Geopolitics
Highlights The chaotic US withdrawal from Afghanistan is symbolic – the US is conducting a strategic pivot to Asia Pacific to confront China. US-Iran negotiations are the linchpin of this pivot. If they fail, war risk will revive in the Middle East and the US will remain entangled in the region. At the moment, there is no deal, so investors should brace for a geopolitical risk premium in oil prices. That is, as long as global demand holds up despite COVID-19, and as long as the OPEC 2.0 cartel remains disciplined. We think they will in the short run. The US and Iran still have fundamental reasons to agree to a deal. If they do, the US will regain global room for maneuver while China’s and Russia’s window of opportunity will close. The implication is that markets face near-term oil supply risks – and long-term geopolitical risks due to Great Power rivalry in Eastern Europe and East Asia. Feature Events in Afghanistan have little macroeconomic significance but the geopolitical changes underway are profound and should be viewed through the lens of our second key view for 2021: the US strategic pivot to Asia. Chart 1The US Pivot To Asia Runs Through Iran Not Afghanistan As we go to press the Taliban is reconquering swathes of Afghanistan while US armed forces evacuate embassy staff and civilians. The chaotic scenes are reminiscent of the US’s humiliating flight from Saigon, Vietnam in 1975. As with Vietnam, the immediate image is one of American weakness but the reality over the long run is likely to be different. Over the past decade we have chronicled the US’s efforts to disentangle itself from wars of choice in the Middle East and South Asia. In accordance with US grand strategy, Washington is refocusing its attention on its rivalries with Russia and especially China, the only power capable of supplanting the US as a global leader (Chart 1). The US has struggled to conduct this “pivot to Asia” over the past decade but the underlying trajectory is clear: while trying to manage its strategic interests in the Middle East through naval power, the US will need to devote greater resources and attention to shoring up its economic and military ties in Asia Pacific (Map 1). The Middle East still plays a critical role – notably through China’s energy import needs – but primarily via the Persian Gulf. Map 1The US Seeks Balance In Middle East In Order To Pivot To Asia And Confront China Thus the critical geopolitical risks today stem from Iran and the Middle East on one hand, and China on the other. They do not stem from the US’s belated and messy exit from Afghanistan, which has limited market relevance outside of South Asia. First, however, we will address the political impact in the United States. US Political Implications Chart 2Americans Agree With Biden And Trump On Exit From Afghanistan American popular opinion has long turned against the “forever wars” in Iraq and Afghanistan, which cumulatively have cost $6.4 trillion and about 7,000 American troops dead1 (Chart 2). Three presidents, from two political parties, campaigned and won election on the basis of winding down these wars. The only presidential candidate since Republicans George W. Bush and John McCain who took a hawkish stance for persistent military engagement, Hillary Clinton, nearly lost the Democratic nomination and did lose the general election to a Republican, President Trump, who had reversed his party’s stance to advocate strategic withdrawal. War hawks have been sidelined in both parties. This is notable even if it were not the case that the current President Biden, whose son Beau fought in Afghanistan, had opposed the troop surge there under Obama. True, Biden will use drones, surgical strikes, and limited troop rotations to manage the aftermath in Afghanistan, both militarily and politically. Americans are still concerned about terrorism in general and any sign of a resurgent terrorist threat to the US homeland will be politically potent (Chart 3). But neither Biden nor the US can roll back the Taliban’s latest gains or achieve anything in Afghanistan that has not been achieved over the past twenty years. Chart 3American Public Cares About Terrorism, Not Afghanistan Per Se True, Biden will suffer a political black eye from Afghanistan. His approval rating has already fallen to 49.6%, slipping beneath 50% for the first time, in the face of the Delta variant of COVID-19 and the Afghan debacle. In both cases his early optimistic statements have now become liabilities. Biden is also 79 years old, which will make the 2024 campaign questionable, and he faces mounting problems in other areas, from lax border security and immigration enforcement to rising domestic crime. Nevertheless, Biden still has sufficient political capital to push through one or both of his major domestic legislative proposals by the end of the year, despite thin majorities in both the House and Senate. Afghanistan will not affect that, for three reasons: 1. The US economy is likely to continue to recover despite hiccups due to the lingering pandemic, since the vaccines so far are effective. The labor market is recovering and business capex and government support are robust. Setbacks, such as volatile consumer confidence, will help Biden pass bills designed to shore up the economy. 2. The public fundamentally agrees with Biden (and Trump) on military withdrawal, as mentioned. Voters will only turn against him if a major attack reinforces an image of weakness on terrorism. A major attack based in Afghanistan is not nearly as likely to succeed as it was prior to the September 11, 2001 attacks. But Biden also faces an imminent increase in tensions in the Middle East that could result in attacks on the US or its allies, or other events that reinforce any image of foreign policy failure. 3. Biden has broad popular support for his infrastructure deal, which also has bipartisan buy-in, with 19 Republican Senators already having voted for it. Further, the Democratic Party has a special fast-track mechanism for passing his social spending agenda, though conviction levels must be modest on this $3.5 trillion bill, which is controversial and will have to be winnowed to pass on a partisan vote in the Senate. If we are correct that Afghanistan will not derail Biden’s legislative efforts then it will not fundamentally affect US fiscal policy or the global macro outlook. Note, however, that a failure of Biden’s bills would be significant for both domestic and global economy and financial markets as it would suggest that US fiscal policy is dysfunctional even under single party rule and would thus help to usher back in a disinflationary context. Might Afghanistan affect the midterm elections and hence the US policy setup post-2022? Not decisively. Republicans are more likely than not to retake at least the House of Representatives regardless. This is a cyclical aspect of US politics driven by voter turnout and other factors. Democrats are partly shielded in public opinion due to the Trump administration’s attempts to pull out of foreign wars. But surely a black eye on terrorism or foreign policy would not help. Similarly, a major failure to manage the Middle East, South Asia, and the pivot to Asia Pacific would marginally hurt the Democrats in 2024, but that is a long way off. Geopolitical Implications The Taliban’s reconquest of Afghanistan has very little if any direct significance for global financial markets. Pakistan and India are the two major markets most likely to be directly affected – and their own geopolitical tensions will escalate as a result – yet both equity markets have been outperforming over the course of the Taliban’s military gains (Chart 4). Afghanistan’s impacts are indirect at best. However, the US withdrawal connects with major geopolitical currents, with both macro and market significance. Afghanistan often marks the tendency of empires to overreach. Russia’s failure in Afghanistan contributed to the collapse of the Soviet Union, though Russia’s command economy was unsustainable anyway. British failures in Afghanistan in the nineteenth and twentieth centuries did not lead to the British empire’s decline – that was due to the world wars – but Afghanistan did accentuate its limitations. Since 9/11 and the US’s wars in Iraq and Afghanistan, the US public’s economic malaise, political polarization, and loss of faith in public institutions have gotten worse. In turn, political divisions have impeded the government’s ability to respond cogently to financial and economic crisis, the resurgence of Russia, the rise of China, nuclear proliferation, constitutional controversies, and the COVID-19 pandemic. Once again Afghanistan marked imperial overreach. It is natural for investors to be concerned about the stability of the United States. And yet the US’s global power has recently stabilized (Chart 5). The US survived the 2020 stress test and innovated new vaccines for the pandemic. It is passing laws to upgrade its domestic technological, manufacturing, and infrastructural base and confronting its global rivals. Chart 4If Indo-Pak Markets Shrug Off Taliban Wins, So Can You Chart 5US Geopolitical Power Is Stabilizing Chart 6US Not Shrinking From Global Role The US is not retreating from its global role, judging by defense spending or trade balances (Chart 6). While the desire to phase out wars could theoretically open the way to defense cuts, the reality is that the great power confrontation with China and Russia will demand continued large defense spending. The US also continues to run large trade deficits, due to its shortage of domestic savings, which gives it influence as a consumer and provider of dollar liquidity across the world. The critical geopolitical problem is Iran, where events have reached a critical juncture: To create a semblance of a balance of power in the Middle East, the US needs an understanding with Iran, which is locked in a struggle with Saudi Arabia over the vulnerable buffer state of Iraq. President Biden was not able to rejoin the 2015 détente with Iran prior to the inauguration of the new president, Ebrahim Raisi, who is a hawk and whose confrontational policies will lead to an escalation of Middle Eastern geopolitical risk in the short term – and, if no US-Iran deal is reached, over the long term. Iran recognizes the US’s war-weariness, as demonstrated by withdrawals from Iraq and Afghanistan. It was also exposed to economic sanctions after the US’s 2018-19 abrogation of the 2015 nuclear deal – it cannot trust the US to hold to a deal across administrations. Still, both the US and Iran face substantial strategic forces pressuring them to conclude a deal. The US needs to pivot to Asia while Iran needs to improve its economy and reduce social unrest prior to its looming leadership succession. But the time frame for negotiation is uncertain. Any failure to agree would revive the risk of a major war that would keep the US entangled in the region. Thus the pivot to Asia could be disrupted again, with major consequences for global politics, not because of Afghanistan but because of a failure to cut a deal with Iran. If the US succeeds in reducing its commitments to the Middle East and South Asia, the window of opportunity that China and Russia have enjoyed since 2001 will close. They will face a United States that has greater room for maneuver on a global scale. This is a threat to their own spheres of influence. But neither Beijing nor Moscow has an interest in a nuclear-armed Iran, so a US-Iran deal is still possible. Unless and until the US and Iran normalize relations, the Middle East is exposed to heightened geopolitical risk and hence oil supply risk. Global oil spare capacity is sufficient to swallow small disturbances but not major risks to stability, such as in Iraq or the Strait of Hormuz. Investment Takeaways Chart 7Near-Term US-Iran Risks Help Oil...Long-Term US-China Risks Help Dollar Back in 2001, the combination of American war spending, and conflict in the Middle East, combined with China’s massive economic opening after joining the WTO, led to a falling US dollar and an oil bull market. Today the US’s massive budget deficits and current account deficits present a structural headwind to the US dollar. Yet the greenback has remained resilient this year. While the pandemic will fade as long as vaccines continue to be effective, China’s potential growth is slowing even as it faces an unprecedented confrontation with the US and its allies. Until the US and Iran normalize relations, geopolitics will tend to threaten Middle Eastern oil supply and put upward pressure on oil prices. However, if the US manages the pivot to Asia, China will face more resolute opposition in its sphere of influence, which will tend to strengthen the dollar. The dollar and oil still tend to move in opposite directions. These geopolitical trends will be influential in determining which direction prevails (Chart 7). Thus geopolitics poses an upward risk to oil prices for now. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Please see Crawford, Neta, "United States Budgetary Costs and Obligations of Post 9/11 Wars Through FY 2020: $6.4 trillion", Watson Institute, Brown University.
BCA Research’s US Political Strategy service concludes that uncertainty about the passage of Biden’s budget reconciliation bill and the debt ceiling will cause volatility to rise in financial markets. With a one-seat de facto majority in the Senate, and a…
Highlights The greatest legislative battle of the Biden presidency will unfold between now and the end of the year. Biden’s bipartisan infrastructure deal is likely to pass the Senate soon but will have to cross several hurdles before passage in the House of Representatives. We maintain our 80% subjective odds that it will pass one way or another. Assuming the infrastructure bill does not fall apart, we will upgrade the odds that Biden’s budget reconciliation bill will pass this fall from 50% to 65%. The latter comprises a nominal $3.5 trillion in social spending and tax hikes that will be watered down and revised heavily by the time it passes, which may take until Christmas. Uncertainty about passage will cause volatility to rise in financial markets. Democrats left the debt ceiling out of their fiscal 2022 budget resolution, which ostensibly means they cannot raise the debt limit via a simple majority but will need 10 Republican senators to join. A bruising standoff will ensue that will add to volatility. Ultimately Republicans will comply as they cannot afford to be held responsible for a default on the national debt. The party is currently unpopular and tarred with accusations of insurrection. If Biden succeeds in passing both bills, US fiscal policy will be frozen in place through at least 2025, though endogenous disinflationary fears will largely be dispelled. Feature The biggest domestic political battle of the Joe Biden presidency is likely to occur between now and Christmas. With a one-seat de facto majority in the Senate, and a four-seat majority in the House, Biden is barely capable of passing his two outstanding legislative proposals. The first of these is the $550 billion bipartisan infrastructure deal, which we have given an 80% subjective chance of passing and which passed the Senate on a 69-30 vote margin as we went to press. The second is the $3.5 trillion partisan reconciliation package, based on the remainder of Biden’s American Jobs and Families Plan, which we have given a 50% chance of passage. We will upgrade these odds to 65% if bipartisan infrastructure does not fall through in the House. Next year will be consumed by campaigning for the 2022 midterms so it will be hard to pass any major legislation with such thin majorities (though bipartisan anti-trust legislation could pass and poses a risk to the equity market). The midterms are likely – though not guaranteed – to result in Republicans taking at least the House. The result will be gridlock in which only the rare bipartisan bill can pass. In other words, after Christmas, Biden’s domestic legislative capability and hence US fiscal policy will likely be frozen in place through 2025. In this report we provide a road map for the budget battle that will define the Biden presidency. Buy The Dip … Unless New Variants Change The Game First, a brief word regarding the COVID-19 pandemic. The Delta variant is ramping up, particularly in states where vaccination rates have lagged and social restrictions are minimal (Chart 1). The new lambda variant is also causing concerns that vaccines may be inadequate. Equity markets could easily suffer more downside in the near term but US-dedicated investors should consider the following: Scientists have created one vaccine for COVID-19 and can create others. There has been a concrete reduction in uncertainty since November 2020. Vaccination rates will never be perfect – many people smoke cigarettes and refuse to wear seat belts! – but greater infection rates and hospitalizations are leading to improvements in vaccination coverage. While new lockdowns are not impossible, the public will only support them as a last resort. Not only is the White House still officially opposed to new lockdowns but also the authority to impose lockdowns rests with governors. If hospital systems are crashing then even Republican governors will endorse new social restrictions. Otherwise, restrictions will not be draconian unless a much more virulent variant emerges (one that is more deadly or that has a worse impact on children). Monetary and fiscal stimulus will ramp up if a new variant is more deadly or the economy otherwise starts to slide back. In the US, additional fiscal stimulus will come faster than in other countries because new short-term measures can easily be tacked onto major bills that are already coming down the pike. Chart 1Stay Constructive Amid Delta Jitters Might the White House leverage a renewed sense of crisis to get its main fiscal bills passed? We can see that. The last thing Biden needs is a sluggish recovery to translate into congressional gridlock in the 2022 midterms – the bane of the Obama administration. Rather, the goal is to harness the sense of crisis to pass stimulus. Biden’s approval rating is falling, as is the norm with modern presidents. However, it is still “above water” (net positive) and still sufficient to get his legislative initiatives across the line. Biden’s forthcoming bills will reinforce economic recovery and sentiment (Chart 2) Chart 2Biden’s Approval Comes Down To Earth What if a variant evades vaccination? Especially if it is more deadly and/or more harmful to children? That would be a game changer and would cause at least a market correction. Still, investors would want to buy the dip given what they know today relative to what they knew in early 2020 (and given that they bought the dip in March 2020 even not knowing what they know today). Bipartisan Structural Reform Our second key view for 2021 – “bipartisan structural reform” – is coming to fruition with the Senate’s 69-30 vote passage of the American Infrastructure and Jobs Act as we go to press. Major bipartisan deals are rare in highly polarized America but we have given an 80% subjective chance of passage to this bill. Passage in the Senate reinforces that view, though the odds of final passage remain the same as there will be hurdles in the House. We include infrastructure as a “structural reform” because of its ability to increase the productivity of an economy. The bill contains funding for traditional infrastructure, like roads, bridges, and ports, as well as non-traditional infrastructure such as subsidies for electric vehicles and high-speed internet (Table 1). Table 1What’s In The Bipartisan Infrastructure Deal? Table 2 shows the 19 Republican senators who voted in favor of this bipartisan deal, along with their ideological ranking and state support rates. This tally provides a nine-seat buffer in case the House version of the bill requires another Senate vote. It also provides a measure of the support that might be brought to bear for bipartisan causes later, such as funding the government, suspending the debt ceiling, or passing bills on popular issues (such as regulating Big Tech) in 2022-24. All Democrats voted in unison for the bill. Table 2Republican Senators Who Voted For Biden’s Bipartisan Infrastructure Bill Our high confidence on infrastructure spending stems both from its popular support (Chart 3) and from the fact that even if bipartisanship fails, there remains a partisan option: budget reconciliation. This is still true today. The bipartisan infrastructure bill could still die in the House, given Speaker Nancy Pelosi’s determination to make its passage contingent on the success of the larger reconciliation bill, which is anathema to Republicans. But if it dies, Democrats would take up the key provisions in the reconciliation bill – and the odds of that bill passing would go up, not down, since Democrats would need to close ranks to clinch a legislative victory ahead of the midterms. Chart 3Popular Support For Bipartisan Infrastructure Deal Thus the real risk is not that infrastructure spending will fail but that its success will reduce the political capital needed to pass the more controversial reconciliation bill, which we discuss below. Over the short and medium term, this bipartisan infrastructure deal emblematizes the sea change in US fiscal policy – the shift against austerity – and thus serves to dispel fears of disinflation. At the same time, the deal epitomizes America’s long-term fiscal predicament. Democrats only want to increase spending while Republicans only want to decrease taxes. The former will not make budget cuts while the latter will not hike taxes. The result, inevitably, is higher budget deficits. This is precisely what occurred with the latest agreement: tax measures to pay for new infrastructure spending are mostly chimerical – the Congressional Budget Office (CBO) estimates that only $200 billion of the new spending will be offset with new revenue. The other $350 billion will add directly to deficits and debt. The difference is small but the political signal is notable. Chart 4 highlights the increase in the deficit likely to occur, with the CBO’s more realistic assessment delineated from the nominal bill. From a macro point of view, the takeaway is that the US economy faces a stark withdrawal of government support in 2022 but this bill slightly cushions the blow. Continued recovery will depend on consumers and businesses (which look to be in good shape). Beginning in 2025 deficits will start to rise again and hence the overall picture is one in which US government support for the economy has taken a step up for the decade. Chart 4Bipartisan Deal Not Paid For = Fiscal Stimulus Side note: Chart 4 is worrisome for President Biden if his reconciliation bill fails, as it points to fiscal drag through 2024, the election year. Bottom Line: We still see an 80% chance that Biden’s infrastructure proposals will pass, as the Democrats have a backup plan if the bipartisan deal somehow collapses in the House. Biden’s Greatest Legislative Battle Up till now we have assigned 50% odds of passage to the subsequent part of the Biden agenda, the American Families Plan, which covers social spending and tax hikes (corporate and individual). If bipartisan infrastructure passes promptly, we would upgrade the reconciliation bill’s odds of passing to 65%. The reason is twofold: first, reconciliation only requires a simple majority consisting of all 50 Senate Democrats plus the vice president; second, hesitant moderate senators ultimately will be forced to recognize that sinking the bill would render the Biden presidency defunct and fan the flames of populist rebellion on both sides of the political spectrum. And yet, since Biden cannot spare a single vote, conviction levels cannot be high. Therefore 65% seems appropriate. On August 9 Senate Democrats presented a $3.5 trillion budget resolution that will form the basis of the reconciliation bill this fall. The bill contains a wish list of spending priorities, as outlined in Table 3. Most of these are familiar from last month when the Senate Budget Committee first put forward its framework. The hang-up stems from House Speaker Pelosi. Knowing that infrastructure’s passage will suck away political capital from social spending, Pelosi is attempting to link the two bills. If the Senate fails to pass the reconciliation bill, the House will not pass the infrastructure bill. This gambit will create a big increase in uncertainty this fall as the legislative battle heats up. Republicans cannot support the infrastructure bill if it is directly tied to the Democrats’ “Nanny State” debt blowout, which will be the basis for their campaign against Democrats in future. They need plausible deniability. If Pelosi insists on linking the two bills, Republican support will evaporate. True, Democrats would then proceed to partisan reconciliation – but they would need to sacrifice other agenda items, such as subsidies for green tech, college, health care, and manufacturing (see Table 3 above). Table 3Senate Democratic FY22 Budget Resolution (July 2021) Biden and the Senate are now united on the infrastructure bill. Biden and Democrats in marginal seats need a legislative victory ahead of the midterms – and a bipartisan victory on a popular policy like infrastructure is critical. A bird in the hand is worth two in the bush. Therefore, Pelosi will probably have to concede, after gaining assurances from moderate Senate Democrats that they will not sink reconciliation. Moderate Democrats, in turn, will need to see the reconciliation bill watered down, both on spending and taxes. Table 4 shows both bills together, as Biden’s “Build Back Better” agenda, with a baseline net deficit impact. Budget deficit scenarios are then updated in Chart 5. Once again what stands out is the large fiscal drag in 2022, the fiscal thrust for the remainder of the decade, and (in this case) minimal fiscal drag for 2024. Table 4Face Value Impact Of Biden’s Spending Proposals Before Congress (Baseline) Chart 5Deficit Scenarios For Bipartisan Infrastructure Deal And Reconciliation Bill This is true even if tax hikes fail to make it into the final reconciliation bill. We still maintain that the corporate tax rate will rise above Senator Joe Manchin’s ideal 25% rate (if not all the way to Biden’s 28%) while individual tax rates will return to pre-Trump levels. It is not clear if capital gains tax hikes will make the final cut. Most likely some tax hikes will occur but they will fall short of Biden’s plan, producing, at most, a one percentage point increase in the budget deficit relative to the Congressional Budget Office’s baseline estimate (Chart 6). Chart 6What Happens If Tax Hikes Fail To Pass Congress? In Table 5 we update our various legislative scenarios, each consisting of different mixes of spending and tax hikes. We assume that the size of the bipartisan infrastructure deal will not be reduced in the House; that the revenue offsets of that deal will be $200 billion maximum; that moderate Senate Democrats will have greater success in watering down tax hikes than spending programs; and that the government overestimates its ability to collect revenue through tougher tax enforcement. Finally we assume that Senate Democrats’ spending proposals will not be cut – an extremely generous assumption that will not hold up in practice. Table 5Legislative Scenarios For Bipartisan Infrastructure Deal And FY22 Reconciliation Bill Each legislative scenario’s impact on the deficit is shown in Table 6. The result is a wide range of deficit impacts, from the baseline of $588 billion to Scenario 6, with $2.59 trillion (zero tax offsets). The more realistic range is from $1 trillion to $2.3 trillion (i.e. all scenarios except the baseline and Scenario 5). Within this range the result depends on the moderate senators’ negotiation skills. Conservatively, the impact will range from $1-$1.5 trillion (Scenarios 1, 2, 4), with moderate senators preventing a $2 trillion price tag as politically impracticable (e.g. Scenario 3). Table 6Scoring Of Legislative Scenarios For Bipartisan Infrastructure Deal And FY22 Reconciliation Bill There are two other aspects of Biden’s massive legislative battle this fall: regular government budget appropriations and the debt ceiling. Government appropriations are supposed to be passed by the end of the fiscal year, September 30, but often run over and likely will this time. Republicans will not support regular spending increases given that Democrats will ram through a partisan spending blowout. Therefore Congress will have to settle for a continuing resolution (a stop-gap measure) that keeps spending levels the same. Otherwise a government shutdown will occur. A shutdown is possible but would weigh heavily on Republicans’ public image, which is already at a low point in recent memory following the scandals of the Trump presidency. That is not all – there is also the debt ceiling (limit on national debt). Democrats made a major gambit by not including a suspension or increase of the debt ceiling in their fiscal 2022 budget resolution. If they had included it, then they could have raised the debt ceiling on their own with a simple majority when they passed their reconciliation bill. Instead they are attempting to make Republicans share the blame. Republicans, however, will mount an aggressive resistance, as they do not want to be seen as authorizing the debt increase necessary to accommodate the Democrats’ “socialist” spending spree. The “X date,” when the Treasury Department runs out of the ability to use extraordinary measures to make payments due on US debt, is expected sometime in October or November, though Treasury Secretary Janet Yellen warns it could come sooner and will try to pressure lawmakers. After this date the US would technically default on national debt obligations, triggering financial turmoil and potentially a global crisis. A debt ceiling showdown is virtually inevitable and volatility will rise – but ultimately a default will be averted, as we outlined in a recent report. First, Democrats still have the ability to revise the budget resolution so as to include a debt ceiling suspension in their final reconciliation bill. While Republicans could arguably block this attempt via a filibuster in the Budget Committee, they would have no interest in doing so (they could abstain and thus keep their hands clean of any debt ceiling increase). Second, Republicans can be forced to agree to a suspension of the debt ceiling when they fund the government, since it is necessary to do so anyway to fund their own infrastructure deal. Suspending the debt ceiling is not the same as raising it. New battles would be set up for later, in 2022 and beyond. But Republicans do not have the political ability to force a default on the public debt of the United States in the same year that Democrats accuse them of raising an insurrection against its Congress. Bottom Line: This fall will see the great legislative battle of the Biden presidency. Infrastructure spending has an 80% chance of passing. Pelosi will not be able to withstand Biden and the Senate in passing this deal separately from the more partisan reconciliation bill. If it passes, then Biden’s reconciliation bill will rise from 50% to 65% odds of passage. The latter will be watered down to a net deficit impact of $1-$1.5 trillion to secure the votes of moderate Senate Democrats, who ultimately will not betray their party to neuter Biden’s presidency. Thin margins in the House and Senate do not permit higher odds of passage or a high level of confidence. Investment Takeaways Political polarization has fallen sharply (Chart 7). This is connected to our view that the Republican Party is split, while Biden’s key initiative (infrastructure) has bipartisan support. However, Biden’s bipartisanship has resulted in a larger loss of Democratic support than a gain of Republican support (Chart 7, bottom panel). And the upcoming reconciliation bill will reignite Republican opposition. Moreover, polarization will remain at historically elevated levels, even to the point of generating domestic terrorist attacks, as we have argued. Biden’s approval rating has fallen but not enough to sink his legislative proposals. The overall economy is strong judging by both consumer confidence (Chart 8) and capital spending (Chart 9). Any soft patch in the economy in the near term will assist Biden in his legislative battles. Passage of either or both major bills will boost his approval rating, potentially ameliorating the Democrats’ challenging situation in the 2022 midterms. Chart 7Bipartisan Biden Lowers Polarization As Dems Waver Chart 8US Consumer Confidence Soars Chart 9US Capital Spending At Peak Levels Still, we expect investors to “buy the rumor and sell the news” of Biden’s upcoming stimulus bills. After the Senate passes the reconciliation measure, investors will have to look forward to the combined impact of tax hikes, the Fed’s tapering of asset purchases and eventual rate hikes, and the various troubles with global growth and geopolitical risk. Until that time, investors must weigh the risks of the COVID-19 variants against actions by both American and Chinese policymakers to dispel deflationary tail risks. Thus for now we are sticking with our key trades of the year: value stocks, materials, and infrastructure plays (Chart 10). After Biden wins his big legislative battles, we will reassess. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com Chart 10Buy Rumor, Sell News On Biden Plan Appendix Table A1USPS Trade Table Table A2Political Risk Matrix Chart A1Presidential Election Model Chart A2Senate Election Model Table A3Political Capital Index Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets Footnotes
BCA Research’s Geopolitical Strategy service expects the Biden administration to pass a bipartisan infrastructure deal – as well as a large spending bill by Christmas. Ten Republicans are now slated to join 50 Democrats in the Senate to pass a $1 trillion…
Highlights China’s July Politburo meeting signaled that policy is unlikely to be overtightened. The Biden administration is likely to pass a bipartisan infrastructure deal – as well as a large spending bill by Christmas. Geopolitical risk in the Middle East will rise as Iran’s new hawkish president stakes out an aggressive position. US-Iran talks just got longer and more complicated. Europe’s relatively low political risk is still a boon for regional assets. However, Russia could still deal negative surprises given its restive domestic politics. Japan will see a rise in political turmoil after the Olympic games but national policy is firmly set on the path that Shinzo Abe blazed. Stay long yen as a tactical hedge. Feature Chart 1Rising Hospitalizations Cause Near-Term Jitters, But UK Rolling Over? Our key view of 2021, that China would verge on overtightening policy but would retreat from such a mistake to preserve its economic recovery, looks to be confirmed after the Politburo’s July meeting opened the way for easier policy in the coming months. Meanwhile the Biden administration is likely to secure a bipartisan infrastructure package and push through a large expansion of the social safety net, further securing the American recovery. Growth and stimulus have peaked in both the US and China but these government actions should keep growth supported at a reasonable level and dispel disinflationary fears. This backdrop should support our pro-cyclical, reflationary trade recommendations in the second half of the year. Jitters continue over COVID-19 variants but new cases have tentatively peaked in the UK, US vaccinations are picking up, and death rates are a lot lower now than they were last year, that is, prior to widescale vaccination (Chart 1). This week we are taking a pause to address some of the very good client questions we have received in recent weeks, ranging from our key views of the year to our outstanding investment recommendations. We hope you find the answers insightful. Will Biden’s Infrastructure Bill Disappoint? Ten Republicans are now slated to join 50 Democrats in the Senate to pass a $1 trillion infrastructure bill that consists of $550 billion in new spending over a ten-year period (Table 1). The deal is not certain to pass and it is ostensibly smaller than Biden’s proposal. But Democrats still have the ability to pass a mammoth spending bill this fall. So the bipartisan bill should not be seen as a disappointment with regard to US fiscal policy or projections. The Republicans appear to have the votes for this bipartisan deal. Traditional infrastructure – including broadband internet – has large popular support, especially when not coupled with tax hikes, as is the case here. Both Biden and Trump ran on a ticket of big infra spending. However, political polarization is still at historic peaks so it is possible the deal could collapse despite the strong signs in the media that it will pass. Going forward, the sense of crisis will dissipate and Republicans will take a more oppositional stance. The Democratic Congress will pass President Joe Biden’s signature reconciliation bill this fall, another dollop of massive spending, without a single Republican vote (Chart 2). After that, fiscal policy will probably be frozen in place through at least 2025. Campaigning will begin for the 2022 midterm elections, which makes major new legislation unlikely in 2022, and congressional gridlock is the likely result of the midterm. Republicans will revert to belt tightening until they gain full control of government or a new global crisis erupts. Table 1Bipartisan Infrastructure Bill Likely To Pass Chart 2Reconciliation Bill Also Likely To Pass Chart 3Biden Cannot Spare A Single Vote In Senate Hence the legislative battle over the reconciliation bill this fall will be the biggest domestic battle of the Biden presidency. The 2021 budget reconciliation bill, based on a $3.5 trillion budget resolution agreed by Democrats in July, will incorporate parts of the American Jobs Plan that did not pass via bipartisan vote (such as $436 billion in green energy subsidies), plus a large expansion of social welfare, the American Families Plan. This bill will likely pass by Christmas but Democrats have only a one-seat margin in the Senate, which means our conviction level must be medium, or subjectively about 65%. The process will be rocky and uncertain (Chart 3). Moderate Democratic senators will ultimately vote with their party because if they do not they will effectively sink the Biden presidency and fan the flames of populist rebellion. US budget deficit projections in Chart 4 show the current status quo, plus scenarios in which we add the bipartisan infra deal, the reconciliation bill, and the reconciliation bill sans tax hikes. The only significant surprise would be if the reconciliation bill passed shorn of tax hikes, which would reduce the fiscal drag by 1% of GDP next year and in coming years. Chart 4APassing Both A Bipartisan Infrastructure Bill And A Reconciliation Bill Cannot Avoid Fiscal Cliff In 2022 … Chart 4B… The Only Major Fiscal Surprise Would Come If Tax Hikes Were Excluded From This Fall’s Reconciliation Bill Chart 5Biden Stimulus Overshadowed By China Policy Tightening ... But China Is Now Marginally Easing There are two implications. First, government support for the economy has taken a significant step up as a result of the pandemic and election in 2020. There is no fiscal austerity, unlike in 2011-16. Second, a fiscal cliff looms in 2022 regardless of whether Biden’s reconciliation bill passes, although the private economy should continue to recover on the back of vaccines and strong consumer sentiment. This is a temporary problem given the first point. Monetary policy has a better chance of normalizing at some point if fiscal policy delivers as expected. But the Federal Reserve will still be exceedingly careful about resuming rate hikes. President Biden could well announce that he will replace Chairman Powell in the coming months, delivering a marginally dovish surprise (otherwise Biden runs the risk that Powell will be too hawkish in 2022-23). Inflation will abate in the short run but remain a risk over the long run. Essentially the outlook for US equities is still positive for H2 but clouds are forming on the horizon due to peak fiscal stimulus, tax hikes in the reconciliation bill, eventual Fed rate hikes (conceivably 2022, likely 2023), and the fact that US and Chinese growth has peaked while global growth is soon to peak as well. All of these factors point toward a transition phase in global financial markets until economies find stable growth in the post-pandemic, post-stimulus era. Investors will buy the rumor and sell the news of Biden’s multi-trillion reconciliation bill in H2. The bill is largely priced out at the moment due to China’s policy tightening (Chart 5). The next section of this report suggests that China’s policy will ease on the margin over the coming 12 months. Bottom Line: US fiscal policy is delivering, not disappointing. Congress is likely to pass a large reconciliation bill by Christmas, despite no buffer in the Senate, because Democratic Senators know that the Biden presidency hangs in the balance. China’s Khodorkovsky Moment? Many clients have asked whether China’s crackdown on private business, from tech to education, is the country’s “Khodorkovsky moment,” i.e. the point at which Beijing converts into a full, autocratic regime where private enterprise is permanently impaired because it is subject to arbitrary seizure and control of the state. The answer is yes, with caveats. Yes, China’s government is taking a more aggressive, nationalist, and illiberal stance that will permanently impair private business and investor sentiment. But no, this process did not begin overnight and will not proceed in a straight line. There is a cyclical aspect that different investors will have to approach differently. First a reminder of the original Khodorkovsky moment. After the Soviet Union’s collapse, extremely wealthy oligarchs emerged who benefited from the privatization of state assets. When President Putin began to reassert the primacy of the state, he arbitrarily imprisoned Khodorkovsky and dismantled his corporate energy empire, Yukos, giving the spoils to state-owned companies. Russia is a petro state so Putin’s control of the energy sector would be critical for government revenues and strategic resurgence, especially at the dawn of a commodity boom. Both the RUB-USD and Russian equity relative performance performed mostly in line with global crude oil prices, as befits Russia’s economy, even though there was a powerful (geo)political risk premium injected during these two decades due to Russia’s centralization of power and clash with the West (Chart 6). Investors could tactically play the rallies after Khodorkovsky but the general trend depended on the commodity cycle and the secular rise of geopolitical risk. Chart 6Russia's 'Khodorkovsky Moment' Was A Geopolitical Turning Point...But Russian Assets Benefited From Oil Bull Market For A While Longer President Xi Jinping is a strongman and hardliner, like Putin, but his mission is to prevent Communist China from collapsing like the Soviet Union, rather than to revive it from its ashes. To that end he must reassert the state while trying to sustain the country’s current high level of economic competitiveness. Since China is a complex economy, not a petro state, this requires the state-backed pursuit of science, technology, competitiveness, and productivity to avoid collapse. Therefore Beijing wants to control but not smother the tech companies. Hence there is a cyclical factor to China’s regulatory crackdown. A crackdown on President Xi Jinping’s potential rivals or powerful figures was always very likely to occur ahead of the Communist Party’s five-year personnel reshuffle in 2022, as we argued prior to tech exec Jack Ma’s disappearance. Sackings of high-level figures have happened around every five-year leadership rotation. Similarly a crackdown on the media was expected. True, the pre-party congress crackdowns are different this time around as they are targeted at the private sector, innovative businesses, tech, and social media. Nevertheless, as in the past, a policy easing phase will follow the tightening phase so as to preserve the economy and the mobilization of private capital for strategic purposes. The critical cyclical factor for global investors is China’s monetary and credit impulse. For example, the crackdown on the financial sector ahead of the national party congress in 2017 caused a global manufacturing slowdown because it tightened credit for the entire Chinese economy, reducing imports from abroad. One reason Chinese markets sold off so heavily this spring and summer, was that macroeconomic indicators began decelerating, leaving nothing for investors to sink their teeth into except communism. The latest Politburo meeting suggests that monetary, fiscal, and regulatory policy is likely to get easier, or at least stay just as easy, going forward (Table 2). Once again, the month of July has proved an inflection point in central economic policy. Financial markets can now look forward to a cyclical easing in regulation combined with easing in monetary and fiscal policy over the next 12-24 months. Table 2China’s Politburo Prepares To Ease Policy, Secure Recovery Despite all of the above, for global investors with a lengthy time horizon, the government’s crackdown points to a secular rise of Communist and Big Government interventionism into the economy, with negative ramifications for China’s private sector, economic freedoms, and attractiveness as a destination for foreign investment. The arbitrary and absolutist nature of its advances will be anathema to long-term global capital. Also, social media, unlike other tech firms, pose potential sociopolitical risks and may not boost productivity much, whereas the government wants to promote new manufacturing, materials, energy, electric vehicles, medicine, and other tradable goods. So while Beijing cannot afford to crush the tech sector, it can afford to crush some social media firms. Chart 7China's Crackdown On Private Sector Reinforces Past Decade's Turn Away From Liberal Reform China’s equity market profile looks conspicuously like Russia’s at the time of Khodorkovsky’s arrest (Chart 7). Chinese renminbi has underperformed the dollar on a multi-year basis since Xi Jinping’s rise to power, in line with falling export prices and slowing economic growth, as a result of economic structural change and the administration’s rolling back Deng Xiaoping’s liberal reform era. We expect a cyclical rebound to occur but we do not recommend playing it. Instead we recommend other cyclical plays as China eases policy, particularly in European equities and US-linked emerging markets like Mexico. Bottom Line: The twentieth national party congress in 2022 is a critical political event that is motivating a cyclical crackdown on potential rivals to Communist Party power. Chinese equities will temporarily bounce back, especially with a better prospect for monetary and fiscal easing. But over the long run global investors should stay focused on the secular decline of China’s economic freedoms and hence productivity. What Happened To The US-Iran Deal? Our second key view for 2021 was the US strategic rotation from the Middle East and South Asia to Asia Pacific. This rotation is visible in the Biden administration’s attempt to withdraw from Iraq and Afghanistan while rejoining the 2015 nuclear deal with Iran. However, Biden here faces challenges that will become very high profile in the coming months. The Biden administration failed to rejoin the 2015 deal under the outgoing leadership of the reformist President Hassan Rouhani. This means a new and much more difficult negotiation process will now begin that could last through Biden’s term or beyond. On August 5, President Ebrahim Raisi will take office with an aggressive flourish. The US is already blaming Iran for an act of sabotage in the Persian Gulf that killed one Romanian and one Briton. Raisi will need to establish that he is not a toady, will not cower before the West. The new Israeli government of Prime Minister Naftali Bennett also needs to demonstrate that despite the fall of his hawkish predecessor Benjamin Netanyahu, Jerusalem is willing and able to uphold Israel’s red lines against Iranian nuclear weaponization and regional terrorism. Hence both Iran and its regional rivals, including Saudi Arabia, will rattle sabers and underscore their red lines. The Persian Gulf and Strait of Hormuz will be subject to threats and attacks in the coming months that could escalate dramatically, posing a risk of oil supply disruptions. Given that the Iranians ultimately do want a deal with the Americans, the pressure should be low-to-medium level and persistent, hence inflationary, as opposed to say a lengthy shutdown of the Strait of Hormuz that would cause a giant spike in prices that ultimately kills global demand. Short term, the US attempt to reduce its commitments in Iraq and Afghanistan will invite US enemies to harass or embarrass the Biden administration. The Taliban is likely to retake control of Afghanistan. The US exit will resemble Saigon in 1975. This will be a black eye for the Biden administration. But public opinion and US grand strategy will urge Biden to be rid of the war. So any delays, or a decision to retain low-key sustained troop presence, will not change the big picture of US withdrawal. Long term, Biden needs to pivot to Asia, while President Raisi is ultimately subject to the Supreme Leader Ali Khamenei, who wants to secure Iran’s domestic stability and his own eventual leadership succession. Rejoining the 2015 nuclear deal leads to sanctions relief, without requiring total abandonment of a nuclear program that could someday be weaponized, so Iran will ultimately agree. The problem will then become the regional rise of Iranian power and the balancing act that the US will have to maintain with its allies to keep Iran contained. Bottom Line: The risk to oil prices lies to the upside until a US-Iran deal comes together. The US and Iran still have a shared interest in rejoining the 2015 deal but the time frame is now delayed for months if not years. We still expect a US-Iran deal eventually but previously we had anticipated a rapid deal that would put downward pressure on oil prices in the second half of the year. What Comes After Biden’s White Flag On Nord Stream II? Our third key view for 2021 highlighted Europe’s positive geopolitical and macro backdrop. This view is correct so far, especially given that China’s policymakers are now more likely to ease policy going forward. But Russia could still upset the view. Italy has been the weak link in European integration over the past decade (excluding the UK). So the national unity coalition that has taken shape under Prime Minister Mario Draghi exemplifies the way in which political risks were overrated. Italy is now the government that has benefited the most from the overall COVID crisis in public opinion (Chart 8). The same chart shows that the German government also improved its public standing, although mostly because outgoing Chancellor Angela Merkel is exiting on a high note. Her Christian Democrat-led coalition has not seen a comparable increase in support. The Greens should outperform their opinion polling in the federal election on September 26. But the same polling suggests that the Greens will be constrained within a ruling coalition (Chart 9). The result will be larger spending without the ability to raise taxes substantially. Markets will cheer a fiscally dovish and pro-European ruling coalition. Chart 8European Political Risk Limited, But Rising, Post-COVID The chief risk to this view of low EU political risk comes from Russia. Russia is a state in long-term decline due to the remorseless fall in fertility and productivity. The result has been foreign policy aggression as President Putin attempts to fortify the country’s strategic position and frontiers ahead of an even bleaker future. Chart 9German Election Polls Point To Gridlock? Now domestic political unrest has grown after a decade of policy austerity and the COVID-19 pandemic. Elections for the Duma will be held on September 19 and will serve as the proximate cause for Russia’s next round of unrest and police repression. Foreign aggressiveness may be used to distract the population from the pandemic and poor economy. We have argued that there would not be a diplomatic reset for the US and Russia on par with the reset of 2009-11. We stand by this view but so far it is facing challenges. Putin did not re-invade Ukraine this spring and Biden did not impose tough sanctions canceling the construction of the Nord Stream II gas pipeline to Germany. Russia is tentatively cooperating on the US’s talks with Iran and withdrawal from Afghanistan. The US gave Germany and Russia a free point by condoning the NordStream II. Now the US will expect Germany to take a tough diplomatic line on Russian and Chinese aggression, while expecting Russia to give the US some goodwill in return. They may not deliver. The makeup of the new German coalition will have some impact on its foreign policy trajectory in the coming years. But the last thing that any German government wants is to be thrust into a new cold war that divides the country down the middle. Exports make up 36% of German output, and exports to the Russian and Chinese spheres account for a substantial share of total exports (Chart 10). The US administration prioritizes multilateralism above transactional benefits so the Germans will not suffer any blowback from the Americans for remaining engaged with Russia and China, at least not anytime soon. Russia, on the other hand, may feel a need to seize the moment and make strategic gains in its region, despite Biden’s diplomatic overtures. If the US wraps up its forever wars, Russia’s window of opportunity closes. So Russia may be forced to act sooner rather than later, whether in suppressing domestic dissent, intimidating or attacking its neighbors, or hacking into US digital networks. In the aftermath of the German and Russian elections, we will reassess the risk from Russia. But our strong conviction is that neither Russian nor American strategy have changed and therefore new conflicts are looming. Therefore we prefer developed market European equities and we do not recommend investors take part in the Russian equity rally. Chart 10Germany Opposes New Cold War With Russia Or China Bottom Line: German and European equities should benefit from global vaccination, Biden’s fiscal and foreign policies, and China’s marginal policy easing (Chart 11). Eastern European emerging markets and Russian assets are riskier than they appear because of latent geopolitical tensions that could explode around the time of important elections in September. Chart 11Geopolitical Tailwinds To European Equities What Comes After The Olympics In Japan? Japan is returning to an era of “revolving door” prime ministers. Prime Minister Yoshihide Suga’s sole purpose was to tie up the loose ends of the Shinzo Abe administration, namely by overseeing the Olympics. After the games end, he will struggle to retain leadership of the Liberal Democratic Party. He will be blamed for spread of Delta variant even if the Olympics were not a major factor. If he somehow retains the party’s helm, the October general election will still be an underwhelming performance by the Liberal Democrats, which will sow the seeds of his downfall within a short time (Chart 12). Suga will need to launch a new fiscal spending package, possibly as an election gimmick, and his party has the strength in the Diet to push it through quickly, which will be favorable for the economy. For the elections the problem is not the Liberal Democrats’ popularity, which is still leagues above the nearest competitor, but rather low enthusiasm and backlash over COVID. Abe’s retirement, and the eventual fall of Abe’s hand-picked deputy, does not entail the loss of Abenomics. The Bank of Japan will retain its ultra-dovish cast at least until Haruhiko Kuroda steps down in 2023. The changes that occurred in Japan from 2008-12 exemplified Japan’s existence as an “earthquake society” that undergoes drastic national changes suddenly and rapidly. The paradigm shift will not be reversed. The drivers were the Great Recession, the LDP’s brief stint in the political wilderness, the Tohoku earthquake and Fukushima nuclear crisis, and the rise of China. The BoJ became ultra-dovish and unorthodox, the LDP became more proactive both at home and abroad. The deflationary economic backdrop and Chinese nationalism are still a powerful impetus for these trends to continue – as highlighted by increasingly alarming rhetoric by Japanese officials, including now Shinzo Abe himself, regarding the Chinese military threat to Taiwan. In other words, Suga’s lack of leadership will not stand even if he somehow stays prime minister into 2022. The Liberal Democrats have several potential leaders waiting in the wings and one of these will emerge, whether Yuriko Koike, Shigeru Ishiba, or Shinjiro Koizumi, or someone else. The popular and geopolitical pressures will force the Liberal Democrats and various institutions to continue providing accommodation to the economy and bulking up the nation’s defenses. This will require the BoJ to stay easier for longer and possibly to roll out new unorthodox policies, as with yield curve control in the 2010s. Japan has some of the highest real rates in the G10 as a result of very low inflation expectations and a deeply negative output gap (Chart 13). Abenomics was bearing fruit, prior to COVID-19, so it will be justified to stay the course given that deflation has reemerged as a threat once again. Chart 12Japan: Back To Revolving Door Of Prime Ministers Chart 13Japan To Keep Fighting Deflation Post-Abe Bottom Line: The political and geopolitical backdrop for Japan is clear. The government and BoJ will have to do whatever it takes to stay the course on Abenomics even in the wake of Abe and Suga. Prime ministers will come and go in rapid succession, like in past eras of political turmoil, but the trajectory of national policy is set. We would favor JGBs relative to more high-beta government bonds like American and Canadian. Given deflation, looming Japanese political turmoil, and the secular rise in geopolitical risk, we continue to recommend holding the yen. These views conform with those of BCA’s fixed income and forex strategists. Investment Takeaways China’s policymakers are backing away from the risk of overtightening policy this year. Policy should ease on the margin going forward. Our number one key forecast for 2021 is tentatively confirmed. Base metals are still overextended but global reflation trades should be able to grind higher. The US fiscal spending orgy will continue through the end of the year via Biden’s reconciliation bill, which we expect to pass. Proactive DM fiscal policy will continue to dispel disinflationary fears. Sparks will fly in the Middle East. The US-Iran negotiations will now be long and drawn out with occasional shows of force that highlight the tail risk of war. We expect geopolitics to add a risk premium to oil prices at least until the two countries can rejoin the 2015 nuclear deal. Germany’s Green Party will surprise to the upside in elections, highlighting Europe’s low level of geopolitical risk. China policy easing is positive for European assets. Russia’s outward aggressiveness is the key risk. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com
Highlights Globalization is recovering to its pre-pandemic trajectory. But it will fail to live up to potential, as the “hyper-globalization” trends of the 1990s are long gone. China was the biggest winner of hyper-globalization. It now faces unprecedented risks in the context of hypo-globalization. Global investors woke up to China’s domestic political risks this year, which include arbitrary regulatory crackdowns on tech and private business. While Chinese officials will ease policy to soothe markets, the cyclical and structural outlook is still negative for this economy. Growth and stimulus have peaked. Political risk will stay high through the national party congress in fall 2022. US-China relations have not stabilized. India, the clearest EM alternative for global investors, is high-priced relative to China and faces troubles of its own. It is too soon to call a bottom for EM relative to DM. Feature Global investors woke up to China’s domestic political risk over the past week, as Beijing extended its regulatory crackdown to private education companies. Our GeoRisk Indicator shows Chinese political risk reaching late 2017 levels while the broad Chinese stock market continued this year’s slide against emerging market peers (Chart 1). Chart 1China: Domestic Political Risk Takes Investors By Surprise A technical bounce in Chinese tech stocks will very likely occur but we would not recommend playing it. The first of our three key views for 2021 is the confluence of internal and external headwinds for China. True, today’s regulatory blitz will pass over like previous ones and the fast money will snap up Chinese tech firms on the cheap. The Communist Party is making a show of force, not destroying its crown jewels in the tech sector. However, the negative factors weighing on China are both cyclical and structural. Until Chinese President Xi Jinping adjusts his strategy and US-China relations stabilize, investors do not have a solid foundation for putting more capital at risk in China. Globalization is in retreat and this is negative for China, the big winner of the past 40 years. Hypo-Globalization Globalization in the truest sense has expanded over millenia. It will only reverse amid civilizational disasters. But the post-Cold War era of “hyper-globalization” is long gone.1 The 2010s saw the emergence of de-globalization. In the wake of COVID-19, global trade is recovering to its post-2008 trend but it is nowhere near recovering the post-1990 trend (Chart 2). Trade exposure has even fallen within the major free trade blocs, like the EU and USMCA (Chart 3). Chart 2Hypo-Globalization Chart 3Trade Intensity Slows Even Within Trade Blocs Of course, with vaccines and stimulus, global trade will recover in the coming decade. We coined the term “hypo-globalization” to capture this predicament, in which globalization is set to rebound but not to its previous trajectory.2 We now inhabit a world that is under-globalized and under-globalizing, i.e. not as open and free as it could be. A major factor is the US-China economic divorce, which is proceeding apace. China’s latest state actions – in diplomacy, finance, and business – underscore its ongoing disengagement from the US-led global architecture. The US, for its part, is now on its third presidency with protectionist leanings. American and European fiscal stimulus are increasingly protectionist in nature, including rising climate protectionism. Bottom Line: The stimulus-fueled recovery from the global pandemic is not leading to re-globalization so much as hypo-globalization. A cyclical reboot of cross-border trade and investment is occurring but will fall short of global potential due to a darkening geopolitical backdrop. Still No Stabilization In US-China Relations Chart 4Do Nations Prefer Growth? Or Security? A giant window of opportunity is closing for China and Russia – they will look back fondly on the days when the US was bogged down in the Middle East. The US current withdrawal from “forever wars” incentivizes Beijing and Moscow to act aggressively now, whether at home or abroad. Investors tend to overrate the Chinese people’s desire for economic prosperity relative to their fear of insecurity and domination by foreign powers. China today is more desirous of strong national defense than faster economic growth (Chart 4). The rise of Chinese nationalism is pronounced since the Great Recession. President Xi Jinping confirmed this trend in his speech for the Communist Party’s first centenary on July 1, 2021. Xi was notably more concerned with foreign threats than his predecessors in 2001 and 2011 (Chart 5).3 China has arrived as a Great Power on the global stage and will resist being foisted into a subsidiary role by western nations. Chart 5Xi Jinping’s Centenary Speech Signaled Nationalist Turn Meanwhile US-China relations have not stabilized. The latest negotiations did not produce agreed upon terms for managing tensions in the relationship. A bilateral summit between Presidents Biden and Xi Jinping has not been agreed to or scheduled, though it could still come together by the end of October. Foreign Minister Wang Yi produced a set of three major demands: that the US not subvert “socialism with Chinese characteristics,” obstruct China’s development, or infringe on China’s sovereignty and territorial integrity (Table 1). The US’s opposition to China’s state-backed economic model, export controls on advanced technology, and attempts to negotiate a trade deal with the province of Taiwan all violate these demands.4 Table 1China’s Three Demands From The United States (July 2021) The removal of US support for China’s economic, development – recently confirmed by the Biden administration – will take a substantial toll on sentiment within China and among global investors. US President Joe Biden and four executive departments have explicitly warned investors not to invest in Hong Kong or in companies with ties to China’s military-industrial complex and human rights abuses. The US now formally accuses China of genocide in the Xinjiang region.5 Bottom Line: There is no stabilization in US-China relations yet. This will keep the risk premium in Chinese currency and equities elevated. The Sino-American divorce is a major driver of hypo-globalization. China’s Regulatory Crackdown President Xi Jinping’s strategy is consistent. He does not want last year’s stimulus splurge to create destabilizing asset bubbles and he wants to continue converting American antagonism into domestic power consolidation, particularly over the private economy. Now China’s sweeping “anti-trust” regulatory crackdown on tech, education, and other sectors is driving a major rethink among investors, ranging from Ark-founder Cathie Wood to perma-bulls like Stephen Roach. The driver of the latest regulatory crackdown is the administration’s reassertion of central party control. The Chinese economy’s potential growth is slowing, putting pressure on the legitimacy of single-party rule. The Communist Party is responding by trying to improve quality of life while promoting nationalism and “socialism with Chinese characteristics,” i.e. strong central government control and guidance over a market economy. Beijing is also using state power and industrial policy to attempt a great leap forward in science and technology in a bid to secure a place in the sun. Fintech, social media, and other innovative platforms have the potential to create networks of information, wealth, and power beyond the party’s control. Their rise can generate social upheaval at home and increase vulnerability to capital markets abroad. They may even divert resources from core technologies that would do more to increase China’s military-industrial capabilities. Beijing’s goal is to guide economic development, break up the concentration of power outside of the party, prevent systemic risks, and increase popular support in an era of falling income growth. Sociopolitical Risks: Social media has demonstrably exacerbated factionalism and social unrest in the United States, while silencing a sitting president. This extent of corporate power is intolerable for China. Economic And Financial Risks: Innovative fintech companies like Ant Group, via platforms like Alipay, were threatening to disrupt one of the Communist Party’s most important levers of power: the banking and financial system. The People’s Bank of China and other regulators insisted that Ant be treated more like a bank if it were to dabble in lending and wealth management. Hence the PBoC imposed capital adequacy and credit reporting requirements.6 Data Security Risks: Didi Chuxing, the ride-sharing company partly owned by Uber, whose business model it copied and elaborated on, defied authorities by attempting to conduct its initial public offering in the United States in June. The Communist Party cracked down on the company after the IPO to show who was in charge. Even more, Beijing wanted to protect its national data and prevent the US from gaining insights into its future technologies such as electric and autonomous vehicles. Foreign Policy Risks: Beijing is also preempting the American financial authorities, who will likely take action to kick Chinese companies that do not conform to common accounting and transparency standards off US stock exchanges. Better to inflict the first blow (and drive Chinese companies to Hong Kong and Shanghai for IPOs) than to allow free-wheeling capitalism to continue, giving Americans both data and leverage. Thus Beijing is continuing the “self-sufficiency” drive, divorcing itself from the US economy and capital markets, while curbing high-flying tech entrepreneurs and companies. The party’s muscle-flexing will culminate in Xi Jinping’s consolidation of power over the Politburo and Central Committee at the twentieth national party congress in fall 2022, where he is expected to take the title of “Chairman” that only Mao Zedong has held before him. The implication is that the regulatory crackdown can easily last for another six-to-12 more months. True, investors will become desensitized to the tech crackdown. But health care and medical technology are said to be in the Chinese government’s sights. So are various mergers and acquisitions. Both regulatory and political risk premia in different sectors can persist. The current administration has waged several sweeping regulatory campaigns against monopolies, corruption, pollution, overcapacity, leverage, and non-governmental organizations. The time between the initial launch of one of these campaigns and their peak intensity ranges from two to five years (Chart 6). Often, but not always, central policy campaigns have an express, three-year plan associated with them. Chart 6ABeijing Cracked Down On Monopolies, Corruption, Pollution... Chart 6B...NGOs, Overcapacity, And Leverage Chart 7China Tech: Buyer Beware The first and second year mark the peak impact. The negative profile of Chinese tech stocks relative to their global peers suggests that the current crackdown is stretched, although there is little sign of bottom formation yet (Chart 7). The crackdown began with Alibaba founder Jack Ma, and Alibaba stocks have yet to arrest their fall either in absolute terms or relative to the Hang Seng tech index. Bottom Line: A technical bounce is highly likely for Chinese stocks, especially tech, but we would not recommend playing it because of the negative structural factors. For instance, we fully expect the US to delist Chinese companies that do not meet accounting standards. The Chinese Government’s Pain Threshold? The government is not all-powerful – it faces financial and economic constraints, even if political checks and balances are missing. Beijing does not have an interest in destroying its most innovative companies and sectors. Its goal is to maintain the regime’s survival and power. China’s crackdown on private companies goes against its strategic interest of promoting innovation and therefore it cannot continue indefinitely. The hurried meeting of the China Securities Regulatory Commission with top bankers on July 28 suggests policymakers are already feeling the heat.7 In the case of Ant Group, the company ultimately paid a roughly $3 billion fine (which is 18% of its annual revenues) and was forced to restructure. Ant learned that if it wants to behave more like a bank athen it will be regulated more like a bank. Yet investors will still have to wrestle with the long-term implications of China’s arbitrary use of state power to crack down on various companies and IPOs. This is negative for entrepreneurship and innovation, regardless of the government’s intentions. Chart 8China's Pain Threshold = Property Sector Ultimately the property sector is the critical bellwether: it is a prime target of the government’s measures against speculative asset bubbles. It is also an area where authorities hope to ease the cost of living for Chinese households, whose birth rates and fertility rates are collapsing. While there is no risk of China’s entire economy crumbling because of a crackdown on ride-hailing apps or tutoring services, there is a risk of the economy crumbling if over-zealous regulators crush animal spirits in the $52 trillion property sector, as estimated by Goldman Sachs in 2019. Property is the primary store of wealth for Chinese households and businesses and falling property prices could well lead to an unsustainable rise in debt burdens, a nationwide debt-deflation spiral, and a Japanese-style liquidity trap. Judging by residential floor space started, China is rapidly approaching its overall economic pain threshold, meaning that property sector restrictions should ease, while monetary and credit policy should get easier as necessary to preserve the economic recovery (Chart 8). The economy should improve just in time for the party congress in late 2022. Bottom Line: China will be forced to maintain relatively easy monetary and fiscal policy and avoid pricking the property bubble, which should lend some support to the global recovery and emerging markets economies over the cyclical (12-month) time frame. China’s Regulation And Demographic Pressures Is the Chinese government not acting in the public interest by tamping down financial excesses, discouraging anti-competitive corporate practices, and combating social ills? Yes, there is truth to this. But arbitrary administrative controls will not increase the birth rate, corporate productivity, or potential GDP growth. First, it is true that Chinese households cite high prices for education, housing, and medicine as reasons not to have children (Chart 9). However, price caps do not attack the root causes of these problems. The lack of financial security and investment options has long fueled high house prices. The rabid desire to get ahead in life and the exam-oriented education system have long fueled high education prices. Monetary and fiscal authorities are forced to maintain an accommodative environment to maintain minimum levels of economic growth amid high indebtedness – and yet easy money policies fuel asset price inflation. In Japan, fertility rates began falling with economic development, the entrance of women in the work force, and the rise of consumer society. The fertility rate kept falling even when the country slipped into deflation. It perked up when prices started rising again! But it relapsed after the Great Recession and Fukushima nuclear crisis (Chart 10, top panel). Chart 9China: Concerns About Having Children China’s fertility rate bottomed in the 1990s and has gradually recovered despite the historic surge in property prices (Chart 10, second panel), though it is still well below the replacement rate needed to reverse China’s demographic decline in the absence of immigration. A lower cost of living and a higher quality of life will be positive for fertility but will require deeper reforms.8 Chart 10Fertility Fell In Japan Despite Falling Prices At the same time, arbitrary regulatory crackdowns that punish entrepreneurs are not likely to boost productivity. Anti-trust actions could increase competition, which would be positive for productivity, but China’s anti-trust actions are not conducted according to rule of law, or due process, so they increase uncertainty rather than providing a more stable investment environment. China’s tech crackdown is also aimed at limiting vulnerability to foreign (American) authorities. Yet disengagement with the global economy will reduce competition, innovation, and productivity in China. Bottom Line: China’s demographic decline will require larger structural changes. It will not be reversed by an arbitrary game of whack-a-mole against the prices of housing, education, and health. India And South Asia Chart 11China Will Ease Policy... Or India Will Break Out Global investors have turned to Indian equities over the course of the year and they are now reaching a major technical top relative to Chinese stocks (Chart 11). Assuming that China pulls back on its policy tightening, this relationship should revert to mean. India faces tactical geopolitical and macroeconomic headwinds that will hit her sails and slow her down. In other words, there is no great option for emerging markets at the moment. Over the long run, India benefits if China falters. Following the peak of the second COVID-19 wave in May 2021, some high frequency indicators have showed an improvement in India’s economy. However, activity levels appear weaker than of other emerging markets (Chart 12). Given the stringency levels of India’s first lockdown last spring, year-on-year growth will look faster than it really is. As the base effect wanes, underlying weak demand will become evident. Moreover India is still vulnerable to COVID-19. Only 25% of the population has received one or more vaccine shots which is lower than the global level of 28%. The result will be a larger than expected budget deficit. India refrained from administering a large dose of government spending in 2020 (Chart 13). With key state elections due from early 2022 onwards, the government could opt for larger stimulus. This could assume the form of excise duty cuts on petroleum products or an increase in revenue expenditure. These kinds of measures will not enhance India’s productivity but will add to its fiscal deficit. Chart 12Weak Post-COVID Rebound In India – And Losing Steam Chart 13India Likely To Expand Fiscal Spending Soon Such an unexpected increase in India’s fiscal deficit could be viewed adversely by markets. India’s fiscal discipline tends to be poorer than that of peers (see Chart 13 above). Meanwhile India’s north views Pakistan unfavorably and key state elections are due in this region. Consequently, Indian policy makers may be forced to adopt a far more aggressive foreign policy response to any terrorist strikes from Pakistan or territorial incursions by China over August 2021. The US withdrawal from Afghanistan poses risks for India as it has revived the Taliban’s influence. India has a long history of being targeted by Afghani terrorist groups. And its diplomatic footprint in Afghanistan has been diminishing. Earlier in July, India decided temporarily to close its consulate in Kandahar and evacuated about 50 diplomats and security personnel. As August marks the last month of formal US presence in Afghanistan, negative surprises emanating from Afghanistan should be expected. Bottom Line: Pare exposure to Indian assets on a tactical basis. Our Emerging Markets Strategy takes a more optimistic view but geopolitical changes could act as a negative catalyst in the short term. We urge clients to stay short Indian banks. Investment Takeaways US stimulus contrasts with China’s turmoil. The US Biden administration and congressional negotiators of both parties have tentatively agreed on a $1 trillion infrastructure deal over eight years. Even if this bipartisan deal falls through, Democrats alone can and will pass another $1.3-$2.5 trillion in net deficit spending by the end of the year. Stay short the renminbi. Prefer a balance of investments in the dollar and the euro, given the cross-currents of global recovery yet mounting risks to the reflation trade. A technical bounce in Chinese stocks and tech stocks is nigh. China’s policymakers are starting to respond to immediate financial pressures. However, growth has peaked and structural factors are still negative. The geopolitical outlook is still gloomy and China’s domestic political clock is a headwind for at least 12 more months. Prefer developed market equities over emerging markets (Chart 14). Emerging markets failed to outperform in the first half of the year, contrary to our expectation that the global reflation trade would lift them. China/EM will benefit when Beijing eases policy and growth rebounds. Chart 14Emerging Markets: Not Out Of The Woods Yet Stay short Indian banks and strongman EM currencies, including the Turkish lira, the Brazilian real, and the Philippine peso. The biggest driver of EM underperformance this year is the divergence between the US and China. But until China’s policy corrects, the rest of EM faces downside risks. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Dani Rodrik, The Globalization Paradox: Democracy and the Future of the World Economy (New York: Norton, 2011). 2 See my "Nationalism And Globalization After COVID-19," Investments & Wealth Monitor (Jan/Feb 2021), pp13-21, investmentsandwealth.org. 3 Our study of Xi’s speech is not limited to this quantitative, word-count analysis. A fuller comparison of his speech with that of his predecessors on the same occasion reveals that Xi was fundamentally more favorable toward Marx, less favorable toward Deng Xiaoping and the pro-market Third Plenum, utterly silent on notions of political reform or liberal reform, more harsh in his rhetoric toward the outside world, and hawkish about the mission of reunifying with Taiwan. 4 The Chinese side also insisted that the US stop revoking visas, punishing companies and institutes, treating the press as foreign agents, and detaining executives. It warned that cooperation – which the US seeks on the environment, Iran, North Korea, and other areas – cannot be achieved while the US imposes punitive measures. 5 See US Department of State, "Xinjiang Supply Chain Business Advisory," July 13, 2021, and "Risks and Considerations for Businesses Operating in Hong Kong," July 16, 2021, state.gov. 6 Top business executives are also subject to these displays of state power. For example, Alibaba founder Jack Ma caricatured China’s traditional banks as “pawn shops” and criticized regulators for stifling innovation. He is now lying low and has taken to painting! 7 See Emily Tan and Evelyn Cheng, "China will still allow IPOs in the United States, securities regulator tells brokerages," CNBC, July 28, 2021, cnbc.com. Officials are sensitive to the market blowback but the fact remains that IPOs in the US have been discouraged and arbitrary regulatory crackdowns are possible at any time. 8 Increasing social spending also requires local governments to raise more revenue but the central government had been cracking down on the major source of revenues for local government: land sales and local government financing vehicles. With the threat of punishment for local excesses and lack of revenue source, local governments have no choice but to cut social services, pushing affluent residents towards private services, while leaving the less fortunate with fewer services. As with financial regulations, the central government may backpedal from too tough regulation of local governments, but more economic and financial pain will be required to make it happen. The Geopolitics Of The Olympics The 2020 Summer Olympics are currently underway in Tokyo, even though it is 2021. The arenas are mostly empty given the global pandemic and economic slowdown. Every four years the Summer Olympics create a golden opportunity for the host nation to showcase its achievements, infrastructure, culture, and beauty. But the Olympics also have a long history of geopolitical significance: terrorist acts, war protests, social demonstrations, and boycotts. In 1906 an Irish athlete climbed a flag pole to wave the Irish flag in protest of his selection to the British team instead of the Irish one. In 1968 two African American athletes raised their fists as an act of protest against racial discrimination in the US after the assassination of Martin Luther King Jr. In 1972, the Palestinian terrorist group Black September massacred eleven Israeli Olympians in Munich, Germany. In 1980 the US led the western bloc to boycott the Moscow Olympics while the Soviet Union and its allies retaliated by boycotting the 1984 Los Angeles Olympics. In 2008, Russia used the Olympics as a convenient distraction from its invasion of Georgia, a major step in its geopolitical resurgence. So far, thankfully, the Tokyo Olympics have gone without incident. However, looking forward, geopolitics is already looming over the upcoming 2022 Winter Olympics in Beijing. How the world has changed. The 2008 Summer Olympics marked China’s global coming-of-age celebration. The breathtaking opening ceremony featured 15,000 performers and cost $100 million. The $350 million Bird’s Nest Stadium showcased to the world China’s long history, economic prowess, and various other triumphs. All of this took place while the western democratic capitalist economies grappled with what would become the worst financial and economic crisis since the Great Depression. In 2008, global elites spoke of China as a “responsible stakeholder” that was conducting a “peaceful rise” in international affairs. The world welcomed its roughly $600 billion stimulus. Now elites speak of China as primarily a threat and a competitor, a “revisionist” state challenging the liberal world order. China is blamed for a lack of transparency (if not virological malfeasance) in handling the COVID-19 pandemic. It is blamed for breaking governance promises and violating human rights in Hong Kong, for alleged genocide in Xinjiang, and for a list of other wrongdoings, including tough “Wolf Warrior” diplomacy, cyber-crime and cyber-sabotage, and revanchist maritime-territorial claims. Even aside from these accusations it is clear that China is suffering greater financial volatility as a result of its conflicting economic goals. Talk of a diplomatic or even full boycott of Beijing’s winter games is already brewing. Sponsors are also second-guessing their involvement. More than half of Canadians support boycotting the winter games. Germany is another bellwether to watch. In 2014, Germany’s president (not chancellor) boycotted the Sochi Olympics; in 2021, the EU and China are witnessing a major deterioration of relations. Parliamentarians in the UK, Italy, Sweden, Switzerland, and Norway have asked their governments to outline their official stance on the winter games. In the age of “woke capitalism,” a sponsorship boycott of the games is a possibility. This is especially true given the recent Chinese backlash against European multinational corporations for violating China’s own rules of political correctness. A boycott which includes any members of the US, Norway, Canada, Sweden, Germany, or the Netherlands would be substantial as these are the top performers in the Winter Olympics. Even if there is no boycott, there is bound to be some political protests and social demonstrations, and China will not be able to censor anything said by Western broadcasters televising the events. Athletes usually suffer backlash at home if they make critical statements about their country, but they run very little risk of a backlash for criticizing China. If anything, protests against China’s handling of human rights will be tacitly encouraged. Beijing, for its part, will likely overreact, as these days it not only controls the message at home but also attempts more actively to export censorship. This is precisely what the western governments are now trying to counteract, for their own political purposes. The bottom line is that the 2008 Beijing Olympics reflected China’s strengths in stark contrast with the failures of democratic capitalism, while the 2022 Olympics are likely to highlight the opposite: China’s weaknesses, even as the liberal democracies attempt a revival of their global leadership. Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Section II: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia Section III: Geopolitical Calendar
Highlights The Delta variant will continue causing jitters but there is much greater evidence today than there was in early 2020 that humanity can curb the virus, both with vaccines and government stimulus. Delta jitters will reinforce the Fed’s dovishness and will, if anything, increase the odds that President Biden passes his mammoth spending package this fall. The very near term could easily see more volatility but by the end of the year the reflationary cast of global policy will have won the day. Tax hikes and rate hikes lurk beyond 2021. There is still no stabilization in US-China policy and the US and its allies have called out China for cyber aggression, signaling a new front of open competition. A cyber event is one of the leading contenders for the next negative shock to the global economy. Structural factors strongly support rising concerns among the global elite about cyber insecurity. Stick to this year’s key themes and views: long gold, long value over growth, long international stocks, long Mexico, long aerospace and defense, and short emerging market “strongmen” regimes. Feature Global equities sank and rose over the past week as investors struggled with “peak growth” in the US and China, the prospect of monetary policy normalization, and other risks on the horizon, including immediate concerns over the Delta variant of COVID-19. The rapid rebound, including for cyclicals like European stocks, suggested that investors are still buying the dip given a very supportive macro and policy backdrop (Chart 1). The BCA House View consists of accommodative policy, economic recovery, a weakening dollar, and the outperformance of cyclical risk assets. We largely agree, with the caveat that there will be “No Return To Normalcy” in the geopolitical realm. Meaning that over the medium and long term the US dollar will remain firmer than expected and cyclical economies and sectors will face headwinds. Chart 1Equity Market Hits Wall Of Worry The pandemic will have unforeseen consequences, such as social unrest and regime failures, while China’s secular slowdown and the Great Power competition between the US and its rivals will intensify. Not only is China slowing but also President Joe Biden has been confirmed as a China hawk, coopting President Trump’s aggressive stance and courting US allies to pile the pressure on Beijing. For most of this year the “normalcy” narrative has prevailed. Now investors are becoming fearful of the “abnormalcy” narrative. The US dollar has surprised its doubters on the basis of relative growth and interest rate differentials (Chart 2). Chart 2Dollar Remains Firm, Reflation Indicator Abates Over the next six months, the key point is that until these geopolitical risks boil over and explode, they reinforce the bullish macro view, since government spending will surge to address national challenges. The rich democracies have awoken to the threat posed by malaise at home and autocracy abroad. They have reactivated fiscal policy to rebuild their states and expand the social safety net. They are increasing investments in infrastructure, renewables, and defense. This trend is especially positive for US allied economies, global manufacturers ex-China, commodity prices, and commodity producing emerging markets, at least until the next shock erupts. We discuss the risk of a cyber shock as well as the points above in this report. Policy Responses To The Delta Variant The Delta variant began in India and has now swept the world. So far the variants respond to COVID vaccines, which are being rolled out globally. National and local political leaders will promote vaccination campaigns first – only if hospital systems are clogged will they resort to social restrictions. New infections have risen much faster than hospitalizations and deaths, although the latter are lagging indicators and will eventually follow cases (Chart 3). But financial markets will largely look past the scare, as they looked past the various waves of the original virus over the past 15 months. Today investors have greater evidence of humanity’s ability to curb the virus and can expect government spending to tide over the economy if new restrictions are necessary. New social restrictions should not be ruled out. They are not politically impossible. Public opinion in the developed countries shows that about 77% of people believe restrictions were about right or should have been tighter, while only 23% believe there should have been fewer restrictions (Chart 4). About 40% of Germans oppose the lifting of restrictions even for the vaccinated! Chart 3Delta Variant: A Limited Risk Unless Hospitals Clog Chart 4ANew Lockdowns Not Impossible Chart 4BNew Lockdowns Not Impossible Any financial or economic distress from virus variants will reinforce ultra-accommodative monetary policy. The European Central Bank adopted a symmetric inflation target of 2% as it completed its strategic review, up from a previous goal which simply aimed at inflation just under 2%. It is likely to expand rather than taper asset purchases (Chart 5). At the Fed, the balance of power between hawks and doves on the Federal Open Market Committee reflects the political and geopolitical trends of the day. In the wake of the Great Recession, the doves overwhelmed the hawks (Chart 6). The institution has fully transitioned today – it now aims to generate an inflation overshoot – and it will not jeopardize its new average inflation targeting regime by tightening policy too soon this year or next. Chart 5Central Banks Will Delay Normalization If COVID Crisis Persists Chart 6Doves Firmly In Ascendancy At Federal Reserve The Delta variant makes it more likely that governments will increase fiscal support. The European Union’s Recovery Fund has a modest impact but the EU Commission is not patrolling budget deficits anymore, in the event that new social restrictions set back the recovery. The Democratic Party will pass President Biden’s $3.5-$4.1 trillion American Jobs and Families Plan through Congress by Christmas (with a net deficit increase of $1.3-$2.5 trillion over eight years). Support rates among independents and Democrats suggest Biden will come up with the votes (Chart 7). A renewed sense of crisis will compel any straggling senators. Chart 7ADelta Variant Makes Biden Stimulus Even More Likely To Pass Chart 7BDelta Variant Makes Biden Stimulus Even More Likely To Pass Markets will cheer more government spending as they have done throughout the vast surge in budget deficits across the world, not least in the developed markets, where austerity stunted the recovery in the wake of the Great Recession (Chart 8). Beyond Delta jitters and reactive stimulus, there are clouds forming on the horizon over the medium and long term. Budget deficits will start contracting, central banks will start hiking rates, and taxes will go up (and not only in the US). Geopolitical risks that are suppressed today will erupt later. Bottom Line: The very near term could easily see more volatility but by the end of the year the reflationary cast of global economic policy will have won the day. The bigger problems come clearly into review after the ink dries on the last installment of the great Biden budget blowout. Chart 8Market Will Cheer Another Round Of Government Spending China Policy And Cyber War What might the next major negative shock be? A leading candidate is China, with its confluence of internal and external risks. China’s policymakers opened the floodgates of credit-and-fiscal stimulus to combat the global pandemic in 2020. They quickly shifted to tightening policy to prevent destabilizing asset bubbles. Now they are easing again. Stimulus and growth have both peaked. Authorities are on the verge of overtightening policy but tactical shifts in economic policy often occur in July. Right on cue the State Council ordered across-the-board cuts to bank reserve requirements on July 9. The Politburo’s July meeting on economic policy will bring an even more important policy signal. The concrete impact of the RRR cut should not be overstated. China has been lowering RRRs since late 2011 as its broad money growth has continually declined. The trend is indicative of China’s secular slowdown. A new series of RRR cuts is often attended by a global equity selloff (Chart 9). Chart 9China Blinked - But One RRR Cut Will Not Prevent A Global Selloff Our China Investment Strategy highlights that policy remains restrictive in other areas. Local governments have been told not to borrow if they have hidden debts. Moreover the crackdown on China’s tech sector also continues apace. These regulatory crackdowns are characteristic of the Xi Jinping administration and can continue for a while as it further consolidates power in advance of the twentieth National Party Congress in fall 2022. The US-China conflict is getting worse. The Biden administration took several punitive actions over the past month. It warned businesses against investing in Hong Kong and Xinjiang. It rejected a restart of the strategic and economic dialogue. While a bilateral summit between Biden and Xi Jinping is possible on October 30-31, it is not yet scheduled and would only temporarily improve relations. One of Biden’s more significant recent moves was to orchestrate a joint statement with allies condemning China for aggressive behavior in cyber space.1 A massive cyber attack should be high up on any investor’s list of “gray rhino” events (high-probability, high-impact events). The world has suffered large shocks from global terrorism, financial crisis, and pandemic. Lightning rarely strikes the same place twice. Of course, nobody knows what will cause the next upset. But a devastating cyber event has been underrated in the investment community and that is changing (Table 1). Fed Chair Powell, asked by a reporter what was the chief risk to the global financial system, said “cyber risk.” To quote in full: So you would worry about a cyber event. That's something that many, many government agencies, including the Fed and all large private businesses and all large private financial companies in particular, monitor very carefully, invest heavily in. And that's really where the risk I would say is now, rather than something that looked like the global financial crisis.2 Table 1Cyber Event Underrated In Consensus View Of Global Risks Here are six structural reasons that cyber risk will continue to escalate: Cyber space is one of the truly ungoverned spaces. The US is the preponderant power in cyber space, as elsewhere, but there is no regular order or code of conduct. The US cyber bureaucracy is decentralized and uncoordinated while its opponents are centrally commanded, aggressive, and sophisticated. Great power competition is escalating. The US is struggling with China, Russia, and Iran and all sides seek to intimidate enemies and gain allies. Cyber capabilities enhance essential tasks like spying, sabotage, and information warfare. The tech race is intensifying, with companies and governments investing heavily in innovation and industry, while US export controls exacerbate China’s frantic efforts to obtain advanced tech by any means. The pandemic boosted digital dependency across industry and commerce, creating a “perfect storm” for cyber attacks and hacking.3 The US and its allies are threatening to retaliate more actively against cyber attacks, which may initially lead to an increase in the total number of attacks. In addition, Israel will need to sabotage Iran’s nuclear program if it is not halted by diplomacy. The US is polarized and war-weary yet claiming greater commitment to its allies, a paradox that encourages foreign rivals to use cyber tools to foment US divisions; strike at regional opponents that lack US security guarantees; and test the US commitment to its allies. The current US-Russia negotiations toward a truce against cyber attacks on critical infrastructure are the sole example of a potential structural improvement. The US and Russia could conceivably lay down some rules of the road in cyber space. There may be a basis for an agreement in that already this year the US refrained from blocking the Nordstream II pipeline with Germany while Russia refrained from re-invading Ukraine. However, a Russo-American truce would not dispel the risk of a global cyber surprise. It could even increase the odds. Russia this year alone showed with the Colonial Pipeline hack and the JBS meat-packing hack that its proxies can disrupt critical US infrastructure. It would make sense to agree to a truce so that the US does not demonstrate the same capability against Russia. Even without a truce, Russia does not benefit from provoking massive US cyber attacks. The US is the world’s leading cyber power and has pledged that it will retaliate. Rather Russia will concentrate its efforts closer to home: suppressing dissent, intimidating the former Soviet Union, and testing the US’s willingness to defend its allies. It would be useful for Russia to use cyber attacks to undermine NATO unity and demonstrate that the US is reluctant to defend NATO members’ critical infrastructure. Remember the cyber strike against Estonia in 2007. Hence huge shocks could still emerge in Europe or elsewhere even if the US and Russia make a ceasefire regarding their own critical infrastructure. The same can be said for China, Iran, and North Korea. Attacks in their neighborhood are even more likely than direct provocations against the United States now that the US is threatening graver consequences. Beijing is concentrating its cyber power on technological acquisition. But it will also try to intimidate its neighbors into neutrality and test America’s commitment to its allies. This applies to markets like Taiwan, South Korea, the Philippines, and Vietnam. Not all cyber attacks would cause a global shock but the danger of Biden’s emphasis on alliances and multilateralism is that the US will be tested and its commitments will expand. Local cyber attacks could escalate if the US believes it must prove its resolve. Bottom Line: Cyber firms’ share prices have risen since we made our contrarian buy call back in March. True, fundamentals are poor despite the strong geopolitical tailwind. The BCA Equity Analyzer shows that valuations, debt, liquidity, and return on equity have deteriorated relative to the global large cap equity universe (Chart 10). Still, as long as liquidity is ample and geopolitical risk is high we expect cyber firms’ share prices to keep grinding upward. Chart 10Cyber Stocks: Poor Fundamentals But Geopolitics A Secular Driver Investment Takeaways We are sticking with our key themes and views: long gold; long value over growth; long DM-ex-US stocks such as FTSE100 (Chart 11) and European industrials; long US neighbors Mexico and Canada; long defense and cyber stocks; and short the assets of emerging market “strongman” regimes from China and Russia to Brazil, Turkey, and the Philippines. Taking several of our trade recommendations alongside the copper-to-gold ratio, a key measure of global reflation, there could be more near-term downside (Chart 12). Nevertheless these are strategic trades designed to bear rewards over 12 months and beyond. Mainland Chinese investors should book gains on long Chinese 10-year government bonds. We would not rule out a bigger bond rally later given China’s risks at home and abroad, but RRR cuts often lead to a selloff and the signal is that the socialist policy “put” remains in place. Book gains on long Italian / short Spanish equities. This tactical trade is now hitting the top of its range and will likely mean revert. We are still optimistic on European stocks and the euro as a whole and view the German election as a positive catalyst almost regardless of outcome. Chart 11Stay The Course: Long Value Over Growth Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Chart 12Stick To Cyclical Trades Over Near-Term Volatility Footnotes 1 White House, “The United States, Joined by Allies and Partners, Attributes Malicious Cyber Activity and Irresponsible State Behavior to the People’s Republic of China,” July 19, 2021, whitehouse.gov. 2 “Jerome Powell: Full 2021 60 Minutes Interview Transcript,” CBS News, April 11, 2021, cbsnews.com. 3 Connor Fairman, “2020: Cybercrime’s Perfect Storm,” Council on Foreign Relations, January 20, 2021, cfr.org.