Iran

Highlights Geopolitical risk is rising once again after a big drop-off in risk during the pandemic and snapback. The Biden administration faces three critical foreign policy tests: China/Taiwan, Russia/Ukraine, and Israel/Iran. Russia could stage a military incursion into Ukraine that would cause a risk-off event. However, global markets would get over it relatively quickly since a total invasion of all Ukraine is unlikely. Iran is nearing the “breakout” threshold of uranium enrichment which will prompt more Israeli demonstrations of its red line against nuclear weaponization. Iran will retaliate. So far our view is on track that tensions will escalate prior to the resolution of a US-Iran deal by August. Taiwan is the most market relevant of all geopolitical risks – but the South China Sea is another scene of US-China saber-rattling. A crisis here is most important if connected to Taiwan. Go long CAD-RUB and CHF-GBP. Feature Chart 1Traffic In The World’s Most Dire Straits Jaw-Jaw Or War-War? Jaw-Jaw Or War-War? British Prime Minister Harold Macmillan, quoting Sir Winston Churchill, once said, “Jaw-jaw is better than war-war.”1 President Joe Biden would undoubtedly prefer jaw-jaw as he faces three imminent foreign policy tests that raise tail-risks of war: Chinese military intimidation of Taiwan, a Russian military build-up on the Ukrainian border, and Iranian acceleration of its nuclear program. All of these areas are heating up simultaneously and a crisis incident could easily occur, causing a pullback in bond yields and equity markets. One way of illustrating the seriousness of these conflicts is to look at the volume of global trade that goes through the relevant geographic chokepoints: the Taiwan Strait, the Strait of Malacca, the Strait of Hormuz, and the Bosphorus Strait (Chart 1). Oil and petroleum products serve as a proxy for overall traffic. The recent, short-lived blockage of the Suez Canal provides an inkling of the magnitude of disruption that is possible if conflict erupts in one of these global bottlenecks. In this report we review recent developments in Biden’s foreign policy tests. Our views are mostly on track. Investors should prepare tactically for more geopolitical risk to be priced into global financial markets, motivating safe-haven flows and potentially a general equity pullback. Cyclically the bull market will continue, barring the worst-case scenarios. Biden’s Three Foreign Policy Tests Biden’s three foreign policy tests are all intensifying as we go to press: China/Taiwan: China is continuing a high-intensity pace of “combat drills” and live-fire drills around the island of Taiwan.2 The US is sending a diplomatic delegation to Taiwan against Beijing’s wishes and is set to deliver a relatively large arms sale to the island. Yet Washington has sent John Kerry, its “climate czar,” to Beijing to set up a bilateral summit between Presidents Biden and Xi Jinping for Earth Day, in a bid to find common ground. Biden’s overarching review of US China policy is due sometime in May. Russia/Ukraine: Russia has amassed more than 85,000 troops on its border with Ukraine and in Crimea, the largest build-up since it invaded Ukraine in 2014-15. Russia has withdrawn its ambassador to Washington and warned that it will retaliate if the US imposes any new sanctions. The US is doing just that, with new sanctions leveled in response to Russian cyberattacks and election interference, including a block on sales of Russian ruble-denominated sovereign bonds from June. Hence Russian retaliation is looming. Israel/Iran: Shortly after the March 23 election, Israel sabotaged the underground Natanz Fuel Enrichment Plant in Iran, prompting the Iranians to declare that they will retaliate on Israeli soil. They also claim they will now enrich uranium to a 60% level, which pushes them close to the 90%-plus levels needed to make a nuclear device. American and Israeli officials had previously signaled that Iran would reach “breakout” levels of weapons-grade uranium between April and August. Negotiations are underway but the process will be beset by attacks. We have written extensively on the Taiwan dynamic this year as it is the most relevant for global investors. In this report we will update the Russian and Iranian situations first and then proceed to China. Bottom Line: Geopolitical risk is back after a reprieve during the pandemic. The new US administration faces three serious foreign policy tests at once. Financial markets have mostly ignored the rise in tensions but we expect safe-haven assets to catch a bid in the near term. However, we have not yet altered our bullish cyclical view. So far we are still in the realm of “jaw-jaw” rather than “war-war,” as we explain in the rest of this report. Stay Short Russia And EM Europe The return of the Democratic Party to power in Washington has led to an immediate increase in US-Russian tensions. The Biden administration is eschewing a diplomatic reset and instead pursuing great power competition. The US is increasing its arms sales and NATO military drills with Ukraine. It is imposing sanctions over Russian cyberattacks and election interference, including taking a long-awaited step against the purchase of ruble bonds. Washington could also force Germany to cancel the Nord Stream II pipeline. However, there are also mitigating signs. President Biden has offered to hold a bilateral summit with President Vladimir Putin in a third country and the two may meet at his Earth Day summit. The US Navy also called back the USS Donald Cook and USS Roosevelt destroyers from going into the Black Sea, after Moscow warned that any American warships in that sea would be in danger, especially if they go near Crimea. Washington’s new volley of sanctions are not truly tantamount to Russian interference in American elections and they do not include new measures on Nord Stream II. An American move to insist that Germany cancel Nord Stream before construction ends would provoke Russia to retaliate. The purpose of Nord Stream is to bypass Ukraine and cement direct economic ties between Russia and Germany. Germany’s government continues to support the project despite Russia’s build-up on the border with Ukraine and suppression of political dissidents. If the US vetoes the pipeline then it is denying Russia access to legitimate trade and restricting Russia’s export options to the Ukrainian route. If the US simultaneously increases military cooperation with Ukraine then it is implicitly trying to control Russia’s energy access to Europe. Russia will likely retaliate by punishing Ukraine. Russia could take aggressive action in Ukraine or elsewhere regardless of what the US does on Nord Stream or in its Ukraine outreach. Russia is struggling with a weak domestic economy and social unrest. Moscow has a record of foreign adventurism when popular support wanes. Moreover legislative elections loom in September. Thus Russia may have an independent reason to stir up conflict in Ukraine, at least for the next half year, that cannot be deterred. Judging by capabilities, Russia has deployed enough troops to stage a military incursion into the breakaway Donbass region of Ukraine. The Russian army build-up on the border is the largest since 2014 – large enough to put most of Russian-speaking Ukraine at risk. A full-scale Russian invasion of all of Ukraine is unlikely but not impossible. It would be extremely costly both in blood and treasure – not only in occupying a hostile Ukraine but also in unifying the West against Russia, the opposite of what Moscow is trying to accomplish (Chart 2). Moscow will want to avoid this outcome unless the US shuts down Nord Stream or tries to bring Ukraine into NATO. Chart 2Russia’s Constraints Over Ukraine Jaw-Jaw Or War-War? Jaw-Jaw Or War-War? From the market’s point of view, intensified fighting in Ukraine between the government and Russian-backed rebels is status quo. This is inevitable and will not have a major impact on global equities. The invasion of Crimea in 2014 led to a maximum 2% drawdown in the S&P 500. It was the shooting down of Malaysian Airline 17, not Russia’s invasion of Ukraine, that shook up financial markets in 2014. Global equities fell by 2.7%, Eurostoxx 500 by 6.2% and Russian equities by 10.7%. Note that the Russian military did ultimately participate in the fighting in 2014-15, it was not only Russian-backed separatists, so global financial markets can stomach that kind of conflict fairly well as long as it is limited to Ukraine, especially disputed regions, and as long as the US and NATO do not get involved. They are disinclined to fight for Ukraine, leaving it vulnerable. A larger flight to safety would occur if Russia pursued the total conquest of all of Ukraine. This is small probability but high impact. It would cause a major global risk-off because it would raise the risk of a larger war on the continent for the first time since World War II. Russia is obsessed with Ukraine from the point of view of grand strategy and national security and will take at least some military action if it deems it necessary. Investors should be prepared for escalation – though neither Washington nor Moscow has yet taken a fatal step. It is important to watch for any aggressive Ukrainian actions but Ukraine is not the main driver of action. The current situation is reminiscent of that in the Republic of Georgia in 2008, when Russia provoked President Mikhail Saakashvili into taking action against separatists that Russia then used as a pretext for intervening and breaking away Abkhazia and South Ossetia. While Ukrainian President Volodymyr Zelenskiy could be baited into a conflict, it is also true that fear of getting baited could result in hesitation that allows Russia to seize the initiative, as occurred in Ukraine in 2014. So for the Ukrainians it is “damned if you do, damned if you don’t.” Russia’s actions will largely depend on its own interests. So far Russian equities have lagged other emerging market equities and the commodity rally, which may partly reflect elevated political and geopolitical risk (Chart 3). The trend for Russian equities can easily get worse from here. Given Russia’s interest in conflict with the West ahead of the September elections, Russian-Ukrainian tensions could persist for most of this year. A major military campaign becomes more probable after mid-May when the weather improves. Russian currency and assets will remain under pressure. We recommend going long the Canadian dollar relative to the Russian ruble. The ruble will underperform commodity currencies as a whole, including the Mexican peso, if Russia intervenes militarily, judging by the Crimea conflict in 2014 (Chart 4). Meanwhile Canadian and Mexican currencies should benefit from the fact that the US economy is hyper-stimulated and rapidly vaccinating. Chart 3Russia Lagged Commodity Rally Russia Lagged Commodity Rally Russia Lagged Commodity Rally Chart 4Favor Loonie And Peso Over Ruble Favor Loonie And Peso Over Ruble Favor Loonie And Peso Over Ruble Chart 5Long DM Europe / Short EM Europe Long DM Europe / Short EM Europe Long DM Europe / Short EM Europe We continue to overweight developed Europe and underweight emerging Europe (Chart 5). Poland, Hungary, the Czech Republic, Romania, and the Baltic states will see a risk premium due to current tensions. The Czech Republic faces considerable political uncertainty surrounding its legislative election in October, an opportunity for Russia to interfere or for anti-establishment (albeit pro-EU) parties to rise to power. What would it take for Biden and Putin to de-escalate? The US and NATO could diminish Ukraine relations, downgrade democracy promotion and psychological counter-warfare, and allow Nord Stream to be completed. Russia could reduce its troop presence on the border and lend a helping hand on the Iranian nuclear deal and Afghanistan withdrawal. This is a risk to our view. Bottom Line: Russia and emerging European markets are some of the few truly cheap markets in the emerging market equity universe (Table 1). Yet the current geopolitical context looks to keep them cheap. For now investors should be prepared for the West’s conflict with Russia to escalate in a major way. At minimum we need to know whether the US will halt Nord Stream II’s construction before taking a more bullish view on EM Europe. Table 1Geopolitical Risk Helps Keep Russia And EM Europe Cheap Jaw-Jaw Or War-War? Jaw-Jaw Or War-War? The worst-case scenario of a full-blown Russian conquest of Ukraine has a small probability but cannot be ruled out. Iran Negotiations: First Explosions, Then A Nuclear Deal Israel has not put together a government after its March 23 election, although Prime Minister Benjamin Netanyahu has the opportunity to lead a government again which means no change in national policy so far. Moreover the Israeli public and political establishment are unified in their opposition to Iran’s regional and nuclear ambitions. Immediately after the Iranians inaugurated new centrifuges at the Natanz nuclear facility, on April 11, the Israelis allegedly sabotaged the facility underground facility in an attack that was supposedly not limited to cyber means and that deactivated a range of centrifuges. An Iranian scientist fell into a crater and hurt himself. The Iranians have vowed retaliation on Israeli soil. More fundamentally their politics are shifting in a hardline direction, to be confirmed with the election of a hawkish president in June, which will exacerbate the mutual antagonism. This power transition is a major reason we have identified the inauguration in August as a key deadline for the US to rejoin the 2015 nuclear deal (the Joint Comprehensive Plan of Action). If the Biden administration cannot get it done by that time then a much more dangerous, multi-year negotiation will get underway. The Israeli attack has not stopped negotiations in the short term, however. The second round of talks begins in Vienna as we go to press. The US has also confirmed it will withdraw from Afghanistan on September 11, which says to Iran that Biden is determined to reduce the US’s strategic footprint in the region, reinforcing the US desire for a deal. The Israelis will continue to underscore their red line against the Iranian nuclear and missile programs in the coming months through clandestine attacks. However, they were not able to stop the US from signing a nuclear deal with Iran in 2015 and they are not likely to stop the US today. They are still bound by a fundamental constraint. Israel needs to maintain its alliance with the United States, which ensures its long-term security against both Iran and the Middle East’s general instability (Chart 6). The Iranians will retaliate against Israel, making it likely that this summer will feature tit-for-tat attacks. These could include critical infrastructure. Iran may also continue its campaign against enemies in Iraq and Saudi Arabia, thus triggering unplanned oil outages and pushing up the oil price. A glance at Israeli, Saudi Arabian, and UAE stock markets suggests that global investors have largely ignored the geopolitical risks so far but may be starting to respond to the likely escalation in conflict prior to any US-Iran deal (Chart 7). Chart 6Israel’s Constraints Over Iran Jaw-Jaw Or War-War? Jaw-Jaw Or War-War? The US, Germany, France, Russia, and China are all officially on board with getting the Iranians back into compliance with the deal. A return to compliance would need to be phased with US sanctions relief. The Iranians demand that the US ease sanctions first, since it was the US that unilaterally walked away from the deal and re-imposed sanctions in 2018. Chart 7Saudi, UAE, Israeli Stocks Signal Danger Saudi, UAE, Israeli Stocks Signal Danger Saudi, UAE, Israeli Stocks Signal Danger Ultimately Biden is capable of making the first move since the American public shows very little concern about Iran. Biden himself is acting on behalf of a strong consensus in Washington that an Iranian deal is necessary to stabilize the region and enable the US to devote more strategic attention to Asia Pacific. Will Russia and China support the Iranian deal, given their simultaneous conflicts with the United States? As long as the US and Iran are satisfied with returning to the existing deal – which begins to expire in 2025 – there is little need for Russia or China to do anything. However, if Washington wants a better deal, then it will have to make major concessions to Moscow and Beijing. A new and better deal would require years to negotiate. Chart 8Russo-Chinese Cooperation Grows Jaw-Jaw Or War-War? Jaw-Jaw Or War-War? Russia and China supported the original nuclear deal because they saw an opportunity to limit the proliferation of nuclear weapons, which dilutes their own power. A Middle Eastern nuclear arms race is not in their interest. Iran is also a useful strategic partner for Russia and China in the Middle East and they are not averse to seeing Iran’s economy grow stronger in order to perpetuate its regime. They are wagering that liberalization of the Iranian economy will not result in liberalization of its politics – it certainly did not in the case of Russia or China – and therefore they will still have an ally but it will be more economically sound and influential. The Russo-Chinese strategic partnership has grown dramatically over the past decade. Both countries share an interest in undermining US global leadership and stoking American internal divisions. Both share an interest in reducing the US military presence near their borders, particularly in strategic territories and seas that they consider essential to their security and political legitimacy. Russia increasingly depends on Chinese demand for its exports and Chinese investment for developing its resources. Neither country trusts the other’s currency for trade but both have a shared interest in diversifying away from the US dollar (Chart 8). Chart 9China Offers Helping Hand On Iran? China Offers Helping Hand On Iran? China Offers Helping Hand On Iran? In cooperating with the US on Iran, Russia and China will expect the US to respect their demands on strategic areas much closer to their core interests. If the Biden administration continues to upgrade its trade and defense relations with Ukraine and Taiwan then Moscow and Beijing will push back aggressively and could at that point prevent or undermine any deal with Iran. China is at least officially enforce sanctions on Iran (Chart 9). Its strategic partnership with Iran is constantly in a state of negotiation – until the US clarifies its sanctions regime. Clearly China hopes to extract concessions from the Americans for cooperation on nuclear threats. This is also the case with North Korea, where a missile crisis would be useful for China’s purposes in creating the need for Chinese arbitration. China sees a chance to persuade Biden to remove restrictions imposed by President Trump. If the Biden administration’s hawkishness on China is confirmed in the coming months, then China’s willingness to cooperate will presumably change. Bottom Line: Israel is underscoring its red lines against Iranian nuclear weaponization and this will cause an increase in conflict this spring and summer. But it is not yet preventing the US and Iran from renegotiating the 2015 nuclear deal. We still expect Biden to agree to a deal by August. Taiwan And The South China Sea For global financial markets the most important test facing Biden lies in the US-China relationship and tensions over the Taiwan Strait. We will not rehash our recent research and arguments on this issue. Suffice it to say that we see a 60% chance of some kind of crisis over the next 12-24 months, including a 5% chance of full-scale war. The odds of total war can rise rapidly in the event of domestic Chinese instability, a game-changing US arms sale, or a Taiwanese declaration of independence. The greatest deterrent to a full Chinese attack on Taiwan – the reason for our current 5% odds – is that it would result in a devastating blowback against the Chinese economy. China’s trade with the developed world, in addition to Taiwan, makes up 63% of exports, or 11% of GDP (Chart 10). Beijing is ultimately willing to pay this price – or any price – to “unify” the country. But it will not do so frivolously. Each passing year gives China greater global economic leverage and greater military capability over Taiwan. Chart 10China’s Constraints Over Taiwan Jaw-Jaw Or War-War? Jaw-Jaw Or War-War? China is increasing its purchases of US treasuries, which waned during the trade war (Chart 11). China often increases purchases when interest rates rise and markets have seen a rapid increase in treasury yields since the vaccine discovery in November. There is no indication from this point of view that China is preparing for outright war with the United States, although this is admittedly a limited measure that could be misleading.   What about a crisis other than war? What do we mean when we say “some kind of crisis” over Taiwan? A major gray zone would be economic sanctions or an economic embargo. While China cut back on tourism after Taiwan’s nominally pro-independence party won the election in 2016, and all tourism ground to a halt with COVID-19, there is no evidence of a broader embargo so far (Chart 12). This could change overnight. While US law forbids an embargo on Taiwan, this is precisely an area where Beijing might wish to test the US’s commitment. Chart 11China Buys More US Treasuries China Buys More US Treasuries China Buys More US Treasuries The current high pressure on Taiwan stems in large part from the confluence of new US export controls and the global semiconductor shortage. China cannot yet meet its domestic demand for semiconductors and it cannot develop advanced computer chips fast enough without the US and its allies (Chart 13). Chart 12No Embargo On Taiwan (Yet) No Embargo On Taiwan (Yet) No Embargo On Taiwan (Yet) If the Biden administration pursues a full technological blockade then China may be forced to take tougher action on Taiwan. But if Biden pursues a more defensive strategy then a new equilibrium will develop that spares China the risks of war. Chart 13China's Demand For Semiconductors China's Demand For Semiconductors China's Demand For Semiconductors The US and China are simultaneously escalating their naval confrontation in the South China Sea, particularly around the Philippines. US and Chinese aircraft carrier groups and other ships have been circling each other as Beijing attempts to intimidate the Philippines and shake its trust in the defense treaty with the US. China claims the South China Sea as its own – and its efforts to deny the US access will be met with US assertions of freedom of navigation, which could lead to sunken ships. The strategic importance of the South China Sea is similar to that of the Taiwan Strait: Chinese control of these bodies of water would threaten Taiwan’s, Japan’s, and South Korea’s supply security while weakening America’s strategic position in the region. We have long highlighted the elevated risks of proxy war for Vietnam and the Philippines but these are hardly issues of global concern compared with Northeast Asia’s security. While Taiwan is far more relevant to global investors, due to the semiconductor issue, there are ample opportunities for a crisis to erupt in the South China Sea. A crisis in this sea cannot be dismissed as marginal because it could involve direct US-China conflict or, worst case, it could be a prelude to action on Taiwan, as China would seek to control the approaches to the island. The final risk in this region is that North Korea has restarted ballistic missile tests. As stated above, a crisis would be well-timed from China’s point of view. For investors, however, North Korea is largely a distraction from the critical Taiwan Strait. It could feed into any risk-off sentiment. Bottom Line: US-China relations are still unsettled and a clash could emerge over the South China Sea and Korean peninsula just as it could emerge over the Taiwan Strait. The Taiwan Strait remains the most significant geography. A direct US-China clash in the South China Sea could cause a global selloff but the markets would recover quickly, unless it is linked to a conflict over Taiwan. Investment Takeaways Geopolitical risk is reviving after a reprieve during the COVID-19 pandemic. That does not mean that frictions will lead straight into war. Diplomacy is possible. If the US, China, Russia, and Iran choose “jaw-jaw” over “war-war” then the global equity rally will see another leg up. From a tactical point of view, however, our arguments above should demonstrate that at least one of Biden’s early foreign policy tests is likely to escalate into a geopolitical incident that prompts negative impacts either in regional or global equity markets. Markets are not prepared for these risks to materialize. Standard measures of global policy uncertainty have fallen sharply for most countries. It is notable that two of the few countries in the world seeing rising policy uncertainty are China and Russia. The latter is likely due to domestic instability – which is a major motivator for an aggressive foreign policy (Chart 14). Chart 14AGlobal Policy Uncertainty Will Revive Global Policy Uncertainty Will Revive Global Policy Uncertainty Will Revive Chart 14BGlobal Policy Uncertainty Will Revive Global Policy Uncertainty Will Revive Global Policy Uncertainty Will Revive Global fiscal stimulus remains exceedingly strong – it is likely to peak this year. Chart 15 shows the latest update in fiscal stimulus for select countries, comparing the COVID-19 crisis to the 2008 financial crisis. There are some notable changes to previous versions of this chart, mostly due to revisions in GDP after last year’s shock, revisions in tax revenues due to the rapid economic snapback, and revisions to the timing and size of stimulus packages. The Biden administration’s $2.3 trillion infrastructure plan is obviously not included. The second panel of Chart 15 shows the changes in the IMF’s estimates from October 2020 to April 2021. Essentially the fiscal stimulus in 2020 was overestimated, as many measures did not kick in and the economic snapback was better than expected, whereas the 2021 stimulus is larger than expected. Russia and China are notable for tightening policy sooner than others – leading to a reduction in IMF estimates of fiscal stimulus for both years. Chart 15Revising Our Global Fiscal Stimulus Chart Jaw-Jaw Or War-War? Jaw-Jaw Or War-War? Commodities have been a major beneficiary of the global recovery (Chart 16). Chinese growth is likely to decelerate this year which will spark a pullback, even aside from geopolitical crises. However, from a cyclical perspective commodities, especially industrial metals, should benefit from limited supply and surging demand. Geopolitical crises and even wars would first be negative but then positive for metals. Chart 16Commodities To Benefit From Geopolitical Conflict Commodities To Benefit From Geopolitical Conflict Commodities To Benefit From Geopolitical Conflict Notably the US is embracing industrial policy alongside China and the EU. In particular the US is joining the green energy race with Biden’s $2.3 trillion American Jobs Plan containing about $370 billion in green initiatives and likely to pass Congress later this year. Symbolically Biden will emphasize the US’s attempt to catch up with Chinese and European green initiatives via his hosting of a global summit on April 22-23 for Earth Day. A brief word on the British pound. We took a tactical pause on our cyclically bullish view of the pound in February in anticipation of the Scottish parliamentary election on May 6. A strong showing by the Scottish National Party could lead to a second independence referendum. This party is flagging in the polls but independence sentiment has ticked back up, reinforcing our point that a nationalist surprise could take place at the ballot box (Chart 17). Once we have clarity on the prospect of a second referendum we will have a clearer view on the pound over the medium term. Chart 17Pound Sees Short-Term Risk From Scots Election Pound Sees Short-Term Risk From Scots Election Pound Sees Short-Term Risk From Scots Election Chart 18Long CHF-GBP For A Tactical Trade Long CHF-GBP For A Tactical Trade Long CHF-GBP For A Tactical Trade In the near term, we continue to pursue tactical safe-haven trades and hedges. Our tactical long Swiss franc trade was stopped out at 5% on March 25. But our Foreign Exchange Strategist Chester Ntonifor has since highlighted that the franc is excessively cheap (Chart 18). This time we recommend a tactical long CHF-GBP, which has an attractive profile in the context of geopolitical risk, taken together with the British political risk highlighted above.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 “Jaw-Jaw Is Best, Macmillan Finds,” New York Times, January 30, 1958, nytimes.com. 2 Taiwan – Province of China.

Highlights Stronger global growth in the wake of continued and expected fiscal and monetary stimulus, and progress against COVID-19 are boosting oil demand assumptions by the major data suppliers for this year.  We lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d, and assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl. Commodity markets are ignoring the rising odds of armed conflict involving the US, Russia and China and their clients and allies.  Russia has massed troops on Ukraine’s border and warned the US not to interfere.  China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert.  Intentional or accidental engagement would spike oil prices.  Two-way price risk abounds.  In addition to the risk of armed hostilities, faster distribution of vaccines would accelerate recovery and boost prices above our forecasts.  Downside risk of a resurgence in COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest (Chart of the Week). Feature Oil-demand estimates – ours included – are reviving in the wake of measurable progress in combating the COVID-19 pandemic in major economies, and an abundance of fiscal and monetary stimulus, particularly out of the US.1 On the back of higher IMF GDP projections, we lifted our 2021 global demand estimate by 640k b/d to 98.25mm b/d in this month’s balances. In our modeling, we assume OPEC 2.0 will make the necessary adjustments to keep Brent prices closer to $60/bbl than not, so as not to disrupt a fragile recovery. In an unusual turn of events, the early stages of the recovery in oil demand will be led by DM markets, which we proxy using OECD oil consumption (Chart 2). Thereafter, EM economies, re-take the growth lead next year and into 2023. Chart of the WeekCOVID-19 Deaths, Hospitalizations Threaten Global Recovery Upside Oil Price Risks Are Increasing Upside Oil Price Risks Are Increasing Chart 2DM Demand Surges This Year DM Demand Surges This Year DM Demand Surges This Year Absorbing OPEC 2.0 Spare Capacity We continue to model OPEC 2.0, the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, as the dominant producer in the market. The growth we are expecting this year will absorb a significant share of OPEC 2.0’s spare capacity, most of which – ~ 6mm b/d of the ~ 8mm b/d – is to be found in KSA (Chart 3). The core producers’ spare capacity allows them to meet recovering demand faster than the US shale producers can mobilize rigs and crews and get new supply into gathering lines and on to main lines. We model the US shale producers as a price-taking cohort, who will produce whatever the market allows them to produce. After falling to 9.22mm b/d in 2020, we expect US production to recover to 9.56mm b/d this year, 10.65mm b/d in 2022, and 11.18mm in 2023 (Chart 4). Lower 48 production growth in the US will be led by the shales, which will account for ~ 80% of total US output each year. Chart 3Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Core OPEC 2.0 Spare Capacity Will Respond First To Higher Demand Chart 4Shale Is The Marginal Barrel In The Price Taking Cohort Shale Is The Marginal Barrel In The Price Taking Cohort Shale Is The Marginal Barrel In The Price Taking Cohort OPEC 2.0’s dominant position on the supply side allows it to capture economic rents before non-coalition producers, which will remain a disincentive to them until the spare capacity is exhausted. Thereafter, the price-taking cohort likely will fund much of its E+P activities out of retained earnings, given their limited ability to attract capital. Equity investors will continue to demand dividends that can be maintained and grown, or return of capital via share buybacks. This will restrain production growth to those firms that are profitable. We expect the OPEC 2.0 coalition’s production discipline will keep supply levels just below demand so that inventories continue to fall, just as they have done during the COVID-19 pandemic, despite the demand destruction it caused (Chart 5). These modeling assumptions lead us to continue to expect supply and demand will continue to move toward balance into 2023 (Table 1). Chart 5Supply-Demand Balances in 2021 Supply-Demand Balances in 2021 Supply-Demand Balances in 2021 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Upside Oil Price Risks Are Increasing Upside Oil Price Risks Are Increasing We continue to expect this balancing to induce persistent physical deficits, which will keep inventories falling into 2023 (Chart 6). As inventories are drawn, OPEC 2.0’s dominant-producer position will allow it to will keep the Brent and WTI forward curves backwardated (Chart 7).2 We are maintaining our 2022 and 2023 Brent forecasts at $65/bbl and $75/bbl (Chart 8). Chart 6OPEC 2.0 Policy Continues To Keep Supply Below Demand... OPEC 2.0 Policy Continues To Keep Supply Below Demand... OPEC 2.0 Policy Continues To Keep Supply Below Demand... Chart 7OECD Inventories Fall to 2023 OECD Inventories Fall to 2023 OECD Inventories Fall to 2023 Chart 8Brent Forecasts Rise As Global Economy Recovers Brent Forecasts Rise As Global Economy Recovers Brent Forecasts Rise As Global Economy Recovers Two-Way Price Risk Abounds Risks to our views abound on the upside and the downside. To the upside, the example of the UK and the US in mobilizing its distribution of vaccines is instructive. Both states got off to a rough start, particularly the US, which did not seem to have a strategy in place as recently as January. After the US kicked its procurement and distribution into high gear its vaccination rates soared and now appear to be on track to deliver a “normal” Fourth of July holiday in the US. The UK has begun its reopening this week. Both states are expected to achieve herd immunity in 3Q21.3 The EU, which mishandled its procurement and distribution likely benefits from lessons learned in the UK and US and achieves herd immunity in 4Q21, according to McKinsey’s research. Any acceleration in this timetable likely would lead to stronger growth and higher oil prices. The next big task for the global community will be making vaccines available to EM economies, particularly those in which the pandemic is accelerating and providing the ideal setting for mutations and the spread of variants that could become difficult to contain. The risk of a resurgence in large-scale COVID-19-induced lockdowns remains, as rising death and hospitalization rates in Brazil, India and Europe attest. Cry Havoc The other big upside risk we see is armed conflict involving the US, Russia, China and their clients and allies. Commodity markets are ignoring these risks at present. Even though they do not rise to the level of war, the odds of kinetic engagement – planes being shot down or ships engaging in battle in the South China Sea – are rising on a daily basis. This is not unexpected, as our colleagues in BCA Research’s Geopolitical Strategy pointed out recently.4 Indeed, our GPS service, led by Matt Gertken, warned the Biden administration would be tested in this manner by Russia and China from the get-go. Russia has massed troops on Ukraine’s border and warned the US not to interfere. China has massed warships off the coast of the Philippines, and continues its incursions in Taiwan’s air-defense zone, keeping US forces on alert. Political dialogue between the US and Russia and the US and China is increasingly vitriolic, with no sign of any leavening in the near future. Intentional or accidental engagement could let slip the dogs of war and spike oil prices briefly. Finally, OPEC 2.0 is going to have to accommodate the “official” return of Iran as a bona fide oil exporter, if, as we expect, it is able to reinstate its nuclear deal – i.e., the Joint Comprehensive Plan of Action (JCPOA) – with Western states, which was abrogated by then-President Donald Trump in 2018. This may prove difficult, given our view that the oil-price collapse of 2014-16 was the result of the Saudis engineering a market-share war to tank prices, in an effort to deny Iran $100+ per-barrel prices that had prevailed between end-2010 and mid-2014. OPEC 2.0, particularly KSA, has not publicly involved itself in the US-Iran negotiations. However, it is worthwhile recalling that following the disastrous market-share war launched in 2014, KSA and the rest of OPEC 2.0 did accommodate Iran’s return to markets post-JCPOA.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Brent and WTI prices rallied sharply following the release of the EIA’s Weekly Petroleum Status Report showing a 9.1mm-barrel decline in US crude and product stocks for the week ended 9 April 2021. This was led by a huge draw in commercial crude and distillate inventories (5.9mm barrels and 2.1mm barrels, respectively). These draws came on the back of generally bullish global demand upgrades by the major data services (EIA, IEA and OPEC) over the past week. These assessments were supported by EIA data showing refined-product demand – i.e., “product supplied” – jumped 1.1mm b/d for the week ended 9 April. With vaccine distributions picking up steam, despite setbacks on the Johnson & Johnson jab, the storage draws and improved demand appear to have catalyze the move higher. Continued weakness in the USD also provided a tailwind, as did falling real interest rates in the US. Base Metals: Bullish Nickel prices fell earlier this week, as China’s official Xinhua news agency reported that Chinese Premier, Li Keqiang stressed the need to strengthen raw materials’ market regulation, amidst rising commodities prices, which been pressuring corporate financial performance (Chart 9). This statement came after China’s top economic advisor, Liu He also called for authorities to track commodities prices last week. Nickel prices fell by around $500/ ton earlier this week on this news, and were trading at $16,114.5/MT on the London Metals exchange as of Tuesday’s close. Other base metals were not affected by this news. Precious Metals: Bullish The US dollar and 10-year treasury yields fell after March US inflation data was released earlier this week. US consumer prices rose by the most in nearly nine years. The demand for an inflation hedge, coupled with the falling US dollar and treasury yields, which reduce the opportunity cost of purchasing gold, caused gold prices to rise (Chart 10). This uncertainty, coupled with the increasing inflationary pressures due to the US fiscal stimulus will increase demand for gold. Spot COMEX gold prices were trading at $1,746.20/oz as of Tuesday’s close. Ags/Softs: Neutral The USDA reported ending stocks of corn in the US stood at 1.35 billion bushels, well below market estimates of 1.39 billion and the 1.50 billion-bushel estimate by the Department last month, according to agriculture.com’s tally.  Global corn stocks ended at 283.9mm MT vs a market estimate of 284.5mm MT and a Department estimate of 287.6mm MT.  Chart 9Base Metals Are Being Bullish Base Metals Are Being Bullish Base Metals Are Being Bullish Chart 10Gold Prices To Rise Gold Prices To Rise Gold Prices To Rise   Footnotes 1     Please see US-Russia Pipeline Standoff Could Push LNG Prices Higher, which we published on 8 April 2021 re the IMF’s latest forecast for global growth.  Briefly, the Fund raised its growth expectations for this year and next to 6% and 4.4%, respectively, nearly a full percentage-point increase versus its January forecast update for 2021 2     A backwardated forward curve – prompt prices trading in excess of deferred prices – is the market’s way of signaling tightness.  It means refiners of crude oil value crude availability right now over availability a year from now.  This is exactly the same dynamic that drives an investor to pay $1 today for a dollar bill delivered tomorrow than for that same dollar bill delivered a year from now (that might only fetch 98 cents today, e.g.). 3    Please see When will the COVID-19 pandemic end?, published 26 March 2021 by McKinsey & Co. 4    Please see The Arsenal Of Democracy, a prescient analysis published 2 April 2021 by BCA’s Geopolitical Strategy.  The report notes the Biden administration “still faces early stress-tests on China/Taiwan, Russia, Iran, and even North Korea.  Game theory helps explain why financial markets cannot ignore the 60% chance of a crisis in the Taiwan Strait. A full-fledged war is still low-probability, but Taiwan remains the world’s preeminent geopolitical risk.”   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights Biden’s policy on China is hawkish so far, as expected, but temporary improvement is possible. We are cyclically bearish on the dollar but are taking a neutral tactical stance as the greenback’s bounce could go higher than expected if US-China relations take another downward dive. US-Iran tensions are on track to escalate in the second quarter as the pressure builds toward what we think will be a third quarter restoration of the 2015 nuclear deal. Oil price volatility is the takeaway. The anticipated US-Russia conflict has emerged and will bring negative surprises, especially for Russian and emerging European markets. Europe still enjoys relative political stability. A German election upset would bring upside risk to the euro and bund yields, while Scottish independence risk is contained for now. In this report we are launching the first in a new series of regular quarterly outlook reports that will supplement our annual Geopolitical Strategy strategic outlook. Feature The decline in global policy uncertainty and geopolitical risk that attended the US election and COVID-19 vaccine discovery has largely played out. Global investors have witnessed successful vaccine rollouts in the US and UK and can look forward to other countries, namely the EU-27, catching up. They have witnessed a splurge of US fiscal spending – $2.8 trillion since December – unprecedented in peacetime. And they have seen the Chinese government offer assurances that monetary tightening will not undermine the economic recovery. The risk of the US doubling down on belligerent trade protectionism has fallen by the wayside along with the Trump presidency. Going forward, there are signs that policy uncertainty and geopolitical risk will revive. First, as the global semiconductor shortage and Suez Canal blockage highlight, the world economy will sputter and strain at the sudden eruption of economic activity as the pandemic subsides and vast government spending takes effect. Financial instability is a likely consequence of the sudden, simultaneous adoption of debt monetization across a range of economies combined with a global high-tech race and energy overhaul. Second, the defeat of the Trump presidency does not reverse the secular increase in geopolitical tensions arising from America’s internal divisions and weakening hand relative to China, Russia, and others. On the contrary, large monetary and fiscal stimulus lowers the economic costs of conflict and encourages autarkic, self-sufficiency policies that make governments more likely to struggle with each other to secure their supply chains. Chart 1AThe Return Of Geopolitical Risk The Return Of Geopolitical Risk The Return Of Geopolitical Risk Chart 1BThe Return Of Geopolitical Risk The Return Of Geopolitical Risk The Return Of Geopolitical Risk If we look at simple, crude measures of geopolitical risk we can see the market awakening to the new wall of worry for this business cycle – Great Power struggle, the persistence of “America First” with a different figurehead, China policy tightening, and a vacuum of European leadership. The US dollar is rising, developed market equities are outperforming emerging markets, safe-haven currencies are ticking up against commodity currencies, and gold is perking back up (Charts 1A & 1B). The cyclical upswing should reverse most of these trends over the medium term but investors should be cautious in the short term. US Stimulus, Chinese Tightening, And The Greenback The US remains the world’s preponderant power despite its political dysfunction and economic decline relative to emerging markets. The US has struggled to formulate a coherent way to deal with declining influence, as shown by dramatic policy reversals toward Iraq, Iran, China, and Russia. The pattern of unpredictability will continue. The Biden administration’s longevity is unknown so foreign states will be cautious of making firm commitments, implementing deals, or taking irrevocable actions. This does not mean the Biden administration will have a small impact – far from it. Biden’s national policy seeks to fire up the American economy, refurbish alliances, export liberal democratic ideology, and compete with China and Russia. The firing up is largely already accomplished – the American Rescue Plan Act (ARPA) and Biden’s forthcoming “Build Back Better” proposals will ultimately rank with Johnson’s Great Society. The Fed estimates that US GDP growth will hit 6.5% this year, higher than the consensus of economic forecasts estimates 5.5%, driven by giant government pump-priming (Chart 2). The US, which is already an insulated economy, is virtually inured to foreign shocks for the time being. Chart 2US Injects Steroids Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Next comes the courting of allies to form a united democratic front against the world’s ambitious dictatorships. This process will be very difficult as the allies are averse to taking risks, especially on behalf of an erratic America. Chart 3US Stimulus Briefly Halts Decline In Global Economic Share Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" The Obama administration spent six full years creating a coalition to pressure an economically miniscule Iran into signing the 2015 nuclear deal. Imagine how long it will take Biden to convince the EU-27 and small Asian states to stick their necks out against Xi Jinping’s China. Especially if they suspect that the US’s purpose is to force China to open its doors primarily for the Americans. If the US grows at the rate of consensus forecasts then its share of global GDP will be 17.6% by 2025 (Chart 3). However, the US’s decline should not be exaggerated. Consider the lesson of the past year, in which the US seemed to flounder in the face of the pandemic. The US’s death count, on a population basis, was in line with other developed markets and yet its citizens exercised a greater degree of individual freedom. It maintained the rule of law despite extreme polarization, social unrest, and a controversial election. Its development of mRNA vaccines highlighted its ongoing innovation edge. And it has rolled out the vaccines rapidly. Internal divisions are still extreme and likely to produce social instability (we are still in the zone of “peak polarization”). But the US economic foundation is now fundamentally supported – political collapse is improbable. Chart 4US Vs China: The Stimulus Impulse US Vs China: The Stimulus Impulse US Vs China: The Stimulus Impulse In short, the US saw the “Civil War Lite” and has moved onto “Reconstruction Lite,” with a big expansion of the social safety net and infrastructure as well as taxes already being drafted. Meanwhile General Secretary Xi has managed to steer China into a good position for the much-ballyhooed 100th anniversary of the Communist Party on July 1. His administration is tightening monetary and fiscal policy marginally to resume the fight against systemic financial risk. China faces vast socioeconomic imbalances that, if left unattended, could eventually overturn the Communist Party’s rule. So far the tightening of policy is modest but the risk of a policy mistake is non-negligible and something global financial markets will have to grapple with in the second quarter. Comparing the US and China reveals an impending divergence in relative monetary and fiscal stimulus (Chart 4). China’s money and credit impulse is peaking – some signs of economic deceleration are popping up – even as the US lets loose a deluge of liquidity and pump-priming. The result is that the world is likely to experience waning Chinese demand and waxing US demand in the second half of the year. It is almost the mirror image of 2009-10, when China’s economy skyrocketed on a stimulus splurge while the US recovered more slowly with less policy support. The medium-to-long-run implication is that the US will have a bumpy downhill ride over the coming decade whereas China will recover more smoothly. Yet the analogy only goes so far. The structural transition facing China’s society and economy is severe and US-led international pressure on its economy will make it more severe. The short-run implication – for Q2 2021 – is that the US dollar’s bounce could run longer than consensus expects. Commodity prices, commodity currencies, and emerging market assets face a correction from very toppy levels. The global cyclical upswing will continue as long as China avoids a policy mistake of overtightening as we expect but the near-term is fraught with downside risk. Bottom Line: We are neutral on the dollar from a tactical point of view. While our bias is to expect the dollar to relapse, in line with the BCA House View and our Foreign Exchange Strategy, we are loathe to bet against the greenback given US stimulus and Chinese tightening. This is not to mention geopolitical tensions highlighted below that would reinforce the dollar. Biden’s China Policy And The Semiconductor Shortage Any spike in US-China strategic tensions in Q2 would exacerbate the above reasoning on the dollar. It would also lead to a deeper selloff in Chinese and EM Asian currencies and risk assets. A spike in tensions is not guaranteed but investors should plan for the worst. One of our core views for many years has been that any Democratic administration taking office in 2020 would remain hawkish on China, albeit less so than the Trump administration. So far this view is holding up. It may not have been the cause of the drop in Chinese and emerging Asian equities but it has not helped. However, the jury is still out on Biden’s China policy and the second quarter will likely see major actions that crystallize the relative hawkish or dovish change in policy. The acrimonious US-China meeting in Alaska meeting does not necessarily mean anything. The Biden administration has a full China policy review underway that will not be completed until around early June. The first bilateral summit between Biden and Xi could occur on Earth Day, April 22, or sometime thereafter, as the countries are looking to restart strategic dialogue and engage on nuclear non-proliferation and carbon emission reductions. Specifically China wants to swap its help on North Korea – which restarted ballistic missile launches as we go to press – for easier US policies on trade and tech. Only if and when a new attempt at engagement breaks down will the Biden administration conclude that it has a basis for pursuing a more offensive policy toward China. The problem is that new engagement probably will break down, sooner or later, for reasons we outlined last week: the areas of cooperation are limited – obviously so on health and cybersecurity, but even on climate change. Engagement on Iran and North Korea may have more success but the bigger conflicts over tech and Taiwan will persist. Ultimately China is fixated on strategic self-sufficiency and rapid tech acquisition in the national interest, leaving little room for US market access or removal of high-tech export controls. The threat that Biden will ultimately adopt and expand on Trump’s punitive measures will hang over Beijing’s head. The risk of a Republican victory in 2024 will also discourage China from implementing any deep structural concessions. The crux of the conflict remains the tech sector and specifically semiconductors.1 China is rapidly gaining market share but the US is using its immense leverage over chip design and equipment to cut off China’s access to chips and industry development. The ongoing threat of an American chip blockade is now being exacerbated by a global shortage of semiconductors as the economy recovers (Chart 5), exposing China’s long-term economic vulnerability. Chart 5Global Semiconductor Shortage Global Semiconductor Shortage Global Semiconductor Shortage There is room for some de-escalation but not much – and it is not to be counted on. The Biden administration, like the Obama administration, subscribes to the view that the US should prioritize maintaining its lead in tech innovation rather than trying to compete with China’s high-subsidy model, which is gobbling up the lower end of the computer chip market. Biden’s policy will at first be defensive rather than offensive – focused on improving US supply chain security rather than curtailing Chinese supply. Biden’s proposal for domestic infrastructure program will include funds for the semiconductor industry and research. While the Biden administration likely prizes leadership and innovation over the on-shoring of US chip production, the US government must also look to supply security, specifically for the military, so some on-shoring of production is inevitable.2 Ultimately the Biden administration can continue using export controls to slow China’s semiconductor development or it can pare these controls back. If it does nothing then China’s state-backed tech program will lead to a rapid increase in Chinese capabilities and market share as has occurred in other industries. If it maintains restrictions then it will delay China’s development, especially on the highest end of chips, but not prevent China from gaining the technology through circumventing export controls, subsidizing its domestic industry, and poaching from Taiwan and South Korea. Given that technological supremacy will lead to military supremacy the US is likely to maintain restrictions. But a full chip blockade on China would require expanding controls and enforcing them on third parties, and massively increases strategic tensions, should Biden ever decide to go this ultra-hawkish route. The Biden administration can adjust the pace and intensity of export controls but cannot give China free rein. Biden will want to block China’s access to the US market, or funds, or parts when these feed its military-industrial complex but relax pressure on China’s commercial trade. This is only a temporary fix. The commercial/military distinction is hard to draw when Beijing continually pursues “civil-military fusion” to maximize its industrial and strategic capabilities. Therefore US-China strategic tensions over tech will worsen over the long run even if Biden pursues engagement in the short run. Bottom Line: Biden’s China policy has started out hawkish as expected but the real policy remains unknown. The second quarter will reveal key details. Biden could pursue engagement, leading to a reduction in tensions. Investors should wait and see rather than bet on de-escalation, given that tensions will escalate anew over the medium and long term and therefore may never really decline. Iran And Oil Price Volatility Biden’s other foreign policy challenges in the second quarter hinge on Iran and Russia. The Biden administration aims to restore the 2015 Iranian nuclear deal and is likely to move quickly. This is not merely a matter of intention but of national capability since US grand strategy is pushing the US to shift focus to Asia Pacific, and an Iranian nuclear crisis divides US attention and resources. Biden has the ability to return to the 2015 deal with a flick of his wrist. The Iranians also have that ability, at least until lame duck President Hassan Rouhani leaves office in August – beyond that, a much longer negotiation would be necessary. US-Iran talks will lead to demonstrations of credible military threats, which means that geopolitical attacks and tensions in the Middle East will likely go higher before they fall on any deal. The past several years have already seen a series of displays of military force by the Iranians and the US and its allies and this process may escalate all summer (Map 1). Map 1Military Incidents In Persian Gulf Since Abqaiq Refinery Attack, 2019 Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" It is too soon to draw conclusions regarding the Israeli election on March 23 but it is possible that Prime Minister Benjamin Netanyahu will remain in power (Chart 6). If this is the case then Israel will oppose the American effort to rejoin the Iranian nuclear deal, culminating in a crisis sometime in the summer (or fall) in which the Israelis make a major show of force against Iran. Even if Netanyahu falls from power, the new Israeli government will still have to show Iran that it cannot be pushed around. Fundamentally, however, a change in leadership in Israel would bring the US and Israel into alignment and thus smooth the process for a deal that seeks to contain Iran’s nuclear program at least through 2025. Any better deal would require an entirely new diplomatic effort. Chart 6Israeli Ruling Coalition Share Of Knesset Shares In Recent Elections Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" The Russians or Saudi Arabians might reduce their oil production discipline once a deal becomes inevitable, so as not to lose market share to Iranian oil that will come back onto global markets. Thus oil markets could face unexpected oil supply outages due to conflict followed by OPEC or Iranian supply increases, implying that prices will be volatile. Our Commodity & Energy Strategy expects prices to average $65/barrel in 2021, $70/barrel in 2022, and $60-$80/barrel through 2025. Bottom Line: Oil prices will be volatile in the second quarter as they may be affected by the twists and turns of US-Iran negotiations, which may not reach a new equilibrium until July or August at earliest. Otherwise a multi-year diplomatic process will be required, which will suck away the Biden administration’s foreign policy capital, resulting either in precipitous reduction in Middle East focus or a neglect of greater long-term challenges from China and Russia. Russian Risks, Germany Elections, And Scottish Independence European politics are more stable than elsewhere in the world – marked by Italy’s sudden formation of a technocratic unity government under Prime Minister Mario Draghi. Draghi is focused on using EU recovery funds to boost Italian productivity and growth. Europe’s economic growth has underperformed that of the US so far this year. The EU is not witnessing the same degree of fiscal stimulus as the US (Chart 7). The core member states all face a fiscal drag in the coming two years and meanwhile the bloc has struggled to roll out COVID-19 vaccines efficiently. However, the vaccines are proven to be effective and will eventually be rolled out, so investors should buy into the discount in the euro and European stocks as a result of the various mishaps. Global and European industrial production and economic sentiment are bouncing back and German yields are rising albeit not as rapidly as American (Chart 8). Chart 7EU Stimulus Lags But Targets Productivity Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 8Global And Euro Area Production To Accelerate Global And Euro Area Production To Accelerate Global And Euro Area Production To Accelerate Chart 9German Conservatives Waver in Polls German Conservatives Waver in Polls German Conservatives Waver in Polls The main exceptions to Europe’s relative political stability come from Germany and Scotland. German Chancellor Angela Merkel is a lame duck and her party is falling in opinion polls with only six months to go before the general election on September 26 (Chart 9). Merkel even faced the threat of a no-confidence motion in the Bundestag this week due to her attempt to extend COVID lockdowns over Easter and sudden retreat in the face of a public backlash. Merkel apologized but her party is looking extremely shaky after recent election losses on the state level. The rise of a new left-wing German governing coalition is much more likely than the market expects. The second quarter will see the selection of a chancellor-candidate for her Christian Democratic Union and its Bavarian sister party the Christian Social Union. Table 1 highlights the likeliest chancellor-candidates of all the parties and their policy stances, from the point of view of whether they have a “hawkish,” hard-line policy stance or “dovish,” easy policy stance on the major issues. What stands out is that the entire German political spectrum is now effectively centrist or dovish on monetary and fiscal policy following the lessons of the 13 years since the global financial crisis. Table 1German Chancellor Candidates, 2021 Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" In other words, while Germany’s conservatives will seek an earlier normalization of policy in the wake of the crisis, none of them are as hawkish as in the past, and an election upset would bring even more dovish leaders into power. Thus the German election is a political risk but not a global market risk. It should not fundamentally alter the trajectory of German equities or bond yields – which is up amid global and European recovery – and if anything it would boost the euro. The potential German chancellor candidates show more variation when it comes to immigration, the environment, and foreign policy. Germany has been leading the charge for renewable energy and will continue on that trajectory (Chart 10). However it has simultaneously pursued the NordStream II natural gas pipeline with Russia, which would bring 55 billion cubic meters of natural gas straight into Germany, bypassing eastern Europe and its fraught geopolitics. This pipeline, which could be completed as early as August, would improve Germany’s energy security and Russia’s economic security, which remain closely intertwined despite animosity in other areas (Chart 11). But the pipeline would come at the expense of eastern Europe’s leverage – and American interests – and therefore opposition is rising, including among the ascendant German Green Party. Chart 10Germany’s Switch To Renewables Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 11Germany Puts Multilateralism To The Test Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Second Quarter Outlook 2021: Geopolitics Upsets The "Return To Normalcy" Chart 12UK-EU Trade Deal Dampens Scots Nationalism UK-EU Trade Deal Dampens Scots Nationalism UK-EU Trade Deal Dampens Scots Nationalism While Merkel and the Christian Democrats are dead-set on completing the pipeline, global investors are underrating the possibility of a major incident in which the US uses diplomacy and sanctions to halt the project. This is not intuitive because Biden is focused on restoring the US alliance with Europe, particularly Germany. But he is doing so in order to counter Russian and Chinese authoritarianism. Therefore the pipeline could mark the first real test of Biden’s – and Germany’s – understanding of multilateralism. Importantly the US is not pursuing a diplomatic “reset” with Russia at the outset of Biden’s term. This has now been confirmed with Biden’s accusation that Russian President Vladimir Putin is a “killer” and the ensuing, highly symbolic Russian withdrawal of its ambassador to the United States, unseen even in the Cold War. The Americans are imposing sanctions in retaliation for Russia’s alleged interference in the 2016 and 2020 elections. Russia is largely inured to US sanctions at this point but if the US wanted to make a difference it would insist on a stop to NordStream by cutting off access to the US market to the various European engineering and insurance companies critical to construction.3 Yet German leaders would have to be cajoled and it may be more realistic for the US to demand other concessions from Germany, particularly on countering China. The US-German arrangement will go a long way toward defining Germany’s and the EU’s risk appetite in the context of Biden’s proposal to build a more robust democratic alliance to counter revisionist authoritarian states. The Russians say they want to avoid a permanent deterioration in relations with the US, which they warn is on the verge of occurring. There is some space for engagement, such as on restoring the Iran deal, which Russia ostensibly supports. Biden may want to keep Russia pacified until he has an Iranian deal in hand. Ultimately, however, US-Russian relations are headed to new lows as the Biden administration brings counter-pressure on the Russians in retribution for the past decade of actions to undermine the United States. Germany’s place in this conflict will determine its own level of geopolitical risk. Clearly we would favor German assets over those of emerging Europe or Russian in this environment. One final risk from Europe is worth mentioning for the second quarter: the UK and Scotland. Scottish elections on May 6 could enable the Scottish National Party to push for a second independence referendum. So far our assessment is correct that Scottish independence will lose momentum after Prime Minister Boris Johnson’s post-Brexit trade deal with the European Union. Scottish nationalists are falling (Chart 12) and support for independence has dropped back toward the 45% level where the 2014 referendum ended up. Nevertheless elections can bring surprises and this narrative bears vigilance as a threat to the pound’s sharp rebound. Bottom Line: Europe’s relative political stability is challenged by US-Russia geopolitical tensions, the higher-than-expected risk of a German election upset, and the tail risk of Scottish independence. Of these only a US-Russia blowup, over NordStream or other issues, poses a major downside risk to global investors. We continue to underweight EM Europe and Russian currency and financial assets. Investment Takeaways Our three key views for 2021, in addition to coordinated monetary and fiscal stimulus, are largely on track for the year so far: China’s Headwinds: China’s renminbi and stock market are indeed suffering due to policy tightening and US geopolitical pressure. Risk to our view: if Biden and Xi make major compromises to reengage, and Xi eases monetary and fiscal policy anew, then the global reflation trade and Chinese equities will receive another boost. US-Iran Triggered Oil Volatility: The US and Iran are still in stalemate and the window of opportunity for a quick restoration of the 2015 deal is rapidly narrowing. Tensions are indeed escalating prior to any resolution, which would come in the third quarter, thus producing first upside then downside pressures for oil prices. Risk to our view: the Biden administration has no need for a new Iran deal and tensions escalate in a major way that causes a major risk premium in oil prices and forces the US to downgrade its pressure campaign against China. Europe’s Outperformance: So far this year the dollar has rallied and the EU has botched its vaccine rollout, challenging our optimistic assessment of Europe. But as highlighted in this report, we anticipated the main risks – government change in Germany, a Scots referendum – and the former is positive for the euro while the downside risk to the pound is contained. The major geopolitical problem is Russia, where we always expected substantial market-negative risks to materialize after Biden’s election. Risk to our view: A US-Russian reset that lowers geopolitical tensions across eastern Europe or a German status quo election followed by a tightening of fiscal policy sooner than the market expects.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 For an excellent recent review of the issues see Danny Crichton, Chris Miller, and Jordan Schneider, "Labs Over Fabs: How The U.S. Should Invest In The Future Of Semiconductors," Foreign Policy Research Institute, March 2021, issuu.com. 2 Alex Fang, "US Congress pushes $100bn research blitz to outcompete China," Nikkei Asia, March 23, 2021, asia.nikkei.com. In anticipation of the Biden administration’s dual attempt to promote, on one hand, innovation, and on the other hand, semiconductor supply security, the US semiconductor giant Intel has announced that it will build a $20 billion chip fabrication plant in Arizona. This is in addition to TSMC’s plans to build a plant in Arizona manufacturing chips that are necessary for the US Air Force’s F-35 jets. See Kif Leswing, "Intel is spending $20 billion to build two new chip plants in Arizona," CNBC, March 23, 2021, cnbc.com. 3 See Margarita Assenova, "Clouds Darkening Over Nord Stream Two Pipeline," Eurasia Daily Monitor 18:17 (2021), Jamestown Foundation, February 1, 2021, Jamestown.org.   Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights Both the US and Iran have the intention and capability of restoring the 2015 nuclear deal so investors should presume that an escalation in tensions will conclude with a new arrangement by August this year. However, the deal that the Iranians will offer, and that Biden can accept, may be unacceptable to the Israeli government, depending on Israel’s March 23 election. Moreover if a deal is not clinched by August, the timeframe will stretch out for most of Biden’s term and strategic tensions will escalate. Major Middle Eastern conflicts and crises tend to occur at the top of the business cycle when commodity prices are soaring rather than in the early stages where we stand today. But regional instability is possible regardless, especially if the US-Iran talks fall apart. Maintain gold and safe-haven assets as the Iranian question can lead to near-term escalation even if a deal is the end-game. Feature Geopolitics is far from investors’ concerns today, so it could create some nasty surprises. Two urgent tests await the Biden administration – China/Taiwan and Iran – and provide a basis for investors to add some safe-haven assets and hedges amidst an exuberant stock rally in which complacency is very high. The past week’s developments underscore these two tests. First, Chinese officials flagged that they would cut off rare earth elements to the US, implying that they would retaliate if Biden refuses to issue waivers for US export controls on semiconductors to China.1 Second, Biden spoke on the phone with Benjamin Netanyahu for the first time. The delay signaled Biden’s distance from Netanyahu and intention to normalize ties with Israel’s arch-enemy Iran. In both the Taiwan Strait and the Persian Gulf, the base case is not a full-fledged military conflict in the short run. This is positive for the bull market. But major incidents short of war are likely in the near term and major wars cannot be ruled out. In this report we update our view of the Iran risk. A long-term solution to the nuclear threat is not at hand, which means that Israel could in the worst-case take military action on its own. Meanwhile tensions and attacks will escalate until a deal is agreed. Iranian-backed forces in Iraq have already attacked a US base near Erbil, killing an American military contractor.2 In the event of an Iranian diplomatic crisis, the stock market selloff will be short. The macro backdrop is highly reflationary and investors will buy on the dips. In the event of full-scale war, the US dollar will suffer for a longer period. Oil Price A Boon But Middle East Regimes Still Vulnerable Chart 1Oil Recovery A Boon For Middle East Markets Oil Recovery A Boon For Middle East Markets Oil Recovery A Boon For Middle East Markets Brent crude oil prices have rebounded to $65 per barrel on the global economic recovery. Middle Eastern equities are rallying in absolute terms, though not relative to other emerging markets (Chart 1). This underperformance is fitting given that the region suffers from poor governance, obstacles to doing business, resource dependency, insufficient technology and capital, and high levels of political and geopolitical risk. Non-oil producers and non-oil sectors in the Middle East have generally lagged the global economic recovery (Chart 2). The continuation of the recovery is essential to these regimes because most of them lack the fiscal room to provide large fiscal relief packages. The global average in fiscal support over the past year has been 7.4% but most Middle Eastern governments have provided 2% or less (Chart 3). Current account deficits have plagued oil producers since the commodity bust of 2014 and twin deficits have become a feature of the region, limiting the fiscal response to the global pandemic. Chart 2Middle East Economy Starts To Recover Middle East Economy Starts To Recover Middle East Economy Starts To Recover Chart 3Middle Eastern Regimes Fiscally Constrained Biden, Iran, Markets Biden, Iran, Markets The good news is that the recovery is likely to continue on the back of vaccines and fiscal pump-priming in all of the major economies. The bad news is that a black cloud hangs over the Middle East in the form of geopolitics. Given the underperformance of regional equities, global investors are not ignoring these risks – but they are a persistent factor until the Biden administration survives its initial tests in the region to create a new equilibrium. The unfinished geopolitical business in the region centers on the role of the US and the question of Iran. It is widely understood that the US has less and less interest in the region due to its newfound energy independence on the back of the shale revolution (Chart 4). This is why the US can afford to sign and break deals as it pleases under different administrations, namely the 2015 Iranian nuclear deal, otherwise known as the Joint Comprehensive Plan of Action (JCPA). The Obama administration spent two terms concluding the deal while the Trump administration spent one term nullifying it, leaving the central geopolitical question of the region in limbo. Israel and Arab governments feel increasingly insecure in light of the US’s apparent lack of foreign policy coherence and declining interest in the region. The US has not truly abandoned the region – if anything the Biden administration is looking to maintain or increase US international involvement.3 Washington still sees the need to preserve a strategic balance between Iran and the Arab states, prevent Iran from gaining nuclear weapons, and maintain security in the critical oil chokepoint of the Persian Gulf and Strait of Hormuz (Chart 5). But Washington’s appetite for commitment and sacrifice is obviously waning. The American public is openly hostile to the idea of Middle Eastern entanglements, and three presidents in a row have been elected on the assurance that they would scale down America’s “forever wars.” A decisive majority of Americans, including military veterans and Republicans, believe the wars in Afghanistan and Iraq were not worth fighting.4 And only 6% of Americans view Iran as the top threat to their country. Chart 4Waning US Interest In Middle East Waning US Interest In Middle East Waning US Interest In Middle East Chart 5Strait Of Hormuz Critical To Global Stability Biden, Iran, Markets Biden, Iran, Markets America’s lack of concern about the Iranian threat marks a difference from the early 2000s and especially from its critical Middle Eastern ally Israel. Naturally Israelis have a much greater fear of Iran, and 58% see it as the nation’s top threat (Chart 6). Israel and the Gulf Arab states are drawing together, under the framework of the Trump administration’s Abraham Accords, in case the US abandons the region. A deal normalizing relations with Iran would enable Iran to expand its power and influence and, if unchecked by the US, would pose a long-lasting threat to US allies. Chart 6No US Appetite For War With Iran – Israel A Different Story Biden, Iran, Markets Biden, Iran, Markets Chart 7China/Asia, Not Iran, The Strategic Priority For The US China/Asia, Not Iran, The Strategic Priority For The US China/Asia, Not Iran, The Strategic Priority For The US The US’s reason for dealing with Iran is that it needs to devote more attention to its strategy in the western Pacific in countering China (Chart 7). But China is also a reason for the US to stay involved in the Middle East. China’s role is expanding because of resource dependency and the desire to expand economic integration. Beijing wants to deepen its global investments, open up new markets, and create closer links with Europe (Chart 8). Chart 8AChina's Expanding Role In Middle East China's Expanding Role In Middle East China's Expanding Role In Middle East Chart 8BChina's Expanding Role In Middle East China's Expanding Role In Middle East China's Expanding Role In Middle East Chart 9Unresolved US-Iran Deal A Geopolitical Risk Unresolved US-Iran Deal A Geopolitical Risk Unresolved US-Iran Deal A Geopolitical Risk The opening of the Iranian economy would give the US (and EU) a greater role in Iran’s development, where China has a special advantage as long as Iran is a pariah. The US would add economic leverage to its military leverage in a region that provides China with its energy. The Chinese are not yet as capable of projecting power into the region but that is changing rapidly. There is a possible strategic balance to be established between these simultaneous foreign policy revolutions: the US-Iran détente, the Israeli-Arab détente, and the rise of Mideast-China ties. But balance is an ideal and not yet a reality. In the meantime these foreign policy revolutions must actually take place – and revolutions are rarely bloodless. It is possible for a meltdown to occur in light of the region’s profound changes. In particular, the US-Iran détente is incomplete and faces Israeli/Arab opposition, Iranian paranoia, and US foreign policy incoherence. At the moment it is premature to declare an end to the bull market in US-Iran tensions. That will come when a deal is actually sealed, and then tested and enforced. In the meantime Iranian incidents will occur (Chart 9). Geopolitical risks threaten to reduce global oil supply. Different regimes and their militant proxies will strike out against each other to establish red lines. But a US-Iran deal is highly likely – and once that occurs, the risk to oil supply shifts to the upside, as Iran’s economy will open up. Not only will Iran start exporting again but Gulf Arab producers will want to preserve their market share, which means they will pump more oil. Iran’s Regime Hardens Its Shell Ahead Of Leadership Succession The COVID-19 crisis has weakened regimes in the Middle East, much like the Great Recession sowed the seeds for the Arab Spring and many other sweeping changes in the region. But unlike the Arab Spring, the regimes most at risk today are majority Shia Muslim – with Lebanon, Iran, and Iraq all teetering on the verge of chaos (Chart 10). Chart 10Iranian Sphere De-Stabilized Amid COVID Biden, Iran, Markets Biden, Iran, Markets Chart 11Iranian Economy Weak (Despite Green Shoots) Iranian Economy Weak (Despite Green Shoots) Iranian Economy Weak (Despite Green Shoots) Chart 12Jobless Iranian Youth Jobless Iranian Youth Jobless Iranian Youth The Iranian economy is starting to show the faintest green shoots but it is far too soon to give the all-clear signal. US sanctions have shut off access to oil export revenues. Domestic demand is weak and imports are still contracting, albeit much less rapidly. The country has seen a double dip recession over the past ten years (Chart 11). Unemployment is rife, especially among the youth. The working-age population makes up 60% of total and periodically rises up in protest (Chart 12). Inflation is soaring and the currency is still wallowing in deep depreciation (Chart 13). All of these points suggest Iran is weaker than it looks and will seek to negotiate a deal with the Biden administration. But Iran cannot trust the US so it will simultaneously prepare for the worst outcome – no deal, sanctions, and eventually war. Chart 13Iran Still Ripe For Social Unrest Iran Still Ripe For Social Unrest Iran Still Ripe For Social Unrest Chart 14Iranian Regime Turning Hawkish Biden, Iran, Markets Biden, Iran, Markets Iran’s response to the US’s withdrawal from the 2015 nuclear deal and imposition of maximum pressure sanctions has been to adopt a siege mentality and fortify the regime for a potential military confrontation. The country is preparing for a highly uncertain and vulnerable transition from Supreme Leader Ali Khamenei to a future leader or group of leaders. The government fixed the 2020 parliamentary elections so that hardliners or “principlists” rose to prominence at the expense of independents and especially the so-called reformists. The reformists have been humiliated by the US betrayal of the deal and re-imposition of sanctions, which exploded the economic reforms of President Hassan Rouhani, who will step down in August (Chart 14). The Timeline Of Biden’s Iran Deal Still, it is likely that the US and Iran will return to some form of the 2015 nuclear deal. Lame duck Rouhani is politically capable of returning to the deal: President Rouhani is a lame duck president whose popularity has cratered. If he can restore the deal before August then he can salvage his legacy and provide a pathway for Iran out of economic ruin by removing sanctions. It is manifestly in Iran’s interests to restore the deal – one reason why it has never left the deal and has only made incremental and reversible infractions against it. If Rouhani falls on his sword he provides the Supreme Leader and the next administration with a convenient scapegoat to enable the deal to be restored. Freshman President Biden has enough political capital to return to the deal: Biden is capable of restoring the deal, as he clearly intends to do judging by his statements, cabinet appointments, and diplomatic actions thus far. He has demanded that Iran enter back into full compliance with the deal before he eases sanctions but even this demand can be fudged. After all, it was the US that exited the deal in the first place, and Iran remains in partial compliance, so it stands to reason that the US should make the first concession to bring Iran back into compliance. None of the signatories have nullified the deal other than the US, and it was an executive (not legislative) deal, so President Biden can ultimately rejoin it by fiat. This would not be a popular move at home but the US public is preoccupied. Biden would achieve a foreign policy objective early in his term. The timeline is critical – an early deal is our base case. But if it falls through, then it could take the rest of Biden’s term in office, or longer, to forge a deal. Tensions would skyrocket over that period. The timeline is shown in Table 1. The US has identified April or May as the time when Iran will reach “breakout” capability, i.e. produce enough highly enriched uranium to make a nuclear bomb. The Israelis, for their part, estimate that breakout phase will be reached in August – the same month Rouhani is set to step down. Both the US and Israel view breakout as a red line, though there is some room for interpretation. Table 1Can Lame Duck Rouhani Salvage US Deal For Legacy By August? Biden, Iran, Markets Biden, Iran, Markets The option of rejoining the old deal with Rouhani as a scapegoat will end when Rouhani exits in August. The next Iranian president is unlikely to repeat Rouhani’s mistake of pinning his administration on a promise from the Americans that could be revoked as early as January 20, 2025. The next Iranian president will be a nationalist or hardliner. Opinion shows that the public looks most favorably upon the firebrand ex-President Mahmoud Ahmadinejad or the hardline candidate from 2017 Ebrahim Raisi. Another possible candidate is Hossein Dehghan, a brigadier general. The least favorable political figures are the reformists like Rouhani (Chart 15). Chart 15Iran’s Next President Will Be Hawkish Biden, Iran, Markets Biden, Iran, Markets We cannot vouch for the quality of these opinion polls but they are corroborated by other polls we have seen and they make sense with what we know and have observed in recent years. Apparently the public has turned its back on the dream of greater economic opening, with self-sufficiency making a comeback in the face of US sanctions (Chart 16). The regime will promote this attitude in advance of the leadership transition as it must be prepared to conduct a smooth succession even under the worst-case scenario of sanctions or war. Chart 16Iran Preparing For Supreme Leader’s Succession Biden, Iran, Markets Biden, Iran, Markets Chart 17Nuclear Bomb Key To Regime Survival Biden, Iran, Markets Biden, Iran, Markets The hitch is that Iran is interested in rejoining the deal it signed in 2015, not a grander deal. It will not sign an expanded deal that covers its regional militant proxies and ballistic missile program or requires irreversible denuclearization. The Supreme Leader has witnessed that an active nuclear weapon program and ballistic missile program provide the surest guarantees of regime survival over the long haul. The contrasting cases of Libya and North Korea illustrate the point (Chart 17). Libya gave up its nuclear program and weapons of mass destruction in the wake of the US invasion of Iraq in 2003 only to see the regime collapse in 2011 and leader Muammar Gaddafi die under NATO military pressure. By contrast, North Korea refused to give up its nuclear and missile programs and repeatedly cut deals with the US that served only to buy time and ease sanctions, and today North Korea possesses an estimated 30-45 nuclear weapons deliverable through multiple platforms. Leader Kim Jong Un has used this leverage to bargain with the great powers. The lesson for Iran could not be clearer: a short-term deal with the Americans may buy time and a reprieve from sanctions. But total, verifiable, and irreversible denuclearization means regime suicide. The Biden administration would prefer to create a much more robust deal rather than suffer the criticism of rejoining the 2015 deal, given its flaws and that the first set of deadlines in 2025 is only four years away. But Biden cannot possibly reconstruct the P5+1 coalition of countries to force Iran into a grander bargain in the context of US-Russia and US-China tensions. The sacrifices that would be necessary to bring Russia and China on board would not be worth it. Therefore Biden’s solution will be to rejoin the existing deal plus an Iranian promise to enter negotiations on a more comprehensive deal in future. The Iranians can accept this option since it serves their purpose of buying time without making irreversible concessions on their nuclear and missile programs. Israel then becomes the sticking point, as Iranian officials have said that the US rejoining the original 2015 deal would be a “calamity” and unacceptable. The Israeli government is studying options for military action in the event that Iran reaches nuclear breakout. However, the Israeli election on March 23 will determine the fate of Benjamin Netanyahu and his government’s hawkish approach to Iran. A change of government in Israel would likely bring the US and Israel into line on concluding a deal with Iran so as to avoid military conflict for the time being. If Netanyahu wins, yet the US and Iran fall back into compliance with the 2015 deal (Table 2), then Iran is still limiting its nuclear capabilities through 2025, obviating the need for a unilateral Israeli strike in the near term. Israel will not launch a unilateral strike except as a last resort, as it fears permanent alienation from its greatest security guarantor, the United States. Table 2Iran’s Compliance (And Non-Compliance) With The Joint Comprehensive Plan Of Action Biden, Iran, Markets Biden, Iran, Markets If a deal cannot be put together by the time Rouhani steps down then the risk of conflict will increase as there will not be a prospect of a short-term fix. A much longer diplomatic arc will be required as Iran would draw out negotiations and the US would have to court allies to pressure Iran. The US and/or Israel could conduct sabotage or air strikes to set back the Iranian nuclear program. It is possible that the Iranian leadership or the increasingly powerful Iranian Revolutionary Guard Corps could overplay their hand in the belief that the US has no stomach for waging war. While it is true that the US public is war-weary, it is also true that that attitude would change overnight in the event of a national humiliation or attack. Investment Takeaways The Trump administration drew a hard line on nuclear proliferation. Trump’s defeat marks a softening in the US line regarding proliferation. This does not mean that the Biden administration will be ineffective – it could be even more effective with a more flexible approach – but it does mean that nuclear aspirants currently feel less pressure to make major concessions. This will hold at least until Biden demonstrates that he too can impose maximum pressure. Hence nuclear and missile tests will go up in the near term – as will various countries’ demonstrations of credible threats and red lines. The global economic recovery will strengthen oil producers by giving them greater government revenues with which to stabilize their domestic politics and restart foreign policy initiatives. The global oil price is reasonably correlated with international conflicts involving oil producers (Chart 18). With rising oil revenues, Russia, Saudi Arabia, Iran, Iraq, and others will be emboldened to pursue their national interests. Chart 18Oil Price And Global Conflict Go Hand In Hand Biden, Iran, Markets Biden, Iran, Markets While the Biden administration’s end-game is a nuclear deal with Iran, the period between now and the conclusion of a deal will see an increase rather than a decrease in tensions and tit-for-tat military strikes across the region. Unexpected cutoffs of oil supplies and a risk premium in the oil price will be injected first, as we have argued. When a deal is visible on the horizon then oil prices face a downside risk, due to the resumption of Iranian oil exports and any loss of OPEC 2.0 discipline. It is possible that this moment is already upon us. This report shows a clear path to a US-Iran deal by August. US Secretary of State Anthony Blinken is reaching out to the Iranians. Saudi Arabia has recently announced that it will not continue with large production cuts. Russian oil officials have argued that the global market is balanced and production cuts are no longer necessary.5 But given that the Russians and Saudis fought an oil market share war as recently as last year, it is not clear that a collapse in OPEC 2.0 discipline is imminent. What will be the market impact if hostilities revive in anticipation of a deal? Or worse, if a deal cannot be achieved and a much longer period of US-Iran conflict opens up for Biden’s term in office? Table 3 provides a list of major geopolitical incidents and crises in the Middle East since the Yom Kippur war. We look at the S&P500’s peak and trough within the three months before and after each crisis. The median drawdown is 8% and the market has usually recovered within one month. Twelve months later the S&P is up by 12%. Table 3Stock Market Reaction To Middle East Geopolitical Crises Biden, Iran, Markets Biden, Iran, Markets Table 4 shows a shortened list of the same incidents with the impact on the trade-weighted dollar, which is notable in the short run but is only persistent in the long run in the case of full-fledged wars like the first and second Persian Gulf wars. Table 4US Dollar Falls On Middle East Geopolitical Crises Biden, Iran, Markets Biden, Iran, Markets The stock market impact can last for a year if the crisis coincides with a bear market and recession. Middle Eastern crises tend to occur at the height of business cycles when economic activity is running hot, inflationary pressures are high, and governments feel confident enough in their economic foundation to take foreign policy risks. The Yom Kippur war and first oil shock initiated a recession in 1973. The first Iraq war also coincided with the onset of a recession. The terrorist attack on the USS Cole occurred near the height of the Dotcom bubble and was followed by the 2001 recession. The 2019 Iranian attack on Saudi Arabia’s Abqaiq refinery also occurred at the peak of the cycle. More analogous to the situation today are crises that occurred in the early stages of the global cycle. The Arab Spring and related events in 2011 coincided with a period of market weakness that lasted for most of the year as the aftershocks of the Great Recession rippled across the emerging world. This scenario is relevant in 2021 and especially 2022, as global stimulus wears off and governments strive to navigate the deceleration in growth. Middle Eastern instability could compound that problem. The chief risk in the coming years would be a failure to resolve the Iranian question followed by a US-Iran or Israel-Iran conflict that generates instability across the Middle East. Such a catastrophe could cause major energy supply shock that would short-circuit the global economy. History shows this risk is more likely to come late in the cycle rather than early but the above analysis indicates that a failure of the Biden administration to conclude a deal this year could lead to a multi-year escalation in strategic tensions with a new hawkish Iranian president. That path, in turn, could bring forward the time frame of a major war and supply shock. The Iranians have taken a hawkish turn, are fortifying their regime for the future, and will reject total denuclearization. The US is fundamentally less interested in the region and thus susceptible to continued foreign policy incoherence. The Israelis are just capable of taking military action on their own in the event of impending Iranian nuclear weaponization. These points suggest that the risk of war with Iran is non-trivial, even though a US-Iran deal is the base case.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Sun Yu and Demetri Sevastopulo, "China targets rare earth export curbs to hobble US defence industry," Financial Times, February 15, 2021, ft.com. 2 For the US response to the Erbil attack see Jim Garamone, "Austin Pleased With Discussions With NATO Leaders," Department of Defense News, February 17, 2021, defense.gov. 3 For example, Biden is unlikely to withdraw precipitously from the region, including Afghanistan, as Trump intended, especially as long as he is in a high-stakes negotiation with Iran. 4 Ruth Igielnik and Kim Parker, "Majorities of U.S. veterans, public say the wars in Iraq and Afghanistan were not worth fighting," Pew Research, July 10, 2019, pewresearch.org. 5 See Benoit Faucon and Summer Said, "Saudi Arabia Set to Raise Oil Output Amid Recovery in Prices," Wall Street Journal, February 17, 2021, wsj.com; Yuliya Fedorinova and Olga Tanas, "Global Oil Markets Are Now Balanced, Russia’s Novak Says," Bloomberg, February 14, 2021, Bloomberg.com.

Highlights With a vaccine already rolling out in the UK and soon in the US, investors have reason to be optimistic about next year. Government bond yields are rising, cyclical equities are outperforming defensives, international stocks hinting at outperforming American, and value stocks are starting to beat growth stocks (Chart 1). Feature President Trump’s defeat in the US election also reduces the risk of a global trade war, or a real war with Iran. European, Chinese, and Emirati stocks have rallied since the election, at least partly due to the reduction in these risks (Chart 2). However, geopolitical risk and global policy uncertainty have been rising on a secular, not just cyclical, basis (Chart 3). Geopolitical tensions have escalated with each crisis since the financial meltdown of 2008. Chart 1A New Global Business Cycle A New Global Business Cycle A New Global Business Cycle Chart 2Biden: No Trade War Or War With Iran? Biden: No Trade War Or War With Iran? Biden: No Trade War Or War With Iran? Chart 3Geopolitical Risk And Global Policy Uncertainty Geopolitical Risk And Global Policy Uncertainty Geopolitical Risk And Global Policy Uncertainty Chart 4The Decline Of The Liberal Democracies? The Decline Of The Liberal Democracies? The Decline Of The Liberal Democracies? Trump was a symptom, not a cause, of what ails the world. The cause is the relative decline of the liberal democracies in political, economic, and military strength relative to that of other global players (Chart 4). This relative decline has emboldened Chinese and Russian challenges to the US-led global order, as well as aggressive and unpredictable moves by middle and small powers. Moreover the aftershocks of the pandemic and recession will create social and political instability in various parts of the world, particularly emerging markets (Chart 5). Chart 5EM Troubles Await EM Troubles Await EM Troubles Await Chart 6Global Arms Build-Up Continues Global Arms Build-Up Continues Global Arms Build-Up Continues   We are bullish on risk assets next year, but our view is driven largely from the birth of a new economic cycle, not from geopolitics. Geopolitical risk is rapidly becoming underrated, judging by the steep drop-off in measured risk. There is no going back to a pre-Trump, pre-Xi Jinping, pre-2008, pre-Putin, pre-9/11, pre-historical golden age in which nations were enlightened, benign, and focused exclusively on peace and prosperity. Hard data, such as military spending, show the world moving in the opposite direction (Chart 6). So while stock markets will grind higher next year, investors should not expect that Biden and the vaccine truly portend a “return to normalcy.” Key View #1: China’s Communist Party Turns 100, With Rising Headwinds Investors should ignore the hype about the Chinese Communist Party’s one hundredth birthday in 2021. Since 1997, the Chinese leadership has laid great emphasis on this “first centenary” as an occasion by which China should become a moderately prosperous society. This has been achieved. China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Chart 7China: Less Money, More Problems China: Less Money, More Problems China: Less Money, More Problems The big day, July 1, will be celebrated with a speech by General Secretary Xi Jinping in which he reiterates the development goals of the five-year plan. This plan – which doubles down on import substitution and the aggressive tech acquisition campaign – will be finalized in March, along with Xi’s yet-to-be released vision for 2035, which marks the halfway point to the “second centenary,” 2049, the hundredth birthday of the regime. Xi’s 2035 goals may contain some surprises but the Communist Party’s policy frameworks should be seen as “best laid plans” that are likely to be overturned by economic and geopolitical realities. It was easier for the country to meet its political development targets during the period of rapid industrialization from 1979-2008. Now China is deep into a structural economic transition that holds out a much more difficult economic, social, and political future. Potential growth is slowing with the graying of society and the country is making a frantic dash, primarily through technology acquisition, to boost productivity and keep from falling into the “middle income trap” (Chart 7). Total debt levels have surged as Beijing attempts to make this transition smoothly, without upsetting social stability. Households and the government are taking on a greater debt load to maintain aggregate demand while the government tries to force the corporate sector to deleverage in fits and starts (Chart 8). The deleveraging process is painful and coincides with a structural transition away from export-led manufacturing. Beijing likely believes it has already led de-industrialization proceed too quickly, given the huge long-term political risks of this process, as witnessed in the US and UK. The fourteenth five-year plan hints that the authorities will give manufacturing a reprieve from structural reform efforts (Chart 9). Chart 8China Struggles To Dismount Debt Bubble China Struggles To Dismount Debt Bubble China Struggles To Dismount Debt Bubble Chart 9China Will Slow De-Industrialization, Stoking Protectionism China Will Slow De-Industrialization, Stoking Protectionism China Will Slow De-Industrialization, Stoking Protectionism Chart 10China Already Reining In Stimulus China Already Reining In Stimulus China Already Reining In Stimulus A premature resumption of deleveraging heightens domestic economic risks. The trade war and then the pandemic forced the Xi administration to abandon its structural reform plans temporarily and drastically ease monetary, fiscal, and credit policy to prevent a recession. Almost immediately the danger of asset bubbles reared its head again. Because the regime is focused on containing systemic financial risk, it has already begun tightening monetary policy as the nation heads into 2021 – even though the rest of the world has not fully recovered from the pandemic (Chart 10). The risk of over-tightening is likely to be contained, since Beijing has no interest in undermining its own recovery. But the risk is understated in financial markets at the moment and, combined with American fiscal risks due to gridlock, this familiar Chinese policy tug-of-war poses a clear risk to the global recovery and emerging market assets next year. Far more important than the first centenary, or even General Secretary Xi’s 2035 vision, is the impending leadership rotation in 2022. Xi was originally supposed to step down at this time – instead he is likely to take on the title of party chairman, like Mao, and aims to stay in power till 2035 or thereabouts. He will consolidate power once again through a range of crackdowns – on political rivals and corruption, on high-flying tech and financial companies, on outdated high-polluting industries, and on ideological dissenters. Beijing must have a stable economy going into its five-year national party congresses, and 2022 is no different. But that goal has largely been achieved through this year’s massive stimulus and the discovery of a global vaccine. In a risk-on environment, the need for economic stability poses a downside risk for financial assets since it implies macro-prudential actions to curb bubbles. The 2017 party congress revealed that Xi sees policy tightening as a key part of his policy agenda and power consolidation. In short, the critical twentieth congress in 2022 offers no promise of plentiful monetary and credit stimulus (Chart 11). All investors can count on is the minimum required for stability. This is positive for emerging markets at the moment, but less so as the lagged effects of this year’s stimulus dissipate. Chart 11No Promise Of Major New Stimulus For Party Congress 2022 No Promise Of Major New Stimulus For Party Congress 2022 No Promise Of Major New Stimulus For Party Congress 2022 Not only will Chinese domestic policy uncertainty remain underestimated, but geopolitical risk will also do so. Superficially, Beijing had a banner year in 2020. It handled the coronavirus better than other countries, especially the US, thus advertising Xi Jinping’s centralized and statist governance model. President Trump lost the election. Regardless of why Trump lost, his trade war precipitated a manufacturing slowdown that hit the Rust Belt in 2019, before the virus, and his loss will warn future presidents against assaulting China’s economy head-on, at least in their first term. All of this is worth gold in Chinese domestic politics. Chart 12China’s Image Suffered In Spite Of Trump 2021 Key Views: No Return To Normalcy 2021 Key Views: No Return To Normalcy Internationally, however, China’s image has collapsed – and this is in spite of Trump’s erratic and belligerent behavior, which alienated most of the world and the US’s allies (Chart 12). Moreover, despite being the origin of COVID-19, China’s is one of the few economies that thrived this year. Its global manufacturing share rose. While delaying and denying transparency regarding the virus, China accused other countries of originating the virus, and unleashed a virulent “wolf warrior” diplomacy, a military standoff with India, and a trade war with Australia. The rest of Asia will be increasingly willing to take calculated risks to counterbalance China’s growing regional clout, and international protectionist headwinds will persist. The United States will play a leading part in this process. Sino-American strategic tensions have grown relentlessly for more than a decade, especially since Xi Jinping rose to power, as is evident from Chinese treasury holdings (Chart 13). The Biden administration will naturally seek a diplomatic “reset” and a new strategic and economic dialogue with China. But Biden has already indicated that he intends to insist on China’s commitments under Trump’s “phase one” trade deal. He says he will keep Trump’s sweeping Section 301 tariffs in place, presumably until China demonstrates improvement on the intellectual property and tech transfer practices that provided the rationale for the tariffs. Biden’s victory in the Rust Belt ensures that he cannot revert to the pre-Trump status quo. Indeed Biden amplifies the US strategic challenge to China’s rise because he is much more likely to assemble a “grand alliance” or “coalition of the willing” focused on constraining China’s illiberal and mercantilist policies. Even the combined economic might of a western coalition is not enough to force China to abandon its statist development model, but it would make negotiations more likely to be successful on the West’s more limited and transactional demands (Chart 14). Chart 13The US-China Divorce Pre-Dates And Post-Dates Trump The US-China Divorce Pre-Dates And Post-Dates Trump The US-China Divorce Pre-Dates And Post-Dates Trump Chart 14Biden's Grand Alliance A Danger To China Biden's Grand Alliance A Danger To China Biden's Grand Alliance A Danger To China The Taiwan Strait is ground zero for US-China geopolitical tensions. The US is reviving its right to arm Taiwan for the sake of its self-defense, but the US commitment is questionable at best – and it is this very uncertainty that makes a miscalculation more likely and hence conflict a major tail risk (Chart 15). True, Beijing has enormous economic leverage over Taiwan, and it is fresh off a triumph of imposing its will over Hong Kong, which vindicates playing the long game rather than taking any preemptive military actions that could prove disastrous. Nevertheless, Xi Jinping’s reassertion of Beijing and communism is driving Taiwanese popular opinion away from the mainland, resulting in a polarizing dynamic that will be extremely difficult to bridge (Chart 16). If China comes to believe that the Biden administration is pursuing a technological blockade just as rapidly and resolutely as the Trump administration, then it could conclude that Taiwan should be brought to heel sooner rather than later. Chart 15US Boosts Arms Sales To Taiwan 2021 Key Views: No Return To Normalcy 2021 Key Views: No Return To Normalcy Chart 16Taiwan Strait Risk Will Explode If Biden Seeks Tech Blockade 2021 Key Views: No Return To Normalcy 2021 Key Views: No Return To Normalcy Bottom Line: On a secular basis, China faces rising domestic economic risks and rising geopolitical risk. Given the rally in Chinese currency and equities in 2021, the downside risk is greater than the upside risk of any fleeting “diplomatic reset” with the United States. Emerging markets will benefit from China’s stimulus this year but will suffer from its policy tightening over time. Key View #2: The US “Pivot To Asia” Is Back On … And Runs Through Iran Most likely President-elect Biden will face gridlock at home. His domestic agenda largely frustrated, he will focus on foreign policy. Given his old age, he may also be a one-term president, which reinforces the need to focus on the achievable. He will aim to restore the Obama administration’s foreign policy, the chief features of which were the 2015 nuclear deal with Iran and the “Pivot to Asia.” The US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. The purpose of the Iranian deal was to limit Iran’s nuclear and regional ambitions, stabilize Iraq, create a semblance of regional balance, and thus enable American military withdrawal. The US could have simply abandoned the region, but Iran’s ensuing supremacy would have destabilized the region and quickly sucked the US back in. The newly energy independent US needed a durable deal. Then it could turn its attention to Asia Pacific, where it needed to rebuild its strategic influence in the face of a challenger that made Iran look like a joke (Chart 17). Chart 17The "Pivot To Asia" In A Nutshell The "Pivot To Asia" In A Nutshell The "Pivot To Asia" In A Nutshell It is possible for Biden to revive the Iranian deal, given that the other five members of the agreement have kept it afloat during the Trump years. Moreover, since it was always an executive deal that lacked Senate approval, Biden can rejoin unilaterally. However, the deal largely expires in 2025 – and the Trump administration accurately criticized the deal’s failure to contain Iran’s missile development and regional ambitions. Therefore Biden is proposing a renegotiation. This could lead to an even greater US-Iran engagement, but it is not clear that a robust new deal is feasible. Iran can also recommit to the old deal, having taken only incremental steps to violate the deal after the US’s departure – manifestly as leverage for future negotiations. Of course, the Iranians are not likely to give up their nuclear program in the long run, as nuclear weapons are the golden ticket to regime survival. Libya gave up its nuclear program and was toppled by NATO; North Korea developed its program into deliverable nuclear weapons and saw an increase in stature. Iran will continue to maintain a nuclear program that someday could be weaponized. Nevertheless, Tehran will be inclined to deal with Biden. President Hassan Rouhani is a lame duck, his legacy in tatters due to Trump, but his final act in office could be to salvage his legacy (and his faction’s hopes) by overseeing a return to the agreement prior to Iran’s presidential election in June. From Supreme Leader Ali Khamenei’s point of view, this would be beneficial. He also needs to secure his legacy, but as he tries to lay the groundwork for his power succession, Iran faces economic collapse, widespread social unrest, and a potentially explosive division between the Iranian Revolutionary Guard Corps and the more pragmatic political faction hoping for economic opening and reform. Iran needs a reprieve from US maximum pressure, so Khamenei will ultimately rejoin a limited nuclear agreement if it enables the regime to live to fight another day. In short, the US is limited by the need to pivot to Asia, while Iran is limited by the risk of regime failure. A deal should be agreed. But this is precisely why conflict could erupt in 2021. First, either in Trump’s final days in office or in the early days of the Biden administration, Israel could take military action – as it has likely done several times this year already – to set back the Iranian nuclear program and try to reinforce its own long-term security. Second, the Biden administration could decide to utilize the immense leverage that President Trump has bequeathed, resulting in a surprisingly confrontational stance that would push Iran to the brink. This is unlikely but it may be necessary due to the following point. Third, China and Russia could refuse to cooperate with the US, eliminating the prospect of a robust renegotiation of the deal, and forcing Biden to choose between accepting the shabby old deal or adopting something similar to Trump’s maximum pressure. China will probably cooperate; Russia is far less certain. Beijing knows that the US intention in Iran is to free up strategic resources to revive the US position in Asia, but it has offered limited cooperation on Iran and North Korea because it does not have an interest in their acquiring nuclear weapons and it needs to mitigate US hostility. Biden has a much stronger political mandate to confront China than he does to confront Iran. Assuming that the Israelis and Saudis can no more prevent Biden’s détente with Iran than they could Obama’s, the next question will be whether Biden effectively shifts from a restored Iranian deal to shoring up these allies and partners. He can possibly build on the Abraham Accords negotiated by the Trump administration smooth Israeli ties with the Arab world. The Middle East could conceivably see a semblance of balance. But not in 2021. The coming year will be the rocky transition phase in which the US-Iran détente succeeds or fails. Chart 18Oil Market Share War Preceded The Last US-Iran Deal Oil Market Share War Preceded The Last US-Iran Deal Oil Market Share War Preceded The Last US-Iran Deal Chart 19Still, Base Case Is For Rising Oil Prices Still, Base Case Is For Rising Oil Prices Still, Base Case Is For Rising Oil Prices Chart 20Biden Needs A Credible Threat Biden Needs A Credible Threat Biden Needs A Credible Threat The lead-up to the 2015 Iranian deal saw a huge collapse in global oil prices due to a market share war with Saudi Arabia, Russia, and the US triggered by US shale production and Iranian sanctions relief (Chart 18). This was despite rising global demand and the emergence of the Islamic State in Iraq. In 2021, global demand will also be reviving and Iraq, though not in the midst of full-scale war, is still unstable. OPEC 2.0 could buckle once again, though Moscow and Riyadh already confirmed this year that they understand the devastating consequences of not cooperating on production discipline. Our Commodity and Energy Strategy projects that the cartel will continue to operate, thus drawing down inventories (Chart 19). The US and/or Israel will have to establish a credible military threat to ensure that Iran is in check, and that will create fireworks and geopolitical risks first before it produces any Middle Eastern balance (Chart 20). Bottom Line: The US and Iran are both driven to revive the 2015 nuclear deal by strategic needs. Whether a better deal can be negotiated is less likely. The return to US-Iran détente is a source of geopolitical risk in 2021 though it should ultimately succeed. The lower risk of full-scale war is negative for global oil prices but OPEC 2.0 cartel behavior will be the key determiner. The cartel flirted with disaster in 2020 and will most likely hang together in 2021 for the sake of its members’ domestic stability. Key View #3: Europe Wins The US Election Chart 21Europe Won The US Election Europe Won The US Election Europe Won The US Election The European Union has not seen as monumental of a challenge from anti-establishment politicians over the past decade as have Britain and America. The establishment has doubled down on integration and solidarity. Now Europe is the big winner of the US election. Brussels and Berlin no longer face a tariff onslaught from Trump, a US-instigated global trade war, or as high of a risk of a major war in the Middle East. Biden’s first order of business will be reviving the trans-Atlantic alliance. Financial markets recognize that Europe is the winner and the euro has finally taken off against the dollar over the past year. European industrials and small caps outperformed during the trade war as well as COVID-19, a bullish signal (Chart 21). Reinforcing this trend is the fact that China is looking to court Europe and reduce momentum for an anti-China coalition. The center of gravity in Europe is Germany and 2021 faces a major transition in German politics. Chancellor Angela Merkel will step down at long last. Her Christian Democratic Union is favored to retain power after receiving a much-needed boost for its handling of this year’s crisis (Chart 22), although the risk of an upset and change of ruling party is much greater than consensus holds. Chart 22German Election Poses Political Risk, Not Investment Risk German Election Poses Political Risk, Not Investment Risk German Election Poses Political Risk, Not Investment Risk However, from an investment point of view, an upset in the German election is not very concerning. A left-wing coalition would take power that would merely reinforce the shift toward more dovish fiscal policy and European solidarity. Either way Germany will affirm what France affirmed in 2017, and what France is on track to reaffirm in 2022: that the European project is intact, despite Brexit, and evolving to address various challenges. The European project is intact, despite Brexit, and evolving to address various challenges. This is not to say that European elections pose no risk. In fact, there will be upsets as a result of this year’s crisis and the troubled aftermath. The countries with upcoming elections – or likely snap elections in the not-too-distant future, like Spain and Italy – show various levels of vulnerability to opposition parties (Chart 23). Chart 23Post-COVID EU Elections Will Not Be A Cakewalk Post-COVID EU Elections Will Not Be A Cakewalk Post-COVID EU Elections Will Not Be A Cakewalk Chart 24Immigration Tailwind For Populism Subsided Immigration Tailwind For Populism Subsided Immigration Tailwind For Populism Subsided The chief risks to Europe stem from fiscal normalization and instability abroad. Regime failures in the Middle East and Africa could send new waves of immigration, and high levels of immigration have fueled anti-establishment politics over the past decade. Yet this is not a problem at the moment (Chart 24). And even more so than the US, the EU has tightened border enforcement and control over immigration (Chart 25). This has enabled the political establishment to save itself from populist discontent. The other danger for Europe is posed by Russian instability. In general, Moscow is focusing on maintaining domestic stability amid the pandemic and ongoing economic austerity, as well as eventual succession concerns. However, Vladimir Putin’s low approval rating has often served as a warning that Russia might take an external action to achieve some limited national objective and instigate opposition from the West, which increases government support at home (Chart 26). Chart 25Europe Tough On Immigration Like US Europe Tough On Immigration Like US Europe Tough On Immigration Like US Chart 26Warning Sign That Russia May Lash Out Warning Sign That Russia May Lash Out Warning Sign That Russia May Lash Out Chart 27Russian Geopolitical Risk Premium Rising Russian Geopolitical Risk Premium Rising Russian Geopolitical Risk Premium Rising The US Democratic Party is also losing faith in engagement with Russia, so while it will need to negotiate on Iran and arms reduction, it will also seek to use sanctions and democracy promotion to undermine Putin’s regime and his leverage over Europe. The Russian geopolitical risk premium will rise, upsetting an otherwise fairly attractive opportunity relative to other emerging markets (Chart 27). Bottom Line: The European democracies have passed a major “stress test” over the past decade. The dollar will fall relative to the euro, in keeping with macro fundamentals, though it will not be supplanted as the leading reserve currency. Europe and the euro will benefit from the change of power in Washington, and a rise in European political risks will still be minor from a global point of view. Russia and the ruble will suffer from a persistent risk premium. Investment Takeaways As the “Year of the Rat” draws to a close, geopolitical risk and global policy uncertainty have come off the boil and safe haven assets have sold off. Yet geopolitical risk will remain elevated in 2021. The secular drivers of the dramatic rise in this risk since 2008 have not been resolved. To play the above themes and views, we are initiating the following strategic investment recommendations: Long developed market equities ex-US – US outperformance over DM has reached extreme levels and the global economic cycle and post-pandemic revival will favor DM-ex-US. Long emerging market equities ex-China – Emerging markets will benefit from a falling dollar and commodity recovery. China has seen the good news but now faces the headwinds outlined above. Long European industrials relative to global – European equities stand to benefit from the change of power in Washington, US-China decoupling, and the global recovery. Long Mexican industrials versus emerging markets – Mexico witnessed the rise of an American protectionist and a landslide election in favor of a populist left-winger. Now it has a new trade deal with the US and the US is diversifying from China, while its ruling party faces a check on its power via midterm elections, and, regardless, has maintained orthodox economic policy. Long Indian equities versus Chinese – Prime Minister Narendra Modi has a single party majority, four years on his political clock, and has recommitted to pro-productivity structural reforms. The nation is taking more concerted action in pursuit of economic development since strategic objectives in South Asia cannot be met without greater dynamism. The US, Japan, Australia, and other countries are looking to develop relations as they diversify from China.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Highlights The Beirut blast calls attention to instability in the Shia Crescent. A turbulent push for political change will now ensue in Lebanon. Hezbollah’s and Iran’s political capital in Lebanon will suffer significantly. Lebanon is a red herring, but Iraq is a Black Swan. It is at risk of social unrest contagion. Iran’s financial troubles are weighing on its ability to maintain its sphere of influence. It is adopting a strategy of measured sabotage and deterrence against US interests in Iraq. The double whammy of low oil prices and pandemic is weighing on Saudi Arabia’s finances. Nevertheless it is prioritizing a cooperative relationship with Iraq. Iran could stage a major attack or President Trump’s poor election prospects could force him to “wag the dog.” Massive excess oil capacity will mute the oil market impact of a supply shortfall in Iraq. However, the risk becomes more relevant as demand recovers and markets rebalance in the second half of the year. Stay long Brent crude oil and gold. Feature The August 4 explosion at the Port of Beirut was devastating. It killed more than 220, wounded over 6000, left 300,000 homeless, and damaged buildings as far away as 9km from the site of the explosion. The blast added insult to injury to the country’s already troubled finances. Estimates for the cost of repair range anywhere between $5 billion and $15 billion. Global investors can largely write off the incident as an idiosyncratic shock. Even though emigration is likely to pick up, Lebanon’s population is only a third of Syria’s prior to its civil war. Assuming that a third of Lebanese become displaced abroad – a generous assumption more suitable to Syrian-style civil war than Lebanon’s situation – about 2 million Lebanese will be displaced, half of which will make their way to Europe or elsewhere outside the Middle East. As long as an antagonistic Turkey upholds its agreement with the EU, a mass exodus from Lebanon does not risk an unmanageable migrant crisis for Europe (Chart 1). Political tensions will rise and potentially lead to a populist backlash, given Europe’s battered economy. But Lebanon alone is not enough. The risk is broader Middle Eastern instability, which is a credible risk. Chart 1Middle Eastern Instability Could Fuel European Populism Middle Eastern Instability Could Fuel European Populism Middle Eastern Instability Could Fuel European Populism Thus Lebanon in itself is a red herring, but it is a bellwether for further unrest in the Middle East in countries that are not red herrings (Map 1). Map 1Lebanon Is A Red Herring; Iraq And Saudi Arabia Are Relevant From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup A major conflict in Iraq is an underrated risk to global oil supply. The catastrophe calls attention to instability the Shia Crescent – a region in a tug of war between rival sectarian and geopolitical interests. Whereas the 2008 crisis led to the largely Sunni Arab states in the so-called Arab Spring, the 2020 crisis is piling pressure onto already unstable Shia states and regions: Iran, Iraq, Lebanon, Syria, and possibly eastern Saudi Arabia. Of particular significance is the fate of Iraq. Popular grievances are eerily similar to Lebanon’s. Baghdad is on shaky ground, yet the ramp up in US-Iran tensions going into the November US elections makes the threat of instability in Iraq more acute. As OPEC’s second ranked oil producer, a major conflict in Iraq poses an underrated risk to global oil supply. Supply losses are a tailwind to oil prices when market conditions are tight. However OPEC 2.0’s 8.3mm b/d of voluntary cuts means massive spare capacity is available globally to offset potential losses in Iraq, reducing the potential upside to oil prices. Nevertheless, this risk becomes more relevant as markets tighten on the back of a demand-side recovery, i.e. as balance is restored to the oil market and as excess spare capacity is eliminated. With oil markets likely rebalancing in 3Q20, unrest in Iraq poses an upside risk to our Commodity & Energy Strategy service’s expectation that 2H20 Brent prices will average $44/bbl and 2021 prices will average $65/bbl (Chart 2). Even though gold has already rallied 30% since mid-March, geopolitical risks including US-Iran tensions suggest any near-term selloff is a buying opportunity (Chart 3). The bullish gold narrative – geopolitical risks, falling dollar, and low real interest rates for the foreseeable future – remain intact even as the downturn gives way to a cyclical recovery. We continue to recommend gold on a strategic time horizon. Chart 2Oil Price Rally Remains Intact Oil Price Rally Remains Intact Oil Price Rally Remains Intact Chart 3Gold Is Due For A Breather Gold Is Due For A Breather Gold Is Due For A Breather Lebanon’s economic collapse highlights risks to other regional economies tied to the oil dependent Arab economies of the Persian Gulf. As the latter grapple with record low oil prices, production cuts, and the pandemic-induced recession, second-order effects will reverberate throughout the region, hitting economies such as Egypt and Jordan whose economic as well as political structures are intimately intertwined with Gulf Cooperation Council finances and policies. Lebanon’s Collapse Was Inevitable Lebanon was already going through an economic and financial meltdown before the explosion (Chart 4). Aside from the humanitarian loss, the economic impact is also profound. The country – highly dependent on imports of basic goods and suffering from food insecurity – must now contend with the loss of its main port and most of its grain reserves, destroyed in the explosion. As the dust settles, grief is morphing into anger on the streets. Regardless of whether the blast was due to happenstance or malice, the immediate cause was 2,750 tons of ammonium nitrate in storage for six years. The government was warned about the risks of the explosive chemicals at least four times this year – with the latest being on the day of the blast. Chart 4Beirut Port Explosion Accelerated Lebanon’s Collapse From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup Mass protests are already taking place, calling on the government to be held accountable for criminal negligence. A controversial petition to return Lebanon to French mandate has gained more than 60,000 signatures. Prime Minister Hassan Diab’s seven-month-old cabinet has resigned. (It was put in place last year amid an earlier bout of unrest.) Official incompetence and neglect are in fact the best-case explanations for the explosion. Many questions remain unanswered. For instance, what triggered the fire? Israel swiftly denied any connection and offered humanitarian aid, while Hezbollah’s leader Hassan Nasrallah claimed to know more about the Port of Haifa than about Beirut Port. Early parliamentary elections and the cabinet’s resignation will not appease the protesters. Photos of Nasrallah, President Aoun, Speaker of Parliament Nabih Berri, and former Prime Minister Saad Hariri were among those hung by protesters in gallows in Martyrs’ Square over the weekend. Berri and Gebran Bassil are known to be the source of the cabinet’s decision-making power.1 They have veto over all decisions, large and small. During the mass protests in October 2019, Nasrallah stated that Hezbollah has two red lines:     Aoun must finish his term, which expires in 2022;     No early elections will be held, i.e. the speaker of the house will not be changed. While early elections have now been promised, these red lines highlight that corruption runs deep in Lebanon and opposition groups face an uphill battle against the establishment. A turbulent push for political change will now ensue. Hezbollah’s and Iran’s political capital in Lebanon will suffer significantly. Another Israeli confrontation with Hezbollah is not the base case but it could occur. Bottom Line: Lebanon is a failed state. As with the Arab Spring, the question is whether popular anger will prove contagious and spread to more market-relevant neighboring countries. The rally in the Israeli shekel in trade weighted terms since mid-March has already started to fizzle and may be tested further as turmoil in Lebanon raises the risk of confrontation. Contagion? In order for a geopolitical event in the Middle East to warrant investors’ attention, it must affect at least two of the following factors : (1) global oil supply, (2) geography of existential significance to a regional power, or (3) sectarian conflict which could lead to contagion. In this context, Lebanon is a red herring, but Iraq is not – therefore investors should watch to see if anything causes destabilization in Iraq. A decline in Iranian funds will weaken Tehran’s sphere of influence. Like Lebanon, Iraq is dominated by a highly corrupt sectarian system that has been plundering the wealth; people are suffering from rising rates of unemployment; and the regime is in the crosshairs of competing foreign agendas (Chart 5). Chart 5Iraqis And Lebanese Suffer Similar Grievances From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup Iraq is in Iran’s sights because it aspires to establish a land bridge to the Mediterranean through a friendly “Shia Crescent” (Map 2). Iran’s modus operandi is to establish a presence in its neighbors’ domestic politics through Iran-backed factions. Map 2Iraq Essential To Iran’s Aspirational ‘Land Bridge’ To The Mediterranean From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup Given the current state of Iran’s economy, it is not far-fetched to envision a significant drop in the funding of its foreign proxies (Chart 6). Historically these funds have followed the ebbs and flows of oil prices. For instance, in 2009, when faced with declining oil prices and US sanctions Iran’s funds to Hezbollah were estimated to have fallen by 40%. This happened again in 2014-16 and is not too different from today. Thus Iraq is at risk of contagion. Iran’s financial troubles are weighing on its ability to maintain its sphere of influence. Syrian fighters have reported paychecks being slashed, Iranian projects in Syria have stalled, and Hezbollah employees report to have missed paychecks and lost other benefits. Tehran’s finances are essential for Hezbollah’s survival.2 Iran’s proxies in Iraq are facing a similar fate.3 Chart 6Iran Suffering Under "Maximum Pressure" Iran Suffering Under "Maximum Pressure" Iran Suffering Under "Maximum Pressure" Bottom Line: Iraq faces an uptick in social unrest due to the poor living conditions and possible contagion from Lebanon. Meanwhile, Iran-backed groups there face a decline in funds from Tehran, which will send them searching for replacement funds. If Lebanon falters the world can usually ignore it but if Iraq falters the world will have to take notice. Saudi Arabia Prioritizes Revenue Over Growth Beirut’s foreign policy stances in recent years have been seen as appeasing Iran at the expense of Gulf Arab states.4 This trend coincides with a decline in Gulf Cooperation Council financing to Lebanon. Now the collapse in oil prices and pandemic have weighed on Saudi Arabia’s budget, which still depends on the energy sector for most of its revenues despite efforts to diversify. State revenues were down 49% year-on-year in Q2 pulling the budget deficit down to $29 billion (Chart 7). Riyadh is reassessing its priorities. Opting for revenue at the expense of growth, Riyadh has tightened the screws on its citizens. The government has had to pare back some of the benefits Saudis have long been accustomed to. The value-added-tax rate tripled from 5% to 15%, and a bonus cost-of-living allowance of $266 for public sector employees ended. The kingdom also announced plans to reduce spending on major projects by $26 billion – including some of those associated with Crown Prince Mohammed bin Salman’s reform agenda, Vision 2030. Chart 7Saudi Arabia Under Pressure From Double Whammy Saudi Arabia Under Pressure From Double Whammy Saudi Arabia Under Pressure From Double Whammy Severe economic turmoil poses a risk to the Saudi social contract in which citizens pledge allegiance to the ruling class in exchange for financial and social guarantees. The risk now is that the fiscal challenges dent Saudi citizens’ pocketbooks and thus impact social and political stability. However, oil prices are recovering to levels consistent with the kingdom’s fiscal breakeven oil price next year. The global economic recovery will begin to support the kingdom’s economy in the second half of this year (Chart 8). This will ease pressure on the budget and hence households. Moreover the slowdown is likely to hit foreign workers hardest and thus hasten the Saudization process. Foreign workers are the lowest hanging fruit and will be the first to find themselves jobless. In that sense the crisis is expediting some of Riyadh’s long-term reform targets. That said, there is still some risk of internal instability or even a palace coup. Tehran could incite sectarian tensions in the kingdom’s Eastern Province where an estimated 30-50% of the population is believed to be Shia. This is relevant given that nearly all Saudi oil production is located there. Chart 8KSA Benefits From EM GDP Growth ... KSA Benefits From EM GDP Growth ... KSA Benefits From EM GDP Growth ... Regarding the possibility of a palace coup, Crown Prince Mohammed bin Salman has spent this year cracking down on potential dissidents. Former Crown Prince Mohammed bin Nayef and King Salman’s only surviving full-brother Prince Ahmed bin Abdulaziz – both influential and well-liked – were among those detained in March. The kingdom’s contradictory policies – reform through repression – may eventually culminate in an overt political crisis. Though such a crisis may not occur until the time of royal succession. These economic and political challenges may force Saudi Arabia to adopt an inward stance. Its foreign interventions to date have been costly and come with little benefit – judging by the war in Yemen. It is also possible that Saudi Arabia, which is already the third largest defense spender globally, will try to strengthen its position vis-à-vis Iran. Crown Prince Mohammed bin Salman has already stated that the kingdom will pursue a nuclear program if Iran develops a nuclear bomb. This is relevant in today’s context with Iran no longer complying with restrictions to its nuclear program (Table 1). Saudi Arabia, like Iran, claims its nuclear program is for peaceful purposes – in order to generate nuclear power as part of efforts to diversify its economy.5 Table 1Iran No Longer Complying With 2015 Nuclear Deal From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup Still, low oil prices tend to discourage petro states from engaging in conflict (Chart 9). Arab petro states may show restraint, at least until oil markets recover. Chart 9Low Oil Prices Discourage Petro States From Engaging In Conflict From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup Overall weakness in oil-producing economies will hurt various countries that rely on remittances (Chart 10). The downturn will also hurt countries dependent on remittances from petro states in the region such as Egypt and Jordan. Bottom Line: The collapse in oil prices is forcing Saudi Arabia to reconsider its priorities and is expediting some long-term reforms. For now, it is adopting a pro-revenue rather than a pro-growth stance. This is likely to result in a focus inward for the kingdom. The implication is that countries that are leveraged to the petro-economies of the Gulf for remittances, bilateral aid, and capital flows will take a hit. These include Lebanon, Egypt, and Jordan. Chart 10Egypt And Jordan Also Vulnerable To Petro State Weakness Egypt And Jordan Also Vulnerable To Petro State Weakness Egypt And Jordan Also Vulnerable To Petro State Weakness Iraq Is The Prize Not unlike Lebanon, Iraq’s political class has been suffering a legitimacy crisis since protests erupted there last October resulting in the resignation of then-Prime Minister Adel Abdul Mahdi. However unlike Lebanon, Iraq is a significant geography for global investors. It is a major OPEC producer – second only to Saudi Arabia – accounting for 16% of the cartel’s production last year. The Iraqi oil minister’s first foreign trip was to the Saudi capital. This is not surprising. Iraq not only seeks Saudi leniency in OPEC 2.0 cuts, but also needs financial assistance to develop a natural gas field that will allow it to reduce dependence on Iran. Saudi Arabia also hopes to reduce Iraq’s dependence on Iranian natural gas and coax it into its sphere of influence. When it comes to crude oil, the additional 1mm b/d of voluntary cuts in June announced unilaterally by Saudi Arabia beyond its agreed OPEC 2.0 commitments are also a sign of Saudi willingness to accommodate Iraq and its non-compliance  (Chart 11).6 Saudi Arabia does not want to see Iraq’s newly elected government failing on the back of budgetary strain. In fact, al-Kadhimi is an opportunity for the Saudis. Formerly the director the National Intelligence Service with warm ties to the US, he is a champion of Iraqi sovereignty. Even though Iraq is being forced to compensate for past overproduction of oil in August and September, it was cajoled by the promise of a $500 million “bridging” loan from Saudi Arabia, to be repaid when oil markets recover. While financial assistance shows the kingdom’s commitment to Iraq, more significantly it reflects Riyadh’s desperation to revive oil markets and bring prices closer to its fiscal breakeven oil price amid the still uncertain demand outlook. Chart 11Saudi Arabia Willing To Accommodate Iraq From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup Neither Saudi Arabia’s nor al-Kadhimi’s efforts are guaranteed to succeed in pulling Iraq out of Iran’s sphere. The prime minister received a rude awakening upon his arrest of 14 Kata’ib Hezbollah fighters in June on grounds of a plan to launch a rocket attack on US interest in Baghdad. They were swiftly released, and the case against them dropped. It is hard to curb Iranian influence. For its part, Iran stood behind al-Kadhimi’s nomination despite him being perceived as pro-Western. Tehran needed to avoid an anti-Iranian backlash on the streets of Baghdad if it had stood against him. Instead, Iran’s calculus was that it is in its best interest to swallow the pill and work with the new government at a time when Iraqi anger was targeted against US involvement rather than at Iranian interference. Prior to the US assassination of Qassem al-Suleimani and Abu Mahdi al-Muhandis on Iraqi soil, Iraqis were rebelling against Iran’s influence. That being said, Iran will maintain pressure on Iraq through continued attacks on US interests there (Table A1 in Appendix). This is also reflected in the July assassination of top Iraqi security expert Hisham al-Hashimi, who had previously advised the government on how to curb Iranian control. Iran was looking to make it to the US election in November without an escalation in tensions, hoping the US elections will result in a more dovish Democratic Party leadership averse to conflict with Iran. However, recent cyber-attacks on key Iranian infrastructure raise the likelihood that tensions will escalate ahead of the elections. The US is also threatening to maintain maximum sanctions even if the United Nations Security Council disagrees. As always, Iraq will find itself in the crossfire of any deterioration in relations. Bottom Line: Maintaining a cooperative relationship with Iraq aligns with both of Saudi Arabia’s interests there: limiting Iranian interference and supporting global oil markets through supply-side discipline. Iran will maintain pressure on Iraq’s new government through continued attacks on US interests. However, these attacks are supposed to fall short of killing US citizens and giving President Trump a reason to launch air strikes that could give him a patriotic boost in opinion polls. Nevertheless, tensions in the Gulf could escalate if Iran stages a major attack or if President Trump’s poor election prospects force him to “wag the dog.” In that case Iraqi oil supply would be disrupted. Investment Implications The Shia Crescent remains at heightened risk of instability on the back of Iran’s economic deterioration. Massive excess oil capacity will mute the oil market impact of a supply shortfall in Iraq. However, the risk becomes more relevant as demand recovers and markets rebalance in the second half of the year. Given that the Saudi loan will ensure Iraq’s commitment to compensatory production cuts in August and September, supply-side risks are a tailwind to oil prices in H2. The elevated risk of an escalation in US-Iran tensions also favors holding gold. President Trump’s polling has bottomed, yet he remains the underdog in the election – we maintain his odds of winning reelection are 35%. This raises the risk that he adopts a “war president” posture. Iran could become a target as the financial price of confronting Iran is negligible for Trump, whereas a major China confrontation could sink the stock market. The collapse in oil prices and pandemic have weighed on Saudi Arabia’s budget. It has adopted a revenue over growth posture. While this could be a risk to domestic stability, our base case is that it accelerates the kingdom’s long-term reforms. The oil market rout and economic downturn will hurt other countries in the region that are leveraged to Arab petro states – chiefly Egypt and Jordan. Investors should monitor risks to state stability in the coming years. Lebanon’s crisis will incentivize emigration, but given the relatively small size of its population, the major risk to Europe comes from any broader state failures and Middle Eastern instability rather than from Lebanon’s failure alone. If the Democratic Party wins the US election, as expected, then the US-Iran strategic détente will resume and Iran will get a lifeline. But the immediate transition will still be rocky given the Israeli and Saudi desire to exploit Iran’s extreme vulnerability and build leverage with Washington. The COVID-19 crisis heralds another round of Middle Eastern crisis, much as the 2008 crisis led to the Arab Spring. Stay strategically long Brent crude oil and gold. Also, in the wake of yesterday’s 15% pullback in silver, go strategically long silver (XAGUSD), which will continue benefiting from the same structural trends favoring gold but also outperform gold as the global economy recovers, given its greater industrial utility.     Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com       Appendix Table A1Iran Adopting Deterrence Strategy In Iraq From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup   Footnotes 1     Berri is of the Hezbollah-allied Amal Movement and has been parliamentary speaker since 1992, while Bassil is President Aoun’s son-in-law and president of the Free Patriotic Movement, which has the most seats in parliament. 2     Hezbollah gains legitimacy at home through its charity work that plugs the gap in services normally provided for by the government. 3    According to a commander of an Iran-backed paramilitary group in Iraq, Iran slashed its monthly funding to the top four militias by nearly half this year. Please see “Coronavirus and sanctions hit Iran’s support of proxies in Iraq,” Reuters, July 2, 2020. 4    Hezbollah has gained control over the foreign policy and Lebanon has recently taken stances that are seen as bowing to Iranian pressure. Lebanon did not attend a March 22, 2018 extraordinary Arab League meeting discussing violations committed by Iran. Prior to that, Beirut did not condemn Iranian attacks on a Saudi diplomatic mission in Tehran. 5    However an undisclosed facility for processing uranium ore in the northeast of the kingdom has recently appeared. 6    This is not unlike the US’s decision to extend sanction waivers by four months, allowing Baghdad to import Iranian energy in order to ensure that the new government of Prime Minister Mustafa al-Kadhimi can stand on its own and is not overly dependent on Iran.

Highlights The tech sector faces mounting domestic political and geopolitical risks. We fully expected stimulus hiccups but believe they will give way to large new fiscal support, given that COVID-19 is weighing on consumer confidence. Europe’s relative political stability is a good basis for the euro rally but any comeback in opinion polling by President Trump could give dollar bulls new life. DXY is approaching a critical threshold below which it would break down further. The US could take aggressive actions on Russia and Iran, but China and the Taiwan Strait remain the biggest geopolitical risk. Feature Near-term risks continue to mount against the equity rally, even as governments’ combined monetary and fiscal policies continue to support a cyclical economic rebound. Chart 1Tech Bubble Amid Tech War Tech Bubble Amid Tech War Tech Bubble Amid Tech War Testimony by the chief executives of Facebook, Apple, Amazon, and Alphabet to the US House of Representatives highlighted the major political risks facing the market leaders. There are three reasons not to dismiss these risks despite the theatrical nature of the hearings. First, the tech companies’ concentration of wealth would be conspicuous during any economic bust, but this bust has left pandemic-stricken consumers more reliant on their services. Second, acrimony is bipartisan – conservatives are enraged by the tendency of the tech companies to side with the Democratic Party in policing the range of acceptable political discourse, and they increasingly agree with liberals that the companies have excessive corporate power warranting anti-trust probes. Executive action is the immediate risk, but in the coming one-to-two years congressional majorities will also be mustered to tighten regulation. Third, technology is the root of the great power struggle between the US and China – a struggle that will not go away if Biden wins the election. Indeed Biden was part of the administration that launched the US’s “Pivot to Asia” and will have better success in galvanizing US diplomatic allies behind western alternatives to Chinese state-backed and military-linked tech companies. US tech companies struggle to outperform Chinese tech companies except during episodes of US tariffs, given the latter firms’ state-backed turn toward innovation and privileged capture of the Chinese domestic market (Chart 1). The US government cannot afford to break up these companies without weighing the strategic consequences for America’s international competitiveness. The attempt to coordinate a western pressure campaign against Huawei and other leading Chinese firms will continue over the long run as they are accused of stealing technology, circumventing UN sanctions, violating human rights, and compromising the national security of the democracies. China, for its part, will be forced to take counter-measures. US tech companies will be caught in the middle. Like the threat of executive regulation in the domestic sphere, the threat of state action in the international sphere is difficult to time. It could happen immediately, especially given that the US is having some success in galvanizing an alliance even under President Trump (see the UK decision to bar Huawei) and that President Trump’s falling election prospects remove the chief constraint on tough action against China (the administration will likely revoke Huawei’s general license on August 13 or closer to the election). Massive domestic economic stimulus empowers the US to impose a technological cordon and China to retaliate. Combining this headline risk to the tech sector with other indications that the equity rally is extended – the surge in gold prices, the fall in the 30-year/5-year Treasury slope – tells us that investors should be cautious about deploying fresh capital in the near term. Republicans Will Capitulate To New Stimulus Just as President Trump has ignored bad news on the coronavirus, financial markets have ignored bad news on the economy. Dismal Q2 GDP releases were fully expected – Germany shrank by 10.1% while the US shrank by 9.5% on a quarterly basis, 32.9% annualized. But the resurgence of the virus is threatening new government restrictions on economic activity. US initial unemployment claims have edged up over the past three weeks. US consumer confidence regarding future expectations plummeted from 106.1 in June to 91.5 in July, according to the Conference Board’s index. Chart 2Global Instability Will Follow Recession A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Setbacks in combating the virus will hurt consumers even assuming that governments lack the political will to enforce new lockdowns. The share of countries in recession has surged to levels not seen in 60 years (Chart 2). Financial markets can look past recessions, but the pandemic-driven recession will result in negative surprises and second-order effects that are unforeseen. Yes, fresh fiscal stimulus is coming, but this is more positive for the cyclical outlook than the tactical outlook. Stimulus “hiccups” could precipitate a near-term pullback – such a pullback may be necessary to force politicians to resolve disputes over the size and composition of new stimulus. This risk is immediate in the United States, where House Democrats, Senate Republicans, and the White House have hit an all-too-predictable impasse over the fifth round of stimulus. The bill under negotiation is likely to be President Trump’s last chance to score a legislative victory before the election and the last significant legislative economic relief until early 2021. The Senate Republicans have proposed a $1.1 trillion HEALS Act in response to the House Democrats’ $3.4 trillion HEROES Act, passed in mid-May. As we go to press, the federal unemployment insurance top-up of $600 per week is expiring, with a potential cost of 3% of GDP in fiscal tightening, as well as the moratorium on home evictions. Congress will have to rush through a stop-gap measure to extend these benefits if it cannot resolve the debate on the larger stimulus package. If Democrats and Republicans split the difference then we will get $2.5 trillion in stimulus, likely by August 10. Compromise on the larger package is easy in principle, as Table 1 shows. If the two sides split the difference between their proposals in a commonsense way, as shown in the fourth and fifth columns of Table 1, then the result will be a $2.5 trillion stimulus. This estimate fits with what we have published in the past and likely meets market expectations for the time being. Table 1Outline Of Fifth US COVID Stimulus Package (Estimate) A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Whether it is enough for the economy depends on how the virus develops and how governments respond once flu season picks up and combines with the coronavirus to pressure the health system this fall. A back-of-the-envelope estimate of the amount of spending necessary to keep the budget deficit from shrinking in the second half of the year comes much closer to the House Democrats’ $3.4 trillion bill (Table 2), which suggests that what appears to be a massive stimulus today could appear insufficient tomorrow. Nevertheless, $2.5 trillion is not exactly small. It would bring the US total to $5 trillion year-to-date, or 24% of GDP! Table 2Reducing The Budget Deficit On A Quarterly Basis Will Slow Economy A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) While a compromise bill should come quickly, the Republican Party is more divided over this round of stimulus than earlier this year. Chart 3US Personal Income Looks Good Compared To 2008-09 US Personal Income Looks Good Compared To 2008-09 US Personal Income Looks Good Compared To 2008-09 First, there is some complacency due to the fact that the economy is recovering, not collapsing as was the case back in March. Our US bond strategist, Ryan Swift, has shown that US personal income is much better off, thus far, than it was in the months following the 2008 financial crisis, even though the initial pre-transfer hit to incomes is larger (Chart 3). Second, the Republican Party is reacting to growing unease within its ranks over the yawning budget deficit, now the largest since World War II (Chart 4). Chart 4If Republicans React To Deficit Concerns They Cook Their Own Goose If Republicans React To Deficit Concerns They Cook Their Own Goose If Republicans React To Deficit Concerns They Cook Their Own Goose Chart 5Consumer Confidence Sends Warning Signal To Republicans A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) If Republicans are guided by complacency and fiscal hawks, they will cook their own goose. A failure to provide government support will cause a financial market selloff, will hurt consumer confidence, and will put the final nail in the coffin of their own chance of re-election as well as President Trump’s. Consumer confidence tracks fairly well with presidential approval rating and election outcomes. A further dip could disqualify Trump, whereas a last-minute boost due to stimulus and an economic surge could line him up for a comeback in the last lap (Chart 5). These constraints are obvious so we maintain our high conviction call that a bill will be passed, likely by August 10. But at these levels on the equity market, we simply have no confidence in the market gyrations leading up to or following the passage of the bill. Our conviction level is on the cyclical, 12-month horizon, in which case we expect US and global stimulus to operate and equities to rise. Bottom Line: Political and economic constraints will force Republicans to join Democrats and pass a new stimulus bill of about $2.5 trillion by around August 10. This is cyclically positive, but hiccups in getting it passed, negative surprises, and other risks tied to US politics discourage us from taking an overtly bullish stance over the next three months. Yes, US-China Tensions Are Still Relevant Chart 6Chinese Politburo"s Bark Worse Than Bite On Stimulus Chinese Politburo"s Bark Worse Than Bite On Stimulus Chinese Politburo"s Bark Worse Than Bite On Stimulus Financial markets have shrugged off US-China tensions this year for understandable reasons. The pandemic, recession, and stimulus have overweighed the ongoing US-China conflict. As we have argued, China is undertaking a sweeping fiscal and quasi-fiscal stimulus – despite lingering hawkish rhetoric – and the size is sufficient to assist in global economic recovery as well as domestic Chinese recovery. What the financial market overlooks is that China’s households and firms are still reluctant to spend (Chart 6). China’s Politburo's late July meetings on the economy are frequently important. Initial reports of this year’s meet-up reinforce the stimulus narrative. Hints of hawkishness here and there serve a political purpose in curbing market exuberance, both at home and in the US election context, but China will ultimately remain accommodative because it has already bumped up against its chief constraint of domestic stability. Note that this assessment also leaves space for market jitters in the near-term. The phase one trade deal remains intact as President Trump is counting on it to make the case for re-election while China is looking to avoid antagonizing a loose cannon president who still has a chance of re-election. As long as broad-based tariff rates do not rise, in keeping with Trump’s deal, financial markets can ignore the small fry. We maintain a 40% risk that Trump levels sweeping punitive measures; our base case is that he goes to the election arguing that he gets results through his deal-making while carrying a big stick. At the same time, our view that domestic stimulus removes the economic constraints on conflict, enabling the two countries to escalate tensions, has been vindicated in recent weeks. Chinese political risk continues on a general uptrend, based on market indicators. The market is also starting to price in the immense geopolitical risks embedded in Taiwan’s situation, which we have highlighted consistently since 2016. While North Korea remains on a diplomatic track, refraining from major military provocations, South Korean political risk is still elevated both for domestic and regional reasons (Chart 7). Chart 7China Political Risk Still Trending Upward China Political Risk Still Trending Upward China Political Risk Still Trending Upward The market is gradually pricing in a higher risk premium in the renminbi, Taiwanese dollar, and Korean won, and this pricing accords with our longstanding political assessment. The closure of the US and Chinese consulates in Houston and Chengdu is only the latest example of this escalating dynamic. While the US’s initial sanctions on China over Hong Kong were limited in economic impact, the longer term negative consequences continue to build. Hong Kong was the symbol of the Chinese Communist Party’s compatibility with western liberalism; the removal of Hong Kong’s autonomy strikes a permanent blow against this compatibility. China’s decision to go forward with the imposition of a national security law in Hong Kong – and now to bar pro-democratic candidates from the September 6 Legislative Council elections, which will probably be postponed anyway – has accelerated coalition-building among the western democracies. The UK is now clashing with China more openly, especially after blocking Huawei from its 5G system and welcoming Hong Kong political refugees. Australia and China have fought a miniature trade war of their own over China’s lack of transparency regarding COVID-19, and Canada is implicated in the Huawei affair. Even the EU has taken a more “realist” approach to China. Across the Taiwan Strait, political leaders are assisting fleeing Hong Kongers, crying out against Beijing’s expansion of control in its periphery, rallying support from informal allies in the US and West, and doubling down on their “Silicon Shield” (prowess in semiconductor production) as a source of protection. Intel Corporation’s decision to increase its dependency on TSMC for advanced microchips only heightens the centrality of this island and this company in the power struggle between the US and China. China cannot fulfill its global ambitions if the US succeeds in creating a technological cordon. Taiwan is the key to China’s breaking through that cordon. Therefore Taiwan is at heightened risk of economic or even military conflict. The base case is that Beijing will impose economic sanctions first, to undermine Taiwanese leadership. The uncertainty over the US’s willingness to defend Taiwan is still elevated, even if the US is gradually signaling a higher level of commitment. This uncertainty makes strategic miscalculations more likely than otherwise. But Taiwan’s extreme economic dependence on the mainland gives Beijing a lever to pursue its interests and at present that is the most important factor in keeping war risk contained. By the same token, Taiwanese economic and political diversification increases that risk. A “fourth Taiwan Strait crisis” that involves trade war and sanctions is our base case, but war cannot be ruled out, and any war would be a major war. Thus investors can safely ignore Tik-Tok, Hong Kong LegCo elections, and accusations of human rights violations in Xinjiang. But they cannot ignore concrete deterioration in the Taiwan Strait. Or, for that matter, the South and East China Seas, which are not about fishing and offshore drilling but about China’s strategic depth and positioning around Taiwan. Taiwan is at heightened risk of economic or military conflict. The latest developments have seen the CNY-USD exchange rate roll over after a period of appreciation associated with bilateral deal-keeping (Chart 8). Depreciation makes it more likely that President Trump will take punitive actions, but these will still be consistent with maintaining the phase one deal unless his re-election bid completely collapses, rendering him a lame duck and removing his constraints on more economically significant confrontation. We are perilously close to such an outcome, which is why Trump’s approval rating and head-to-head polling against Joe Biden must be monitored closely. If his budding rebound is dashed, then all bets are off with regard to China and Asian power politics. Chart 8A Warning Of Further US-China Escalation A Warning Of Further US-China Escalation A Warning Of Further US-China Escalation Bottom Line: China’s stimulus, like the US stimulus, is a reason for cyclical optimism regarding risk assets. The phase one trade deal with President Trump is less certain – there is a 40% chance it collapses as stimulus and/or Trump’s political woes remove constraints on conflict. Hong Kong is a red herring except with regard to coalition-building between the US and Europe; the Taiwan Strait is the real geopolitical risk. Maritime conflicts relate to Taiwan and are also market-relevant. Europe, Russia, And Oil Risks Europe has proved a geopolitical opportunity rather than a risk, as we have contended. The passage of joint debt issuance in keeping with the seven-year budget reinforces the point. The Dutch, facing an election early next year, held up the negotiations, but ultimately relented as expected. Emmanuel Macron, who convinced German Chancellor Angela Merkel to embrace this major compromise for European solidarity, is seeing his support bounce in opinion polls at home. He is being rewarded for taking a leadership position in favor of European integration as well as for overseeing a domestic economic rebound. His setback in local elections is overstated as a political risk given that the parties that benefited do not pose a risk to European integration, and will ally with him in 2022 against any populist or anti-establishment challenger. We still refrain from reinitiating our long EUR-USD trade, however, given the immediate risks from the US election cycle (Chart 9). We will reevaluate if Trump’s odds of victory fall further. A Biden victory is very favorable for the euro in our view. Chart 9EUR-USD Gets Boost From EU Solidarity EUR-USD Gets Boost From EU Solidarity EUR-USD Gets Boost From EU Solidarity We are bullish on pound sterling because even a delay or otherwise sub-optimal outcome to trade talks is mostly priced in at current levels (Charts 10A and 10B). Prime Minister Boris Johnson has the raw ability to walk away without a deal, in the context of strong domestic stimulus, but the long-term economic consequences could condemn him to a single term in office. Compromise is better and in both parties’ interests. Chart 10APound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Chart 10BPound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Pound Sterling A Buy Over Long Run Two other risks are worth a mention in this month’s GeoRisk Update: Chart 11Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: GeoRisk Indicator Russian Bonds May Face Sanctions Russia: In recent reports we have maintained that Russian geopolitical risk is understated by markets. Domestic unrest is rising, the Trump administration could impose penalties over Nordstream 2 or other issues to head off criticism on the campaign trail, and a Biden administration would be outright confrontational toward Putin’s regime. Moscow may intervene in the US elections or conduct larger cyber attacks. US sanctions could ultimately target trading of local currency Russian government bonds, which so far have been spared (Chart 11). Iran: The jury is still out on whether the recent series of mysterious explosions affecting critical infrastructure in Iran are evidence of a clandestine campaign of sabotage (Table 3). The nature of the incidents leaves some room for accident and coincidence.1 But the inclusion of military and nuclear sites in the list leads us to believe that some degree of “wag the dog” is going on. The prime suspect would be Israel and/or the United States during the window of opportunity afforded by the Trump administration, which looks to be closing over the next six months. Trump likely has a high tolerance for conflict with Iran ahead of the election. Even though Americans are war-weary, they will rally to the president’s defense if Iran is seen as the instigator, as opinion polls showed they did in September 2019 and January of this year. Iran is avoiding goading Trump so far but if it suffers too great of damage from sabotage then it may be forced to react. The dynamic is unstable and hence an oil price spike cannot be ruled out. Table 3Wag The Dog Scenario Playing Out In Iran A Tech Bubble Amid A Tech War (GeoRisk Update) A Tech Bubble Amid A Tech War (GeoRisk Update) Chart 12Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil Supply Risks Stem From Iran/Iraq, But COVID Threat To Demand Persists Oil markets have the capacity and the large inventories necessary to absorb supply disruptions caused by a single Iranian incident (Chart 12). Only a chain reaction or major conflict would add to upward pressure. This would also require global demand to stay firm. The threat from COVID-19 suggests that volatility is the only thing one can count on in the near-term. Over the long run we remain bullish crude oil due to the unfettered commitment by world governments to reflation. Bottom Line: The euro rally is fundamentally supported but faces exogenous risks in the short run. We would steer clear of Russian currency and local currency bonds over the US election campaign and aftermath, particularly if Trump’s polling upturn becomes a dead cat bounce. Iran is a “gray swan” geopolitical risk, hiding in plain sight, but its impact on oil markets will be limited unless a major war occurs. Investment Implications The US dollar is at a critical juncture. Our Foreign Exchange Strategist Chester Ntonifor argues that if the DXY index breaks beneath the 93-94 then the greenback has entered a structural bear market. The most recent close was 93.45 and it has hovered below 94 since Monday. Failure to pass US stimulus quickly could result in a dollar bounce along with other safe havens. Over the short run, investors should be prepared for this and other negative surprises relating to the US election and significant geopolitical risks, especially involving China, the tech war, and the Taiwan Strait. Over the long run, investors should position for more fiscal support to combine with ultra-easy monetary policy for as far as the eye can see. The Federal Reserve is not even “thinking about thinking about raising rates.” This combination ultimately entails rising commodity prices, a weakening dollar, and international equity outperformance relative to both US equities and government bonds.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Raz Zimmt, "When it comes to Iran, not everything that goes boom in the night is sabotage," Atlantic Council, July 30, 2020. Section II: Appendix : GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights The bull market in US-Iran tensions was never resolved, and now a series of suspicious explosions in Iran raises the possibility that tensions will re-escalate. Iran’s interest lies in waiting out Trump so that a Democratic victory in the US election can restore the US-Iran strategic détente agreed in 2015. However, both the Trump administration and US ally Israel are applying “maximum pressure” on Iran and could go on the offensive at a time when Trump’s odds of re-election are collapsing. Israel cannot engage in a full-fledged war with Iran alone but it would have American backing for pressure tactics through the duration of Trump’s term. A “wag the dog” scenario is not inconceivable because the US and Israel have long-term national security interests at stake while Iran is on the verge of economic collapse. Investors should prepare for near-term global equity volatility and safe-haven demand for a number of reasons but a major escalation in Iran would add to the list. Stay long Brent crude oil. Feature Since May 2018 we have argued that US-Iran tensions will remain market-relevant. We downgraded the odds of US air strikes from 40% in June 2019 to 20% in January of this year after Iran’s lackluster retaliation to the US assassination of its top military commander. Now things are heating up again due to a series of extremely suspicious explosions in Iran that may or may not be linked to Israel and the United States. The COVID-19 pandemic, oil price rout, and global recession have reinforced this bull market in US-Iran tensions by weakening and destabilizing the entire Shia Crescent, from Lebanon to Iran. They have also pushed President Trump dangerously close to “lame duck” status, which reduces the constraints on conflict with Iran for the remainder of his term. In this report we update our Iran view by looking at whether the Trump administration or Israel could attempt to “wag the dog,” i.e. provoke a conflict with Iran to boost Trump’s re-election odds or achieve some long-term strategic objectives while Trump is still in power. We have long held the view that Iran poses a market-relevant geopolitical risk and now the mysterious attacks in Iran suggest it could be materializing. Nothing is confirmed, but it is wise for investors to monitor these developments in case they escalate. Geopolitical incidents often cause buying opportunities but they can create substantial equity drawdowns first. Cyber-Rattling In The Middle East A string of mysterious explosions and fires at military and economic facilities have rocked Iran in recent days (Table 1). Table 1Iran Hit By A String Of Mysterious Attacks Cyber-Rattling In The Middle East Cyber-Rattling In The Middle East The most significant of these incidents is the July 2 explosion at the Natanz nuclear facility – Iran’s main uranium enrichment facility, which houses a new centrifuge assembly center.1 The fire resulted in a significant setback to the development and production of advanced IR-6 and IR-8 centrifuges used to enrich uranium – by up to two years. Iranian officials initially downplayed the incidents as unsuspicious accidents. However the Natanz explosion was too significant to cast off. Iran’s state-run news agency IRNA declared that the Natanz incident may be the work of foreign countries, “especially the Zionist regime [Israel] and the US,” and vowed Iranian retaliation if sabotage is proven to be the case. Similarly, the New York Times reported that an anonymous Middle Eastern intelligence official – rumored to be Mossad chief Yossi Cohen – called the incident the work of Israel.2 Israel’s response to these allegations has been oblique, but the accusation is not far-fetched. Israel has a successful history of halting the advancement of nuclear programs in the region. Mossad’s Operation Opera destroyed Iraq’s only known nuclear facility in 1981, and Operation Outside the Box bombed a suspected nuclear reactor at the Kibar site in Syria in 2007. Israeli intelligence has also previously been accused of targeting Iran’s missile program – with the assassination of four Iranian nuclear scientists between 2010 and 2012. Israel is also believed to be involved, with the US, in Operation Olympic Games, the Stuxnet cyber attacks that stunted Iran’s uranium enrichment program circa 2010. Iran’s ballistic missile program and alleged nuclear weapons ambitions remain Israel’s greatest long-term strategic threat in the region. More recently, Iran and Israel have been locked in a series of cyber-attacks. Israel claims to have foiled an Iranian attack on its water facilities in April which attempted a cyber break on water control systems. A May 9 cyberattack on Iranian shipping hub Shahid Rajaae – through which half of Iran’s maritime trade traverses – is seen as Israeli retaliation. Most recently, Israel’s Mossad revealed that it thwarted Iranian attempts to attack Israeli diplomatic missions in Europe. These attacks come as the US increases pressure on UN Security Council members to support the indefinite extension of the UN arms embargo against Iran, which is scheduled to expire on October 18.3 But other signatories to the 2015 Iranian nuclear agreement – China, Russia, Germany, Britain, and France – argue that since the US withdrew from the Joint Comprehensive Plan of Action (JCPA), its threat to invoke a “snapback” provision of the deal to reimpose former UN sanctions on Iran is not legally valid. The other JCPA signatories remain committed to the deal, arguing for its necessity in order to continue IAEA inspections that prevent Iran from developing nuclear weapons. They are biding their time to see if Trump is re-elected before deciding anything. Iran has moved further from the JCPA’s requirements since announcing, on January 5, 2020, that it will no longer comply with restrictions to its nuclear program (Table 2). The risk is that unless controlled, this will eventually significantly reduce Iran’s “breakout time” – the time required to acquire enough fissile material for one bomb. The nuclear deal aimed to maintain at least a one-year breakout time, and this is generally understood to be the US’s “red line.” Table 2Iran No Longer Complying With 2015 Nuclear Deal Cyber-Rattling In The Middle East Cyber-Rattling In The Middle East Despite some non-compliance, Iran is still permitting IAEA inspectors to monitor and verify its nuclear activities. Yet the IAEA Board of Governors passed a resolution, requesting Iran’s cooperation in the investigation into possible undeclared nuclear materials and sites.4 Chart 1Iran's Sphere Of Influence In Collapse Iran's Sphere Of Influence In Collapse Iran's Sphere Of Influence In Collapse As tensions with US and Israel escalate, Tehran has been keen to highlight its military capabilities. Revolutionary Guard Navy Commander Rear Admiral Alireza revealed the existence of onshore and offshore underground missile sites along the Persian Gulf and Gulf of Oman, holding advanced long-range missiles and new weapons, more capable of launching attacks against enemies. Escalating tensions raise the likelihood of retaliation as Iran reconsiders its “strategic patience” policy.5 Tehran had been playing the waiting game, especially since Trump’s decision to assassinate Quds Force chief Qassem Soleimani in January. Iran has an interest in avoiding confrontation in the months ahead of the US election on November 3. Iran’s attack on Saudi Arabia in September 2019 led to a boost in Trump’s approval rating. A major conflict today would cause a patriotic rally around the president at a time when he is beset with negative opinion over the coronavirus response and poor race relations. Iran has an interest in Joe Biden winning the presidency in November. Biden would likely restore the US-Iran deal, which would remove sanctions and allow Iran to open its economy. However, neither the Trump administration nor the Israeli government share that interest. The latest attacks raise the possibility that the US and/or Israel are going on the offensive. This could force Iran to retaliate. Iranian moderates are already suffering domestically. Iran’s hardline parliamentarians were never on board with the nuclear deal and criticized President Hassan Rouhani when President Trump pulled out of it in May 2018. This past weekend Foreign Minister Javad Zarif, an ally of Rouhani whose reputation also rests on the deal, was heckled as he addressed the parliament. As of February, parliament is mostly comprised of hardliners.6 Iran is also on shaky ground in the Shia Crescent. Lebanon and Iraq – the two countries most entrenched in Iran’s sphere of influence – have been experiencing civil unrest. Protesters in both countries initially took to the streets last fall in demonstration of anger over government corruption, the sectarian based political system, and poor economic conditions. The pandemic and recession have breathed new life into these movements. The Lebanese pound collapsed on the parallel market since October, and some groups have called for the disarmament of Iran-backed Hezbollah (Chart 1). Meanwhile a June cabinet decision in Iraq to cap the amount and number of state salaries and pension payments collected – in attempt to buttress the country’s ailing finances – fueled outrage. Iraq’s Prime Minister Mustafa al-Kadhimi is also in a tussle with Iran-backed paramilitary forces as he attempts to curb their influence and bring them under state control.7 Chart 2Iran Has Little To Lose Iran Has Little To Lose Iran Has Little To Lose Thus a timid stance by Iran in face of foreign attacks will not go down well. Instead, with oil production having collapsed, the economy in shambles, and its sphere of influence in turmoil, Tehran has little to lose in protecting what is left of its nuclear program and deterring American or Israeli aggression (Chart 2). With few options left, Iran is likely to move further away from its “strategic patience” in response to the uptick in “maximum pressure.” Bottom Line: Tensions are escalating between Tehran and Washington/Tel Aviv. Cyber attacks are likely to increase in the lead up to the expiration of the arms embargo on October 18 and US elections this fall. Iran may be forced to abandon its policy of “strategic patience” if its foes sabotage its nuclear capabilities. Expect the conflict to spillover to Iran’s proxies in the region – Iraq, Lebanon, and Syria. So What? Massive monetary and fiscal stimulus and continued commitment from OPEC 2.0 on the supply side will keep oil prices moving higher this year. Barring a second COVID-19 wave, our Commodity & Energy Strategists expect oil markets to rebalance beginning in 3Q2020, with Brent prices averaging $40/bbl this year and $65/bbl in 2021 (Chart 3). We remain long Brent which is up 70.55% since initiation in March.   The escalation in tensions in the Persian Gulf is an upside risk to this assessment. That said, with major oil producers now operating significantly below capacity in compliance with the OPEC 2.0 production agreement, the net impact on oil prices will likely be muted and short-lived. Production can be increased to fill gaps. As demonstrated by the recent acts of sabotage in Iran and Israel, the increase in geopolitical tensions globally will manifest in cyberattacks, supporting cyber stocks. Our strategically long ISE Cyber Security Index relative to the S&P500 Info Tech sector trade is up 2% since initiation in April (Chart 4). Chart 3Oil Markets On The Way To Recovery Oil Markets On The Way To Recovery Oil Markets On The Way To Recovery Chart 4Buy Cybersecurity Stocks Buy Cybersecurity Stocks Buy Cybersecurity Stocks Finally, we should note that Iran is not the only geopolitical risk that could explode amid the US election cycle. China is the greater risk. But President Trump faces fewer financial and economic constraints in a conflict with Iran than he does in a conflict with China. A conflict with Iran could change the game ahead of the election at a time when Trump is beset with the coronavirus and social unrest. His opinion polling would benefit from a rally around the flag, as it did in September 2019. The risk for Trump is that this bump may not last long. Americans are less concerned about Iran than China and Russia and Trump himself has benefited from American weariness of Middle Eastern wars. All we can say for certain is that the US election is of critical strategic importance to several major and minor powers. Trump’s allies and enemies know that the next six months offer their best chance to take actions that either affect the election or exploit the current alignment of US foreign policy relative to a Democratic Party alignment. While China probably prefers Biden, it can deal with either ruling party. Whereas Israel has a unique opportunity to advance its objectives under Trump and Iran has a clear imperative to remove Trump from office.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The damaged building was constructed in 2013 to be a site for the development of advanced centrifuges. Work there was stopped in 2015 as per requirements of the JCPA, but was restarted when the US withdrew from the deal in 2018. 2 Meanwhile a group of dissidents from within Iran’s military and security forces, calling themselves Homeland Cheetahs, claimed responsibility for the Natanz attack. However, it is possible that the claim was made with the intention to mislead. Please see Jiyar Gol, "Iran blasts: What is behind mysterious fires at key sites?" BBC News, July 6, 2020. 3 The draft US resolution bans Iran from supplying, selling, or transferring weapons after the October 18 expiration of the embargo. It bans UN member states from purchasing Iranian arms or permitting citizens to train or provide financial resources or assistance to Iran without Security Council approval. 4 This resolution, introduced by France, Germany, and the UK, refers to an undeclared uranium metal disc, potential fuel-cycle-related activities such as uranium processing and conversion, and suspected storage of nuclear material. Iran’s parliament responded by issuing a statement signed by 240 out of the 290 members which called the resolution excessive and requested that Iran halt voluntary implementation of additional protocol and change inspections 5 Iran’s state-run news agency IRNA published the following commentary in response to the Natanz explosion: "The Islamic Republic of Iran has so far tried to prevent intensifying crises and the formation of unpredictable conditions and situation … the crossing of red lines of the Islamic Republic of Iran by hostile countries, especially the Zionist regime and the US, means that strategy … should be revised." 6 In addition, 120 out of the 290 parliamentarians signed and delivered a motion to the presiding board of the assembly, requesting that Rouhani be summoned for questioning. The presiding board may not issue the summons and is unlikely to result in Rouhani’s impeachment as Khamenei has requested unity amid high foreign tensions. It nonetheless reflects Rouhani’s weakened position ahead of next year’s elections. 7 Hisham al-Hashemi, an advisor to Prime Minister Mustafa al-Kadhimi who had advised the government on reducing the influence of Iran-backed militias in Iraq, was killed on July 6, days after receiving threatening telephone calls from militias.

Highlights The collapse in oil prices supercharges the geopolitical risks stemming from the global pandemic and recession. Low oil prices should discourage petro-states from waging war, but Iran may be an important exception. Russian instability is one of the most important secular geopolitical consequences of this year’s crisis. President Trump’s precarious status this election year raises the possibility of provocations or reactions on his part. Europe faces instability on its eastern and southern borders in coming years, but integration rather than breakup is the response. Over a strategic time frame, go long AAA-rated municipal bonds, cyber security stocks, infrastructure stocks, and China reflation plays. Feature Chart 1Someone Took Physical Delivery! Someone Took Physical Delivery! Someone Took Physical Delivery! Oil markets melted this week. Oil volatility measured by the Crude Oil ETF Volatility Index surpassed 300% as WTI futures for May 2020 delivery fell into a black hole, bottoming at -$40.40 per barrel (Chart 1). Our own long Brent trade, initiated on 27 March 2020 at $24.92 per barrel, is down 17.9% as we go to press. Strategically we are putting cash to work acquiring risk assets and we remain long Brent. The forward curve implies that prices will rise to $35 and $31 per barrel for Brent and WTI by April 2021. We initiated this trade because we assessed that: The US and EU would gradually reopen their economies (they are doing so). Oil production would be destroyed (more on this below). Russia and Saudi Arabia would agree to production cuts (they did). Monetary and fiscal stimulus would take effect (the tsunami of stimulus is still growing). Global demand would start the long process of recovery (no turn yet, unknown timing). On a shorter time horizon, we are defensively positioned but things are starting to look up on COVID-19 – New York Governor Andrew Cuomo has released results of a study showing that 15% of New Yorkers have antibodies, implying a death rate of only 0.5%. The US dollar and global policy uncertainty may be peaking as we go to press (Chart 2). However, second-order effects still pose risks that keep us wary. Chart 2Dollar And Policy Uncertainty Roaring Dollar And Policy Uncertainty Roaring Dollar And Policy Uncertainty Roaring Geopolitics is the “next shoe to drop” – and it is already dropping. A host of risks are flying under the radar as the world focuses on the virus. Taken alone, not every risk warrants a risk-off positioning. But combined, these risks reveal extreme global uncertainty which does warrant a risk-off position in the near term. This week’s threats between the US and Iran, in particular, show that the political and geopolitical fallout from COVID-19 begins now, it will not “wait” until the pandemic crisis subsides. In this report we focus on the risks from oil-producing economies, but we first we update our fiscal stimulus tally. Stimulus Tsunami Chart 3Stimulus Tsunami Still Building Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Policymakers responded to COVID-19 by doing “whatever it takes” to prop up demand (Chart 3). Please see the Appendix for our latest update of our global fiscal stimulus table. The latest fiscal and monetary measures show that countries are still adding stimulus – i.e. there is not yet a substantial shift away from providing stimulus: China has increased its measures to a total of 10% of GDP for the year so far, according to BCA Research China Investment Strategy. This includes a general increase in credit growth, a big increase in government spending (2% of GDP), a bank re-lending scheme (1.5% of GDP), an increase in general purpose local government bonds (2% of GDP), plus special purpose bonds (4% of GDP) and other measures. On the political front, the government has rolled out a new slogan, “the Six Stabilities and the Six Guarantees,” and President Xi Jinping said on an inspection tour to Shaanxi that the state will increase investments to ensure that employment is stabilized. This is the maximum reflationary signal from China that we have long expected. The US agreed to a $484 billion “fourth phase” stimulus package, bringing its total to 13% of GDP. President Trump is already pushing for a fifth phase involving bailouts of state and local governments and infrastructure, which we fully expect to take place even if it takes a bit longer than packages that have been passed so far this year. German Chancellor Angela Merkel has opened the way for the EU to issue Eurobonds, in keeping with our expectations. Germany is spending 12% of GDP in total – which can go much higher depending on how many corporate loans are tapped – while Italy is increasing its stimulus to 3% of GDP. As deficits rise to astronomical sums, and economies gradually reopen, will legislatures balk at passing new stimulus? Yes, eventually. Financial markets will have to put more pressure on policymakers to get them to pass more stimulus. This can lead to volatility. In the US the pandemic is coinciding with “peak polarization” over the 2020 election. Lack of coordination between federal and state governments is increasing uncertainty. Currently disputes center on the timing of economic reopening and the provisioning bailout funds for state and local governments. Senate Majority Leader Mitch McConnell is threatening to deny bailouts for American states with large, unfunded public pension benefits (Chart 4A). He is insisting that the Senate “push the pause button” on coronavirus relief measures; specifically that nothing new be passed until the Senate convenes in Washington on May 4. He may then lead a charge in the Republican Senate to try to require structural reforms from states in exchange for bailouts. Estimates of the total state budget shortfall due to the crisis stand at $500 billion over the next three years, which is almost certainly an understatement (Chart 4B). Chart 4AUS States Have Unfunded Liabilities Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 4BUS States Face Funding Shortfalls Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Could a local government or state declare bankruptcy? Not anytime soon. Technically there is no provision for states to declare bankruptcy. A constitutional challenge to such a declaration would go to the Supreme Court. One commonly cited precedent, Arkansas in 1933, ended up with a federal bailout.1 A unilateral declaration could conceivably become a kind of “Lehman moment” in the public sector, but state governors will ask their legislatures to provide more fiscal flexibility and will seek bailouts from the federal government first. The Federal Reserve is already committed to buying state and local bonds and can expand these purchases to keep interest rates low. Washington would be forced to provide at least short-term funding if state workers started getting fired in the midst of the crisis because of straightened state finances – another $500 billion for the states is entirely feasible in today’s climate. Constraints will prevail on the GOP Senate to provide state bailout funds. This conflict over state finances could have a negative impact on US equities in the near term, but it is largely a bluff – McConnell will lose this battle. The fundamental dynamic in Washington is that of populism combined with a pandemic that neutralizes arguments about moral hazard. Big-spending Democrats in the House of Representatives control the purse strings while big-spending President Trump faces an election. Senate Republicans are cornered on all sides – and their fate is tied to the President’s – so they will eventually capitulate. Bottom Line: The global fiscal and monetary policy tsunami is still building. But there are plenty of chances for near-term debacles. Over the long run the gargantuan stimulus is the signal while the rest is noise. Over the long run we expect the reflationary efforts to prevail and therefore we are long Treasury inflation-protected securities and US investment grade corporate bonds. We recommend going strategically long AAA-rated US municipal bonds relative to 10-year Treasuries. Petro-State Meltdown Since March we have highlighted that the collapse in oil prices will destabilize oil producers above and beyond the pandemic and recession. This leaves Iran in danger, but even threatens the stability of great powers like Russia. Normally there is something of a correlation between the global oil price and the willingness of petro-states to engage in war (Chart 5). Chart 5Petro-States Cease Fire When Oil Drops Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) When prices fall, revenues dry up and governments have to prioritize domestic stability. This tends to defer inter-state conflict. We can loosely corroborate this evidence by showing that global defense stocks tend to be correlated with oil prices (Chart 6). Global growth is the obvious driver of both of these indicators. But states whose budgets are closely tied to the commodity cycle are the most likely to cut defense spending. Chart 6Global Growth Drives Oil And Guns Global Growth Drives Oil And Guns Global Growth Drives Oil And Guns Russia is case in point. Revenues from Rostec, one of Russia’s largest arms firms, rise and fall with the Urals crude oil price (Chart 7). The Russians launch into foreign adventures during oil bull markets, when state coffers are flush with cash. They have an uncanny way of calling the top of the cycle by invading countries (Chart 8). Chart 7Oil Correlates With Russian Arms Sales Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 8Russian Invasions Call Peak In Oil Bull Markets Russian Invasions Call Peak In Oil Bull Markets Russian Invasions Call Peak In Oil Bull Markets Chart 9Turkish Political Risk On The Rise Turkish Political Risk On The Rise Turkish Political Risk On The Rise In the current oil rout, there is already some evidence of hostilities dying down in this way. For instance, after years of dogged fighting in Yemen, Saudi Arabia is finally declaring a ceasefire there. Turkey, which benefits from low oil prices, has temporarily gotten the upper hand in Libya vis-à-vis Khalifa Haftar and the Libyan National Army, which depends on oil revenues and backing from petro-states like Russia and the GCC. Of course, Turkey’s deepening involvement in foreign conflicts is evidence of populism at home so it does not bode well for the lira or Turkish assets (Chart 9). But it does highlight the impact of weak oil on petro-players such as Haftar. However, the tendency of petro-states to cease fire amid low prices is merely a rule of thumb, not a law of physics. Past performance is no guarantee of future results. Already we are seeing that Iran is defying this dynamic by engaging in provocative saber-rattling with the United States. Iran And Iraq The US and Iran are rattling sabers again. One would think that Iran, deep in the throes of recession and COVID-19, would eschew a conflict with the US at a time when a vulnerable and anti-Iranian US president is only seven months away from an election. Chart 10US Maximum Pressure On Iran US Maximum Pressure On Iran US Maximum Pressure On Iran Iran has survived nearly two years of “maximum pressure” from President Trump (Chart 10), and previous US sanction regimes, and has a fair chance of seeing the Democrats retake Washington. The Democrats would restart negotiations to restore the 2015 nuclear deal, which was favorable to Iran. Therefore risking air strikes from President Trump is counterproductive and potentially disastrous. Yet this logic only holds if the Iranian regime is capable of sustaining the pain of a pandemic and global recession on top of its already collapsing economy. Iran’s ability to circumvent sanctions to acquire funds depended on the economy outside of Iran doing fine. Now Iran’s illicit funds are drying up. This could lead to a pullback in funding for militant proxies across the region as Iran cuts costs. But it also removes the constraint on Iran taking bolder actions. If the economy is collapsing anyway then Iran can take bigger risks. Furthermore if Iran is teetering, there may be an incentive to initiate foreign conflicts to refocus domestic angst. This could be done without crossing Trump’s red lines by attacking Iraq or Saudi Arabia. With weak oil demand, Iran’s leverage declines. But a major attack would reduce oil production and accelerate the global supply-demand rebalance. Iran’s attack on the Saudi Abqaiq refinery last September took six million barrels per day offline briefly, but it was clearly not intended to shut down that production permanently. Threats against shipping in the Persian Gulf bring about 14 million barrels per day into jeopardy (Chart 11). Chart 11Closing Hormuz Would Be The Biggest Oil Shock Ever Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Iran-backed militias in Iraq have continued to attack American assets and have provoked American air strikes over the past month, despite the near-war scenario that erupted just before COVID. Iranian ships have harassed US naval ships in recent days. President Trump has ordered the navy to destroy ships that threaten it; Iranian commander has warned that Iran will sink US warships that threaten its ships in the Gulf. There is a 20% chance of armed hostilities between the US and Iran. Why would Iran be willing to confront the United States? First, Iran rightly believes that the US is war-weary and that Trump is committed to withdrawing from the Middle East. But this could prompt a fateful mistake. The equation changes if the US public is incensed and Trump’s election campaign could benefit from conflict. Chart 12Youth Pose Stability Risk To Iran Youth Pose Stability Risk To Iran Youth Pose Stability Risk To Iran Second, the US is never going to engage in a ground invasion of Iran. Airstrikes would not easily dislodge the regime. They could have the opposite effect and convert an entire generation of young, modernizing Iranians into battle-hardened supporters of the Islamic revolution (Chart 12). This is a dire calculation that the Iranian leaders would only make if they believed their regime was about to collapse. But they are quite possibly the closest to collapse that they have been since the 1980s and nobody knows where their pain threshold lies. They are especially vulnerable as the regime approaches the uncharted succession of Supreme Leader Ali Khamanei. Since early 2018 we have argued that there is a 20% chance of armed hostilities between the US and Iran. We upgraded this to 40% in June 2019 and downgraded it back to 20% after the Iranians shied from direct conflict this January. Our position remains the same 20%. This is still a major understated risk at a time when the global focus is entirely elsewhere. It will persist into 2021 if Trump is reelected. If the Democrats win the US election, this war risk will abate. The Iranians will play hard to get but they are politically prohibited from pursuing confrontation with the US when a 2015-type deal is available. This would open up the possibility for greater oil supply to be unlocked in the future, but sanctions are not likely to be lifted till 2022 at earliest. Russia Russia may not be on the verge of invading anyone, but it is internally vulnerable and fully capable of striking out against foreign opponents. Cyberattacks, election interference, or disinformation campaigns would sow confusion or heighten tensions among the great powers. The Russian state is suffering a triple whammy of pandemic, recession, and oil collapse. President Vladimir Putin’s approval rating has fallen this year so far, whereas other leaders in the western world have all seen polling bounces (even President Trump, slightly) (Chart 13). Putin postponed a referendum designed to keep him in office through 2036 due to the COVID crisis. In other words, the pandemic has already disrupted his carefully laid succession plans. While Putin can bypass a referendum, he would have been better off in the long run with the public mandate. Generally it is Putin’s administration, not his personal popularity, that is at risk, but the looming impact on Russian health and livelihoods puts both in jeopardy (Chart 14) and requires larger fiscal outlays to try to stabilize approval (Chart 15). Chart 13Putin Saw No COVID Popularity Bump Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 14Russian Regime Faces Political Discontent Russian Regime Faces Political Discontent Russian Regime Faces Political Discontent Moreover, regardless of popular opinion, Putin is likely to settle scores with the oligarchs. The fateful decision to clash with the Saudis in March, which led to the oil collapse, will fall on Igor Sechin, Chief Executive of Rosneft, and his faction. An extensive political purge may well ensue that would jeopardize domestic stability (Chart 16). Chart 15Russia To Focus On Domestic Stability Russia To Focus On Domestic Stability Russia To Focus On Domestic Stability Chart 16Russian Political Risk Will Rise Russian Political Risk Will Rise Russian Political Risk Will Rise Russian tensions with the US will rise over the US election in November. The Democrats would seek to make Russia pay for interfering in US politics to help President Trump win in 2016. But even President Trump may no longer be a reliable “ally” of Putin given that Putin’s oil tactics have bankrupted the US shale industry during Trump’s reelection campaign. The American and Russian air forces are currently sparring in the air space over Syria and the Mediterranean. The US has also warned against a malign actor threatening to hack the health care system of the Czech Republic, which could be Russia or another actor like North Korea or Iran. These issues have taken place off the radar due to the coronavirus but they are no less real for that. Venezuela We have predicted Venezuela’s regime change for several years but the oil meltdown, pandemic, and insufficient Russian and Chinese support should put the final nail in the regime’s coffin. Hugo Chavez’s rise to power, the last “regime change,” occurred as oil prices bottomed in 1998. Historically the Venezuelan armed forces have frequently overthrown civilian authorities, but in several cases not until oil prices recovered (Chart 17). Chart 17Venezuelan Coups Follow Oil Rebounds Venezuelan Coups Follow Oil Rebounds Venezuelan Coups Follow Oil Rebounds The US decision to designate Nicolas Maduro as a “narco-terrorist,” to deploy greater naval and coast guard assets around Venezuela, to reassert the Monroe Doctrine and Roosevelt Corollary, and to pull Chevron from the country all suggest that Washington is preparing for regime change. Such a change may or may not involve any American orchestration. Venezuela is an easy punching-bag for President Trump if he seeks to “wag the dog” ahead of the election. Venezuela would be a strategic prize and yet it cannot hurt the US economy or financial markets substantially, giving limited downside to President Trump if he pursues such a strategy. Obviously any conflict with Venezuela this year is far less relevant to global investors than one with Iran, North Korea, China, or Russia. Regime change would be positive for oil supply and negative for prices over the long run. But that is a story for the next cycle of energy development, as it would take years for government and oil industry change in Venezuela to increase production. The US election cycle is a critical aggravating factor for all of these petro-state risks. Shale producers are going bankrupt, putting pressure on the economy and some swing states. The risk of a conflict arises not only from Trump playing “wag the dog” after the crisis abates, but also from other states provoking the president, causing him to react or overreact. The “Other Guys” Oil producers outside the US, Canada, gulf OPEC, and Russia – the “other guys” – are extremely vulnerable to this year’s global crisis and price collapse. Comprising half of global production, they were already seeing production declines and a falling global market share over the past decade when they should have benefited from a global economic expansion. They never recovered from the 2014-15 oil plunge and market share war (Chart 18). Angola (1.4 million barrels per day), Algeria (one million barrels per day), and Nigeria (1.8 million barrels per day) are relatively sizable producers whose domestic stability is in question in the coming years as they cut budgets and deplete limited forex reserves to adjust to the lower oil price. This means fewer fiscal resources to keep political and regional factions cooperating and provide basic services. Algeria is particularly vulnerable. President Abdelaziz Bouteflika, who ruled as a strongman from 1999, was forced out last year, leaving a power vacuum that persists under Prime Minister Abdelaziz Djerad, in the wake of the low-participation elections in December. An active popular protest movement, Hirak, already exists and is under police suppression. Unemployment is high, especially among the youth. Neighboring Libya is in the midst of a war and extremist militants within Libya and North Africa would like to expand their range of operations in a destabilized Algeria. Instability would send immigrants north to Europe. Oil production will be reduced involuntarily as well as voluntarily this year due to regime failures. Brazil is not facing the risk of state failure like Algeria, but it is facing a deteriorating domestic political outlook (Chart 19). President Jair Bolsonaro’s popularity was already low relative to most previous presidents before COVID. His narrow base in the Chamber of Deputies got narrower when he abandoned his political party. He has defied the pandemic, refused to endorse social distancing or lockdown orders by local governments, and fired his Health Minister Luiz Henrique Mandetta. Chart 18Petro-States: 'Other Guys' Face Instability Petro-States: 'Other Guys' Face Instability Petro-States: 'Other Guys' Face Instability Chart 19Brazilian Political Risk Rising Again Brazilian Political Risk Rising Again Brazilian Political Risk Rising Again Brazil has a high number of coronavirus deaths per million people relative to other emerging markets with similar health capacity and susceptibility to the disease. This, combined with sharply rising unemployment, could prove toxic for Bolsonaro, who has not received a bounce in popular opinion from the crisis like most other world leaders. Thus on balance we expect the October local elections to mark a comeback for the Worker’s Party. The limited fiscal gains of Bolsonaro’s pension reform are already wiped out by the global recession, which will set back the country’s frail recovery from its biggest recession in a century. The country is still on an unsustainable fiscal path. Bolsonaro does not have a strong personal commitment to neoliberal structural reform, which has been put aside anyway due to the need for government fiscal spending amid the crisis. Unless Bolsonaro’s popularity increases in the wake of the crisis – due to backlash against the state-level lockdowns – the economic shock is negative for Brazil’s political stability and economic policy orthodoxy. Bottom Line: Our rule of thumb about petro-states suggests that they will generally act less aggressive amid a historic oil price collapse, but Iran may prove a critical exception. Investors should not underestimate the risk of a US-Iran conflict this year. Beyond that, the US election will have a decisive impact as the Democrats will seek to resume the Iranian nuclear deal and Iran would eventually play ball. Venezuela is less globally relevant this year – although a “wag the dog” scenario is a distinct possibility – but it may well be a major oil supply surprise in the 2020s. More broadly the takeaway is that oil production will be reduced involuntarily as well as voluntarily this year due to regime failures. Investment Takeaways Obviously any conflict with Iran could affect the range of Middle Eastern OPEC supply, not just the portion already shuttered due to sanctions on Iran itself. Any Iran war risk is entirely separate from the risk of supply destruction from more routine state failures in Africa. These shortages have been far less consequential lately and have plenty of room to grow in significance (Chart 20). The extreme lows in oil prices today will create the conditions for higher oil prices later when demand recovers, via supply destruction. Chart 20More Unplanned Outages To Come Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 21European Political Risk No Longer Underrated European Political Risk No Longer Underrated European Political Risk No Longer Underrated An important implication – to be explored in future reports – is that Europe’s neighborhood is about to get a lot more dangerous in the coming years, as the Middle East and Russia will become less stable. Middle East instability will result in new waves of immigration and terrorism after a lull since 2015-16. These waves would fuel right-wing political sentiment in parts of Europe that are the most vulnerable in today’ crisis: Italy, Spain, and France (Chart 21). This should not be equated with the EU breaking apart, however, as the populist parties in these countries are pursuing soft rather than hard Euroskepticism. Unless that changes the risk is to the Euro Area’s policy coherence rather than its existence. Finally Russian domestic instability is one of the major secular consequences of the pandemic and recession and its consequences could be far-reaching, particularly in its great power struggle with the United States. We are reinitiating a strategic long in cyber security stocks, the ISE Cyber Security Index, relative to the S&P500 Info Tech sector. Cyberattacks are a form of asymmetrical warfare that we expect to ramp up with the general increase in global geopolitical tensions. The US’s recent official warning against an unknown actor that apparently intended to attack the health system of the Czech Republic highlights the way in which malign actors could attempt to capitalize on the chaos of the pandemic. We also recommend strategic investors reinitiate our “China Play Index” – commodities and equities sensitive to China’s reflation – and our BCA Infrastructure Basket, which will benefit from Chinese reflation as well as US deficit spending. China’s reflation will help industrial metals more so than oil, but it is positive for the latter as well. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 John Mauldin, "Don't Be So Sure That States Can't Go Bankrupt," Forbes, July 28, 2016, forbes.com.   Section II: Appendix : GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Appendix Table 1 The Global Fiscal Stimulus Response To COVID-19 Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Section III: Geopolitical Calendar

Highlights The US election cycle is an understated risk to US equities – and the risk of a left-wing populist outperforming in the Democratic primary election is frontloaded in February. The US-Iran conflict is unresolved and remains market-relevant. Iraq is at the center of the conflict and oil supply disruption there or elsewhere in the region is a substantial risk. Even if war does not erupt, Iran has the potential to give President Trump’s foreign policy a black eye and thus could marginally impact the election dynamic. Feature Stocks have rallied mightily since our August report on Trump’s “tactical trade retreat,” but new headwinds face the market. In this report we call attention to four hurdles arising from US election uncertainty. Then we focus on the status of Iran and Iraq in the wake of this month’s hostilities, which brought the US and Iran to the brink of outright war. We maintain that the Iran risk is unresolved and will remain market-relevant in advance of the US election. Primarily due to the US Democratic primary election, we urge caution on US equities in the near term, along with our Global Investment Strategy, despite our cyclically bullish House View. Four Hurdles In The US Election Cycle The US election cycle is the chief political risk to the bull market this year – and geopolitical risks largely radiate from it. There are four immediate hurdles that financial markets are underestimating: Risks to Trump's re-election: Global investors have come around to our view since 2018 that Trump is slightly favored to win re-election (Chart 1). Bets on the related question of which party will hold the White House have flipped from Democratic to Republican (Chart 2). Everyone now recognizes that Trump will not be removed from office through impeachment. Chart 1Trump Re-election Odds Add To Risk-On Trump Re-election Odds Add To Risk-On Trump Re-election Odds Add To Risk-On Chart 2Republicans Now Favored For White House Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Yet, anecdotally, investors may be becoming complacent about Trump’s chances. He is not a shoo-in. Subjectively we have argued that his odds of victory are 55%. Our quantitative election model shows that Wisconsin has shifted to the Republican camp since November, but it places the odds of winning that state (and Pennsylvania) at less than 52% (Chart 3). This gives Trump 289 electoral votes, only 19 more than necessary. If both of these states tipped in the opposite direction then investors would be facing a major policy reversal in the United States. Chart 3Our US 2020 Election Model Shows Trump Win With 289 Electoral College Votes Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Chart 4The US Economy Is Still A Risk To Trump The US Economy Is Still A Risk To Trump The US Economy Is Still A Risk To Trump Trump’s low approval rating remains a liability – and in this sense impeachment is still relevant, in that it can either help or hurt his approval, or prompt him to seek distractions abroad that could deliver negative surprises. Moreover the US manufacturing sector and labor market are not out of the woods yet (Chart 4). In short, the election is still ten months away and a lot can happen between now and then. We see Trump as only slightly favored. Moreover other hurdles are more immediate than the benefits of policy continuity upon a Trump win. 2. Risks to Biden's nomination: Throughout last year we maintained that former Vice President Joe Biden was the frontrunner for the Democratic nomination, albeit with very low conviction. In particular, after Vermont Senator Bernie Sanders’s poor showing in the third debate and subsequent heart attack, we expected Massachusetts Senator Elizabeth Warren to consolidate the progressive vote and trigger a policy-induced selloff in US equities. This never occurred because Biden held firm, Sanders recovered, and Warren fell. The risk to equities from a left-wing populist Democratic nominee is frontloaded in February and March. Now, however, the risk to equities is back. The Democratic Party faces a last-ditch effort from its left or “progressive” wing and anti-establishment voters to oppose Biden. With the primary election now upon us – the Iowa Caucus is February 3 – national opinion polls show that Sanders is pushing up against Biden (Chart 5). It is less clear if Sanders is breaking through in the primary polling state-by-state, where multiple candidates remain competitive (Chart 6). But online gamblers are reasserting Biden over Sanders at just the moment when progressives are set to launch their biggest push (Chart 7). Meanwhile New York Mayor Michael Bloomberg is finally gaining some traction – and he eats away at Biden’s support from centrist voters. Everything is in flux, which warrants caution. Chart 5Biden Is The Frontrunner, But Sanders Is Challenger Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Chart 6Biden Not A Shoo-In For Early Democratic Primary States Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Biden is still favored to win the nomination, but he has not clinched it. The market faces volatility during the period when Democrats get “cold feet” about nominating another establishment candidate. Moreover the fundamental knock against Sanders – that he is not as “electable” as Biden – is debatable, judging by head-to-head polls against Trump (Chart 8). This means that a shift in momentum – for instance, if Biden lurches from disappointments in early states to underperformance in his bulwark of South Carolina – would have legs. Ultimately a “contested convention” is not impossible. This would be a negative surprise to market participants currently assuming that the world faces the relatively benign choice of two known quantities: an establishment Democrat or a continuation of Trump policies. Chart 7Betting Markets Overlooking Party 'Cold Feet' Over Biden Betting Markets Overlooking Party 'Cold Feet' Over Biden Betting Markets Overlooking Party 'Cold Feet' Over Biden Chart 8Electability Fears May Not Stop Sanders Rally Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Risks to the Republican Senate: Assuming Biden clinches the nomination, he has a 45% chance of winning the election – and in that case, his chance of bringing the Senate over to the Democrats is higher than investors realize. This is another risk that the market will awaken to later this year. Chart 9Democrats Underestimated In Senate Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran The consensus holds that Republicans will hold the Senate, particularly with Republican senators in Maine and Iowa leading their Democratic challengers in polling. The problem is that for Democrats to unseat an incumbent president they will necessarily have generated strong turnout from key demographic groups: young people, suburbanites, women, and minorities. If that is the case, then the election will not be as tight as expected and Republicans will be less likely to hold the Senate. This would require rising unemployment or some other blow that fundamentally damages the Trump administration’s popular support in key swing states. At least until it becomes clear that the manufacturing sector is out of the woods, the Democrats should be seen as far more likely to take the Senate than the Republicans are to retake the House of Representatives – yet this goes against the consensus (Chart 9). Rising odds of a Senate victory would mean that even a “centrist” Democrat like Biden would have fewer political constraints in office – he would pose a greater threat of increasing taxes, minimum wages, and passing legislative regulation than the market currently expects. In short, Biden would be pulled to the left of the political spectrum by his party and expectations of an establishment Democrat posing a minimal threat to corporate profits would be greatly disappointed. Risks of Trump's second term: Finally, assuming the manufacturing sector rebounds and that Trump’s odds of re-election rise above 55%, market complacency becomes an even bigger concern for a long-term investor. For in his second term Trump would become virtually unshackled with regard to economic and financial constraints, since he cannot run for office again. He would still face the senate, the Supreme Court, and other constraints, but these would certainly not preclude a doubling down on trade war (or confrontations with nuclear-aspirants like Iran or North Korea). We have argued that Trump will not instigate a trade war with Europe, at least until the economy has clearly rebounded, and most likely not until his second term. But we fully expect chapter two of the trade war to begin in 2021 – and this could mean China, Europe, or even a two-front war. Re-election could go to Trump’s head and prompt him to overreach on the global stage. Hence we expect the relief rally on Trump’s re-election to be short-lived and would be looking to sell the news. But the S&P 500 faces more immediate hurdles anyway, and that is why we urge caution in the very near term. Iran is still a major geopolitical risk this year. Bottom Line: None of these hurdles are insurmountable, but the US election cycle is now an understated risk to the equity bull market. We agree with our Global Investment Strategy that it is prudent to shift to a neutral position tactically on US equities, especially for the February and March period when uncertainty rises over the Democratic Party primary. This does not change our view that the underlying global economy is improving, largely on China’s rebound, and that the cyclical outlook is positive. Don’t Bet On Regime Collapse In Iran (Yet) The January 8 Iranian attack on US bases in Iraq was intended to serve as a breather for Iranian leaders. It was meant to put on pause the rapid escalation in US-Iran tensions – allowing Iranian leaders to recover from the assassination of top military commander Qassem Suleimani – all the while appeasing the public through a public show of revenge. As fate would have it, however, the Iranian regime was granted no such respite. Days later, domestic unrest descended on the Islamic Republic as protesters returned to the streets across the country, criticizing the regime’s downing of a civilian airliner and re-stating their long-running complaints against the regime. Civil strife is not uncommon in Iran (Table 1). Economic inefficiencies, corruption, and discriminatory policies which serve to reward regime loyalists while suppressing the private sector are only some of the grievances faced by Iranians.1 Table 1Civil Strife Ongoing Problem In Iran Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Today’s strife is relevant, however, because it is fueled by US-imposed “maximum pressure” sanctions that have created an even bleaker economic reality. Iranian exports were down 37% in 2019 following an 18% decline the previous year. Oil exports fell to 129 thousand barrels per day in December 2019, down from an average 2.1 million barrels per day in 2017 (Chart 10). Households are facing the brunt, experiencing a 17% unemployment rate and a whopping 36% inflation rate (Chart 11). Chart 10US 'Maximum Pressure' Sanctions On Iranian Oil Exports US 'Maximum Pressure' Sanctions On Iranian Oil Exports US 'Maximum Pressure' Sanctions On Iranian Oil Exports Chart 11Iranian Households Bear Brunt Of Economic Shock Iranian Households Bear Brunt Of Economic Shock Iranian Households Bear Brunt Of Economic Shock The 2020-21 budget, released in December and described as a weapon of “resistance against US sanctions,” intends to plug the deficit using state bonds and state property sales (Chart 12). However Iran’s fiscal condition is shaky. The International Monetary Fund estimates a fiscal breakeven oil price of $194.6 per barrel for Iran, more than 3 times higher than current oil prices. Chart 12Iran’s Fiscal Condition Is Shaky Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Chart 13Iran Avoiding Devaluation Under Trump Iran Avoiding Devaluation Under Trump Iran Avoiding Devaluation Under Trump Chart 14Iranians Also Blame Their Government For Malaise Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran The solution of former President Mahmoud Ahmadinejad, the populist hawk who led the government during the US’s previous round of sanctions, was to devalue the official exchange rate. The weaker rial raised local currency revenues for each barrel of exported oil and encouraged import substitution in other industries. However devaluation came at a steep political cost and sparked riots and protests. So far President Hassan Rouhani has eschewed this strategy, instead maintaining a stable official exchange rate, used as the reference for subsidized basic goods and medicine (Chart 13). Nevertheless, the unofficial market rate has weakened 68% since the beginning of 2018. It is no surprise then that Iranians all over the country are taking to the streets. The latest bout of unrest is significant in size, geographic reach, and in that protesters are calling on Grand Ayatollah Ali Khamenei to step down as supreme leader. Despite US sanctions, Iranian protesters are partially blaming Khamenei and the government for the country’s malaise (Chart 14). Even prior to the US withdrawal from the 2015 nuclear deal, Joint Comprehensive Plan of Action (JCPA), Iranians were angry about economic mismanagement. Nevertheless, according to our checklist for an Iranian revolution, the regime is not yet at risk of collapse (Table 2). Although the street movement is picking up pace, it is not organized or unified. There is no alternative being offered against the all-powerful supreme leader, and the political elite are mostly united in preserving the current system. Table 2Iran Regime Stability Checklist Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran The regime has two main options going forward: seek immediate economic relief through negotiations with the United States, or hunker down and wait to see whether President Trump is reelected and able to sustain his campaign of maximum pressure, and go from there. We fully expect the latter. Domestic dissent can still be suppressed for the time being. The parliamentary – or Majlis – elections scheduled for February 21 could in theory offer Iranians an opportunity to voice their discontent through the ballot box. However this democratic exercise conceals the known political reality that the supreme leader holds supreme authority, even in the selection of parliament or the president (Diagram 1). Thus the election result will not drive major policy change. Diagram 1Supreme Leader Controls Iran Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran A case in point was the regime’s 2016 strategy in the parliamentary election. At that time, the conservative-dominated Guardian Council, responsible for screening potential candidates, rejected well-known reformist applicants (Chart 15). As a result, the reformists who were able to win seats were either lesser-known figures or unaligned with liberals in the reformist movement. Thus while the reformist presence in parliament nominally surged, these lawmakers were ineffective, reneging on campaign promises or collaborating with the conservative faction. The 2016 election serves as a blueprint for what to expect in the upcoming elections in February. The Guardian Council ruled that out of around 15,000 candidates, only 60 (relatively unknown) reformist candidates were qualified to run for the election.2 The elections will not change anything, but this means the grievances of the population will fester in the coming years, especially if the US does not change policies. This is where the medium-term risk to regime stability – namely through elite divisions – becomes apparent. The impending leadership succession is a major source of uncertainty. Supreme Leader Khamenei is the main barrier to political change. At 80 years old and reportedly suffering from poor health, a change in leadership is imminent. However, no one has been officially endorsed as his successor. This is an immense source of uncertainty in the coming years. There are several possibilities for the succession.3 A successor is appointed by the Assembly of Experts. Because we exclude Rouhani as a candidate for supreme leader, the potential candidates for Iran’s top position listed below ascribe to Khamanei’s hardline ideology: Hojjat ol-Eslam Ebrahim Raisi, head of judiciary and of the Imam Reza shrine since March 2019. Raisi is reportedly Khamenei’s favorite for succession. He is a hardliner who lost the May 2017 presidential election to Rouhani.4 Ayatollah Sadeq Larijani, the conservative former head of the judiciary and current chairman of the Expediency Discernment Council, which is responsible for resolving disputes among government branches. Larijani is also a member of the Guardian Council.5 Ayatollah Ahmad Khatemi, hardline Tehran Friday prayer leader and senior member of the Assembly of Experts. The Iranian Revolutionary Guard Corps (IRGC) – a military force with immense influence in the regime – may choose to rule itself. We assign a low likelihood of this occurring. The IRGC is more likely to ensure that Khamenei’s successor is someone who supports its hardline ideology and vision for Iran. Some moderate clerics are advocating a change in structure, whereby the position of supreme leader is abolished. This school of thought argues that political leaders should be selected based on popular election rather than appointment.6 We do not assign high odds to this scenario. Until the Assembly of Experts selects the successor, a three-member council made up of the Iranian president, the head of judiciary, and a theologian of the Guardian Council, will assume the functions of supreme leader. Such a “triumvirate” could last longer than expected, or could even be formally decided as an alternative to a new supreme leader. In the context of such extreme uncertainty for the regime’s leadership in the coming decade, it is highly unlikely that the current political leaders will engage in negotiations with President Trump until they are sure of his staying power (Chart 16). First, the Iranians will continue to refuse talks prior to the US election. They will seek to undermine the Trump administration, yet without crossing red lines on the nuclear program (one year till nuclear breakout) or militant activities (killing American citizens). Chart 15Iran’s Guardians Vet Election Candidates Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Second, if Trump wins, then the shift to negotiations may or may not come, but the subsequent diplomatic process will be prolonged. Trump will have to gain the full cooperation of Europe, Russia, and China – and any new US-Iran deal is an open question and will involve tensions flaring up more than once. Chart 16Iranians Opposed To Talks With Trump Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Third, even if the Democrats win, the regime will play “hard to get” and will not immediately return to status quo ante Trump, although eventually there could be a restoration of the 2015 Joint Comprehensive Plan of Action or something like it. This process could also involve saber-rattling despite the Democrats’ more dovish disposition toward Iran. Bottom Line: The US maximum pressure campaign is not aimed at regime change in Iran, but if it brings any political change it will be a shift in a more hawkish direction as the regime faces immense internal and external pressures and an uncertain succession in the coming years. Iran’s leaders will continue to suppress unrest and can probably succeed in the near term. The confrontation with the US discredits any political actors who advocate negotiations. The path toward reform and improved relations with the West is closed until after the US election at minimum. Since Iran will seek to undermine both President Trump and the US presence in the Middle East in the meantime, US-Iran tensions remain a market-relevant source of risk in 2020. Iraq Still Poses An Oil Supply Risk Chart 17Iraqis Suffering From Poor Governance Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Iraq is ground zero for the US-Iran showdown, since the two powers have eschewed direct military confrontation. Iraqis have also been suffering the consequences of an ill-functioning political system (Chart 17). Corruption has prevented the trickle down of oil revenues, resulting in endemic poverty and inequality (Chart 18). Yet unlike its neighbor, Iraq is not ruled by a supreme leader who controls a powerful armed forces to which anger can be directed. Instead, protesters have been blaming the deep seated influence of the Iranian regime, which often results in what Iraqis’ argue to be a prioritization of foreign – i.e. Iranian – objectives over national ones. The demonstrations were successful in forcing the resignation of Prime Minister Adel Abdul Mahdi and the passing of a new electoral law. However Iraq remains in a state of chaos as Iraqis have vowed to remain on the street until all their conditions are met, including the appointment of an acceptable prime minister and early elections. Chart 18Poverty, Inequality, Corruption Plague Iraq Poverty, Inequality, Corruption Plague Iraq Poverty, Inequality, Corruption Plague Iraq This batch of reforms has been challenging for politicians to execute. For one, there is a lack of clarity as to which political group holds the majority of seats in Iraq’s Council of Representatives. Both the Iran-backed al-Binaa bloc as well as the al-Islah coalition led by Muqtada al-Sadr claim this position (Chart 19). A list of candidates for the temporary position of prime minister until early elections are held, proposed by Binaa in December, was rejected by President Barham Salih on grounds that it did not include anyone who would possess the support of the demonstrators. Chart 19Iraqi Parliamentary Control Up For Grabs Market Hurdles: From Sanders To Iran Market Hurdles: From Sanders To Iran Iraqi protesters have consistently reiterated their desire for a sovereign state, free from both American and Iranian interference. However, this nationalistic call has been disrupted and overshadowed by the US-Iran conflict. Importantly, the protest movement has now lost its most influential backer within the Iraqi political system: Sadr of the Islah bloc. This year’s Iran tensions and the parliamentary resolution to eject US troops from Iraq have unified the warring Shia political blocs. Sadr has called on the Mahdi army – a notoriously anti-American force also known as the Peace Brigades – to re-assemble. On January 13, in what can only be interpreted as a rapprochement among the main Shia political factions, Sadr met with paramilitary leaders making up the Popular Mobilization Forces in the Iranian city of Qom. They discussed the creation of a “united resistance” and the need jointly to expel foreign troops. Sadr also called for a “million-man march” against US troops in Iraq.7 Sadr’s pivot to Iran has not gone down well in Iraq’s streets, where protesters are accusing him of putting aside national goals for his own personal aspirations. While the protest movement will keep going, it is now largely headless and competing with the unified priorities of the Shia parties. This state of affairs weakens the odds of a sovereign Iraq that curbs Iranian regional influence. The political class is more likely to turn a blind eye to the repression of protesters, which is likely to increase as the system notches up its crackdown on dissent. A return to the status quo ante in Iraq is also now more likely. A new government may be elected. It may include more technocratic politicians in a nod to the protestors, but the pro-Iranian faction has fortified its position as kingmaker. Meanwhile, Sadr has decided that reform should be postponed for a later day. Iraqis who have been camping out on the streets for nearly four months, risking their lives, are unlikely to be easily put down. Instead their frustrations will manifest in more aggressive forms, such as through violence and the sabotage of infrastructure. Saudi Arabia may or may not seek to interfere in Iraq to maintain the pressure on Iranian interests. If it does so, it risks escalating the situation and provoking retaliation from Iran. Iraqi efforts to force a US troop withdrawal will clash with US interests. President Trump wants to reduce commitments but does not want to risk anything remotely resembling a Saigon-style evacuation during an election year. As such, some form of sanctions against Iraq is possible. The US administration may pass up imposing sanctions on oil sales and instead target USD flows to Iraq’s central bank. Blocking or reducing access to Iraqi accounts at the Federal Reserve Bank in New York – to which all revenues from Iraqi oil sales are directed – would debilitate the economy and amplify the risk to stability and hence oil flows. Washington’s decision whether to renew waivers allowing Iraq to import Iranian gas – set to expire mid-February – will signal whether the events earlier this year changed the US’s calculus. Iraq is extremely dependent on Iranian gas to generate power. A decision not to extend the waivers would cause greater friction between the Iraqi street and the ruling elite.8 Bottom Line: Baghdad is getting dragged deeper into chaos. Alignment with Iran, and delays in government formation and economic reform, will aggravate tensions between the street and the political class. Dissent may take on more violent forms going forward. Middle Eastern oil supply will remain vulnerable to instability and sabotage in Iraq and the broader Persian Gulf. Investment Conclusions In the very near term we expect US equities to encounter headwinds due to the over extension of the rally and immediate risks from the US election cycle. We also see global risk appetite suffering due to US uncertainty, as well as to fears about the new coronavirus. These may reach a crescendo in the wake of Chinese New Year travel season. However, China’s stimulative policy trajectory will ultimately be reinforced due to the economic threat from the outbreak. And China’s economy is showing signs of rebounding. This reinforces our constructive view on the global business cycle overall, on commodities, and on select emerging markets that produce oil or are undertaking structural reforms. The US-Iran conflict is ongoing and we expect it to continue injecting a risk premium into oil markets. The two sides are effectively playing Russian roulette.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 The IRGC and bonyads – para-governmental organizations that provide funding for groups supporting the Islamic Republic – have access to subsidies, favorable contracts, and cheap loans. Together they run a considerable part of the economy. 2 Questions Loom In Iran As Reformist Factions Lose Hope In Elections," dated January 23, 2020, available at en.radiofarda.com. 3 In an interview with Fars news agency in June 2019, Ayatollah Mohsen Araki, a prominent member of the Assembly of Experts, mentioned that a committee of three members from the Assembly of Experts were working on a list of prospective supreme leaders, which they will present to the full AE when necessary. Please see "Is Iran’s Next Supreme Leader Already Chosen?," dated June 18, 2019, available at en.radiofarda.com. 4 Please see "Ebrahim Raisi: The Cleric Who Could End Iranian Hopes For Change," dated January 5, 2019, available at aljazeera.com. 5 Please see “A Right-Wing Loyalist, Sadeq Larijani, Gains More Power in Iran,” dated January 8, 2019, available at atlanticcouncil.org. 6 Mohsen Kadivar, an unorthodox cleric who was forced to flee Iran due to his political views, and is now an instructor at Duke University is a critic of the system of Velayet-e Faqih, or clerical rule. He claims that since the death of Khomeini, a majority of Iran’s religious scholars hold a “secretive belief” that supreme clerical rule should be abolished as it only leads to despotism. 7 In response to Sadr’s call for a “million man march”, Ayatollah al-Sistani repeated his warning against “those who seek to exploit the protests that call for reforms to achieve certain goals that will hurt the primary interests of the Iraqi people and are not in line with their true values.” 8 The last time Iran reduced electricity exports to Iraq resulted in mass protests in Iraq in July 2018. Thus if the sanction waivers are not renewed the cutoff of gas risks a greater clash between the Iraqi street and government, especially during the hot summer months.