while overweighting TIPS at the expense of nominal Treasuries. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Long-term bond yields can be decomposed into the expected path of short-term rates and a term premium, which compensates an investor for the uncertainties that can arise over the extended time period that s/he is locking up his/her money by buying a longer-maturity instrument. 2 In the monthly employment report, the headline unemployment rate, which includes only jobless workers who are actively seeking work, is labeled U-3 unemployment. The U-6 series broadens the definition of unemployment to include the jobless who aren't actively searching and those who are working part time only because they cannot find a full-time position. 3 Please see the November 7, 2016 U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability," available at usis.bcaresearch.com, for a discussion of fiscal multipliers under a range of scenarios. 4 Greenspan, Alan. The Age of Turbulence: Adventures in a New World, Penguin (New York): 2007, p.113. To this day, several members of the G.H.W. Bush administration continue to pin a large measure of blame for its 1992 electoral loss on overly conservative monetary policy. The ex-president himself, in a 1998 television interview, said, "I reappointed him [Greenspan], and he disappointed me." 5 Granville, Kevin. "A President at War With His Fed Chief, 5 Decades Before Trump," New York Times, June 15, 2017, page B3 (updated July 19, 2018). https://www.nytimes.com/2017/06/13/business/economy/a-president-at-war-with-his-fed-chief-5-decades-before-trump.html 6 "How Richard Nixon Pressured Arthur Burns: Evidence from the Nixon Tapes, Vol. 20, No. 4," Journal of Economic Perspectives (Fall 2006). https://fraser.stlouisfed.org/title/1167/item/2388, accessed on July 24, 2018.
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