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Highlights A partial reinvasion of Ukraine cannot be ruled out. The constraints on Russia are not prohibitive, especially amid global energy shortages. On this issue, it is better to be alarmist than complacent. We would put the risk of a partial re-invasion of Ukraine as high as 50/50, albeit with an uncertain time frame over 12-36 months. The negative impact of conflict may not stay contained within Russian and eastern European markets. The US and EU are now threatening major retaliatory sanctions if Russia invades. In response Russia could reduce energy exports, exacerbating global shortages and damaging Europe’s overall economy. Investors should stay short Russian assets and overweight developed European equities over emerging European peers. Stay long gold and GBP-CZK. The dollar will be flat-to-up. Feature Chart 1Ruble Faces More Downside From Geopolitics Geopolitical tensions surrounding Russia remain unresolved and investors should continue to reduce holdings of assets exposed to any renewed conflict in Ukraine and the former Soviet Union. The ruble has dropped off its peaks since early November when strategic tensions revived (Chart 1). Presidents Joe Biden and Vladimir Putin held their second bilateral summit on a secure video link on December 7 to discuss the situation in Ukraine, where Russia has amassed 95,000-120,000 troops on the border in a major show of force. Russia also mustered troops in April and only partially drew them down after the Biden-Putin summit in Geneva where the two sides agreed to hold talks to address differences. The two presidents agreed to hold consultations regarding Ukraine. Putin accused NATO of building up Ukraine’s military and demanded “reliable, legally fixed guarantees excluding the expansion of NATO in the eastern direction and the deployment of offensive strike weapons systems in the states adjacent to Russia.”1 President Putin’s red line against Ukraine joining NATO is well known. Recently he said his red line includes the placement of western military infrastructure or missile systems in Ukraine. Biden refused to accept any limits on NATO membership in keeping with past policy. After the summit National Security Adviser Jake Sullivan said, “I will tell you clearly and directly [Biden] made no such commitments or concessions. He stands by the proposition that countries should be able to freely choose who they associate with.” 2 Biden, who had conferred with the UK, France, Germany, and Italy prior to the call, outlined the coordinated economic sanctions that would be leveled against Russia if it resorted to military force, as well as defense aid that would go to Ukraine and other eastern European countries. Thus Putin gave an ultimatum and Biden rebuffed it – and yet the two agreed to keep talking. The Russians have since said that they will present proposals to the Americans in less than a week. Talks are better than nothing. But neither side has given concrete indication of a change in position that would de-escalate strategic tensions – instead they have both raised the stakes. Therefore investors should proceed with the strong presumption that tensions will remain elevated or escalate in the coming months. Clearing Away Misconceptions Before going further we should clear away a few misconceptions about the current situation: Ukraine has unique strategic value to Russia. Like Belarus, but unlike Central Asia, Ukraine serves as critical buffer territory protecting Moscow and the Russian core from any would-be invaders. Russia lacks firm geological borders so it protects itself by means of distance and winter. This grand strategy succeeded against King Charles XII of Sweden, Napoleon, and Hitler. The collapse of the Soviet Union left Russia shorn of much of its buffer territory. Ukraine also offers access to the Black Sea. Russia has long striven to gain access to warm-water ports. The loss of control over Ukraine resulted in a loss of access. Russia’s seizure of Crimea in 2014 only partially rectified the situation. Ukraine’s southern coastline around Crimea is the territory at risk today (Map 1). It is Ukraine’s physical existence and unique strategic value – not its democratic leanings or ideological orientation – that ensures perpetual tensions with post-Soviet Russia. Russia has a strategic imperative to reassert control or at least prevent control by foreign powers. Ideological opposition may make things worse but an anti-Russian Ukrainian dictator would also face Russian coercion or aggression, perhaps even more than the current weak democracy. In fact Russia is trying to force Ukraine to revise its constitution and adopt a federal structure so as to grant greater autonomy to separatist regions Donetsk and Luhansk that Russia helped break away in 2014. But Ukraine has not relented to Moscow’s demands of political reform. It is not authoritarianism but a permanent foreclosure of Ukrainian membership in the EU and NATO that Moscow is after. Yet it is highly unlikely that Russia would try to invade and conquer all of Ukraine. Ukraine is the largest country by territory in Europe and has 255,000 active soldiers and 900,000 reserves (contra Russia’s 1 million active and 2 million reserves) who would defend their freedom and sovereignty against an invader.3 Russia would not be able to stage a full-scale invasion with the 175,000 maximum troop buildup that US intelligence is warning about. It would have to mobilize fully, dangerously neglecting other vast dimensions of its national security, and would inevitably get bogged down fighting a vicious insurgency backed by the NATO powers. It would save blood and treasure by paralyzing Ukraine’s politics and preventing it from allying with western militaries, which is what Putin is attempting to do today. Putin uses foreign adventures to strengthen his grip at home but an adventure of this nature would impose such burdens as to threaten his grip at home. A limited re-invasion of Ukraine could yield historic strategic advantages to Russia. Moscow could focus on a partial military incursion that would annex or shore up Donbass, or extend its control from Donbass to the Black Sea, conceivably all the way to the Dnieper river. This pathway would yield Russia maritime access and a buffer space to fortify Crimea. Naval warfare could also yield control of deep-water ports (Yuzhne, Odessa, Mykolaiv, Chornomorsk), control of the mouth of the Dnieper, control of the canal that supplies water to Crimea, and a means of bottling up the Ukrainian navy and preventing foreign maritime assistance. Ukraine would be further weakened and Russia would have a larger beachhead in Ukraine for future pressure tactics. Russia is not bluffing – its military buildup poses a credible threat. If there is anywhere Russia’s threats are credible, it is in taking military action against former Soviet republics like Georgia (2008) and Ukraine (2014) that have pro-western leanings yet lack the collective security of the NATO alliance. At very least, given that Russian forces did deploy in Ukraine in 2014, Russian action in Ukraine cannot be ruled out. The military balance has not changed so significantly in that time and strongly favors Russia (Chart 2). The US has provided around $2.5 billion in military aid to Ukraine since 2014, and has sent lethal weapons including Javelin anti-tank missiles and launchers since 2017-18, including $450 million worth of military aid under the Biden administration (and $300 million just authorized by Congress on December 7). NATO allies have also provided defense aid. This is part of Putin’s complaint but these new arms are not game changers that would prevent Russia from taking military action. Thus if the West rejects Moscow’s core demands, war is likely. This is true even if Russia would prefer to achieve its aims through political and economic rather than military means. Russia does not deem the West’s threat of sanctions as prohibitive of invasion. The West’s sanctions since 2014 have failed to change Russia’s government, strategy, or posture in Ukraine. Yes, European nations joined the US in imposing sanctions. But Germany also pursued the Nord Stream II pipeline as a means of bypassing Ukraine and working directly with Russia to preserve economic engagement and energy security. Former Chancellor Merkel forced the pipeline through despite the objections of eastern Europeans and the United States. The allies also formed the “Normandy Quartet,” excluding the US, to force Ukraine to accept the Minsk agreements on resolving the conflict. Thus the lesson of 2014-21 is not that NATO allies stood shoulder-to-shoulder in defense of Ukraine’s sovereignty and territorial integrity but rather that Germany and the EU, and the EU and the US, have major differences in interests and risk-tolerance in dealing with Russia. Russia does not face, or may think it does not face, a united front among the western powers. A partial reinvasion of Ukraine would bring the western allies together initially but probably not for long. Russia determines the timing of any new military incursion in Ukraine. Winter is not the ideal time to invade Ukraine, though it is possible. Russia could act in spring 2022, as the US has warned, but it could also act in the summer of 2023, the spring of 2024, or other times. From a strategic point of view, Russia has enjoyed a historic window of opportunity since 2001 when the US got bogged down in Afghanistan and Iraq and then the US and the EU got bogged down in economic and financial crisis. Given that the American political establishment is withdrawing from foreign quagmires, reactivating fiscal policy, bulking up the military-industrial complex, and making a dedicated effort to revitalize its global alliances, Russia may believe that its historic window is closing. Russia’s domestic fundamentals are deteriorating over time. Putin could decide it is necessary to seize strategic ground in Ukraine sooner rather than later. Bottom Line: Ukraine offers unique and irreplaceable buffer space and maritime access to Russia. Russia’s military actions in 2014 led to stalemate, such that Russia remains insecure, Ukraine remains defiant, and the West is still entertaining defense cooperation or even NATO membership with Ukraine. Yet the Crimea conflict also revealed a lack of concert among western powers exemplified by Germany’s Nord Stream II pipeline. Today Russia has the military capability to seize another slice of Ukrainian territory. Western retaliatory actions would be painful but may not be deemed prohibitive. Investors cannot rule out a partial re-invasion of Ukraine. Nord Stream Pipeline Is Not The Sole Factor Is Russia not making a show of military force merely to ensure that Nord Stream II pipeline goes into operation? Will Russia not back down if the pipeline is guaranteed? A common view in Washington and the financial industry is that Russia’s military buildup is just a bluff, i.e. Moscow’s aggressive way of demanding that Germany’s new government and the European Union approve Nord Stream. The pipeline finished construction in September but now awaits formal regulatory certification. Approval was originally expected by May 2022 but has now been delayed. The pipeline would carry 55 billion cubic meters of natural gas into Europe, about half of Russia’s current export capacity outside of Ukraine. Ukraine’s total capacity is around 150 billion cubic meters. The pipeline enables Russia and Germany to bypass Ukraine, whose conflicts with Moscow since 2004 have threatened Germany’s energy security. About 18% of EU’s total energy imports come from Russia, whilst this figure is 16% for Germany. That is about 0.5% and 0.2% of EU and German GDP, respectively. Meanwhile Russian energy exports to Germany and the EU make up 0.8% and 5.6% of GDP, respectively (Chart 3). The problem with this reasoning is that the US conceded Nord Stream to Russia over the summer. The US initially raised the threat of sanctions because the pipeline strengthened Russo-German ties, diminished Ukraine’s leverage, and deprived the US of a chance to sell liquefied natural gas to Europe. But the Biden administration proved unwilling to take this aggressive approach. Secretary of State Anthony Blinken has a long history of arguing that the US should prioritize strong relations with its European allies rather than punitive measures to try to block Russian gas sales. Biden met with outgoing Chancellor Angela Merkel in July and agreed to let Nord Stream go forward. The only proviso was that Russia not “weaponize natural gas,” i.e. withhold supplies for geopolitical purposes, as it has done in the past.4 Before Russia’s military threats, Germany and the EU were expected to certify the pipeline by no later than May 2022 and an earlier certification looked possible because of Europe’s low natural gas supplies. Yet Russia, fresh off parliamentary elections, did precisely what Germany said it was not supposed to do. The pipeline was completed in September and reports of Russian limitations on natural gas supply surfaced in October. Moscow not only weaponized the gas but also mustered its army on the Ukrainian border again. Putin may have feared that the new German government, which officially took office on December 8, would change policy and refuse to certify the pipeline. He also could have feared that the US Congress would pass a Republican-backed provision that would require Biden to impose sanctions that would halt the pipeline. But these explanations are not satisfactory. First, the German government was not likely to halt Nord Stream. Quite the opposite, Berlin has pushed against all opposition to speed the pipeline into action. It only delayed the regulatory approval when Russia did the one thing that Germany had expressly prohibited, which was weaponize natural gas. Second, the US Congress was never likely to pass mandatory sanctions on Nord Stream operators. The Democrats opposed it, as it would have tied Biden’s hands, whereas presidents always retain discretion over foreign policy and national security. Even moderate Republicans opposed the measure, for the same reason. If either of these were the reason for Putin’s latest buildup, then the buildup will probably dissipate in the coming months. Putin also wants to force Ukraine to implement the Minsk agreements. But the Biden administration adopted the Minsk framework in June for the first time, which was a concession to Russia. So the latest military threats are not solely about coercing Europe to approve the pipeline or Ukraine to implement Minsk. Putin is driving at something else. Putin’s Focus On Ukraine And NATO Putin used military pressure on Ukraine’s border to force the US to accept the pipeline and the Minsk agreements. He is now using the same tactic to raise the stakes and demand that the US and its allies permanently rule out NATO membership and defense cooperation with Ukraine. Biden rejected the first demand during the summit, as mentioned. There is no way that the US or NATO will forswear any and all eastward expansion. Even on Ukraine specifically, Biden cannot give Russia a legal guarantee because it would require a 60-seat majority in the Senate (not likely). Any future president would retain prerogative over the matter anyway and Putin knows this. Moreover Ukraine is never going to join NATO. Russia would attack. And NATO members would not be unanimous (as is required for new members) because the collective defense treaty would require them to defend Ukraine. They would be signing up for a war with Russia. Still Biden is unlikely to disavow Ukrainian NATO membership because to do so would be to deny the self-determination of nations, capitulate to Russian coercion, and demoralize the Ukrainians, whom the US hopes will maintain a plucky resistance against Russian domination. It would also demoralize US allies and partners – namely Taiwan, which also lacks a formal defense treaty and would be forced to sue for peace with China in the face of American abandonment. Biden’s refusal to ban Ukraine from NATO is encapsulated in Diagram 1, an exercise in game theory that exemplifies why the risk of war should not be dismissed. Diagram 1Game Theory Suggests Russia Will Keep Applying Military Pressure Biden may give private or executive assurances on Ukraine and NATO but Putin will know that these mean nothing since Biden may be out of office as early as January 2025 and then Putin would have to renegotiate. America is not a credible negotiator because partisanship has resulted in extreme foreign policy vacillations – the next president could revoke the deal. Even after Putin is gone Russia would have to negotiate with the US to prevent the US from arming Ukraine. Hence Moscow may decide to reduce Ukraine and improve Russia’s strategic position by force of arms. This is true even if Biden forswears the NATO option, as Diagram 1 illustrates. Putin’s second demand – that the US not provide offensive weapon systems in countries adjacent to Russia – is more material. This is what the new round of talks will focus on. This new Ukraine line of talks is separate, more urgent and important, than the other bilateral dialogues on the arms race, and cyber-war. US-Russia talks on Iran are also urgent, however, and Russia’s cooperation there may be contingent on US concessions regarding Ukraine. The US may be willing to stop its defense cooperation with Ukraine but not with other allies and partners, however. It is also not clear what Putin will accept. These negotiations will have to be watched. Biden cannot make major concessions with a gun to his head. It is unclear how far the US is willing to concede on defense cooperation with countries around Russia. The US may quietly abandon Ukraine but then it would need to reinforce its other defense relationships. If Putin draws down the troops, and Biden calls a stop to defense aid to Ukraine, then a crisis may be averted. What Could Go Wrong? Economic sanctions under consideration in Washington are significant: the US could freeze bank transactions, expand restrictions on trading Russian sovereign and corporate debt, and lobby Belgium to kick Russia off the SWIFT financial messaging system. However, these sanctions may not be effective in preventing Russia from using military force. Russia has weathered US sanctions since 2014, and the smaller and weaker Iranian economy has weathered maximum pressure sanctions since 2019. Energy producers like Russia and Iran have maximum geopolitical leverage when global energy inventories draw down, as is the case today. Even in the face of Russian military aggression, the Biden administration is vacillating on sanctions targeting Russia’s energy sector that would contribute to global shortages and ultimately raise prices at the pump for voters in a midterm election year.5 Germany’s new government also hesitates to declare unambiguously that it will discontinue the Nord Stream II pipeline if Russia invades Ukraine. True, Germany signaled that the pipeline would be halted. Its energy regulator declared that the pipeline’s ownership must be unbundled, which pushes back the certification date to sometime after May 2022 – this was a geopolitical not a legalistic decision. But construction is completed, the pipeline physically exists, which will vitiate Germany’s commitment to sanctions whenever natural gas shortages occur, as is the case this winter (Chart 4). Shortages will continue to occur and Russia controls a large share of supply. It would take a catastrophe to drive Germany to restart coal and nuclear plants, so natural gas will continue to be in demand. Germany does not have liquefied natural gas import capability yet. If Europe imposes crippling sanctions on Russia, Russia could reduce energy supplies and harm Europe’s economy (Chart 5). The Russian economy and society would suffer which is one reason any military action in Ukraine would be limited in scope. Still, Moscow may believe that Germany would restrain the EU, and the EU would restrain the US, thereby preventing sanctions from being fully, uniformly, and durably implemented. Prior to Russia’s aggression, public opinion polls showed that the German public strongly supported Nord Stream. Even a majority of Green Party members supported it despite the fact that the Greens were the most critical of increasing Germany’s dependency on fossil fuels and an authoritarian petro-state. While public approval of the pipeline has surely suffered in the face of Russian aggression, a majority probably still favors the pipeline. Germany has a national consensus in support of engagement with Russia and avoiding a new cold war, given that the original Cold War cut Germany in half. For that reason invasion may only temporarily unite the western powers – it could ultimately drive a wedge between Germany and other EU members, namely in the former Soviet bloc. It would also divide the more risk-averse EU from the US in terms of how to deal with Russia. And it would weaken the Biden administration at a time when it is extremely vulnerable, exacerbating America’s internal divisions. Russian domestic patriotism would rally, at least initially. Note that Russia could miscalculate on this issue and that is one reason for high level of risk. Perhaps the West would prove far more unified and aggressive in its sanctions enforcement than it was after 2014. A falling ruble and rising inflation could cause Russian social unrest. But Russia could misread the situation. Unless the US and Europe escalate the sanctions threat massively to better deter Russia, their lack of concert is another reason for investors not to be complacent about renewed conflict. Bottom Line: The threat of sanctions may prove insufficient to deter renewed Russian aggression against Ukraine. Germany favors engagement with Russia and Europe’s energy dependency on Russia makes it vulnerable to supply disruptions. Russia has leverage given tight global energy markets, Europe’s low natural gas inventories, and US domestic political considerations ahead of the 2022 midterms. Investment Takeaways The point of this report argues that a partial re-invasion of Ukraine cannot be ruled out. Russia has the capability to reinforce de facto control of Donbas, or expand its footprint in southern Ukraine, though not to invade the whole country. The threat of economic sanctions is not yet so overwhelming as to warrant overconfident predictions of de-escalation. In this case it is better to be alarmist than complacent. Russia would want to maintain an element of surprise so the timing of any belligerence is hard to predict. For de-escalation, investors should watch for Russia to withdraw troops from the Ukrainian border, US-Russia consultations to begin promptly and proceed regularly, and for the US and allies to delay or halt defense cooperation and arms transfers to Ukraine. While global investors would quickly become de-sensitized to conflict that is entirely contained in Ukraine, the trans-Atlantic threat of major sanctions now raises the stakes and suggests that global energy shocks could negatively affect the European or global economy in the event of conflict. Any conflict could also spill outside of Ukraine’s borders, as with Malaysian Airlines flight MH17, which was shot down by Russian-backed Ukrainian separatists in July 2014. The Black Sea has seen a dangerous uptick in naval saber-rattling and that strategic situation would become permanently more dangerous if Russia seized more of coastal Ukraine. Russian military integration with Belarus is also a source of insecurity for EU and NATO members. Global financial markets have only started to price the geopolitical risk emanating from Russia. Our Russian GeoRisk Indicator has ticked up (Chart 6). But Russian equity performance relative to broad emerging markets is only arguably underperforming what is implied by Brent crude oil prices. Chart 6Market Slow To React To Ukraine Crisis - Risk To Downside For Russian Assets This relatively muted reaction suggests more downside lies ahead if we are right that strategic tensions will be flat-to-up over the coming months. Sell the RUB-USD on any strength. Stay long GBP-CZK. Tactically short Russian equities versus EM-ex-Asia (Chart 7). They are exposed to further correction as a result of escalating geopolitical risk. Chart 7Russia Falling Off Peaks Of Performance Versus EM-Ex-Asia Chart 8Developed Europe A Safer Bet Than Emerging Europe Amid Tensions Stick to long DM Europe versus EM Europe – our main trade this year to capture rising geopolitical risk between Russia and the West (Chart 8). Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 President of Russia, "Meeting with US President Joseph Biden," December 7, 2021, kremlin.ru. 2 White House, "Press Briefing by Press Secretary Jen Psaki and National Security Advisor Jake Sullivan, December 7, 2021," whitehouse.gov. 3 Dan Peleschuk, "Ukraine’s military poses a tougher challenge for Russia than in 2014," Politico, April 14, 2021, politico.eu.; see also Gav Don, "LONG READ: Russia looks poised to invade Ukraine, but what would an invasion actually look like?" Intellinews, November 24, 2021, intellinews.com. 4 US Department of State, "Joint Statement of the United States and Germany on Support for Ukraine, European Energy Security, and our Climate Goals," July 21, 2021, state.gov. 5 Kylie Atwood and Natasha Bertrand, "US likely to hold off for now on energy sanctions for Russia, fearing impact on global prices," CNN, December 9, 2021, cnn.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)
Highlights Our theme for the year, “No Return To Normalcy,” is largely vindicated. Inflation is back! The geopolitical method still points to three long-term strategic themes: multipolarity, hypo-globalization, and populism. All are inflationary in today’s context. Our three key views for 2021 produced two hits and one miss: China sold off, oil prices held up, but the euro fell hard. Our view on Iran is still in flux. COVID-19 proved more relevant for investors than we believed, though we took some risk off the table before the Delta and Omicron variants emerged. Our biggest miss was long Korea / short Taiwan equities. Our geopolitical forecast was spot on but our trade recommendation collapsed. Our biggest hit was long India / short China equities. China’s historic confluence of internal and external risk drove investors to India, the most promising strategic EM play. Feature Every year we conduct a review of the past year’s geopolitical forecasts and investment recommendations. The intention is to hold ourselves to account, prepare for our annual outlook, and improve our analytical framework. Our three key views for 2021 were: 1. China’s historic confluence of political and geopolitical risk = bearish view of Chinese equities; 2. The US pivot to Asia runs through Iran = neutral-to-bullish view of oil prices; 3. Europe wins the US election = bullish view of the euro and European equities. The first view on China was a direct hit. The second view is in flux. The third view was initially right but then turned sour. A crude way of assessing these views would be to look at equity performance relative to long-term trends: China sold off, the UAE rallied, and Europe sold off (Chart 1). Chart 1Three Key Views For 2021: Two Hits, One Miss This is not the whole story. We modified our views over the course of the year as new information came to light. In March we turned neutral on the US dollar, with negative implications for the euro. In June we adjusted our position on Europe overall, arguing that European political risk had bottomed and would rise going forward. In August we adjusted our position on Iran, warning of an imminent crisis due to the Biden administration’s refusal to lift sanctions and Iran’s pursuit of “breakout” uranium enrichment capacity. We stayed bearish on China throughout the year. Going forward, given that a near-term crisis is necessary to determine whether Iran will stay on a diplomatic track, we would short UAE or Saudi equities. We would expect oil to remain volatile given upside risks from geopolitics but downside risks from the new Omicron variant and China’s slowdown. China’s slowdown was also a controlling factor for the Europe view. The energy crisis and showdown with Russia can also get worse before they get better. So we prefer US assets for now and will revisit this issue in our annual strategic outlook due in the coming weeks. Before we get to the worst (and best) calls of the year, we have a few words on our analytical framework in the context of this year’s signal developments. The Geopolitical Method: Lessons From 2021 As with any method rooted in practice, the geopolitical method has many flaws. But it has the advantage of being systematic, empirical, probabilistic, and non-partisan. How do we check ourselves on the thorny problem of partisanship? First, geopolitics requires practicing empathetic analysis, i.e. striving to understand and empathize with the interests of each nation and nation-state when analyzing their behavior. For example: China: China’s ruling party believes it is necessary to have an all-powerful leader to deal with the urgent systemic risks facing the country. We refrain from criticizing single-party rule or China’s human rights record. But we do see compelling evidence that the Communist Party’s shift from consensus rule to personal rule will have a negative impact on governance and relations with the West.1 China obviously rejects foreign diplomatic and military support for Taiwan, which Beijing sees as a renegade province, and hence the odds of a war in the Taiwan Strait are high over the long run. Russia: Russia is threatening its neighbors on multiple fronts not because it is an evil empire but because of its insecurity in the face of the US and NATO, and particularly its opposition to western defense cooperation with Ukraine. Its unproductive domestic economy and vulnerability to social unrest are additional reasons to expect aggression abroad. Second, we take very seriously any complaints of bias we receive from clients. Such complaints are rare, which is encouraging. But we treat all feedback as an opportunity to improve. At the same time, the need to draw clean-cut investment conclusions for all clients will always override the political sensitivities of any subset of clients. Geopolitics is based in the idea that politics is rooted in structural forces like geography and demography, i.e. forces that limit or constrain individual actors and only change at a glacial pace. Geopolitical analysts focus on measurable and material factors rather than ever-changing opinions and ideas. It is impossible for investors today to ignore the global political environment, so the important thing is to analyze it in a cold and clinical manner. To combine this method with global macroeconomic and investment research, one must assess whether and to what extent financial markets have already priced any given policy outcome. The result will be a geopolitically informed macro conclusion, which should yield better decisions about conserving and growing wealth. This is the ideal for which we aim, even though we often fall short. Over the years our method has produced three primary strategic themes: Great Power struggle (multipolarity); hypo-globalization; and domestic populism (Table 1). Table 1Our Major Themes Point To Persistent Inflation Risk The macro impact of these themes will vary with events but in general they point toward a reflationary and inflationary context. They involve a larger role of government in society, new constraints on supply, demand-side stimulus, and budget indiscipline. Bottom Line: Nation-states are mobilizing, which means they will run up against resource constraints. A Return To Normalcy? Or Not? As the year draws to a close, our annual theme is vindicated: “No Return To Normalcy.” The term “normalcy” comes from President Warren G. Harding’s election campaign in 1920. It was an appeal to an American public that yearned to move on from World War I and the Spanish influenza pandemic. A hundred years later, in December 2020, the emergence of a vaccine for COVID-19 and the election of an orthodox American president (after the unorthodox President Trump) made it look as if 2021 would witness another such return to normalcy. We foresaw this narrative and rejected it. Primarily we rejected it on geopolitical grounds – global policy will not revert to the pre-Trump status quo. We also argued that the pandemic and the gargantuan fiscal relief designed to shield the economy would have lasting consequences. Specifically they would create a more inflationary context. Chart 2No Return To Normalcy In 2021 The most obvious sign that things have not returned to normal in 2021 is the “Misery Index,” the sum of unemployment and headline inflation. Misery Indexes skyrocketed during the crisis and today stand at 10.8% in the US and 11.4% in the EMU, up from 5.2% and 8.1% in 2019, respectively (Chart 2). Unemployment rates are falling but inflation has surged to the highest levels since the 1990s. For investors to be concerned about inflation at the beginning of a new business cycle is unusual and requires explanation. It suggests that inflation will be a persistent problem going forward, as the unemployment rate falls beneath NAIRU and participation rates rise. While we expected inflation, we did not expect the political blowback to come so quickly. President Biden’s approval rating collapsed to 42.2% this fall. Approval of his handling of the economy fell even lower, to 39.6%, below President Trump’s rating at this stage. Consumer confidence has fallen by 15.1% since its post-election peak in June 2021. Republicans are automatically favored to win the House of Representatives in the 2022 midterm elections – but if the economy does not improve they will also win the Senate. Despite Biden’s unpopularity, we argued that his $550 billion bipartisan infrastructure bill and his $1.75 trillion partisan social spending bill would pass Congress. So far this view is on track, with infrastructure signed into law and the Senate looking to vote on the social bill in December (or January). These bills illustrate the strategic themes listed above: the US is reviving public investments in civil and military sectors, reducing global dependencies, and expanding its social safety net. However, large new government spending when the output gap is virtually closed will tend to be inflationary. Russia and China also have high or rising misery indexes, which underscores that political and geopolitical risks will rise rather than fall over the coming 12 months. Unemployment rates are not always reliable in authoritarian states, so the Misery Index is if anything overly optimistic regarding social and economic conditions. China is not immune to social unrest but Russia is particularly at risk. Quality of life and public trust in government have both deteriorated. Inflation will make it worse. Russians remember inflation bitterly from the ruble crisis of 1998. President Putin is already ratcheting up tensions with the West to distract from domestic woes. While we were positioned for higher inflation in 2021, we were too dismissive of the global pandemic. We expected vaccination campaigns to move faster, especially in the US, and we underrated the Delta variant as a driver of financial markets, at least relative to politics. A close look at Treasury yields, oil prices, and airline stocks shows that the evolution of the pandemic marked the key inflection points in the market this year (Chart 3). Chart 3COVID-19 Stayed Relevant In 2021 ... Now Omicron Variant Emerging Bottom Line: Tactically the market impact of the newly discovered Omicron variant of the virus should not be underrated. It is critical to find out if it is more harmful to younger people than Delta and other variants. Cyclically inflation will remain a persistent risk even if it abates somewhat in 2022. Worst Calls Of 2021 We now proceed to our main feature. As always we begin with the worst calls of the year: Chart 4Taiwan Rolled Over ... But Not Against Korea 1. Long Korea / Short Taiwan. Geopolitical view correct, market view incorrect. US-China conflict is a secular trend and contains elements of all our major themes: Great Power struggle, hypo-globalization, and populism. Taiwan is the epicenter of this conflict and a war is likely over the long run. For 2021 we predicted a 5% chance of war but a 60% chance of a “fourth Taiwan Strait crisis,” i.e. a diplomatic crisis, and our contrarian short of Taiwanese equities was premised on this expectation. Investors are starting to respond to these self-evident geopolitical risks, judging by the TWD-USD exchange rate and the relative performance of Taiwanese equities, which have peaked and are lagging expectations based on global semiconductor stocks. But our choice of South Korean equities as the long end of the pair trade was very unfortunate and the trade is down by 22% (Chart 4). Korea is suffering from a long de-rating process in the face of China’s industrial slowdown and a downgrade to Korean tech sector earnings, as our Emerging Markets Strategy has highlighted. 2. Short CNY Versus USD And EUR. Geopolitical view correct, market view incorrect. This year we argued that President Biden would be just as hawkish on China as President Trump and would not remove tariffs or export controls. We also argued that the SEC would punish US-listed China stocks and that bilateral relations would not improve despite a likely Biden-Xi summit. These views proved correct. But our neutral view on the dollar and bullish view on the euro betrayed us and the trade has lost 4% so far. The euro collapsed amid its domestic energy crisis and China’s import slowdown (Chart 5). China’s exports boomed while the People’s Bank kept the currency strong to fend off inflation. Chart 5China Tensions Sure, But Don't Fight The People's Bank Chart 6Value Surged Then Fell Back Against Growth Stocks 3. Long Value Versus Growth. Geopolitical view correct, market view incorrect. We have long favored value over growth stocks, expecting that our strategic themes would lead to more muscular fiscal spending, government intervention in the economy, and a return of inflation. In 2021 we bet that rising inflation expectations and higher bond yields would favor value over growth. This was only one aspect of our larger pro-cyclical view that tech-heavy US equities would underperform their global peers and emerging markets would outpace developed markets. These expectations came true during the first part of the year when exuberance over the “reflation trade” led to a big pop in value (Chart 6). By the second quarter we had pared back our pro-cyclical leanings but we maintained value over growth, ultimately at a loss of 3.75%. The reality nowadays is that value is a byword for low quality, as our colleagues Juan Correa-Ossa and Lucas Laskey have shown. Growth stocks continue to provide investors with innovation and robust earnings amid a lingering pandemic. 4. Long Aerospace And Defense Stocks. Geopolitical view mixed, market view incorrect. We are perennially bullish on defense stocks given our strategic themes. We expected aerospace and defense stocks to recover as vaccines spread and travel revived. We successfully played the rebound in absolute terms. But the slow pace of vaccination and the emergence of the Delta variant dealt a blow to the sector relative to the broad market. And now comes Omicron. As for defense stocks specifically, investors are downplaying Great Power struggle and worried that government defense budgets will be flat or down. Significant saber-rattling is occurring as expected in the major hotspots – the Taiwan Strait, the Persian Gulf, and Russia’s periphery – but investors do not care about saber-rattling for the sake of saber-rattling. Geopolitical tensions went nowhere so far this year and hence defense stocks floundered relative to the broad market (Chart 7). Still we would be buyers at today’s cheap valuations as we see geopolitical risk rising on a secular basis and the odds of military action are non-negligible in all three of the hotspots just mentioned. 5. Long Safe Havens. Geopolitical view mixed, market view incorrect. Measured geopolitical risk and policy uncertainty collapsed over the second half of 2020. By early 2021 we expected it to revive on US-China, US-Russia, and US-Iran tensions. As such we expected safe-haven assets to catch a bid, especially having fallen as the global economy reopened. We stayed long gold (up 22.6% since inception, down 5.2% YTD) and at various times bought the Japanese yen and Swiss franc. Some of these trades generated positive returns but in general safe havens remained out of favor (Chart 8). As with defense stocks, we are still constructive on the yen and franc. Chart 7Market Ignored Saber-Rattling 6. Long Developed Europe / Short Emerging Europe. Geopolitical view correct, market view incorrect. Our pessimistic view of Russia’s relations with the West, and hence of Russian currency and equities, clashed with our positive outlook on oil and commodity prices this year. To play Russian risks we favored developed European equities over their emerging peers (mainly Russian stocks). But emerging Europe has outperformed by 5% since we initiated the trade and other variations on this theme had mixed results (Chart 9). Of course, geopolitical tensions are escalating in eastern Europe we go to press. Chart 8Safe Havens Fell After US Election, Insurrection Chart 9Refrain From The Russia Rally We do not think investors can afford to ignore the US-Russia conflict, which has escalated over two decades. President Putin has not changed his strategy of building a sphere of influence in the former Soviet Union. The US is internally divided and distracted by a range of challenges, while it continues to lack close coordination with its European allies. Western responses to Russian aggression have failed to change Russia’s cost-benefit analysis. Thus we continue to expect market-negative surprises from Russia, whether that means a seizure of littoral territory in Ukraine, a militarization of the Belarussian border, more disruptive cyber attacks, or some other big surprise. Bottom Line: While our geopolitical forecasts generally hit the mark this year, global financial markets ignored most geopolitical risks other than China. The global recovery, inflation, and the pandemic, vaccines, variants, and social distancing remained the key dynamics. This threw many of our trades off track. However, we are sticking with some of our worst calls this year given the underlying geopolitical and economic forces motivating them beyond a 12-month time frame. Best Calls Of 2021 1. Long India / Short China. Geopolitical view correct, market view mixed. Our number one view for 2021 was that China would suffer a historic confluence of political and geopolitical risk that would be negative for equities. This view contrasted with our bullish view on India. Prime Minister Narendra Modi had won another single-party majority in the 2019 elections and stood to benefit from the attempts of the US and other democracies to diversify away from China. We favored Indian stocks and local currency bonds – both trades saw a sharp run-up (Chart 10). Unfortunately, we took profits too soon, only netting 12% on the long India / short China equity trade. Some of our other India trades did not go so well. Going forward we expect a tactical reset given India’s tremendous performance this year. 2. Booking Gains At Peak Biden. Geopolitical view correct, market view correct. We closed several of our reflation trades in the first quarter, when exuberance over vaccines and the Democrat’s election sweep reached extreme levels (Chart 11). We captured a 24% gain on our materials trade and a 37% gain on energy stocks. We turned a 17% profit on our BCA Infrastructure Basket relative trade. We were prompted to close these trades by dangers over Taiwan and Ukraine that soon dissipated. But we also believed that markets were priced for perfection. By the second quarter we had taken some risk off the table, which served us well throughout the middle of the year when the Delta variant struck. While global energy and materials rose to new highs later in the year, the Fed and Omicron interrupted their run. Chart 10Call Of The Year: Long India, Short China 3. Long Natural Gas On Russia Risks. Geopolitical view correct, market view correct. All year we held the contrarian view that the new Nord Stream II pipeline linking Russia and Germany would become a major geopolitical flashpoint and that it was much less likely to go into operation than consensus held. Chart 11Reflation Trade' Peaked Early, Peaked Again, Then Omicron We also fully expected Russia to act aggressive in its periphery. In March we argued that while Russia probably would not re-invade Ukraine, long-term risk was substantial (and accordingly a new military standoff began in the fall) We also noted that Russia had other tools to coerce its neighbors. As a result we went long natural gas futures, following our colleagues at Commodity & Energy Strategy. While the trade returned 20%, we took profits before the European energy crisis really took off (Chart 12). 4. The “Back To War” Trade. Geopolitical view correct, market view correct. Cyber warfare is one of the ways that the Great Powers can compete without engaging in conventional war. We have long been bullish on cyber-security stocks. However, the pandemic created a unique tactical opportunity to initiate a pair trade of long traditional defense stocks / short cyber stocks that returned 10%. It was a geopolitical variation on the “back to work” trades that characterized the revival of economic activity after pandemic lockdowns. Cyber stocks will enjoy a tailwind as long as the pandemic persists and working from home remains a major trend. But over the cyclical time frame defense stocks should rebound relative to their cyber peers, just as physical geopolitical tensions should begin to take on renewed urgency with nations scrambling for territory and resources (Chart 13). Chart 12Hold Onto The Good Ones: Long Natural Gas Chart 13The 'Back To War' Trade Chart 14Rare Earths Revived On Commodity Surge 5. Long Rare Earth Metals. Geopolitical view correct, market view mixed. We have long maintained that rare earth metals would catch a bid as US-China tensions rose. The pandemic stimulus galvanized a new capex cycle with a focus on strategic goals like supply chain resilience, military-industrial upgrades, and de-carbonization that will boost demand for rare earths. Our trade made a 9% gain, despite difficulties throughout the year arising from our homemade BCA Rare Earth Basket, which proved to be an idiosyncratic instrument. Going forward we will express our view via the benchmark MVIS Rare Earth Index (Chart 14). Bottom Line: Our successful trades hinged on broad geopolitical views: China’s confluence of internal and external risk, Biden’s reflationary agenda, persistent US-Russia conflict, and India’s attractiveness relative to other emerging markets. The change in 2022 is that Biden’s legislative agenda will be spent so the market will shift from American reflation to the Fed and global concerns. If China does not stabilize its economy, more bad news will hit China-related plays and global risk assets. Honorable Mentions: For Better And For Worse Short EM “Strongmen.” Geopolitical view correct, market view mixed. We shorted the currencies of Turkey, Brazil, and the Philippines relative to benchmark EM currencies. Though we closed the trade too early, earning a paltry sum, the political analysis proved correct and the market ultimately responded in a major way (Chart 15). Upcoming elections for these countries in 2022-23 will ensure that their dysfunctional politics remain negative for investors, while other emerging market currencies continue to outperform. Chart 15Short EM 'Strongman' Leaders ¡Viva México! Geopolitical view correct, market view mixed. Mexico benefited from US stimulus, the USMCA trade deal, the West’s economic divorce from China, and the resumption of tourism, immigration, and remittances. In general Latin America stands aloof from the Great Power struggles afflicting emerging markets in Europe and East Asia. But Latin America’s perennial problem with domestic populism and political instability undermines US dollar returns. Mexico looks to be a notable exception. Chart 16¡Viva México! Mexico suffered the biggest opportunity cost from the West’s love affair with China over the past 40 years. Now it stands to gain from the US drive to relocate supply chains, onshore to North America, and diversify from China. Two of our Mexico trades were ill-timed this year, but favoring Mexico over other emerging markets, particularly Brazil, was fundamentally the right call (Chart 16). Bottom Line: Cyclically Mexico is an emerging market with a compelling story based on fundamentals. Tactically disfavor emerging market “strongmen” regimes. Investment Takeaways Our batting average this year was 65%. 2021 will be remembered as a transitional year in which the world tried but did not quite return to normal amid a lingering pandemic. Inflation reemerged as a major concern of consumers, governments, and central banks. Developed markets adopted proactive fiscal policy but global cyclicals faced crosswinds as China resumed its monetary, fiscal, and regulatory tightening campaign. Our bearish call on China was a direct hit. China’s political risks will persist ahead of the twentieth national party congress in fall 2022. Cyclically stay short CNY-USD and TWD-USD. Our worst market call was long Korean / short Taiwanese equities. But the world awoke to Taiwan risk and Taiwanese stocks peaked relative to global equities. Over the long run we think war is likely in the Taiwan Strait. Re-initiate long JPY-KRW as a strategic trade. Our best market call was long Indian / short Chinese equities. Tactically this trade will probably reverse but strategically we maintain the general thesis. The US and Iran failed to rejoin their nuclear deal this year as we originally expected. In August we adjusted our view to expect a short-term Persian Gulf crisis, which in turn will lead either to diplomacy or a new war path. Oil shocks and volatility should be expected over the next 12 months. Tactically go short UAE equities relative to global. European equities and the euro disappointed this year, even though we were right that Scotland would not secede from the UK, that Italian politics would not matter, and that Germany’s election would be an upset but not negative for markets. In March we turned neutral on the US dollar and in June we argued that European political risk had bottomed and would escalate going forward. We remain tactically negative on the euro, though we are cyclically constructive. We still prefer DM Europe over EM Europe due to Russian geopolitical risks. Re-initiate long CAD-RUB and long GBP-CZK as strategic trades. We are waiting for a tactical re-entry point for the following trades: long CHF-USD, CHF-GBP, GBP-EUR, short EM ‘Strongman’ currencies versus EM currencies, long US infrastructure stocks, long European industrials, and long Italian versus Spanish stocks. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 While autocracy is agreed to be negative for governance indicators, the connection between regime type and economic growth is debatable. Suffice it to say that the determinants of total factor productivity, such as human capital, trade openness, and effectiveness of the legislature, are often difficult to sustain under autocratic or authoritarian regimes. On this point see United Nations Industrial Development Organization, "Determinants of total factor productivity: a literature review," Staff Working Paper 2 (2007). For further discussion, see Carl Henrik Knutsen, "A business case for democracy: regime type, growth, and growth volatility," Democratization 28 (2021), pp 1505-24; Ryan H. Murphy, "Governance and the dimensions of autocracy," Constitutional Political Economy 30 (2019), pp 131-48. For a skeptical view of the relationship, see Adam Przeworski and Fernando Limongi, "Political Regimes and Economic Growth," Journal of Economic Perspectives 7:3 (1993), pp 51-69. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)
Highlights Remain neutral on the US dollar. A breakout of the dollar would cause a shift in strategy. Russia’s conflict with the West is heating up now that Germany has delayed the certification of the Nord Stream II pipeline. As long as the focus remains on the pipeline, the crisis will dissipate sometime in the middle of next year. But there is an equal chance of a massive escalation of strategic tensions. Our GeoRisk Indicators will keep rising in Europe, negatively affecting investor risk appetite. Stick with DM Europe over EM Europe stocks. If the dollar does not break out, South Korea and Australia offer cyclical opportunities. Turkish and Brazilian equities will not be able to bounce back sustainably in the midst of chaotic election cycles and deep structural problems. Rallies are to be faded. Feature We were struck this week by JP Morgan CEO Jamie Dimon’s claim that his business will “not swayed by geopolitical winds.”1 If he had said “political winds” we might have agreed. It is often the case that business executives need to turn up their collars against the ever-changing, noisy, and acrimonious political environment. However, we take issue with his specific formulation. Geopolitical winds cannot shrugged off so easily – or they are not truly geopolitical. Geopolitics is not primarily about individual world leaders or topical issues. It is primarily about things that are very hard and slow to change: geography, demography, economic structure, military and technological capabilities, and national interests. This is the importance of having a geopolitically informed approach to macroeconomics and financial markets: investment is about preserving and growing wealth over the long run despite the whirlwind of changes affecting politicians, parties, and local political tactics. In this month’s GeoRisk Update we update our market-based, quantitative geopolitical risk indicators with a special focus on how financial markets are responding to the interplay of near-term and cyclical political risks with structural and tectonic pressures underlying a select group of economies and political systems. Is King Dollar Breaking Out? Chart 1King Dollar Breaking Out? Our first observation is that the US dollar is on the verge of breaking out and rallying (Chart 1). This potential rally is observable in trade-weighted terms and especially relative to the euro, which has slumped sharply since November 5th. Our view on the dollar remains neutral but we are watching this rally closely. This year was supposed to be a year in which global growth recovered from the pandemic on the back of vaccination campaigns, leading the counter-cyclical dollar to drop off. The DXY bounce early in the year peaked on April 2nd but then began anew after hitting a major resistance level at 90. The United States is still the preponderant power within the international system. The USD remains the world’s leading currency by transactions and reserves. The pandemic, social unrest, and contested election of 2020 served as a “stress test” that the American system survived, whether judging by the innovation of vaccines, the restoration of order, or the preservation of the constitutional transfer of power. Meanwhile Europe faces several new hurdles that have weighed on the euro. These include the negative ramifications of the slowdown in Asia, energy supply shortages, a new wave of COVID-19 cases, and the partial reimposition of social restrictions. Moreover the Federal Reserve is likely to hike interest rates faster and higher than the European Central Bank over the coming years. Potential growth is higher in the US than Europe and the US growth is supercharged by fiscal stimulus whereas Europe’s stimulus is more limited. Of course, the US’s orgy of monetary and fiscal stimulus and ballooning trade deficits raise risks for the dollar. Global growth is expected to rotate to other parts of the world over the coming 12 months as vaccination spreads. There is still a chance that the dollar’s bounce is a counter-trend bounce and that the dollar will relapse next year. Hence our neutral view. Yet from a geopolitical perspective, the US population and economy are larger, more dynamic, more innovative, safer, and more secure than those of the European Union. The US still exhibits an ability to avoid the reckoning that is overdue from a macroeconomic perspective. Russia-West Conflict Resumes In our third quarter outlook we argued that European geopolitical risk had hit a bottom, after coming off the sovereign debt crisis of 2010-15, and that geopolitical risk would begin to rise over the long term for this region. Our reasoning was that the markets had fully priced the Europeans’ decision to band together in the face of risks to the EU’s and EMU’s integrity. What markets would need to price going forward would be greater risks to Europe’s stability from a chaotic external environment that Europe lacked the willingness or ability to control: conflict with Russia, immigration, terrorism, and the slowdown in Asia. In particular we argued that Russia’s secular conflict with the West would resume. US-Russia relations would not improve despite presidential summits. The Nord Stream II pipeline would become a lightning rod for conflict, as its operation was more likely to be halted than the consensus held. (German regulators paused the approval process this week, raising the potential for certification to be delayed past the expected March-May months of 2022.) Most importantly we argued that the Russian strategy of political and military aggression in its near-abroad would continue since Russia would continue to feel threatened by domestic instability at home and Western attempts to improve economic integration and security coordination with former Soviet Union countries. Chart 2Putin Showdown With West To Escalate Further For this reason we recommended that investors eschew Russian equities despite a major rally in commodity prices. Any rally would be undercut by the slowing economy in Asia or geopolitical conflicts that frightened investors away from Russian companies, or both. Today the market is in the process of pricing the impact on Russian equities from commodity prices coming off the boil. But politics may also have something to do with the selloff in Russian equities (Chart 2). The selloff can continue given still-negative hard economic data from Asia and the escalation of tensions around Russia’s strategically sensitive borders: Ukraine, Belarus, Poland, Lithuania, Moldova, and the Black Sea. The equity risk premium will remain elevated for eastern European markets as a result of the latest materialization of country risk and geopolitical risk – the long running trend of outperformance by developed Europe has been confirmed on a technical resistance level (Chart 3). Our mistake was closing our recommendation to buy European natural gas prices too early this year. Chart 3Favor DM Europe Amid Russia Showdown In early 2021, our market-based geopolitical risk indicator for Russia slumped, implying that global investors expected a positive diplomatic “reset” between the US and Russia. We advised clients to ignore this signal and argued that Russian geopolitical risk would take back off again. We said the same thing when the indicator slumped again in the second half of the year and now it is clear the indicator will move sharply higher (Chart 4). The point is that geopolitics keeps interfering with investors’ desire to resuscitate Russian equities based on macro and fundamental factors: cheap valuations, commodity price rises, some local improvements in competitiveness, and the search for yield. Chart 4Russian GeoRisk Indicator - Risks Not Yet Priced Russia may or may not stage a new military incursion into Ukraine – the odds are 50/50, given that Russia has invaded already and has the raw capability in place on Ukraine’s borders. The intention of an incursion would be to push Russian control across the entire southern border of Ukraine to Odessa, bringing a larger swathe of the Black Sea coast under Moscow’s control in pursuit of Russia’s historic quest for warm water ports. The limitations on Russia are obvious. It would undertake new military and fiscal burdens of occupation, push the US and EU closer together, provoke a stronger NATO defense alliance, and invite further economic sanctions. Yet similar tradeoffs did not prevent Russia from taking surprise military action in Georgia in 2008 or Ukraine in 2014. After the past 13 years the US and EU are still uncoordinated and indecisive. The US is still internally divided. With energy prices high, domestic political support low, and Russia’s long-term strategic situation bleak, Moscow may believe that the time is right to expand its buffer territory further into Ukraine. We cannot rule out such an outcome, now or over the next few years. If Russia attacks, global risk assets will suffer a meaningful pullback. It will not be a bear market unless the conflict spills out beyond Ukraine to affect major economies. We have not taken a second Ukraine invasion as our base case because Russia is focused primarily on getting the Nord Stream pipeline certified. A broader war would prevent that from happening. Military threats after Nord Stream is certified will be more worrisome. A less belligerent but still aggressive move would be for Russia to militarize the Belarussian border amid the conflict with the EU over Belarus’s funneling of Middle Eastern migrants into the EU via Poland and Lithuania. A closer integration of Russia’s and Belarus’s economies and militaries would fit with Russia’s grand strategy, improve Russia’s military posture in eastern Europe, and escalate fears of eventual war in Poland and the Baltic states. The West would wring its hands and announce more sanctions but may not have a higher caliber response as such a move would not involve hostilities or the violation of mutual defense treaties. This outcome would be negative but also digested fairly quickly by financial markets. Our European GeoRisk Indicators (see Appendix) are likely to respond to the new Russia crisis, in keeping with our view that European geopolitical risk will rise in the 2020s: German risk has dropped off since the election but will now revive at least until Nord Stream II is certified. If Russia re-invades Ukraine it will rise, as it did in 2014. French risk was already heating up due to the presidential election beginning April 10 (first round) but now may heat up more. Not that Russia poses a direct threat to France but more that broader regional insecurities would hurt sentiment. The election itself is not a major risk to investors, though terrorist attacks could tick up. President Macron has an incentive to be hawkish on a range of issues over the next half year. The UK is in the midst of the Russia conflict. Its defense cooperation with Ukraine and naval activity in the Black Sea, such as port calls in Georgia, have prompted Russia’s military threats – including a threat to bomb a Royal Navy vessel earlier this year. Not to mention ongoing complications around Brexit. The Russian situation is by far the most significant factor. Spain is at a further remove from Russia but its risks are rising due to domestic political polarization and the rising likelihood of a breakdown in the ruling government. Bottom Line: We still favor these countries’ equities to those of eastern Europe but our risk indicators will rise, suggesting that geopolitical incidents could cause a setback for some or all of these markets in absolute terms. A pickup in Asian growth would be beneficial for developed European assets so we are cyclically constructive. We remain neutral on the USD-EUR though a buying opportunity may present itself if and when the Nord Stream II pipeline is certified. Korea: Nobody’s Heard From Kim In A While Chart 5Korea GeoRisk Indicator Still Elevated Geopolitical risk has risen in South Korea due to COVID-19 and its aftershocks, including supply kinks, shortages, and policy tightening by the giant to the West (Chart 5). South Korea’s geopolitical risk indicator is still very high but not because of North Korea. Our Dear Leader Kim Jong Un has not been overly provocative, although he has restarted the cycle of provocations during the Biden administration. Yet South Korean geopolitical risk has skyrocketed. The problem is that investors have lost a lot of appetite for South Korea in a global environment in which demographics are languishing, globalization is retreating, a regional cold war is developing, and debt levels are high. Domestic politics have become more redistributive without accompanying reforms to improve competitiveness or reform corporate conglomerates. The revival of the South Korean conservatives ahead of elections in 2022 suggests political risk will remain elevated. Of course, North Korea could still move the dial. A massive provocation, say something on the scale of the surprise naval attack on the Chonan in the wake of the global financial crisis in spring of 2010, could push up the risk indicator higher and increase volatility for the Korean won and equities. Kim could take such an action to insist that President Biden pay heed to him, like President Trump did, or at least not ignore him, in a context in which Biden is doing just that due to far more pressing concerns. Biden would be forced to reestablish a credible threat. Still, North Korea is not the major factor today. Not compared to the economic and financial instability in the region. At the same time, if global growth surprises pick up and the dollar does not break out, Korea will be a beneficiary. We have taken a constructive cyclical view, although our specific long Korea trade has not worked out this year. Korean equities depreciated by 11.2% in USD terms year-to-date, compared to 0.3% for the rest of EM. Structurally, Korea cannot overcome the negative demographic and economic factors mentioned above. Geopolitically it remains a “shrimp between two whales” and will fail to reconcile its economic interests with its defense alliance with the United States. Australia: Wait On The Dollar Chart 6Australian GeoRisk Indicator Still Elevated Australian geopolitical risk has not fallen back much from this year’s highs, according to our quant indicator (Chart 6). Global shortages and a miniature trade war were the culprits of this year’s spike. The advantage for Australia is that commodity prices and metals look to remain in high demand as the world economy fully mends. Various nations are implementing large public investment programs, especially re-gearing their energy sectors to focus more on renewables. The reassertion of the US security alliance is positive for Australia but geopolitical risk is rising on a secular basis regardless. Cyclically we would look positively toward Australian stocks. Yet they have risen by 4.3% in common currency terms this year so far, compared to the developed market-ex-US average of 11.0%. Moreover the Aussie’s latest moves confirm that the US dollar is on the verge of breaking out which would be negative for this bourse. Structurally Australia will go through a painful economic transition but it will be motivated to do so by the new regional cold war and threats to national security. The US alliance is a geopolitical positive. Turkey And Brazil The greenback’s rally could be sustainable not only because of the divergence of US from Asian and global growth but also because of the humiliating domestic political environment of most prominent emerging markets. Chart 7Emerging Market Bull Trap We booked gains our “short” trade of the currencies of EM “strongmen,” such as Brazil’s Jair Bolsonaro and Turkey’s Recep Erdogan, earlier this year. But we noted that we still hold a negative view on these economies and currencies. This is especially true today as contentious elections approach in both countries in 2022 and 2023 respectively (Chart 7). Turkey is trapped into an inflation spiral of its own design, which enervates the economy, as our Emerging Markets Strategy has shown. It is also trapped in a geopolitical stance in which it has repeatedly raised the stakes in simultaneous clashes with Russia, the US, Europe, Israel, the Arab states, Libya, and Iran. Russia’s maneuvers in the Black Sea are fundamentally threatening to Turkey, so while Erdogan has maintained a balance with Russia for several years, Russian aggression could upset that balance. Turkey has backed off from some recent confrontations with the West lately but there is not yet a trend of improvement. The COVID-19 crisis gave Erdogan a badly needed bump in polls, unlike other EM peers. But this simply reinforces the market’s overrating of his odds of being re-elected. In reality the odds of a contested election or an election upset are fairly high. New lows in the lira show that the market is reacting to the whole negative complex of issues around Turkey. But the full weight of the government’s mismanaging of economic policy to stay in power and stay geopolitically relevant has not yet been felt. The election is still 19 months away. A narrow outcome, for or against Erdogan and his party, would make things worse, not better. Brazil’s domestic political and geopolitical risks are more manageable than Turkey’s. But it faces a tumultuous election in which institutional flaws and failures will be on full display. Investors will try to front-run the election believing that former President Luiz Inácio Lula da Silva will restore the good old days. But we discourage that approach. We see at least two massive hurdles for the market: first, Brazil has to pass its constitutional stress test; second, the next administration needs to be forced into difficult decisions to preserve growth and debt management. These will come at the expense of either growth or the currency, according to our Emerging Markets Strategy. We still prefer Mexican stocks. Geopolitically, Turkey will struggle with Russia’s insecurity and aggression, Europe’s use of economic coercion, and Middle Eastern instability. Brazil does not have these external problems, although social stability will always be fragile. Investment Takeaways The dollar is acting as if it may break out in a major rally. Our view has been neutral but our generally reflationary perspective on the global economy is being challenged. Russia’s conflict with the West will escalate, not de-escalate, in the wake of Germany’s decision to delay the certification of the Nord Stream II pipeline. Russia has greater leverage now than usual because of energy shortages. A re-invasion of Ukraine cannot be ruled out. But the pipeline is Russia’s immediate focus. Investors have seen conflict in Ukraine so they will be desensitized quickly unless the conflict spreads into new geographies or spills out to affect major economies. The same goes for trouble on Belarus’s borders. Stick with long DM Europe / short EM Europe. Opportunities may emerge to become more bullish on the euro and European equities if and when the Nord Stream II situation looks to be resolved and Asian risks to global growth are allayed. If the dollar does not break out, South Korea and Australia are cyclical beneficiaries. Whereas “strongman” regimes will remain volatile and the source of bull traps, especially Turkey. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 “JP Morgan chief becomes first Wall Street boss to visit during pandemic,” Financial Times, November 15, 2021, ft.com. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Open Trades & Positions Section II: Appendix: GeoRisk Indicator Russia United Kingdom Germany France Italy Canada Spain Korea Turkey Brazil Australia South Africa Section III: Geopolitical Calendar
Highlights Geopolitical conflicts point to energy price spikes and could add to inflation surprises in the near term. However, US fiscal drag and China’s economic slowdown are both disinflationary risks to be aware of. Specifically, energy-producers like Russia and Iran gain greater leverage amid energy shortages. Europe’s natural gas prices could spike again. Conflict in the Middle East could disrupt oil flows. President Biden’s $1.75 trillion social spending bill is a litmus test for fiscal fatigue in developed markets. It could fail, and even assuming it passes it will not prevent overall fiscal drag in 2022-23. However, it is inflationary over the long run. China’s slowdown poses the chief disinflationary risk. But we still think policy will ease to avoid an economic crash ahead of the fall 2022 national party congress. We are closing this year’s long value / short growth trade for a loss of 3.75%. Cyclical sectors ended up being a better way to play the reopening trade. Feature Equity markets rallied in recent weeks despite sharp upward moves in core inflation across the world (Chart 1). Inflation is fast becoming a popular concern and we see geopolitical risks that could drive headline inflation still higher in the short run. We also see underrated disinflationary factors, namely China’s property sector distress and economic slowdown. Several major developments have occurred in recent weeks that we will cover in this report. Our conclusions: Biden’s domestic agenda will pass but risks are high and macro impact is limited. Congress passed Biden’s infrastructure deal and will probably still pass his signature social spending bill, although inflation is creating pushback. Together these bills have little impact on the budget deficit outlook but they will add to inflationary pressures. Energy shortages embolden Russia and Iran. Winter weather is unpredictable, the energy crisis may not be over. But investors are underrating Russia’s aggressive posture toward the West. Any conflict with Iran could also cause oil disruptions in the near future. US-China relations may improve but not for long. A bilateral summit between Presidents Joe Biden and Xi Jinping will not reduce tensions for very long, if at all. Climate change cooperation is an insufficient basis to reverse the cold war-style confrontation over the long run. Chart 1Inflation Rattles Policymakers The investment takeaway is that geopolitical tensions could push energy prices still higher in the short term. Iran and Russia need to be monitored. However, China’s economic slowdown will weigh on growth. China poses an underrated disinflationary risk to our views. US Congress: Bellwether For Fiscal Fatigue While inflation is starting to trouble households and voters, investors should bear in mind that the current set of politicians have long aimed to generate an inflation overshoot. They spent the previous decade in fear of deflation, since it generated anti-establishment or populist parties that threatened to disrupt the political system. They quietly built up an institutional consensus around more robust fiscal policy and monetary-fiscal coordination. Now they are seeing that agenda succeed but are facing the first major hurdle in the form of higher prices. They will not simply cut and run. Inflation is accompanied by rising wages, which today’s leaders want to see – almost all of them have promised households a greater share of the fruits of their labor, in keeping with the new, pro-worker, populist zeitgeist. Real wages are growing at 1.1% in the US and 0.9% across the G7 (Chart 2). Even more than central bankers, political leaders are focused on jobs and employment, i.e. voters. Yet the labor market still has considerable slack (Chart 3). Almost all of the major western governments have been politically recapitalized since the pandemic, either through elections or new coalitions. Almost all of them were elected on promises of robust public investment programs to “build back better,” i.e. create jobs, build infrastructure, revitalize industry, and decarbonize the energy economy. Thus while they are concerned about inflation, they will leave that to central banks, as they will be loathe to abandon their grand investment plans. Chart 2Higher Wages: Real Or Nominal? Still, there will be a breaking point at which inflation forces governments to put their spending plans on hold. The US Congress is the immediate test of whether today’s inflation will trigger fiscal fatigue and force a course correction. Chart 3Policymakers Fear Populism, Focus On Employment President Biden’s $550 billion infrastructure bill passed Congress last week and will be signed into law around November 15. Now he is worried that his signature $1.75 trillion social spending bill will falter due to inflation fears. He cannot spare a single vote in the Senate (and only three votes in the House of Representatives). Odds that the bill fails are about 35%. Democratic Party leaders will not abandon the cause due to recent inflation prints. They see a once-in-a-generation opportunity to expand the role of government, the social safety net, and the interests of their constituents. If they miss this chance due to inflation that ends up being transitory then they will lose the enthusiastic left wing of the party and suffer a devastating loss in next year’s midterm elections, in which they are already at a disadvantage. Biden’s social bill is also likely to pass because the budget reconciliation process necessary to pass the bill is the same process needed to raise the national debt limit by December 3. A linkage of the two by party leaders would ensure that both pass … and otherwise Democrats risk self-inflicting a national debt default. The reconciliation bill is more about long-term than short-term inflation risk. The bill does not look to have a substantial impact on the budget outlook: the new spending is partially offset by new taxes and spread out over ten years. The various legislative scenarios look virtually the same in our back-of-the-envelope budget projections (Chart 4). However, given that the output gap is virtually closed, this bill combined with the infrastructure bill will add to inflationary pressures. The fiscal drag will diminish by 2024, not coincidentally the presidential election year 2024, not coincidentally the presidential election year. The deficit is not expected to increase or decrease substantially between 2023 and 2024. From then onward the budget deficit will expand. The increased government demand for goods and services and the increased disposable income for low-earning families will add to inflationary pressures. Other developed markets face a similar situation: inflation is picking up, but big spending has been promised and normalizing budgets will marginally weigh on growth in the next few years (Chart 5). True, growth should hold up since the private economy is rebounding in the wake of the pandemic. But politicians will not be inclined to renege on campaign promises of liberal spending in the face of fiscal drag. The current crop of leaders is primed to make major public investments. This is true of Germany, Japan, Canada, and Italy as well as the United States. It is partly true in France, where fiscal retrenchment has been put on hold given the presidential election in the spring. The effect will be inflationary, especially for the US where populist spending is more extravagant than elsewhere. The long run will depend on structural factors and how much the new investments improve productivity. Bottom Line: A single vote in the US Senate could derail the president’s social spending bill, so the US is now the bellwether for fiscal fatigue in the developed world. Biden is likely to pass the bill, as global fiscal drag is disinflationary over the next 12 months. Yet inflation could stay elevated for other reasons. And this fiscal drag will dissipate later in the business cycle. Russia And Iran Gain Leverage Amid Energy Crunch The global energy price spike arose from a combination of structural factors – namely the pandemic and stimulus. It has abated in recent weeks but will remain a latent problem through the winter season, especially if La Niña makes temperatures unusually cold as expected. Rising energy prices feed into general producer prices, which are being passed onto consumers (Chart 6). They look to be moderating but the weather is unpredictable. There is another reason that near-term energy prices could spike or stay elevated: geopolitics. Tight global energy supply-demand balances mean that there is little margin of safety if unexpected supply disruptions occur. This gives greater leverage to energy producers, two of which are especially relevant at the moment: Russia and Iran. Russia’s long-running conflict with the West is heating up on several fronts, as expected. Russia may not have caused the European energy crisis but it is exacerbating shortages by restricting flows of natural gas for political reasons, as it is wont to do (Chart 7). Moscow always maintains plausible deniability but it is currently flexing its energy muscles in several areas: Chart 6Energy Price Depends On Winter ... And Russia/Iran! Ukraine: Russia has avoided filling up and fully utilizing pipelines and storage facilities in Ukraine, where the US is now warning that Russia could stage a large military action in retaliation for Ukrainian drone strikes in the still-simmering Russia-Ukraine war. Belarus: Russia says it will not increase the gas flow through the major Yamal-Europe natural gas pipeline in 2022 even as Belarus threatens to halt the pipeline’s operation entirely. Belarus, backed by Russia, is locked in a conflict with Poland and the EU over Belarus’s funneling of migrants into their territory (Chart 8). The conflict could lead not only to energy supply disruptions but also to a broader closure of trade and a military standoff.1 Russia has flown two Tu-160 nuclear-armed bombers over Belarus and the border area in a sign of support. Moldova: Russia is withholding natural gas to pressure the new, pro-EU Moldovan government. Russia’s main motive is obvious: it wants Germany and the EU to approve and certify the new Nord Stream II pipeline. Nord Stream II enables Germany and Russia to bypass Ukraine, where pipeline politics raise the risk of shortages and wars. Lame duck German Chancellor Angela Merkel worked with Russia to complete this pipeline before the end of her term, convincing the Biden administration to issue a waiver on congressional sanctions that could have halted its construction. However, two of the parties in the incoming German government, the Greens and the Free Democrats, oppose the pipeline. While these parties may not have been able to stop the pipeline from operating, Russia does not want to take any chances and is trying to force Germany’s and the EU’s hand. The energy crisis makes it more likely that the pipeline will be approved, since the European Commission will have to make its decision during a period when cold weather and shortages will make it politically acceptable to certify the pipeline.2 The decision will further drive a wedge between Germany and eastern EU members, which is what Russia wants. EU natural gas prices will likely subside sometime next year and will probably not derail the economic recovery, according to both our commodity and Europe strategists. A bigger and longer-lasting Russian energy squeeze would emerge if the Nord Stream II pipeline is not certified. This is a low risk at this point but the next six months could bring surprises. More broadly, the West’s conflict with Russia can easily escalate from here. First, President Vladimir Putin faces economic challenges and weak political support. He frequently diverts popular attention by staging aggressive moves abroad. There is no reason to believe his post-2004 strategy of restoring Russia’s sphere of influence in the former Soviet space has changed. High energy prices give him greater leverage even aside from pipeline coercion – so it is not surprising that Russia is moving troops to the Ukraine border again. Growing military support for Belarus, or an expanded conflict in Ukraine, are likely to create a crisis now or later. Second, the US-Germany agreement to allow Nord Stream II explicitly states that Russia must not weaponize natural gas supply. This statement has had zero effect so far. But when the energy shortage subsides, the EU could pursue retaliatory measures along with the United States. Of course, Russia has been able to weather sanctions. But tensions are already escalating significantly. After Russia, Iran also gains leverage during times of tight energy supplies. With global oil inventories drawing down, Iran is in the position to inflict “maximum pressure” on the US and its allies, a role reversal from the 2017-20 period in which large inventories enabled the US to impose crippling sanctions on Iran after pulling out of the 2015 nuclear deal (Chart 9). Iran is rapidly advancing on its nuclear program and a new round of diplomatic negotiations may only serve to buy time before it crosses the “breakout” threshold of uranium enrichment capability as early as this month or next. In a recent special report we argued that there is a 40% chance of a crisis over Iran in the Middle East. Such a crisis could ultimately lead to an oil shock in the Persian Gulf or Strait of Hormuz. Chart 9Now Iran Can Use 'Maximum Pressure' Bottom Line: Russia’s natural gas coercion of Europe could keep European energy prices high through March or May. More broadly Russia’s renewed tensions with the West confirm our view that oil producers gain geopolitical leverage amid the current supply shortages. Iran also gains leverage and its conflict with the US could lead to global oil supply disruptions anytime over the next 12 months. Until Nord Stream II is certified and a new Iranian nuclear agreement is signed, there are two clear sources of potential energy shocks. Moreover in today’s inflationary context there is limited margin of safety for unexpected supply disruptions regardless of source. Xi’s Historical Rewrite China continues to be a major source of risk for the global economy and financial markets in the lead-up to the twentieth national party congress in fall 2022. While Chinese assets have sold off this year, global risk assets are still vulnerable to negative surprises from China. The five-year political reshuffle in 2022 is more important than usual since President Xi Jinping was originally supposed to step down but will instead stick around as leader for life, like China’s previous strongmen Mao Zedong and Deng Xiaoping.3 Xi’s rejection of term limits became clear in 2017 and is not really news. But Xi will fortify himself and his faction in 2022 against any opposition whatsoever. He is extremely vigilant about any threats that could disrupt this process, whether at home or abroad. The Communist Party’s sixth plenary session this week highlights both Xi’s success within the Communist Party and the sensitivity of the period. Xi produced a new “historical resolution,” or interpretation of the party’s history, which is only the third such resolution. A few remarks on this historical resolution are pertinent: Mao’s resolution: Chairman Mao wrote the first such resolution in 1945 to lay down his version of the party’s history and solidify his personal control. It is naturally a revolutionary leftist document. Deng’s revision of Mao: General Deng Xiaoping then produced a major revision in 1981, shortly after initiating China’s economic opening and reform. Deng’s interpretation aimed to hold Mao accountable for “gross mistakes” during the Cultural Revolution and yet to recognize the Communist Party’s positive achievements in founding the People’s Republic. His version gave credit to the party and collective leadership rather than Mao’s personal rule. Two 30-year periods: The implication was that the party’s history should be divided into two thirty-year periods: the period of foundations and conflict with Mao as the party’s core and the period of improvement and prosperity with Deng as the core. Jiang’s support of Deng: Deng’s telling came under scrutiny from new leftists in the wake of Tiananmen Square incident in 1989. But General Secretary Jiang Zemin largely held to Deng’s version of the story that the days of reform and opening were a far better example of the party’s leadership because they were so much more stable and prosperous.4 Xi’s reaction to Jiang and Deng: Since coming to power in 2012, Xi Jinping has shown an interest in revising the party’s official interpretation of its own history. The central claim of the revisionists is that China could never have achieved its economic success if not for Mao’s strongman rule. Mao’s rule and the Communist Party’s central control thus regain their centrality to modern China’s story. China’s prosperity owes its existence to these primary political conditions. The two periods cannot be separated. Xi’s synthesis of Deng and Mao: Now Xi has written himself into that history above all other figures – indeed the communique from the Sixth Plenum mentions Xi more often than Marx, Mao, or Deng (Chart 10). The implication is that Xi is the synthesis of Mao and Deng, as we argued back in 2017 at the end of the nineteenth national party congress. The synthesis consists of a strongman who nevertheless maintains a vibrant economy for strategic ends. What are the practical policy implications of this history lesson? Higher Country Risk: China’s revival of personal rule, as opposed to consensus rule, marks a permanent increase in “country risk” and political risk for investors. Autocratic governments lack institutional guardrails (checks and balances) that prevent drastic policy mistakes. When Xi tries to step down there will probably be a succession crisis. Higher Macroeconomic Risk: China is more likely to get stuck in the “middle-income trap.” Liberal or pro-market economic reform is de-emphasized both in the new historical resolution and in the Xi administration’s broader program. Centralization is already suppressing animal spirits, entrepreneurship, and the private sector. Higher Geopolitical Risk: The return to autocracy and the withdrawal from economic liberalism also entail a conflict with the United States, which is still the world’s largest economy and most powerful military. The US is not what it once was but it will put pressure on China’s economy and build alliances aimed at strategic containment. Bottom Line: China is trying to escape the middle-income trap, like Taiwan, Japan, and South Korea, but it is trying to do so by means of autocracy, import substitution, and conflict with the United States. These other Asian economies improved productivity by democratizing, embracing globalization, and maintaining a special relationship with the United States. China’s odds of succeeding are low. China will focus on power consolidation through fall 2022 and this will lead to negative surprises for financial markets. China Slowdown: The Disinflationary Risk While it is very unlikely that Xi will face serious challenges to his rule, strange things can happen at critical junctures. Therefore the regime will be extremely alert for any threats, foreign or domestic, and will ultimately prioritize politics above all other things, which means investors will suffer negative surprises. The lingering pandemic still poses an inflationary risk for the rest of the world while the other main risk is disinflationary: Inflationary Risk – Zero COVID: The “Covid Zero” policy of attempting to stamp out any trace of the virus will still be relevant at least over the next 12 months (Chart 11). Clampdowns serve a dual purpose since the Xi administration wants to minimize foreign interference and domestic dissent before the party congress. Hence the global economy can suffer more negative supply shocks if ports or factories are closed. Inflationary Risk – Energy Closures: The government is rationing electricity amid energy shortages to prioritize household heating and essential services. This could hurt factory output over the winter if the weather is bad. Disinflationary Risk – Property Bust: The country is still flirting with overtightening monetary, fiscal, and regulatory policies. Throughout the year we have argued that authorities would avoid overtightening. But China is still very much in a danger zone in which policy mistakes could be made. Recent rumors suggest the government is trying to “correct the overcorrection” of regulatory policy. The government is reportedly mulling measures to relax the curbs on the property sector. We are inclined to agree but there is no sign yet that markets are responding, judging by corporate defaults and the crunch in financial conditions (Chart 12). Chart 12China Has Not Contained Property Turmoil Evergrande, the world’s most indebted property developer, is still hobbling along, but its troubles are not over. There are signs of contagion among other developers, including state-owned enterprises, that cannot meet the government’s “three red lines.” 5 Credit growth has now broken beneath the government’s target range of 12%, though money growth has bounced off the lower 8% limit set for this year (Chart 13). China is dangerously close to overtightening. China’s economic slowdown has not yet been fully felt in the global economy based on China’s import volumes, which are tightly linked to the combined credit-and-fiscal-spending impulse (Chart 14). The implication is that recent pullbacks in industrial metal prices and commodity indexes will continue. Chart 13China Tries To Avoid Over-Tightening Chart 14China Slowdown Not Yet Fully Felt Until China eases policy more substantially, it poses a disinflationary risk and a strong point in favor of the transitory view of global inflation. It is difficult for China to ease policy – let alone stimulate – when producer prices are so high (see Chart 6 above). The result is a dangerous quandary in which the government’s regulatory crackdowns are triggering a property bust yet the government is prevented from providing the usual policy support as the going gets tough. Asset prices and broader risk sentiment could go into free fall. However, the party has a powerful incentive to prevent a generalized crisis ahead of the party congress. So we are inclined to accept signs that property curbs and other policies will be eased. Bottom Line: The full disinflationary impact of China’s financial turmoil and economic slowdown has yet to be felt globally. Biden-Xi Summit Not A Game Changer As long as inflation prevents robust monetary and fiscal easing, Beijing is incentivized to improve sentiment in other ways. One way is to back away from the regulatory crackdown in other sectors, such as Big Tech. The other is to improve relations with the United States. A stabilization of US ties would be useful before the party congress since President Xi would prefer not to have the US interfering in China’s internal affairs during such a critical hour. No surprise that China is showing signs of trying to stabilize the relationship. The US is apparently reciprocating. Presidents Biden and Xi also agreed to hold a virtual bilateral summit next week, which could lead to a new series of talks. The US Trade Representative also plans to restart trade negotiations. The plan is to enforce the Phase One trade deal, issue waivers for tariffs that hurt US companies, and pursue new talks over outstanding structural disputes. The Phase One trade deal has fallen far short of its goals in general but on the energy front it is doing well. China will continue importing US commodities amid global shortages (Chart 15). The summit alone will have a limited impact. Biden had a summit with Putin earlier this year but relations could deteriorate tomorrow over cyber-attacks, Ukraine, or Belarus. However, there is some basis for the US and China to cooperate next year: Iran. Xi is consolidating power at home in 2022 and probably wants to use negotiations to keep the Americans at bay. Biden is pivoting to foreign policy in 2022, since Congress will not get anything done, and will primarily focus on halting Iran’s nuclear program. If China assists the US with Iran, then there is a basis for a reduction in tensions. The problem is not only Iran itself but also that China will not jump to enforce sanctions on Iran amid energy shortages. And China is not about to make sweeping structural economic concessions to the US as the Xi administration doubles down on state-guided industrial policy. Meanwhile the US is pursuing a long-term policy of strategic containment and Biden will not want to be seen as appeasing China ahead of midterm elections, especially given Xi’s reversion to autocracy. What about cooperation on climate change? The US and China also delivered a surprise joint statement at the United Nations climate change conference in Scotland (COP26), confirming the widely held expectation that climate policy is an area of engagement. These powers and Europe have a strategic interest in reducing dependency on Middle Eastern oil (Chart 16). Climate talks will begin in the first half of next year. However, climate cooperation is not significant enough alone to outweigh the deeper conflicts between the US and China. Moreover climate policy itself is somewhat antagonistic, as the EU and US are looking at applying “carbon adjustment fees” to carbon-intensive imports, e.g. iron and steel exports from China and other high-polluting producers (Chart 17). While the EU and US are not on the same page yet, and these carbon tariffs are far from implementation, the emergence of green protectionism does not bode well for US-China relations even aside from their fundamental political and military disputes. Bottom Line: Some short-term stabilization of US-China relations is possible but not guaranteed. Markets will cheer if it happens but the effect will be fleeting. Chinese assets are still extremely vulnerable to political and geopolitical risks. Investment Takeaways Gold can still go higher. Financial markets are pricing higher inflation and weak real rates. Gold has been our chief trade to prepare both for higher inflation and geopolitical risk. We are closing our long value / growth equity trade for a loss of 3.75%. We are maintaining our long DM Europe / short EM Europe trade. This trade has performed poorly due to the rally in energy prices and hence Russian equities. But while energy prices may overshoot in the near term, investors will flee Russian equities as geopolitical risks materialize. We are maintaining our long Korea / short Taiwan trade despite its being deeply in the red. This trade is valid over a strategic or long-term time horizon, in which a major geopolitical crisis and/or war is likely. Our expectation that China will ease policy to stabilize the economy ahead of fall 2022 should support Korean equities. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Over the past year President Alexander Lukashenko’s repression of domestic unrest prompted the EU to impose sanctions. Lukashenko responded by organizing an immigration scheme in which Middle Eastern migrants are flown into Belarus and funneled into the EU via Poland. The EU is threatening to expand sanctions while Belarus is threatening to cut off the Yamal-Europe pipeline amid Europe’s energy crisis. See Pavel Felgenhauer, “Belarus as Latest Front in Acute East-West Standoff,” Jamestown Foundation, November 11, 2021, Jamestown.org. 2 Both Germany and the EU must approve of Nord Stream II for it to enter into operation. The German Federal Network Agency has until January 8, 2022 to certify the project. The Economy Ministry has already given the green light. Then the European Commission has two-to-four months to respond. The EU is supposed to consider whether the pipeline meets the EU’s requirement that gas transport be “unbundled” or separated from gas production and sales. This is a higher hurdle but Germany’s clout will be felt. Hence final approval could come by March 8 or May 8, 2022. The energy crisis will put pressure for an early certification but the EU Commission may take the full time to pretend that it is not being blackmailed. See Joseph Nasr and Christoph Steitz, “Certifying Nord Stream 2 poses no threat to gas supply to EU – Germany,” Reuters, October 26, 2021, reuters.com. 3 Xi is not serving for an “unprecedented third term,” as the mainstream media keeps reporting. China’s top office is not constant nor were term limits ever firmly established. Each leader’s reign should be measured by their effective control rather than technical terms in office. Mao reigned for 27 years (1949-76), Deng for 14 years or more (1978-92), Jiang Zemin for 10 years (1992-2002), and Hu Jintao for 10 years (2002-2012). 4 See Joseph Fewsmith, “Mao’s Shadow” Hoover Institution, China Leadership Monitor 43 (2014), and “The 19th Party Congress: Ringing In Xi Jinping’s New Age,” Hoover Institution, China Leadership Monitor 55 (2018), hoover.org. 5 Liability-to-asset ratios less than 70%, debt-to-equity less than 100%, and cash-to-short-term-debt ratios of more than 1.0x. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Open Trades & Positions
Highlights Short-term inflation risk will escalate further if politics causes new supply disruptions. Long-term inflation risk is significant as well. There is a distinct risk of a geopolitical crisis in the Middle East that would push up energy prices: the US’s unfinished business with Iran. The primary disinflationary risk is China’s property sector distress. However, Beijing will strive to maintain stability prior to the twentieth national party congress in fall 2022. South Asian geopolitical risks are rising. The Indo-Pakistani ceasefire is likely to break down, while Afghani terrorism will rebound. Book gains on our emerging market currency short targeting “strongman” regimes. Feature Investors are underrating the risk of a global oil shock. This was our geopolitical takeaway from the BCA Conference this year. Investors are focused on the risk of inflation and stagflation, always with reference to the 1970s. The sharp increase in energy prices due to the Arab Oil Embargo of 1973 and the Iranian Revolution of 1979 are universally cited as aggravating factors of stagflation at that time. But these events are also given as critical differences between the situation in the 1970s and today. Unfortunately, there could be similarities. From a strictly geopolitical perspective, the risk of a conflict in the Middle East is significant both in the near term and over the coming year or so. The risk stems from the US’s unfinished business with Iran. More broadly, any supply disruption would have an outsized impact as global energy inventories decline. OPEC’s spare capacity at present can cover a 5 million barrel shock (Chart 1). In this week’s report we also provide tactical updates on China, Russia, and India. Geopolitics And The 1970s Inflation Chart 2Wage-Price Spiral, Stagflation In 1970s Fundamentally the stagflation of the 1970s occurred because global policymakers engendered a spiral of higher wages and higher prices. The wage-price spiral was exacerbated by a falling dollar, after President Nixon abandoned the gold standard, and a commodity price surge (Chart 2). Monetary policy clearly played a role. It was too easy for too long, with broad money supply consistently rising relative to nominal GDP (Chart 3). Central banks including the Federal Reserve were focused exclusively on employment. Policymakers saw the primary risk to the institution’s credibility as recession and unemployment, not inflation. Fear of the Great Depression lurked under the surface. Fiscal policy also played a role. The size of the US budget deficit at this time is often exaggerated but there is no question that they were growing and contributed to the bout of inflation and spike in bond yields (Chart 4). The reason was not only President Johnson’s large social spending program, known as the “Great Society.” It was also Johnson’s war – the Vietnam war. Chart 3Central Banks Focused On Employment, Not Prices, In 1970s On top of this heady mix of inflationary variables came geopolitics. The Yom Kippur war in 1973 prompted Arab states to impose an embargo on Israel’s supporters in the West. The Arab embargo cut off 8% of global oil demand at the time. Oil prices skyrocketed, precipitating a deep recession (Chart 5). Chart 4Johnson's 'Great Society' And Vietnam War Spending The embargo came to a halt in spring of 1974 after Israeli forces withdrew to the east of the Suez Canal. The oil shock exacerbated the underlying inflationary wave that continued throughout the decade. The Iranian revolution triggered another oil shock in 1979, bringing the rise in general prices to their peak in the early 1980s, at which point policymakers intervened decisively. Chart 5Arab Oil Embargo And Iranian Revolution There is an analogy with today’s global policy mix. Fear of the Great Recession and deflation rules within policymaking circles, albeit less so among the general public. The Fed and the European Central Bank have adjusted their strategies to pursue an average inflation target and “maximum employment.” Chart 6Wage-Price Spiral Today? The Biden administration is reviving big government with a framework agreement of around $1.2 trillion in new deficit spending on infrastructure, green energy, and social programs likely to pass Congress before year’s end. In short, the macro and policy backdrop are changing in a way that is reminiscent of the 1970s despite various structural differences between the two periods. It is too early to declare that a wage-price spiral has developed but core inflation is rising and investors are right to be concerned about the direction and potential for inflation surprises down the road (Chart 6). These trends would not be nearly as concerning if they were not occurring in the context of a shift in public opinion in favor of government versus markets, labor versus capital, onshoring versus offshoring, and protectionism versus free trade. Investors should note that the last policy sea change (in the opposite direction) lasted roughly 30-40 years. The global savings glut – shown here as the combined current account balances of the world’s major economies – has begun to decline, implying that a major deflationary force might be subsiding. Asian exporters apparently have substantial pricing power, as witnessed by rising export prices, although they have yet to break above the secular downtrend of the post-2008 period (Chart 7). Chart 7Hypo-Globalization Is Inflationary A commodity price surge is also underway, of course, though it is so far manageable. The US and EU economies are less energy-intensive than in the 1970s and there is considerable buffer between today’s high prices and an economic recession (Chart 8). Chart 8Wage-Price Spiral Today? The problem is that there is a diminishing margin of safety. Furthermore, a crisis in the Middle East is not far-fetched, as there is a concrete and distinct reason for worrying about one: the US’s unresolved collision course with Iran. A crisis in the Persian Gulf would greatly exacerbate today’s energy shortages. Iran: The Risk Of An Oil Shock Iran now says it will rejoin diplomatic talks over its nuclear program in late November. This development was expected, and is important, but it masks the urgent and dangerous trajectory of events that could blow up any day now. It is emphatically not an “all clear” sign for geopolitical risk in the Persian Gulf. The US is hinting, merely hinting, that it is willing to use military force to prevent Iran from going nuclear. The Iranians doubt US appetite for war and have every reason to think that nuclear status will guarantee them regime survival. Thus the Iranians are incentivized to use diplomacy as a screen while pursuing nuclear weaponization – unless the US and Israel make a convincing display of military strength to force Iran back to genuine diplomacy. A convincing display is hard to do. A secret war is taking place, of sabotage and cyber-attacks. On October 26 a cyber-attack disrupted Iranian gas stations. But even attacks on nuclear scientists and facilities have not dissuaded the Iranians from making progress on their nuclear program yet. Iran does not want to be attacked but it knows that a ground invasion is virtually impossible and air strikes alone have a poor record of winning wars. The Iranians have achieved 60% highly enriched uranium and are expected to achieve nuclear breakout capacity – the ability to make a nuclear device – sometime between now and December (Table 1). The IAEA no longer has any visibility in Iran. The regime’s verified production of uranium metal can only be used for the construction of a warhead. Recent technical progress may be irreversible, according to the Institute for Science and International Security.1 If that is true then the upcoming round of diplomatic negotiations is already doomed. Table 1Iran’s Compliance With Nuclear Deal And Time Until Breakout (Oct 2021) American policymakers seem overconfident in the face of this clear nuclear proliferation risk. This is strange given that North Korea successfully manipulated them over the past three decades and now has an arsenal of 40-50 nuclear weapons. The consensus goes as follows: Regime instability: Americans emphasize that the Iranian regime is unstable, lacks genuine support, and faces a large and restive youth population. This is all true. Indeed Iran is one of the most likely candidates for major regime instability in the wake of the COVID-19 shock. Chart 9AIran's Economy Sees Inflation Spike ... Chart 9B... Yet Some Green Shoots Are Rising However, popular protest has not had any effect on the regime over the past 12 years. Today the economy is improving and illicit oil revenues are rising (Chart 9). A new nationalist government is in charge that has far greater support than the discredited reformist faction that failed on both the economic and foreign policy fronts (Chart 10). The sophisticated idea that achieving nuclear breakout will somehow weaken the regime is wishful thinking. If it provokes US and/or Israeli air strikes, it will most likely see the people rally around the flag and convince the next generation to adopt the revolutionary cause.2 If it does not provoke a war, then the regime’s strategic wisdom will be confirmed. American military and economic superiority: Americans tend to think that Iran will back down in the face of the US’s and Israel’s overwhelming military and economic superiority. It is true that a massive show of force – combined with the sale of specialized weaponry to Israel to enable a successful strike against extremely hardened nuclear facilities – could force Iran to pause its nuclear quest and go back to negotiations. Yet the US’s awesome display of military power in both Iraq and Afghanistan ended in ignominy and have not deterred Iran, just next door, after 20 years. Nor have American economic sanctions, including “maximum pressure” sanctions since 2019. The US is starkly divided, very few people view Iran as a major threat, and there is an aversion to wars in the Middle East (Chart 11). The Iranians could be forgiven for doubting that the US has the appetite to enforce its demands. In short the US is attempting to turn its strategic focus to China and Asia Pacific, which creates a power vacuum in the Middle East that Iran may attempt to fill. Meanwhile global supply and demand balances for energy are tight, with shortages popping up around the world, giving Iran greater leverage. From an investment point of view, a crisis is likely in the near term regardless of what happens afterwards. A crisis is necessary to force the US and Iran to return to a durable nuclear deal like in 2015. Otherwise Iran will reach nuclear breakout and an even bigger crisis will erupt, potentially forcing the US and Israel (or Israel alone) to take military action. Diplomatic efforts will need to have some quick and substantial victories in the coming months to convince us that the countries have moved off their collision course. A conflict with Iran will not necessarily go to the extreme of Iran shutting down the Strait of Hormuz and cutting off 21% of the world’s oil and 26% of liquefied natural gas (Chart 12). If that happens a global recession is unavoidable. It would more likely involve lesser conflicts, at least initially, such as “Tanker War 2.0” in the Persian Gulf.3 Or it could involve a flare-up of the ongoing proxy war by missile and drone strikes, such as with the Abqaiq attack in 2019 that knocked 5.7 million barrels per day offline overnight. The impact on oil markets will depend on the nature and magnitude of the event. What are the odds of a military conflict? In past reports we have demonstrated that there is a 40% chance of conflict with Iran. The country’s nuclear program is at a critical juncture. The longer the world goes without a diplomatic track to defuse tensions, the more investors should brace for negative surprises. Bottom Line: There is a clear and present danger of a geopolitical oil shock. The implication is that oil and LNG prices could spike in the coming zero-to-12 months. The implication would be a dramatic “up then down” movement in global energy prices. Inflation expectations should benefit from simmering tensions but a full-blown war would cause an extreme price spike and global recession. China: The Return Of The Authoritative Person Another reason that today’s inflation risk could last longer than expected is that China’s government is likely to backpedal from overtightening monetary, fiscal, and regulatory policy. If this is true then China will secure its economic recovery, the global recovery will continue, commodity prices will stay elevated, and the inflation expectations and bond yields will recover. If it is not true then investors will start talking about disinflation and deflation again soon. We are not bullish on Chinese assets – far from it. We see China entering a property-induced debt-deflation crisis over the long run. But over the 2021-22 period we have argued that China would pull back from the brink of overtightening. Our GeoRisk Indicator for China highlights how policy risk remains elevated (see Appendix). So far our assessment appears largely accurate. The government has quietly intervened to prevent the troubled developer Evergrande from suffering a Lehman-style collapse. The long-delayed imposition of a nationwide property tax is once again being diluted into a few regional trial balloons. Alibaba founder Jack Ma, whom the government disappeared last year, has reappeared in public view, which implies that Beijing recognizes that its crackdown on Big Tech could cause long-term damage to innovation. At this critical juncture, a mysterious “authoritative” commentator has returned to the scene after five years of silence. Widely believed to be Vice Premier Liu He, a Politburo member and Xi Jinping confidante on economic affairs, the authoritative person argues in a recent editorial that China will stick with its current economic policies.4 However, the message was not entirely hawkish. Table 2 highlights the key arguments – China is not oblivious to the risk of a policy mistake. Table 2Messages From China’s ‘Authoritative Person’ On Economic Policy (2021) Readers will recall that a similar “authoritative Person” first appeared in the People’s Daily in May 2016. At that time, the Chinese government had just relented in the face of economic instability and stimulated the economy. It saw a 3.5% of GDP increase in fiscal spending and a 10.0% of GDP increase in the credit impulse from the trough in 2015 to the peak in 2016. The authoritative person was explaining that the intention to reform would persist despite the relapse into debt-fueled growth. So one must wonder today whether the authoritative person is emerging because Beijing is sticking to its guns (consensus view) or rather because it is gradually being forced to relax policy by the manifest risk of financial instability. To be fair, a recent announcement on government special purpose bonds does not indicate major fiscal easing. If local governments accelerate their issuance of new special purpose bonds to meet their quota for the year then they are still not dramatically increasing the fiscal support for the economy. But this announcement could protect against downside growth risks. The first quarter of 2022 will be the true test of whether China will remain hawkish. Going forward there are two significant dangers as we see it. The first is that policymakers prove ideological rather than pragmatic. An autocratic government could get so wrapped up in its populist campaign to restrain high housing costs that it refuses to slacken policies enough and causes a crash. The second danger is that inflation stays higher for longer, preventing authorities from easing policy even when they know they need to do so to stabilize growth. The second danger is the bigger of the two risks. As for the first risk, ideology will take a backseat to necessity. Xi Jinping needs to secure key promotions for his faction in the top positions of the Communist Party at the twentieth national party congress in 2022. He cannot be sure to succeed if the economy is in free fall. A self-induced crash would be a very peculiar way of trying to solidify one’s stature as leader for life at the critical hour. Similarly China cannot maintain a long-term great power competition with the United States if it deliberately triggers property deflation and financial turmoil. It can and will continue modernizing and upgrading its military, e.g. developing hypersonic missiles, even if it faces financial turmoil. But it will have a much greater chance of neutralizing US regional allies and creating a regional buffer space if its economic growth is stable. Ultimately China cannot prevent financial instability, economic distress, and political risk from rising in the coming years. There will be a reckoning for its vast imbalances, as with all countries. It could be that this reckoning will upset the Xi administration’s best-laid plans for 2022. But before that happens we expect policy to ease. A policy mistake today would mean that very negative economic outcomes will arrive precisely in time to affect sociopolitical stability ahead of the party congress next fall. We will keep betting against that. Bottom Line: China’s “authoritative” media commentator shows that policymakers are not as hawkish as the consensus holds. The main takeaway is that policymakers will adjust the intensity of their reform efforts to maintain stability. This is standard Chinese policymaking and it is more important than usual ahead of the political rotation in 2022. Otherwise global inflation risk will quickly give way to deflation risk as defaults among China’s property developers spread and morph into broader financial and economic instability. Indo-Pakistani Ceasefire: A Breakdown Is Nigh India and Pakistan agreed to a ceasefire along the line of control in February 2021. While the agreement has held up so far, a breakdown is probably around the corner. It was never likely to last for long. Over the short run, the ceasefire made sense for both countries: COVID-19 Risks: The first wave of the pandemic had abated but COVID-19-related risks loomed large. India had administered less than 15 million vaccine doses back then and Pakistan only 100,000. Dangerous Transitions Were Underway: With America’s withdrawal from Afghanistan in the works, Pakistan was fully focused on its western border. India was pre-occupied with its eastern front, where skirmishes with Chinese troops forced it to redirect some of its military focus. As we now head towards the end of 2021, these constraints are no longer binding. COVID-19 Risks Under Control: The vaccination campaign in India and Pakistan has gathered pace. More than 50% of India’s population and 30% of Pakistan’s have been given at least one dose. Pakistan’s Ducks Are Lined-up In Afghanistan: America’s withdrawal from Afghanistan has been completed. Afghanistan is under Taliban’s control and Pakistan has a better hold over the affairs of its western neighbor. One constraint remains: India and China remain embroiled in border disputes. Conciliatory talks between their military commanders broke down a fortnight ago. Winter makes it nearly impossible to undertake significant operations in the Himalayas but a failure of coordination today could set up a conflict either immediately or in the spring. While India may see greater value in maintaining the ceasefire than Pakistan, India has elections due in key northern states in 2022. India’s northern states harbor even less favorable views of Pakistan than the rest of India. Hence any small event could trigger a disproportionate response from India. Bottom Line: While it is impossible to predict the timing, a breakdown in the Indo-Pakistani ceasefire may materialize in 2022 or sooner. Depending on the exact nature of any conflict, a geopolitically induced selloff in Indian equities could create a much-needed consolidation of this year’s rally and ultimately a buying opportunity. Russia, Global Terrorism, And Great Power Relations Part of Putin’s strategy of rebuilding the Russian empire involves ensuring that Russia has a seat at the table for every major negotiation in Eurasia. Now that the US has withdrawn forces from Afghanistan, Russia is pursuing a greater role there. Most recently Russia hosted delegations from China, Pakistan, India, and the Taliban. India too is planning to host a national security advisor-level conference next month to discuss the Afghanistan situation. Do these conferences matter for global investors? Not directly. But regional developments can give insight into the strategies of the great powers in a world that is witnessing a secular rise in geopolitical risk. China, Russia, and India have skin in the game when it comes to Afghanistan’s future. This is because all three powers have much to lose if Afghanistan becomes a large-scale incubator for terrorists who can infiltrate Russia through Central Asia, China through Xinjiang, or India through Pakistan. Hence all three regional powers will be constrained to stay involved in the affairs of Afghanistan. Terrorism-related risks in South Asia have been capped over the last decade due to the American war (Chart 13). The US withdrawal will lead to the activation of latent terrorist activity. This poses risks specifically for India, which has a history of being targeted by Afghani terrorist groups. And yet, while China and Russia saw the Afghan vacuum coming and have been engaging with Taliban from the get-go, India only recently began engaging with Taliban. The evolution of Afghanistan under the Taliban will also influence the risk of terrorism for the rest of the world. In the wake of the global pandemic and recession, social misery and regime failures in areas with large youth populations will continue to combine with modern communications technology to create a revival of terrorist threats (Chart 14). American officials recently warned of the potential for transnational attacks based in Afghanistan to strike the homeland within six months. That risk may be exaggerated today but it is real over the long run, especially as US intelligence turns its strategic focus toward states and away from non-state actors. India, Europe, and other targets are probably even more vulnerable than the United States. If Russia and China succeed in shaping the new Afghanistan’s leadership then the focus of militant proxies will be directed elsewhere. Beyond terrorism, if Russia and China coordinate closely over Afghanistan then India may be left in the cold. This would reinforce recent trends in which a tightening Russo-Chinese partnership hastens India’s shift away from neutrality and toward favoring the US and the West in strategic matters. If these trends continue to the point of alliance formation, then they increase the risk that any conflicts between two powers will implicate others. Bottom Line: Afghanistan is now a regional barometer of multilateral cooperation on counterterrorism, the exclusivity of Russo-Chinese cooperation, and India’s strategic isolation or alignment with the West. Investment Takeaways It is too soon to play down inflation risks. We share the BCA House View that they will subside next year as pandemic effects wane. But we also see clear near-term risks to this view. In the short run (zero to 12 months), a distinct risk of a Middle Eastern geopolitical crisis looms. A gradual escalation of tensions is inflationary whereas a sharp spike in conflict would push energy prices into punitive territory and kill global demand. Over the next 12 months, China’s economic and financial instability will also elicit policy easing or fiscal stimulus as necessary to preserve stability, as highlighted by the regime’s mouthpiece. Obviously stimulus will not be utilized if the economic recovery is stable, given elevated producer prices. In a future report we will show that Russia is willing and able to manipulate natural gas prices to increase its bargaining leverage over Europe. This dynamic, combined with the risk of cold winter weather exacerbating shortages, suggests that the worst is not yet over. Geopolitical conflict with Russia will resume over the long run. Stay long gold as a hedge against both inflation and geopolitical crises involving Iran, Taiwan/China, and Russia. Maintain “value” plays as a cheap hedge against inflation. Book a profit of 2.5% on our short trade for currencies of emerging market “strongmen,” Turkey, Brazil, and the Philippines. Our view is still negative on these economies. Stay long cyber-security stocks. Over the long run, inflation risk must be monitored. We expect significant inflation risk to persist as a result of a generational change in global policy in favor of government and labor over business and capital. But the US is maintaining easy immigration policy and boosting productivity-enhancing investments. Meanwhile China’s secular slowdown is disinflationary. The dollar may remain resilient in the face of persistently high geopolitical risk. The jury is still out. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 David Albright and Sarah Burkhard, "Iran’s Recent, Irreversible Nuclear Advances," Institute for Science and International Security, September 22, 2021, isis-online.org. 2 Ray Takeyh, "The Bomb Will Backfire On Iran," Foreign Affairs, October 18, 2021, foreignaffairs.com. 3 See Aaron Stein and Afshon Ostovar, "Tanker War 2.0: Iranian Strategy In The Gulf," Foreign Policy Research Institute, August 10, 2021, fpri.org. 4 "Ten Questions About China’s Economy," Xinhua, October 24, 2021, news.cn. Section II: Appendix: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia South Africa Section III: Geopolitical Calendar
Highlights Major cryptocurrencies have failed to break above important technical levels. Meanwhile, the appeal of fiat money is increasing as many central banks are reining in monetary stimulus. Cryptocurrencies continue to seriously lag fiat as a unit of account. There has been a surge in the development of central bank digital currencies around the world (CBDCs). This will replicate the advantages and success of cryptos. Cryptocurrencies are unlikely to disappear anytime soon. However, conservative investors should stick with gold and silver. Remain long silver relative to gold, along with a petrocurrency basket (RUB, MXN and COP) versus the euro. Feature Chart I-1Cryptos Are At Important Technical Levels The world of cryptocurrencies continues to generate headlines. The latest hype is the Shiba Inu coin, created by the anonymous Ryoshi. Shiba Inu’s raison d'être is to kill Dogecoin, another cryptocurrency created in part as a joke, and in part to displace Bitcoin. As these two meme coins compete in a race to the moon (both have done phenomenally well this year), the more important price action has been among the dominant players in the space. Bitcoin peaked near US$67,000 this year and has been facing strong upside resistance just as in April. Similarly, Ethereum has failed to break above the $US4,400 level twice this year. Taken together, both assets are exhibiting a classic double-top formation (Chart I-1). Historically, that has been symptomatic of a non-negligible drawdown. The Merit (Or Not) Of Cryptocurrencies Our first report on cryptocurrencies suggested that they deserved merit. For one, blockchain technology provides a decentralized, peer-to-peer system, which alleviates the need for an intermediary to validate transactions and arbitrate disputes. This is good news for transaction costs and will likely upend a few business models soon (banking, law, and so forth). This process of creative destruction is exactly what a society needs to become more productive. The fact that the creation, distribution, and use of cryptocurrencies is outside the purview of central banks also enhances the autonomy and anonymity of cryptos, an important feature for many users. Meanwhile, cryptocurrencies have been improving as a medium of exchange. The ability to swap fiat currency into Bitcoins, Ethereum or even Dogecoins and back is fairly easy. In a nutshell, the global turnover of cryptocurrencies has been rising rapidly. On the flip side, little regulation around cryptos has led to a plethora of alternatives. There are currently about 7000 cryptos in circulation, a feat that seriously challenges their value proposition against fiat debasement (Chart I-2). The Shiba Inu coin has a supply of one quadrillion, almost half of which is claimed to have been “burned.” This is occurring within a context where many central banks are sticking to policy orthodoxy, curtailing quantitative easing (and so curbing the growth of the monetary base), and lifting interest rates. The volatility of cryptocurrencies is a serious drawback as both a store of value and unit of account. As highlighted in Chart I-1, both Bitcoin and Ethereum are at critical technical levels. In a broader sense, the drawdown in cryptocurrency prices has been around 80% a year or 40%-50% over three months (Chart I-3). These are much more volatile than currencies such as the Turkish lira, one of the worst-performing currencies this year. Chart I-3Due For Another 40-50% Drawdown? The inherent volatility of cryptos also makes them unsuitable as a unit of account. The world is currently experiencing an inflationary boom. In a world dominated by cryptos, should a price correction occur, it would exacerbate this trend. Shiba Inu coins have fallen in value by around 30% from their peak, while inflation in the US is rising by 5.4% per annum. With both Bitcoin and Ethereum off their highs, a similar or even more significant decline cannot be ruled out. The Return Of Fiat Chart I-4The Carry From Fiat Money Is Improving In recent months, central bankers have been staple champions in maintaining their currencies’ purchasing power. The Bank of Canada joined a quorum of central banks in ending quantitative easing this week. A few developed and emerging central banks have already raised interest rates to fend off inflationary pressures (Chart I-4). President Richard Nixon ended dollar convertibility into gold in the 1970s because he believed a fiat money regime was a better solution for the US. In the end, he was right as the real effective exchange rate of the dollar has been rather flat since then (Chart I-5). This has led to the dollar maintaining its reserve status over the last several decades, despite a few challenges over time. This puts cryptocurrencies a long way off from the starting line. Chart I-5Despite Rolling Cycles, The Dollar Has Been Flat Over Time More importantly, many fiat currencies are likely to do well next year, which will curb the appeal of cryptos. If Bloomberg estimates are right, the world is about to see a big rotation in growth next year from the US towards other countries which have lagged so far (Chart I-6). In this environment, currencies such as the CAD, AUD, and the Scandinavian currencies will do particularly well. This will provide lots of alternatives to cryptocurrencies. Chart I-6AA Global Growth Rebound Outside The US Chart I-6BA Global Growth Rebound Outside The US Taking a step back, the correlation between the dollar and cryptos has not been straight forward. This year, the dollar is rising along with the price of many cryptocurrencies. In previous years, there was a loose but clear inverse correlation (Chart I-7). Therefore, our bias is that this year’s rise is partly due to overexuberance. Chart I-7Bitcoin And The Dollar Central Bank Digital Currencies National governments regulate national currencies. This puts a natural limit to how much widespread acceptance cryptos can achieve before policy makers start clamping down on them. So far, the instances of government intervention is heavily stacking up against cryptos. As the turnover in cryptocurrencies overtakes global trading in various domestic currencies, many countries are moving to ban cryptocurrency transactions (Table I-1). China has been a major case in point. Meanwhile, many central banks are also moving to establish their own digital currencies. According to the Atlantic Council, there are almost 70 CDBCs that are either in the research or development phase or in pilot programs (Map I-1). There is an undeniable benefit to adopting blockchain technology. CDBCs will ensure that many of the advantages of using a cryptocurrency are captured without some of the known pitfalls. We highlighted at our conference that many governments will be loathe to relinquish control over money supply. For one, the loss in seigniorage revenue will be significant, to the tune of around $100bn for the US. Second, the use of cryptocurrencies continues to encourage the proliferation of illegal activities, a well-known flaw, and something governments will push back against. Once CDBCs become mainstream, the need for alternative cryptocurrencies will not disappear but fall greatly. In a nutshell, a monetary standard which includes both paper currency and CBDCs will provide the flexibility that central bankers need to smooth out economic cycles, along with the security, speed and low cost offered by cryptocurrencies. The Case For Precious Metals When Bitcoin was first introduced, one of the advantages was its limited supply, to the tune of 21 million coins. This resonated particularly well with anti-fiat enthusiasts who have viewed quantitative easing and rising fiscal deficits as a threat to the purchasing power of fiat money. With the number of cryptocurrencies ballooning to fresh new highs every day, this rationale no longer has solid footing. Within this context, precious metals are becoming attractive, especially in a world where inflation is overshooting, and real rates are deeply negative. On this basis, we went long the silver/gold ratio last week, partly as a hedged play on persistently high inflation and partly because we expect both gold and silver to fare well in this environment (Chart I-8). Silver (and platinum) particularly benefit since they remain a much smaller share of the anti-fiat market (Chart I-9). Chart I-8A Hedged Bet On High Inflation Chart I-9Cryptos Versus Precious Metals Central banks (the biggest holders of US Treasuries) will be another big force behind precious metals. Central banks tend to have strong hands. This is because they are ideological while private investors can be swayed by momentum. Since the middle of the last decade, there has been a tectonic shift in central bank purchases of gold, especially from developing nations. For example, China and Russia, countries that have a geopolitical imperative to diversify out of dollars, have almost 4% and 25% respectively of their foreign exchange reserves in gold. An asset backed by strong hands is a very attractive conservative play. Investment Conclusions And Housekeeping The chorus from many central banks over the last few weeks has generally been biased towards less stimulus. This is brightening the outlook for many fiat currencies. We particularly like petrocurrencies (which we bought last week), and the Scandinavian currencies which are a cheap play on dollar downside. Oil prices will likely stay elevated in the coming months, especially given that the forward curve remains very backwardated, and could be subject to upward reprising, according to our colleagues in the Commodity & Energy Strategy. As such, a bet on being long oil producers versus consumers will prove profitable. In a nutshell, many petrocurrencies provide an attractive relative carry, and as a lot of oil players see a rebound in their domestic economies, real rates should improve further. Finally, cryptocurrencies are due for a relapse from a technical standpoint. We continue to believe that cryptocurrencies will have intermittent rallies, and as such can be wonderful speculative instruments. However, rising regulation and the proliferation of CBDCs pose a structural threat. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The US economy has been softening of late: The manufacturing PMI fell from 60.7 to 59.2 in October. The Chicago Fed National activity index was also soft, falling from 0.29 to -0.13 in September. House prices in the US continue to inflect higher to the tune of 20% year-on-year. The conference board consumer confidence index was rather upbeat. The present situation rose from 143.4 to 147.4 and the expectations component rose from 86.6 to 91.3. Durable goods orders softened by 0.4% month-on-month in September. The Q3 GDP report was rather weak, rising only 2% quarter-on-quarter (annualized). The US dollar DXY index fell this week. A chorus of central banks have been more proactive curtailing accommodative policy settings, as inflation pressures remain front and center. This is boosting confidence in most procyclical currencies and pressuring the dollar lower. Report Links: Arbitrating Between Dollar Bulls And Bears - March 19, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Euro area data also on the softer side this week: The manufacturing PMI was relatively flat, at 58.5 in October. Both consumer and industrial confidence were rather flat in October as well. The ECB kept monetary policy on hold at this week’s meeting. The euro was up 0.3% this week. The markets continue to challenge Governor Christine Lagarde’s dovish stance with both euro area bonds yields and the euro rising amidst a rather dovish communique. This is because in the current environment, global, as well as domestic conditions, are important for the euro area. And the global landscape suggests inflation might be more sticky than central banks expect, warranting a tighter monetary policy stance. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 The Euro Dance: One Step Back, Two Steps Forward - April 2, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent Japanese data has been weak: Departmental store sales both in Tokyo and nationwide were rather weak in September. In Tokyo they rose only 0.7% year-on-year. Nationwide, they fell 4.3% year-on-year. Retail sales were weak but beat expectations. The came in -0.6% year-on-year, but with a 2.7% month-on-month increase. The Bank of Japan kept policy on hold, even though it downgraded its forecasts. The yen was flat this week. The yen is in a stalemate as we await the results of the October 31 Japanese elections. Our report next week will be solely focused on this. From a contrarian standpoint, we remain bullish the yen as it is one of the most shorted G10 currencies. Meanwhile, Japanese data could positively surprise to the upside. Report Links: The Case For Japan - June 11, 2021 The Dollar Bull Case Will Soon Fade - March 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent UK data has been rather upbeat: The manufacturing PMI rose from 57.1 to 57.7 in October. The service PMI rose from 55.4 to 58. CBI retailing reported sales rose from 11 to 30 in October. Retail sales were rather weak in September, falling 1.3%. The pound rose by 0.3% this week. We continue to believe the hawkish shift priced in by markets for the BoE is overdone. We remain bullish sterling on a cyclical horizon but are also long EUR/GBP tactically as a play on a policy convergence between the BoE and the ECB. Report Links: Why Are UK Interest Rates Still So Low? - March 10, 2021 Portfolio And Model Review - February 5, 2021 Thoughts On The British Pound - December 18, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The inflation data out of Australia was rather strong: Q3 CPI rose 3% year-on-year. The trimmed-mean number was 2.1%, like the trimmed-median print. The import price index surged 5.4% quarter-on-quarter in Q3. The AUD rose 0.9% this week. The RBA has been one of the most dovish central banks in the G10, communicating no interest rate increase until at least 2024. This has put downward pressure on the AUD, setting the stage for a coiled-spring rebound. Meanwhile, the AUD is cheap, especially on a terms of trade basis. At the crosses, we are long AUD/NZD as a play on these trends. Report Links: The Dollar Bull Case Will Soon Fade - March 5, 2021 Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Data out of New Zealand this week was on the weaker side: The ANZ consumer confidence index fell from 104.5 to 98 in October. Exports were flattish near NZ$4.40bn in September. The NZD rose by 0.5% this week. Of all the central banks we follow, the RBNZ might be more prone to a policy error should inflation prove to be transitory, and/or a housing slowdown develops, especially if triggered by higher mortgage rates. At 2.6%, New Zealand currently has the highest G10 10-year rate. We continue to believe the NZD will fare well cyclically, but hawkish expectations from the RBNZ are already priced in. This provides room for disappointment. Report Links: How High Can The Kiwi Rise? - April 30, 2021 Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 The Bank of Canada decision was the main highlight this week: Retail sales remained robust at 2.1% month-on-month in August. The Bloomberg nanos confidence index was flat at 59 for the week of October 22. The Bank of Canada kept rates on hold at its latest policy meeting. The CAD has been flat this week. The BoC delivered a hawkish message, ending QE and signaling that interest rate increases could occur sooner than the market expects. Our thesis this year has always been that on a cyclical basis, the CAD is backed by robust oil prices, and an orthodox central bank that will raise rates to curb high inflation and real estate speculation. As such, our bias is that the path of least resistance for the CAD is up. Report Links: Relative Growth, The Euro, And The Loonie - April 16, 2021 Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 The Outlook For The Canadian Dollar - October 9, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: Total sight deposits were flat at CHF 715.3bn in the week ended October 22. The Credit Suisse survey expectations fell from 25.7 to 15.6 in October. CHF rose by 0.5% this week. We remain long CHF/NZD on a bet that volatility in currency markets will eventually rise. That said, the SNB will likely be that last central bank to curtail monetary accommodation. This suggests that CHF will lag both the EUR and other European currencies over a cyclical horizon. Report Links: An Update On The Swiss Franc - April 9, 2021 Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was scant data out of Norway this week: Retail sales rose 0.5% month-on-month in September. The unemployment rate fell from 4.2% to 4.0% in August. The NOK was up 0.3% this week. We continue to believe being long the NOK is the sweet spot in currency markets. The central bank has hiked interest rates, oil prices are robust and the Norwegian economy is on the mend. As such, stay short EUR/NOK and USD/NOK. Report Links: The Norwegian Method - June 4, 2021 Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Data out of Sweden this week has been rather robust: PPI rose 17.2% year-on-year in September. The trade balance came in at a surplus of SEK 6.3bn in September, a big swing from the August deficit of SEK 10.3bn. Manufacturing confidence rose from 126.6 to 128.5 in October. Q3 GDP came in at 4.7% year-on-year, well above expectations of a 3% quarter-on-quarter rise. Retail sales also rose 4.8% year-on-year in September. The SEK rose by 80 bps this week. We remain short both EUR/SEK and USD/SEK as reflation plays. Incoming data continues to suggest the Swedish economy remains on a mend, even if slowing from stronger growth earlier this year. This could lead to a hawkish surprise from the Riksbank should economic conditions remain robust. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Sweden Beyond The Pandemic: Poised To Re-leverage - March 19, 2020 Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary