中国と新興アジア

Highlights China’s new plan for “common prosperity” is a long-term strategic plan to bulk up the middle class that will strengthen China – if it is implemented successfully. The record on implementing reforms is mixed. Large budget deficits to provide subsidies for households and key industries are inevitable. But fiscal reforms will be more difficult. Implementation will proceed gradually and some provinces will move faster than others. Cyclically, the common prosperity plan will not be allowed to interfere with the post-pandemic economic recovery. Beijing will have to ease monetary and fiscal policy to secure the recovery. But large debt levels create a limit on the ability to push through key reforms. Macro policy easing is beneficial for the rest of the world but Chinese investors must deal with a rise in uncertainty and an anti-business turn in the policy environment. Beijing has centralized political power to move rapidly on reforms. However, centralization creates new structural problems while antagonizing foreign nations. Feature Chinese President Xi Jinping laid out a plan on August 18 for “common prosperity” in China that will help guide national policy over the coming decades. The plan seeks to reduce social and economic imbalances and hence strengthen China and reinforce the Communist Party’s rule. The plan confirms our top key view for the year – China’s confluence of internal and external risks – as well as our long-running theme that Chinese domestic political risk is greater than it looks because of underlying problems like inequality and weak governance. The market has woken up to these views and themes (Chart 1). Now Beijing is turning to address these problems, which is positive if it follows through. But investors will have to cope with new policies and laws that reverse the pro-business context of recent decades. In this report we review the new plan and its implications in the context of overall Chinese economic policy. The chief investment takeaway is that while China will push forward various reforms, Beijing cannot afford to self-inflict an economic collapse. Monetary and fiscal policy will ease over the coming 12 months. As such China policy tightening will not short-circuit the global recovery. However, Chinese corporate earnings and the renminbi will not benefit from the country’s anti-business turn. Chart 1Market Wakes Up To China's Political Risk What Is In The Common Prosperity Plan? The first thing to understand about Beijing’s new plan for “common prosperity” is that it is aspirational: it contains few specific targets or concrete policies. It builds on existing policy goals set for 2049, the hundredth anniversary of the People’s Republic. Implementation will be gradual. The plan is consistent with the Xi administration’s previous emphasis on improving the country’s quality of life and tackling systemic risks. It takes aim at social immobility, income and wealth inequality, poor public services, a weak social safety net, and other problems that did not receive enough attention during China’s rapid growth phase over the past forty years. Left unattended, China’s socioeconomic imbalances could fester and eventually destabilize the regime. From the beginning, the Xi administration has tackled the most pressing popular concerns to try to rebuild the party’s legitimacy, increase public support, and avoid crises. Crackdowns on pollution and excessive debt are prime examples. China does indeed suffer from high income inequality and low social mobility, as we have highlighted in key reports. It is comparable to the United States as well as Italy, Argentina, and Chile, all of which have suffered from significant social and political upheaval in recent memory (Chart 2). By contrast, Japan, Germany, and Australia have been relatively politically stable. Chart 2China Risks Social Unrest Like The Americas Table 1 summarizes the common prosperity plan. The key takeaways are the long 2049 deadline, the emphasis on “mixed ownership” in the corporate sphere (retaining a big role for state control and state-owned enterprises but attracting private capital), the redistribution of household income (reform the tax code), the establishment of property rights, the censorship of media/discourse, and the need to reduce rural disparity. The most important point of all is that Beijing intends to grow the size and wellbeing of the middle class – the foundation of a country’s strength. Table 1China’s “Common Prosperity” Plan For 2049 Coastal China today has reached Taiwanese and Korean levels of per capita income and has slightly exceeded their levels of wealth inequality (Chart 3). These countries witnessed social unrest and regime change in the 1980s due to such problems. The urban-rural gap is even more problematic in China due to its large rural population and territory. The Chinese public is expected to become more demanding as it evolves. Hence Beijing is pledging to redistribute wealth, grow the middle class, speed up income growth among the poorest, reduce rural disparities, expand access to elderly care, medicine, and housing, and establish a better legal framework for business. These goals are positive in principle, especially for household sentiment, social stability, and political support for the administration. But they also entail a higher tax/wage/regulation environment for business and corporate earnings. The question for investors centers on implementation. Chart 3China's Wealth Disparities Outstrip Comparable Neighbors What About Vested Interests? Table 1 above shows that the super-committee that issued the common prosperity plan also addressed China’s ongoing battle against financial risk. The financial policy statement was neither new nor surprising but it highlights something important: “preventing risks” will have to be balanced with “ensuring stable growth.” This balancing of reform and growth is essential to Chinese government and will guide the implementation of the common prosperity plan just as it has guided President Xi’s crackdown on shadow banking. This is an especially pertinent point today, as Beijing runs the risk of overtightening monetary, fiscal, and regulatory policies. While Beijing’s vision of a better regulated, more heavily taxed, and higher-wage society should not be underrated, reform initiatives will be delayed if they threaten to derail the post-pandemic recovery. Time and again the Xi administration has ruled against a rapid, resolute, and disruptive approach to reform, such as the “assault phase of reform” spearheaded by Premier Zhu Rongji in the late 1990s. In the plan’s own words: “achieving common prosperity will be a long-term, arduous, and complicated task and it should be achieved in a gradual and progressive manner.” Having said that, the pattern of reform has been a vigorous launch, a market riot, and then backtracking or delay. This means markets face more volatility first before things settle down. An initial volley of policy actions should be expected between now and spring of 2023, when the National People’s Congress solidifies the plans of the twentieth National Party Congress in fall 2022. As with the ongoing regulatory crackdown on Big Tech, the market may experience a technical rebound but the political assessment suggests government pressure will be sustained for at least the next 12 months. We do not recommend bottom feeding in Chinese equities. Will the reforms be effective over time? When the Xi administration took power in 2012-13, it issued a visionary policy document calling for wide-ranging reforms to China’s economy (“Decision on Several Major Questions About Deepening Reform”).1 Over the past decade these reforms have had mixed success. Rhodium Group maintains a reform tracker to monitor progress – the results are lackluster (Table 2). Some core principles, such as the claim that China would make market forces “decisive” in allocating resources, have been totally reversed. Table 2China’s Progress On Reforms Over Past Decade While China’s government model is absolutist, there are still social and economic limits on what the government can achieve. Beijing cannot raise a nationwide property tax, estate tax, and capital gains tax overnight just to reduce inequality. In fact, the long saga of the property tax tells a very different story. Beijing is limited in how it can tax the bubbling property sector because Chinese households store their wealth in houses and because any sustained price deflation would lead to a national debt crisis. Officials have pledged to advance a nationwide property tax in the past three five-year plans with little progress. A serious effort to impose the tax in 2014 was only implemented in two provinces, notably Shanghai’s tax on second or third homes owned by the same household.2 The common prosperity plan entails that the government will revive the property tax but the rollout will still be gradual and step-by-step reform. The tax will focus on major urban areas, not minor ones where population decline could weigh on prices. The government work report in early 2023 will be a key watchpoint for where and when the property tax will be levied but there can be little doubt that it will gradually be levied for top-tier cities. Other aspects of the common prosperity plan will be implemented with provincial trial runs. It all begins with a “demonstration zone,” namely Zhejiang province, a wealthy coastal state where President Xi Jinping once served as party secretary and first army secretary. Zhejiang is expected to make some progress by 2025 and achieve most the goals by 2035 (in keeping with Xi’s 2035 strategic vision). The Zhejiang plan includes concrete numerical targets and as such sheds light on the broader national plan and how other provinces will implement it. The most important target is the desire to have 80% of the population earn an annual disposable income of CNY 100,000-500,000 ($15,400-77,000). The labor share of output should be greater than 50%, compared to a national average of 35%-40%. The urbanization rate should hit 75%, up from 72%. Urban incomes should be capped at just short of twice that of rural income. Enrollment rates in higher education will go up, life expectancy should reach above 80 years, pollution should be further controlled, and the unemployment rate should stay below 5.5%. A host of other goals, ranging from technology to fertility and the social safety net, are shown in Table 3. Table 3China: Zhejiang Province As Bellwether For “Common Prosperity” Plan Some of the plan’s intentions will be undermined by Chinese governance. It is difficult to improve social fairness and property rights in the context of autocracy because the central and local governments create distortions and cannot be held to account for their own mistakes and abuses. The immediate political context of the common prosperity plan should not be missed: the president is outlining a bright future to justify the fact that he will not step down from power as earlier term limits required in fall 2022. The president’s 2035 vision implies an important strategic window in which to accomplish ambitious goals but the lack of checks and balances suggests that the next 14 years could be very similar to the last 10 years, in which arbitrary and absolutist decisions govern policy. The problem is highlighted by China’s recent 10-point plan on government under rule of law, which is undercut by the arbitrary actions of regulators in the tech crackdown (see Appendix). In other words, while social stability may improve in many ways, the shift away from consensus rule, toward rule of a single person, will increase policy uncertainty and create new governance problems at the same time that could produce greater instability over the long run. Having said all that, it is essential to acknowledge that a comprehensive plan to grow the middle class and expand the social safety net could be very positive for China if implemented. A Global Social Justice Race? If investors are thinking that the Xi administration’s calls for “social fairness and justice” and big new investments in “elderly care, medical security, and housing supply” resemble those of US President Joe Biden in his American Families Plan, then they are right. But while the US is already at historic levels of social division after failing to deal with inequality, China is attempting to learn from the US’s problems and rebalance society before polarization, factionalization, and social unrest occur. The Communist Party tends to take major action in response to American crises. Beijing’s crackdown on extremism and domestic terrorism in the early 2000s followed from the September 11 attacks. Its crackdown on local government debt and shadow banking stemmed from the 2008 financial crisis. And its crackdown on Big Tech, social media, and inequality today responds to the rise of populism in the US and Europe. The fact that deindustrialization has led to political crises in the developed world, and that social media companies can both exacerbate social unrest and silence a sitting president, is not lost on the Chinese administration. Unfortunately, China’s approach will probably escalate conflict with the West. First, Beijing is coupling its new social agenda with an aggressive campaign of military modernization and technological acquisition. It is doubling down on advanced manufacturing as its future economic model. The liberal democracies will not only be forced to defend their own political systems and governance models but will also be pressured into more hawkish stances on foreign, trade, and defense policy toward China. So far China is still attractive to foreign investors but the combination of socialist policy, import substitution, and foreign protectionism should put a cap on investment flows over time (Chart 4). What is the net effect of social largesse at home and great power competition abroad? Larger budget deficits. Fiscal expansionism is the key mechanism for the US and China to reboot their economies, reduce social pressures, secure supply chains, and compete with other each other. And expansionary fiscal policies will boost inflation expectations on the margin. One thing is clear: China’s regime will be imperiled if instead of common prosperity and “national rejuvenation” it gets economic collapse. Beijing is already seeing capital outflows reminiscent of the crisis period in 2014-15 when aggressive reforms triggered a collapse in risk appetite and a stock market crash (Chart 5). The implication is that monetary and fiscal easing will accompany the reform agenda. Chart 4China's New Policies Will Deter Foreign Investment Chart 5Capital Flight And Capital Controls A Risk If Implementation Aggressive That would be marginally positive for global growth and EM countries that export to China. Investors in China, however, will have to deal with greater policy uncertainty as China attempts to redistribute wealth while waging a cold war abroad. Investment Takeaways None of Beijing’s social goals can be met if overall growth and job creation slow too much. Reforms are constantly subject to the ultimate constraint of maintaining overall stability. Already in 2021 Beijing is verging on excessive monetary and fiscal policy tightening (Chart 6). The Politburo signaled in July that it would take its foot off the brakes but policy uncertainty is still wreaking havoc in the equity market and overall animal spirits are downbeat. We expect policy to ease over the coming year to ensure stability ahead of the twentieth national party congress. This would be marginally good news for global growth, contingent on the effects of the global pandemic. Of course we cannot deny that more bad news for global risk assets may be necessary in the very near term to prompt the policy easing that we expect. Policymakers will backtrack on various policies when the market revolts or when the risk of debt-deflation rears its ugly head. Corporate and even household debt have expanded so much in recent years that Chinese policymakers have their hands tied when they try to push reforms too aggressively (Chart 7). A Japanese-style combination of a shrinking and graying population could create a feedback loop with debt deleveraging in the event of a sharp drop in asset prices. On the whole we maintain a pessimistic outlook on Chinese currency and assets. Chart 6China Runs Risk Of Overtightening Policy Chart 7Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com     Appendix Table A1China: 10-Point Guidelines On Government Under Rule Of Law (2021-25) Footnotes 1     See Arthur R. Kroeber, “Xi Jinping’s Ambitious Agenda for Economic Reform in China,” Brookings, November 17, 2013, brookings.edu. 2     Chongqing’s property tax only affects luxury houses. Shenzhen and Hainan are the next pilot projects.

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.

Highlights Three distinct forces are likely to make South Asia’s geopolitical risks increasingly relevant to global investors. First, India’s tensions with China stem from China’s growing foreign policy assertiveness and India’s shift away from traditional neutrality toward aligning with the US and its allies. This creates a security dilemma in South Asia, just as in East Asia. Second, India’s economy is sputtering in the wake of the COVID-19 pandemic, adding fuel to nationalism and populism in advance of a series of important elections. India will stimulate the economy but it could also become more reactive on the international scene. Third, the US is withdrawing from Afghanistan and negotiating a deal with Iran in an effort to reduce the US military presence in the Middle East and South Asia. This will create a scramble for influence across both regions and a power vacuum in Afghanistan that is highly likely to yield negative surprises for India and its neighbors. Traditionally geopolitical risks in South Asia have a limited impact on markets. India’s growth slowdown and forthcoming fiscal stimulus are more relevant for investors. However, a sharp rise in geopolitical risk would undermine India’s structural advantages as the West diversifies away from China. Stay short Indian banks. Feature Geopolitical risks in South Asia are slowly but surely rising. India-Pakistan and China-India are well-known “conflict-dyads” or pairings. Historically, these two sets have been fighting each other over their fuzzy Himalayan border with limited global financial market consequences. But now fundamental changes are afoot that are altering the geopolitical setting in the region. Specifically, the coming together of three distinct forces could trigger a significant geopolitical event in South Asia. The three forces are as follow: Force #1: Sino-Indian Tensions Get Real About a year ago, Indian and Chinese troops clashed in Ladakh, a disputed territory in the Kashmir region. Following these clashes China reduced its military presence in the Pangong Tso area but its presence in some neighboring areas remains meaningful. Besides the troop build-up along India’s eastern border, China is building more air combat infrastructure in its India-facing western theatre. China’s major air bases have historically been concentrated in China’s eastern region, away from the Indian border (Map 1). Consequently, India has historically enjoyed an advantage in airpower. But China appears to be working to mitigate this disadvantage. Map 1Most Of China’s Major Aviation Units Are Located Away From India Owing to China’s increased military focus along the Sino-India border, India’s threat perception of China has undergone a fundamental change in recent years. Notably, India has diverted some of its key army units away from its western Indo-Pak border towards its eastern border with China. India could now have nearly 200,000 troops deployed along its border with China, which would mark a 40% increase from last year.1 Turning attention to the Indo-Pak border, India’s problems with Pakistan appear under control for now. This is owing to the ceasefire agreement that was renewed by the two countries in February 2021. However, this peace cannot possibly be expected to last. This is mainly because core problems between the two countries (like Pakistan’s support of militant proxies and India’s control over Kashmir) remain unaddressed. History too suggests that bouts of peace between the two warring neighbors rarely last long. These bouts usually end abruptly when a terrorist attack takes place in India. With both political turbulence and economic distress in Pakistan rising, the fragile ceasefire between India and Pakistan could be upended over the next six months. In fact, two events over the last week point to the fragility of the ceasefire: Two drones carrying explosives entered an Indian air force station located in Jammu and Kashmir (i.e. a northern territory that India recently reorganized, to Pakistan’s chagrin). Even as no casualties were reported, this attack marks a turning point for terrorist activity in India as this was the first-time terrorists used drones to enter an Indian military base. Hours later, another drone attack struck an Indian base at the Ratnuchak-Kaluchak army station, the site of a major terrorist attack in 2002. Chart 1China, Pakistan And India Cumulatively Added 41 Nuclear Warheads Over 2020 Given that the ceasefire was agreed recently, any further increase in terrorist activity in India over the next six months would suggest that a more substantial breakdown in relations is nigh. Distinct from these recent tensions, China’s troop deployment along India’s eastern arm and Pakistan’s presence along India’s western arm creates a strategic “pincer” that increasingly threatens India. India is naturally concerned. China and Pakistan are allies who have been working closely on projects including the strategic China-Pakistan Economic Corridor (CPEC). The CPEC is a collection of infrastructure projects in Pakistan that includes the development of a port in Gwadar where a future presence of the People's Liberation Army Navy (PLAN) is envisaged. Gwadar has the potential of providing China land-based access to the Indian Ocean. Trust in the South Asian region is clearly running low. Distinct from troop build-ups and drone-attacks, China, Pakistan, and India cumulatively added more than 40 nuclear warheads over the last year (Chart 1). China is reputed to be engaged in an even larger increase in its nuclear arsenal than the data show.2 From a structural perspective, too, geopolitical risks in the South Asian peninsula are bound to keep rising. When it comes to the conflicting Indo-Pak dyad, India’s geopolitical power has been rising relative to that of Pakistan in the 2000s. However, the geopolitical muscle of the Sino-Pak alliance is much greater than that of India on a standalone basis (Chart 2). Chart 2India Has Aligned With The QUAD To Counter The Sino-Pak Alliance China’s active involvement in South Asia is responsible for driving India’s increasing desire to abandon its historical foreign policy stance of non-alignment. India’s membership in the Quadrilateral Security Dialogue (also known as the QUAD, whose other members include the US, Japan, and Australia) bears testimony to India’s active effort to develop closer relations with the US and its allies (Chart 2). India’s alignment with the US is deepening China’s and Pakistan’s distrust of India. Conventional and nuclear military deterrence should prevent full-scale war. But the regional balance is increasingly fluid which means geopolitical risks will slowly but surely rise in South Asia over the coming year and years. Force #2: A Growth Slowdown Alongside India’s Loaded Election Calendar The pandemic has hit the economies of South Asia particularly hard. South Asia historically maintained higher real GDP growth rates relative to Emerging Markets (EMs). But in 2021, this region’s growth rate is set to be lower than that of EM peers (Chart 3). History is replete with examples of a rise in economic distress triggering geopolitical events. South Asia is characterized by unusually low per capita incomes (Chart 4) and the latest slowdown could exacerbate the risk of both social unrest and geopolitical incidents materialising. Chart 3South Asian Economies Have Been Hit Hard By The Pandemic Chart 4South Asia Is Characterized By Very Low Per Capita Incomes To complicate matters a busy state elections calendar is coming up in India. Elections will be due in seven Indian states in 2022. These states account for about 25% of India’s population. State elections due in 2022 will amount to a high-stakes political battle. During state elections in 2021, the ruling Bharatiya Janata Party (BJP) was the incumbent in only one of the five states. In 2022, the BJP is the incumbent party in most of the states that are due for elections, which means it has the advantage but also has a lot to lose, especially in a post-pandemic environment. Elections kick off in the crucial state of Uttar Pradesh next February. Last time this state faced elections Prime Minister Narendra Modi was willing to go to great lengths to boost his popularity ahead of time. Specifically, he upset the nation with a large-scale and unprecedented de-monetization program. Given the busy state election calendar in 2022, we expect the BJP-led central government to focus on policy actions that can improve its support among Indian voters. Two policies in particular are likely to come through: Fiscal Stimulus Measures To Provide Economic Relief: India has refrained from administering a large post-pandemic stimulus thus far. As per budget estimates, the Indian central government’s total expenditure in FY22 is set to increase only by 1% on a year-on-year basis. But the expenditure-side restraint shown by India’s central government could change. With elections and a pandemic (which has now claimed over 400,000 lives in India), the central government could consider a meaningful increase in spending closer to February 2022. Map 2Northern India Views Pakistan Even More Unfavorably Than Rest Of India India’s Finance Minister already announced a fiscal stimulus package of $85 billion (amounting to 2.8% of GDP) earlier this week. Whilst this stimulus entails limited fresh spending (amounting to about 0.6% of India’s GDP), we would not be surprised if the government follows it up with more spending closer to February 2022. Assertive Foreign Policy To Ward-Off Unfriendly Neighbors: India’s northern states are known to harbor unfavorable views of Pakistan (Map 2). The roots of this phenomenon can be traced to geography and the bloody civil strife of 1947 that was triggered by the partition of British-ruled India into the two independent dominions of India and Pakistan. Given the north’s unfavorable views of Pakistan and given looming elections, 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. This kind of response was observed most recently ahead of the Indian General Elections in April-May 2019. An Indian military convoy was attacked by a suicide-bomber in early February 2019 and a Pakistan-based terrorist group claimed responsibility. A fortnight later the Indian air force launched unexpected airstrikes across the Line of Control which were then followed by the Pakistan air force conducting air strikes in Jammu and Kashmir. While the next round of Pakistani and Indian general elections is not due until 2023 and 2024, respectively, it is worth noting that of the seven state elections due in India in 2022, four are in the north (Uttar Pradesh, Punjab, Uttarakhand, and Himachal Pradesh). Force #3: Power Vacuum In Afghanistan The final reason to be wary of the South Asian geopolitical dynamic is the change in US policy: both the Iran nuclear deal expected in August and the impending withdrawal from Afghanistan in September. The US public has now elected three presidents on the demand that foreign wars be reduced. In the wake of Trump and populism the political establishment is now responding. Therefore Biden will ultimately implement both the Iran deal and the Afghan withdrawal regardless of delays or hang-ups. But then he will have to do damage control. In the case of Iran, a last-minute flare-up of conflict in the region is likely this summer, as the US, Israel, Saudi Arabia, and Iran underscore their red lines before the US and Iran settle down to a deal. Indeed it is already happening, with recent US attacks against Iran-backed Shia militias in Syria and Iraq. A major incident would push up oil prices, which is negative for India. But the endgame, an Iranian economic opening, is positive for India, since it imports oil and has had close relations with Iran historically. In the case of Afghanistan, the US exit will activate latent terrorist forces. It will also create a scramble for influence over this landlocked country that could lead to negative surprises across the region. The first principle of the peace agreement between the US and Afghanistan states that the latter will make all efforts to ensure that Afghan soil is not used to further terrorist activity. However, the enforceability of such a guarantee is next to impossible. Notably, the US withdrawal from Afghanistan will revive the Taliban’s influence in the region. This poses major risks for India, which has a long history of being targeted by Afghani terrorist groups. The Taliban played a critical role in the release of terrorists into Pakistan following the hijacking of an Indian Airlines flight in 1999. Furthermore, the Haqqani network, which has pledged allegiance to the Taliban, has attacked Indian assets in the past. Any attack on India deriving from the power vacuum in Afghanistan would upset the precarious regional balance. Whilst there are no immediate triggers for Afghani groups to launch a terrorist attack in India, the US withdrawal will trigger a tectonic shift in the region. Negative surprises emanating from Afghanistan should be expected. Investment Conclusions Chart 5Indian Banks Appear To Have Factored In All Positives We reiterate the need to pare exposure to Indian assets on a tactical basis. India’s growth engine is likely to misfire over the second half of the Indian financial year. Macroeconomic headwinds pose the chief risk for investors, but major geopolitical changes could act as a negative catalyst in the current context. So we urge clients to stay short Indian Banks (Chart 5). Financials account for the lion’s share of India’s benchmark index (26% weight). India could opt for an unexpected expansion in its fiscal deficit soon. Whilst we continue to watch fiscal dynamics closely, we expect the fiscal expansion to materialize closer to February 2022 when India’s most populous state (i.e. Uttar Pradesh) will undergo elections. Over the long run, India’s sense of insecurity will escalate in the context of a more assertive China, stronger Sino-Pakistani ties, and a power vacuum in Afghanistan. For that reason, New Delhi will continue to shed its neutrality and improve relations with the US-led coalition of democratic countries, with an aim to balance China. This process will feed China’s insecurity of being surrounded and contained by a hegemonic American system. This security dilemma is a source of South Asian geopolitical risk that will become more globally relevant over time. China’s conflict with the US and western world should create incentives for India to attract trade and investment. However, its ability to do so will be contingent upon domestic political factors and regional geopolitical factors.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Sudhi Ranjan Sen, ‘India Shifts 50,000 Troops to China Border in Historic Move’, Bloomberg, June 28, 2021, bloomberg.com. 2 Joby Warrick, “China is building more than 100 missile silos in its western desert, analysts say,” Washington Post, June 30, 2021, washingtonpost.com.

Highlights The US is withdrawing from the Middle East and South Asia and making a strategic pivot to Asia Pacific. The third quarter will see risks flare around Iran and the US rejoin the 2015 Iranian nuclear deal. The result is briefly negative for oil prices but the rise of Iran is a new geopolitical trend that will increase Middle Eastern risk over the long run. The geopolitical outlook is dollar bullish, while the macroeconomic outlook is getting less dollar-bearish due to China’s risk of over-tightening policy. Stay neutral USD and be wary of commodities and emerging markets in the third quarter. European political risk is bottoming. The German and French elections are at best minor risks. However, the continent is ripe for negative black swans, especially due to Russian aggression. Go tactically long global large caps and defensives. Feature Chart 1Three Key Views On Track (So Far) We chose “No Return To Normalcy” as the theme of our 2021 outlook. While the COVID-19 vaccine promised economic recovery, we argued that normalization would create complacency regarding fundamental changes that have taken place in the geopolitical environment. A contradiction between an improving macroeconomic backdrop and a foreboding geopolitical backdrop would develop in 2021 and beyond. The “reflation trade” has begun to lose steam as we go to press. However, global recovery will still be the dominant story in the second half of the year as vaccination spreads. The question for the third quarter and the rest of the year is whether reflation will continue. As a matter of forecasting, we think it will. But as a matter of investment strategy, we are taking a more defensive stance until China relaxes economic policy. In our annual outlook we highlighted three key geopolitical views: (1) China’s headwinds, both at home and abroad (2) US détente with Iran and pivot to Asia (3) Europe’s opportunity. All three trends are broadly on track and can be illustrated by looking at equity performance in the relevant regions for the year so far: Chinese stocks sold off, UAE stocks rallied, and European stocks rallied (Chart 1). However, these trends are not exclusively tied to absolute equity performance. The most important question is what happens to global growth and the US dollar as these three key views continue. Stay Neutral On The Dollar It paid off for us to maintain a neutral stance on the dollar. True, the global recovery and exorbitant US trade and budget deficits are bearish for the dollar and bullish for other currencies. But the greenback’s “counter-trend bounce” is proving more formidable than many investors expected. The fundamentals of the American economy and global position remain strong. Since the outbreak of COVID-19, the US has secured its recovery with fiscal policy, maintained rule of law amid a contested election, innovated and distributed vaccines, benefited from more flexible social restrictions, refurbished global alliances, and put pressure on its geopolitical rivals. In essence, the combined effect of President Trump’s and Biden’s policies has been to make America “great again” (Chart 2). From a geopolitical perspective, the dollar is appealing. Chart 2Trump-Biden Make America Great Again? In addition, the first two geopolitical views mentioned above – China’s headwinds and the US-Iran détente – imply a negative environment for China and the renminbi. The reason for the US to do a suboptimal deal with Iran, both in 2015 and 2021, is to reduce the risk of war and buy time to enable a strategic pivot to Asia Pacific. Three US presidents have been elected on the pledge to conclude the “forever wars” in the Middle East and South Asia. Biden is withdrawing US troops from Afghanistan in September. There can be little doubt Biden is committed to an Iran deal, which is supposed to free up the US’s hands (Chart 3). Meanwhile the US public and Congress are unified in their desire to better defend US interests against China’s economic and military rise. There has not yet been a stabilization of US-China policies. Biden is not likely to hold a summit with Chinese President Xi Jinping until late October at earliest – and that is a guess, not a confirmed summit. The Biden administration has completed its review of China policy and is maintaining the Trump administration’s hawkish posture, as predicted. The US and China may resume their strategic and economic dialogue at some point but it is impossible to go back to the status quo ante 2015. That was the year the US adopted a more confrontational stance toward China – a stance later supercharged by Trump’s election and trade tariffs. The hawkish consensus on China is one of the rare unifying factors in a deeply divided America. The Biden administration explicitly says the US-China relationship is now defined by “competition” instead of “engagement.”1 One exception to this neutral view on the dollar has been our decision to go long the Japanese yen and Swiss franc, which has not panned out so far. Our reasoning is that geopolitical risk will boost these currencies but otherwise the reduction of geopolitical risk will weigh on the dollar in the context of global growth recovery. So far geopolitical risk has remained subdued while the US dollar has outperformed. We are still sympathetic to these safe-haven currencies, however, as they are attractively valued as long as one expects geopolitical risks to materialize (Chart 4). Chart 3US Pivot To Asia Runs Through Iran Our third key view, that EU was the real winner of the US election last year, remains on track. This is marginally positive for the euro at the expense of the dollar. Given the above points, we favor an equal-weighted basket of the euro and the dollar relative to the renminbi (Chart 5). Chart 4Safe-Haven Currencies Attractive Chart 5Favor Euro And Dollar Over Renminbi The geopolitical outlook is dollar-bullish. The macroeconomic outlook is dollar-bearish, except that China’s economy looks to slow down. We expect China to ease policy in the second half of the year but it may come late. We remain neutral dollar in the third quarter. Wait For China To Relax Policy July 1 marks the centenary of the Communist Party of China. The main thing investors should know is that the Communist Party predates China’s capitalist phase by sixty years. The party adopted capitalism to improve the economy – it never sacrificed its political or foreign policy goals. This poses a major geopolitical problem today because the Communist Party’s consolidation of power across Greater China, symbolized by Beijing’s revocation of Hong Kong’s special status in 2019, has convinced the western democracies that China is no longer compatible with the liberal world order. China launched a 13.8% of GDP monetary-and-fiscal stimulus over 2018-20 due to the trade war and COVID-19 pandemic. So the economy is stable for the hundredth anniversary celebration. The centenary goals are largely accomplished: GDP is larger, poverty is nearly extinguished, although urban incomes are still lagging (Chart 6). General Secretary Xi Jinping will mark the occasion with a speech. The speech will contribute to his governing philosophy, Xi Jinping Thought, a synthesis of communist Mao Zedong Thought and the pro-capitalist “socialism with Chinese characteristics” pioneered by General Secretary Deng Xiaoping in the 1980s-90s. The effect is to reassert Communist Party and central government primacy after the long period of decentralization that enabled China’s rapid growth phase. It is also to endorse an inward economic turn after the four-decade export-manufacturing boom. The Xi administration’s re-centralization of policy has entailed mini-cycles of tightening and loosening control over the economy. The administration leans against the country’s tendency to gorge itself on debt and grow at any cost – until it must lean the other way for fear of triggering a destabilizing slowdown. For this reason Beijing tightened policy proactively last year, producing a sharp drop in money, credit, and fiscal expansion in 2021 that now threatens to undermine the global recovery. By our measures, any further tightening will result in undershooting the regime’s money and credit targets, i.e. overtightening, and hence threaten to drag on the global recovery (Chart 7). Chart 6China's Communist Party Centenary Goals Chart 7China Verges On Over-Tightening Policy Overtightening would be a policy mistake with potentially disastrous consequences. So the base case should be that the government will relax policy rather than undermine the post-COVID recovery. However, investors cannot be confident about the timing. The 2015 financial turmoil and renminbi devaluation occurred because policymakers reacted too slowly. One reason to believe policy will be eased is that after July 1 the government will turn its attention to the twentieth national party congress in 2022, the once-in-five-years rotation of the Central Committee and Politburo. The party congress begins at the local level at the beginning of next year and culminates in the fall of 2022 with the national rotation of top party leaders. Xi Jinping was originally slated to step down in 2022. So he needs to squash any last-minute push against him by opposing factions of the party. He may have himself named chairman of the Communist Party, like Mao before him. Most importantly he will put his stamp on the “seventh generation” of China’s leaders by promoting his followers into key positions. All of this suggests that the Xi administration cannot risk triggering a recession, even if its preferences remain hawkish on economic policy. Policy easing could come as early as the end of July. As a rule of thumb, we have noticed that the Politburo’s July meeting on economic policy is often an inflection point, as was the case in 2007, 2015, 2018, and 2020 (Table 1). Some observers claim the April Politburo meeting already signaled an easing in policy, although we do not see that. If July clearly signals relaxation, global investors will cheer and emerging market assets and commodities will rise. Table 1China’s Politburo Often Hits Inflection Point On Economic Policy In July Still we maintain a defensive posture going into the third quarter because we do not have a high level of confidence that policymakers will act preemptively. A market riot may precede and motivate the inflection point in policy. Also the negative impact of previous policy tightening will be felt in the third quarter. China plays and industrial metals are extremely vulnerable to further correction (Chart 8). Chart 8China Plays And Metals Vulnerable To Further Correction The earliest occasion for a Biden-Xi summit comes at the end of October, as mentioned. While US-China talks will occur at some level, relations will remain fundamentally unstable. While a Biden-Xi summit may improve the atmosphere and lead to a new round of strategic and economic dialogue, or Phase Two trade talks, the fact is that the US is seeking to contain China’s rise and China is seeking to break out of the strictures of the US-led world order. The global elite and mainstream media will put a lot of emphasis on the post-Trump return to diplomatic “normalcy” and summits. But this is to overemphasize style at the expense of substance. Note that the positive feelings of the Biden-Putin summit on June 16 fizzled in less than a week when Russia allegedly dropped bombs in the path of a British destroyer in the Black Sea. The US and UK were training Ukraine’s military. Britain denies any bombs were dropped but Russia says next time they will hit their target. (More on this below.) This episode is instructive for US-China relations: summitry is overrated. China is building a sphere of influence and the US no longer believes dialogue alone is the answer. Tit-for-tat punitive measures and proxy battles in China’s neighboring areas, from the Korean peninsula to the Taiwan Strait to the South and East China Seas, are the new normal. Bottom Line: Tactically, stay defensive on global risk assets, especially China plays. Strategically, maintain a constructive outlook on the cycle given the global recovery and China’s need eventually to relax monetary and fiscal policy. US-Iran Deal Likely – Then The Real Trouble Starts The US will likely rejoin the 2015 Iranian nuclear deal (Joint Comprehensive Plan of Action) by August and pull out of its longest-ever war in Afghanistan in September. The US is wrapping up its “forever wars” to meet the demands of a war-weary public. Ironically, the long-term consequence is to create power vacuums that invite new geopolitical conflicts in the context of the US’s great power struggle with China and Russia. But for now a deal with Iran – once it is settled – reduces geopolitical risk by reducing the odds of military escalation in the region. The Iran talks are more significant than the Afghanistan pullout. We are confident in a deal because Biden can rejoin the 2015 deal unilaterally – it was never approved by the US Senate as a formal treaty. The Iranians will not support any militant action so aggressive as to scupper a deal that offers them the chance of reviving their economy at a critical time in the regime’s history. Reviving the deal poses a downside risk for oil prices in the third quarter though not over the long run. It is negative in the short run because investors will have to price not only Iran’s current and future production (Chart 9) but also any resulting loss of OPEC 2.0 discipline. Brent crude is trading at $76 per barrel as we go to press, above the $65-$70 per barrel average that our Commodity & Energy Strategy service expects to see over the coming five years (Chart 10). Chart 9Iran's Oil Production Will Return Chart 10Brent Price Faces Short-Term Downside Risk From Iranian Crude The oil price ceiling is enforced by the cartel of oil producers who fear that too high of prices will incentivize US shale oil production as well as the global shift to renewable energy. The Russians have always dragged their feet over oil production cuts and are now pushing for production hikes. The government needs an oil price of around $50-55 per barrel for the budget to break even. The Saudis need higher prices to break even, at $70-75 per barrel. Moscow must coordinate various oil producers, led by the country’s powerful oligarchs and their factions, which is inherently more difficult than the Saudi position of coordinating one producer, Aramco. The Russians and Saudis have maintained cartel discipline so far in 2021, as expected, because the wounds of the market-share war last year are still raw. They retreated from that showdown in less than a month. However, a major escalation in Saudi Arabia’s strategic conflict with Iran could push the Saudis to seek greater market share at Iran’s expense, as occurred before the original Iran deal in 2014-15. Hence our view that the risk to oil prices will shift from the upside to the downside in the second half of the year if the US-Iran deal is reconstituted. Over the long run, the deal is not negative for oil prices. The deal is a tradeoff for lower geopolitical risk today but higher risk in the future. The reason is that Iran’s economic recovery will strengthen its strategic hand and generate a backlash in the region. The global oil supply and demand balance will fluctuate according to circumstances but regional conflict will inject a risk premium over time. Biden’s likely decision to rejoin the 2015 deal should be seen as a delaying tactic. It is impossible to go back to 2015, when the US had mustered a coalition of nations to pressure Iran and when Iran’s “reformist” faction stood to receive a historic boost from the opening of the country’s economy. Now the US lacks a coalition and the reformists are leaving office in disgrace, with the hardliners (“principlists”) taking full power for the foreseeable future. Iran is happy to go back to complying with a deal that consists of sanctions relief in exchange for temporary limits on its nuclear program. The 2015 deal’s restrictions on Iran’s nuclear program begin expiring in 2023 and continue to expire through 2040. Biden has no chance of negotiating a newer and more expansive deal that extends these sunset clauses while also restricting Iran’s ballistic missile program and regional militant activities. He will say that easing sanctions is premised on a broader “follow on” deal to achieve these US goals. But the broader deal is unlikely to materialize anytime soon. The Iranians will commit to future talks but they will have no intention of agreeing to a more expansive deal unless forced. The country’s leaders will never abandon their nuclear program after witnessing the invasions of non-nuclear Libya and Ukraine – in stark contrast with nuclear-armed North Korea. Moreover Biden cannot possibly reassemble the P5+1 coalition with Russia and China anytime soon. The US is directly confronting these states. They could conceivably work with the US when Iran is on the brink of obtaining nuclear weapons but not before then. They did not prevent North Korea. The Supreme Leader Ali Khamenei, the soon-to-be-inaugurated President Ebrahim Raisi, the Iranian Revolutionary Guard Corps, the Ministry of Intelligence, and other pillars of the regime are focused exclusively on strengthening the regime in advance of Khamenei’s impending succession sometime in the coming decade. The succession could easily lead to domestic unrest and a political crisis, which makes the 2020s a critical period for the Islamic Republic. With Tehran focused on a delicate succession, it is not a foregone conclusion that Iran will go on the offensive to expand its sphere of influence immediately after the US deal. But sooner or later a major new geopolitical trend will emerge: the rise of Iran. With sanctions removed, trade and investment increasing, and Chinese and Russian support, Iran will be capable of pursuing its strategic aims in the region more effectively. It will extend its influence across the “Shia Crescent,” including Iraq. The fear that this will inspire in Israel and the Gulf Arab states has already generated a slow-boiling war in the region. This war will intensify as the US will be reluctant to intervene. The purpose of the deal is to enable the war-weary US to reduce its active involvement in the region. The US foreign policy and defense establishment do not entirely see it this way – they emphasize that the US will remain engaged. But US allies in the Middle East will not be convinced. The region already has a taste for the way this works after the US’s precipitous withdrawal from Iraq in 2011, which lead to the rise of the Islamic State terrorist group. Biden will try not to be so precipitous but the writing is on the wall: the US will reduce its focus and commitment. A scramble for power in the region will begin the moment the ink dries on Biden’s signature of the JCPA. Israel and the Arab states are forming a de facto alliance – based on last year’s Abraham Accords – to prepare for Iran’s push to dominate the region. Even if Iran is not overly aggressive (a big if), Israel and the Gulf Arabs will overreact as a result of their fear of abandonment. They will also seek to hedge their bets by improving ties with the Chinese and Russians, making the Middle East the scene of a major new proxy battle in the global great power struggle. As a risk to our view: if the Biden administration changes course this summer and refuses to lift sanctions or rejoin the Iran deal – low but not zero probability – then tensions with Iran will explode almost instantaneously. The Iranians will threaten to close the Strait of Hormuz and a crisis will erupt in the third or fourth quarter. Bottom Line: The US will most likely rejoin the Iranian nuclear deal by August to avoid an immediate crisis or war. The Biden administration will wager that it can lend enough support to regional allies to keep Iran contained. This might work, as the Iranians will focus on fortifying the regime ahead of its leadership succession. However, Iran’s hardline leadership will see an opportunity in America’s withdrawal from its “forever wars.” Iran will increasingly cooperate with Russia and China. Iran’s conflict with Israel and Saudi Arabia will be extremely difficult to manage and will escalate over time, quite possibly creating a revolution or war in Iraq. The Gulf Arabs are already under immense pressure from the green energy revolution. Thus while oil prices might temporarily fall on the return of Iranian exports, they will later see upward pressure from a new wave of Middle Eastern instability. European Political Risk Has (Probably) Bottomed By contrast with all the above we have viewed Europe as a negligible source of (geo)political risk in 2021. European policy uncertainty is falling in Europe relative to these other powers and the rest of the world (Chart 11). Chart 11Europe's Relative Policy Uncertainty Bottoming Chart 12EU Break-Up Risk Hits Floor (Again) The risk of a break-up of the European Union has wilted and remains at historic lows (Chart 12). There is no immediate threat of any European countries emulating the UK and attempting to exit. Even Italian support for the euro has surged. Immigration flows have plummeted. European solidarity is not on the ballot in the upcoming German and French elections. Germany is choosing between the status quo and a “green revolution” that would not really be a revolution due to the constraints of coalition politics. The Greens have lost some momentum relative to their polling earlier this year but underlying trends suggest they will surprise to the upside in the September 26 vote (Charts 13A and 13B). They embrace EU solidarity, robust government spending, weariness with the Merkel regime, and concerns about climate change, Russia, China, and social justice. Chart 13AGerman Greens Will Surprise To Upside Chart 13BGerman Greens Will Surprise To Upside We expect the Greens to surprise to the upside. But as they are forced into a coalition with the ruling Christian Democrats then they will be limited to raising spending rather raising taxes (Table 2). The market will cheer this result. Table 2German Greens’ Ambitious Tax Hike Proposals If the Greens disappoint then a right-leaning government and too early fiscal tightening could become a risk – but it is a minor risk because Merkel’s hand-picked successor, the CDU Chancellor Candidate Armin Laschet, will be pro-Europe and fiscally dovish, just like the mainstream of his party under Merkel. The only limitation on this dovishness is that it would take another global shock for there to be enough votes in the Bundestag to loosen the schuldenbremse or “debt brake.” In France, President Emmanuel Macron is likely to win re-election – the populist candidate Marine Le Pen remains an underdog who is unlikely to make it through France’s two-round electoral system. In Italy, Prime Minister Mario Draghi is overseeing a national unity coalition that will dole out EU recovery funds. An election cannot be held ahead of the presidential election in January, which will be secured by the establishment parties as a major check on any future populist ruling coalition. The risk in these countries, as in Spain and elsewhere, is that neoliberal structural reform and competitiveness are falling by the wayside. Fiscal largesse is positive for securing the recovery but long-term growth potential will remain depressed (Chart 14). Chart 14European And Global Fiscal Stimulus (Updated June 2021) Europe remains stuck in a liquidity trap over the long run. It depends on the rest of the world for growth. This is a problem given that China’s potential growth is slowing and there is no ready substitute that will prop up global growth. Europe is increasingly ripe for negative “black swan” events. The power vacuum in the Middle East described above will lead to instability and regime failures that will threaten European security. Russia will remain aggressive, a reflection of its crumbling structural foundations. The Putin administration has not changed its strategy of building a sphere of influence in the former Soviet Union and pushing back against the West, as signaled by the threat to bomb ships that sail in Crimean waters – a unilateral expansion of Russia’s territorial waters following the Crimean invasion. The Biden administration is not seeking anything comparable to the diplomatic “reset” with Russia from 2009-11, which ended in acrimony. In other words, European political risk may be bottoming as we speak. Investment Takeaways Chart 15Limited Equity Upside From Likely US Infrastructure Bill US Peak Fiscal Stimulus: The Biden administration is highly likely to pass an infrastructure package through Congress, either as a bipartisan deal with Republicans or as part of the American Jobs Plan. The result is another $1-$1.5 trillion fiscal stimulus, albeit over an eight-year period, with infrastructure funding taking until 2024-25 to ramp up. Biden’s other plans probably will not pass before the 2022 midterm election, which will likely bring gridlock. Investors are well aware of these proposals and the policy setting will probably be frozen after this year. Hence there is limited remaining upside for global materials sector and US infrastructure plays (Chart 15). The extravagant US fiscal thrust of 2020-21 will turn into a huge fiscal drag in 2022 (Chart 16). The Federal Reserve, however, will remain ultra-dovish as long as labor market slack persists – regardless of who is at the helm. Chart 16US Fiscal Drag Very Large In 2022 Chart 17Go Long Large Caps And Defensives China’s Headwinds Persist: China may or may not ease policy in time to prevent a market riot. China plays and industrial metals are highly exposed to a correction and we recommend steering clear. US-Iran Deal Weighs On Oil Price: Tactically we are neutral on oil and oil plays. An Iran deal could depress oil prices temporarily – and potentially in a major way if the Saudis agree with the Russians on increasing production. Fundamentals are positive but depend on the OPEC 2.0 cartel. The cartel faces the risk that higher prices will incentivize both alternative oil providers and the green revolution. Europe’s Opportunity: We continue to see the euro and European stocks offering value. Given the troubles with Russia we favor developed Europe plays over emerging Europe. The German election would be a bullish catalyst for European assets but headwinds from China will prevail, which is negative for cyclical European stocks. The Russian Duma election, also in September, creates high potential for Russia to clash with the West between now and then. Tactically, go long global large caps and defensives (Chart 17).   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Independent Vermont Senator Bernie Sanders recently felt it was necessary to warn against a second cold war. Sanders, a democratic socialist, is a reliable indicator of the left wing of the Democratic Party and a dissenter who puts pressure on the center-left Biden administration. His fears underscore the dominance of the new hawkish consensus. Appendix China Russia UK Germany France Italy Canada Spain Taiwan – Province Of China Korea Turkey Brazil Australia

特別レポート

Highlights China’s Communist Party has overcome a range of challenges over the past 100 years, performed especially well over the past 42 years, but the macro and geopolitical outlook is darkening. The “East Asian miracle” phase of Chinese growth has ended. Potential GDP growth is slowing and it will be harder for Beijing to maintain financial and sociopolitical stability. The Communist Party has shifted the basis of its legitimacy from rapid growth to quality of life and nationalist foreign policy. The latter, however, will undermine the former by stirring up foreign protectionism. In the near term, global investors should favor developed market equities over China/EM equities. But they should favor China and Hong Kong stocks over Taiwanese stocks given significant geopolitical risk over the Taiwan Strait. Structurally, favor the US dollar and euro over the renminbi. Feature Ten years ago, in the lead up to the Communist Party’s 90th anniversary, I wrote a report called “China and the End of the Deng Dynasty,” referring to Deng Xiaoping, the Chinese Communist Party’s great pro-market reformer.1 The argument rested on three points: the end of the export-manufacturing economic model, an increasingly assertive foreign policy, and the revival of Maoist nationalism. After ten years the report holds up reasonably well but it did not venture to forecast what precisely would come next. In reality it is the rule of the Communist Party, and not the leader of any one man, that fits into China’s history of dynastic cycles. As the party celebrates a hundred years since its founding on July 23, 1921, it is necessary to pause and reflect on what the party has achieved over the past century and what the current Xi Jinping era implies for the country’s next 100 years. Single-Party Rule Can Bring Economic Success. Communism Cannot. Regime type does not preclude wealth. Countries can prosper regardless of whether they are ruled by one person, one party, or many parties. The richest countries in the world grew rich over centuries in which their governments evolved from monarchy to democracy and sometimes back again. Even today several of the world’s wealthy democracies are better described as republics or oligarchies. Chart 1China Outperformed Communism But Not Liberal Democracy The rule of one person, or autocracy, is not necessarily bad for economic growth. For every Kim Il Sung of North Korea there is a Lee Kuan Yew of Singapore. But authority based on a single person often expires with that person and rarely survives his grandchild. In China, Chairman Mao Zedong’s death occasioned a power struggle. Deng Xiaoping’s attempts to step down led to popular unrest that threatened the Communist Party’s rule on two separate occasions in the 1980s. The rule of a single party is thought to be more sustainable. Japan and Singapore are effectively single-party states and the wealthiest countries in Asia. They are democracies with leadership rotation and a popular voice in national affairs. And yet South Korea’s boom times occurred under single-party military rule. The same goes for the renegade province of Taiwan. Only around the time these two reached about $11,000-$14,000 GDP per capita did they evolve into multi-party democracies – though their wealth grew rapidly in the wake of that transition. China and soon Vietnam will test whether non-democratic, single-party rule can persist beyond the middle-income economic status that brought about democratic transition in Taiwan (Chart 1). Vietnam and Taiwan are the closest communist and non-communist governing systems, respectively, to mainland China. Insofar as China and Vietnam succeed at catching up with Taiwan it will be for reasons other than Marxist-Leninist ideology. Most communist systems have failed. At the height of international communism in the twentieth century there were 44 states ruled by communist parties; today there are five. China and Vietnam are the rare examples of communist states that not only survived the Soviet Union’s fall but also unleashed market forces and prospered (Chart 2). North Korea survived in squalor; Cuba’s experience is mixed. States that close off their economies do not have a good record of generating wealth. Closed economies lack competition and investment, struggle with stagflation, and often succumb to corruption and political strife. Openness seems to be a more diagnostic variable than government type or ideology, given the prosperity of democratic Japan and non-democratic China. Has the CPC performed better than other communist regimes? Arguably. It performs better than Vietnam but worse than Cuba on critical measures like infant mortality rates and life expectancy. Has it performed better than comparable non-communist regimes? Not really, though it is fast approaching Taiwan in all of these measures (Chart 3). Chart 2Communist States Get Rich By Compromising Their Communism Chart 3China Catching Up To Cuba On Basic Wellbeing What can be said for certain is that, since China’s 1979 reform and opening up, the CPC has avoided many errors and catastrophes. It survived the 1980s, 1990s, and 2000s without succumbing to international isolation, internal divisions, or economic crisis. It has drastically increased its share of global power (Table 1). Contrast this global ascent with the litany of mistakes and crises in the US since the year 2000. The CPC also managed the past decade relatively well despite the Chinese financial turmoil of 2015-16, the US trade war of 2018-19, and the COVID-19 pandemic. However, these events hint at greater challenges to come. China’s transition to a consumer-oriented economy has hardly begun. The struggle to manage systemic financial risk is intensifying today at risk to growth and stability (Chart 4). The trade war is simmering despite the Phase One trade deal and the change of party in the White House. And it is too soon to draw conclusions about the impact of the global pandemic, though China suppressed the virus more rapidly than other countries and led the world into recovery. Table 1China’s Global Rise After ‘Reform And Opening Up’ Chart 4China To Keep Struggling With Financial Instability Judging by the points above, there are two significant risks on the horizon. First, the CPC’s revival of neo-Maoist ideology, particularly the new economic mantra of self-reliance and “dual circulation” (import substitution), poses the risk of closing the economy and undermining productivity.2 Second, China’s sliding back into the rule of a single person – after the “consensus rule” that prevailed after Deng Xiaoping – increases the risk of unpredictable decision-making and a succession crisis whenever General Secretary Xi Jinping steps down. The party’s internal logic holds that China’s economic and geopolitical challenges are so enormous as to require a strongman leader at the helm of a single-party and centralized state. But because of the traditional problems with one-man rule, there is no guarantee that the country will remain as stable as it has been over the past 42 years. Slowing Growth Drives Clash With Foreign Powers Every major East Asian economy has enjoyed a “miracle” phase of growth – and every one of them has seen this phase come to an end. Now it is China’s turn. The country’s potential GDP growth is slowing as the population peaks, the labor force shrinks, wages rise, and companies outsource production to cheaper neighbors (Charts 5A & 5B). The Communist Party is attempting to reverse the collapse in the fertility rate by shifting from its historic “one Child policy,” which sharply reduced births. It shifted to a two-child policy in 2016 and a three-child policy in 2021 but the results have not been encouraging over the past five years. Chart 5AChina’s Demographic Decline Accelerating Chart 5BChina’s Demographic Decline Accelerating In the best case China’s growth will follow the trajectory of Taiwan and South Korea, which implies at most a 6% yearly growth rate over the next decade (Chart 6). This is not too slow but it will induce financial instability as well as hardship for overly indebted households, firms, and local governments. Chart 6China's Growth Rates Will Converge With Taiwan, South Korea The Communist Party’s legitimacy was not originally based on rapid economic growth but it came to be seen that way over the roaring decades of the 1980s through the 2000s. Thus when the Great Recession struck the party had to shift the party’s base of legitimacy. The new focus became quality of life, as marked by the Xi administration’s ongoing initiatives to cut back on corruption, pollution, poverty, credit excesses, and industrial overcapacity while increasing spending on health, education, and society (Chart 7). Chart 7China’s Fiscal Burdens Will Rise On Social Welfare Needs The party’s efforts to improve standards of living and consumer safety also coincided with an increase in propaganda, censorship, and repression to foreclose political dissent. The country falls far short in global governance indicators (Chart 8). Chart 8China Lags In Governance, Rule Of Law A second major new source of party legitimacy is nationalist foreign policy. China adopted a “more assertive” foreign and trade policy in the mid-2000s as its import dependencies ballooned. It helped that the US was distracted with wars of choice and financial crises. After the Great Recession the CPC’s foreign policy nationalism became a tool of generating domestic popular support amid slower economic growth. This was apparent in the clashes with Japan and other countries in the East and South China Seas in the early 2010s, in territorial disputes with India throughout the past decade, in political spats with Norway and most recently Australia, and in military showdowns over the Korean peninsula (2015-16) and today the Taiwan Strait (Chart 9). Chart 9Proxy Wars A Real Risk In China’s Periphery If China were primarily focused on foreign policy and global strategy then it would not provoke multiple neighbors on opposite sides of its territory at the same time. This is a good way to motivate the formation of a global balance-of-power coalition that can constrain China in the coming years. But China’s outward assertiveness is not driven primarily by foreign policy considerations. It is driven by the secular economic slowdown at home and the need to use nationalism to drum up domestic support. This is why China seems indifferent to offending multiple countries at once (like India and Australia) as well as more distant trade partners whom it “should be” courting rather than offending (like Europe). Such assertive foreign policy threatens to undermine quality of life, namely by provoking international protectionism and sanctions on trade and investment. The US is galvanizing a coalition of democracies to put pressure on China over its trade practices and human rights. The Asian allies are mostly in step with the US because they fear China’s growing clout. The European states do not have as much to fear from China’s military but they do fear China’s state-backed industry and technological rise. Europe’s elites also worry about anti-establishment political movements just like American elites and therefore are trying to win back the hearts and minds of the working class through a more proactive use of fiscal and industrial policy. This entails a more assertive trade policy. China has so far not adapted to the potential for a unified front among the democracies, other than through rhetoric. Thus the international horizon is darkening even as China’s growth rates shift downward. China’s Geopolitical Outlook Is Dimming China’s government has overcome a range of challenges and crises. The country takes an ever larger role in global trade despite its falling share of global population because of its productivity and competitiveness. The drop in China’s outward direct investment is tied to the global pandemic and may not mark a top, given that the country will still run substantial current account surpluses for the foreseeable future and will need to recycle these into natural resources and foreign production (Chart 10). However, the limited adoption of the renminbi as a reserve currency in the face of this formidable commercial power reveals the world’s reservations about Beijing’s ability to maintain macroeconomic stability, good governance, and peaceful foreign relations. Chart 10China's Rise Continues Chart 11China's Policy Uncertainty: A Structural Uptrend China is not in a position to alter the course of national policy dramatically prior to the Communist Party’s twentieth national congress in 2022. The Xi administration is focused on normalizing monetary and fiscal policy and heading off any sociopolitical disturbances prior to that critical event, in which General Secretary Xi Jinping, who was originally slated to step down at this time according to the old rules, may be anointed the overarching “chairman” position that Mao Zedong once held. The seventh generation of Chinese leaders will be promoted at this five-year rotation of the Central Committee and will further consolidate the Xi administration’s grip. It will also cement the party’s rotation back to leaders who have ideological educations, as opposed to the norm in the 1990s and early 2000s of promoting leaders with technocratic skills and scientific educations.3 This does not mean that President Xi will refuse to hold a summit with US President Biden in the coming months nor does it mean that US-China strategic and economic dialogue will remain defunct. But it does mean that Beijing is unlikely to make any major course correction until after the 2022 reshuffle – and even then a course correction is unlikely. China has taken its current path because the Communist Party fears the sociopolitical consequences of relinquishing economic control just as potential growth slows. The new ruling philosophy holds that the Soviet Union fell because of Mikhail Gorbachev’s glasnost and perestroika, not because openness and restructuring came too late. Moreover it is far from clear that the US, Europe, and other democratic allies will apply such significant and sustained pressure as to force China to change its overall strategy. America is still internally divided and its foreign policy incoherent; the EU remains reactive and risk-averse. China has a well-established set of strategic goals for 2035 and 2049, the 100th anniversary of the People’s Republic, and the broad outlines will not be abandoned. The implication is that tensions with the US and China’s Asian neighbors will persist. Rising policy uncertainty is a secular trend that will pick back up sooner rather than later (Chart 11), to the detriment of a stable and predictable investment environment. Chart 12Chinese Government’s Net Worth High But Hidden Liabilities Pose Risks Monetary and fiscal dovishness and a continued debt buildup are the obvious and necessary solutions to China’s combination of falling growth potential, rising social liabilities, the need to maintain the rapid military buildup in the face of geopolitical challenges. Sovereign countries can amass vast debts if they own their own debt and keep nominal growth above average bond yields. China’s government has a very favorable balance sheet when national assets are taken into consideration as well as liabilities, according to the IMF (Chart 12). On the other hand, China’s government is having to assume a lot of hidden liabilities from inefficient state-owned companies and local governments. In the short run there are major systemic financial risks even though in the long run Beijing will be able to increase its borrowing and bail out failing entities in order to maintain stability, just like Japan, the US, and Europe have had to do. The question for China is whether the social and political system will be able to handle major crises as well as the US and Europe have done, which is not that well. Investment Takeaways The rule of a single party is not a bar to economic success – but the rule of a single person is a liability due to the problem of succession. Marxism-Leninism is terrible for productivity unless it is compromised to allow for markets to operate, as in China and Vietnam. States that close their economies to the outside world usually atrophy. There is no compelling evidence that China’s Communist Party has performed better than a non-communist alternative would have done, given the province of Taiwan’s superior performance on most economic indicators. Since 1979, the Communist Party has avoided catastrophic errors. It has capitalized on domestic economic potential and a favorable international environment. Now, in the 2020s, both of these factors are changing for the worse. China’s “miracle” phase of growth has expired, as it did for other East Asian states before it. The maturation of the economy and slowdown of potential GDP have forced the Communist Party to shift the base of its political legitimacy to something other than rapid income growth: namely, quality of life and nationalist foreign policy. An aggressive foreign policy works against quality of life by provoking protectionism from foreign powers, particularly the United States, which is capable of leading a coalition of states to pressure China. The Communist Party’s policy trajectory is unlikely to change much through the twentieth national party congress in 2022. After that, a major course correction to improve relations with the West is conceivable, though we would not bet on it. Between 2021 and China’s 2035 and 2049 milestones, the Communist Party must navigate between rising socioeconomic pressures at home and rising geopolitical pressures abroad. An economic or political breakdown at home, or a total breakdown in relations with the US, could lead to proxy wars in China’s periphery, including but not limited to the Taiwan Strait. For now, global investors should favor the euro and US dollar over the renminbi (Chart 13). Chart 13Prefer The Dollar And Euro To The Renminbi Mainland investors should favor government bonds relative to stocks. Chinese stocks hit a major peak earlier this year and the government’s seizure of control over the tech sector is taking a toll. Investors should prefer developed market equities relative to Chinese equities until China’s current phase of policy tightening ends and there is at least a temporary improvement in relations with the United States. But investors should also prefer Chinese and Hong Kong stocks relative to Taiwanese due to the high risk of a diplomatic crisis and the tail risk of a war. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 The report concluded, “the emerging trends suggest a likely break from Deng's position toward heavier state intervention in the economy, more contentious relationships with neighbors, and a Party that rules primarily through ideology and social control.” Co-written with Jennifer Richmond, "China and the End of the Deng Dynasty," Stratfor, April 19, 2011, worldview.stratfor.com. 2 The Xi administration’s new concept of “dual circulation” entails that state policy will encourage the domestic economy whereas the international economy will play a secondary role. This is a reversal of the outward and trade-oriented economic model under Deng Xiaoping. See “Xi: China’s economy has potential to maintain long-term stable development,” November 4, 2020, news.cgtn.com. 3 See Willy Wo-Lap Lam, "China’s Seventh-Generation Leadership Emerges onto the Stage," Jamestown Foundation, China Brief 19:7, April 9, 2019, Jamestown.org.

Highlights Geopolitical risk is trickling back into financial markets. China’s fiscal-and-credit impulse collapsed again. The Global Economic Policy Uncertainty Index is ticking back up after the sharp drop from 2020. All of our proprietary GeoRisk Indicators are elevated or rising. Geopolitical risk often rises during bull markets – the Geopolitical Risk Index can even spike without triggering a bear market or recession. Nevertheless a rise in geopolitical risk is positive for the US dollar, which happens to stand at a critical technical point. The macroeconomic backdrop for the dollar is becoming less bearish given China’s impending slowdown. President Biden’s trip to Europe and summit with Russian President Vladimir Putin will underscore a foreign policy of forming a democratic alliance to confront Russia and China, confirming the secular trend of rising geopolitical risk. Shift to a defensive tactical position. Feature Back in March 2017 we wrote a report, “Donald Trump Is Who We Thought He Was,” in which we reaffirmed our 2016 view that President Trump would succeed in steering the US in the direction of fiscal largesse and trade protectionism. Now it is time for us to do the same with President Biden. Our forecast for Biden rested on the same points: the US would pursue fiscal profligacy and mercantilist trade policy. The recognition of a consistent national policy despite extreme partisan divisions is a testament to the usefulness of macro analysis and the geopolitical method. Trump stole the Democrats’ thunder with his anti-austerity and anti-free trade message. Biden stole it back. It was the median voter in the Rust Belt who was calling the shots all along (after all, Biden would still have won the election without Arizona and Georgia). We did make some qualifications, of course. Biden would maintain a hawkish line on China and Russia but he would reject Trump’s aggressive foreign and trade policy when it came to US allies.1 Biden would restore President Obama’s policy on Iran and immigration but not Russia, where there would be no “diplomatic reset.” And Biden’s fiscal profligacy, unlike Trump’s, would come with tax hikes on corporations and the wealthy … even though they would fall far short of offsetting the new spending. This is what brings us to this week’s report: New developments are confirming this view of the Biden administration. Geopolitical Risk And Bull Markets Chart 1Global Geopolitical Risk And The Dollar In recent weeks Biden has adopted a hawkish policy on China, lowered tensions with Europe, and sought to restore President Obama’s policy of détente with Iran. The jury is still out on relations with Russia – Biden will meet with Putin on June 16 – but we do not expect a 2009-style “reset” that increases engagement. Still, it is too soon to declare a “Biden doctrine” of foreign policy because Biden has not yet faced a major foreign crisis. A major test is coming soon. Biden’s decision to double down on hawkish policy toward China will bring ramifications. His possible deal with Iran faces a range of enemies, including within Iran. His reduction in tensions with Russia is not settled yet. While the specific source and timing of his first major foreign policy crisis is impossible predict, structural tensions are rebuilding. An aggregate of our 13 market-based GeoRisk indicators suggests that global political risk is skyrocketing once again. A sharp spike in the indicator, which is happening now, usually correlates with a dollar rally (Chart 1). This indicator is mean-reverting since it measures the deviation of emerging market currencies, or developed market equity markets, from underlying macroeconomic fundamentals. The implication is positive for the dollar, although the correlation is not always positive. Looking at both the DXY’s level and its rate of change shows periods when the global risk indicator fell yet the dollar stayed strong – and vice versa. The big increase in the indicator over the past week stems mostly from Germany, South Korea, Brazil, and Australia, though all 13 of the indicators are now either elevated or rising, including the China/Taiwan indicators. Some of the increase is due to base effects. As global exports recover, currencies and equities that we monitor are staying weaker than one would expect. This causes the relevant BCA GeoRisk indicator to rise. Base effects from the weak economy in June 2020 will fall out in coming weeks. But the aggregate shows that all of the indicators are either high or rising and, on a country by country level, they are now in established uptrends even aside from base effects. Chart 2Global Policy Uncertainty Revives Meanwhile the global Economic Policy Uncertainty Index is recovering across the world after the drop in uncertainty following the COVID-19 crisis (Chart 2). Policy uncertainty is also linked to the dollar and this indicator shows that it is rising on a secular basis. The Geopolitical Risk Index, maintained by Matteo Iacoviello and a group of academics affiliated with the Policy Uncertainty Index, is also in a secular uptrend, although cyclically it has not recovered from the post-COVID drop-off. It is sensitive to traditional, war-linked geopolitical risk as reported in newspapers. By contrast our proprietary indicators are sensitive to market perceptions of any kind of risk, not just political, both domestic and international. A comparison of the Geopolitical Risk Index with the S&P 500 over the past century shows that a geopolitical crisis may occur at the beginning of a business cycle but it may not be linked with a recession or bear market. Risk can rise, even extravagantly, during economic expansions without causing major pullbacks. But a crisis event certainly can trigger a recession or bear market, particularly if it is tied to the global oil supply, as in the early 1970s, 1980s, and 1990s (Chart 3). Chart 3Secular Rise In Geopolitical Risk Soon To Reassert Itself While geopolitical risk is normally positive for the dollar, the macroeconomic backdrop is negative. The dollar’s attempt to recover earlier this year faltered. This underlying cyclical bearish dollar trend is due to global economic recovery – which will continue – and extravagant American monetary expansion and budget deficits. This is why we have preferred gold – it is a hedge against both geopolitical risk and inflation expectations. Tactically this year we have refrained from betting against the dollar except when building up some safe-haven positions like Japanese yen. Over the medium and long term we expect geopolitical risk to put a floor under the greenback. The bottom line is that the US dollar is at a critical technical crossroads where it could break out or break down. Macro factors suggest a breakdown but the recovery of global policy uncertainty and geopolitical risk suggests the opposite. We remain neutral. A final quantitative indicator of the recovery of geopolitical risk is the performance of global aerospace and defense stocks (Chart 4). Defense shares are rising in absolute and relative terms. Chart 4Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Can The WWII Peace Be Prolonged? Qualitative assessments of geopolitical risk are necessary to explain why risk is on a secular upswing – why drops in the quantitative indicators are temporary and the troughs keep getting higher. Great nations are returning to aggressive competition after a period of relative peace and prosperity. Over the past two decades Russia and China took advantage of America’s preoccupations with the Middle East, the financial crisis, and domestic partisanship in order to build up their global influence. The result is a world in which authority is contested. The current crisis is not merely about the end of the post-Cold War international order. It is much scarier than that. It is about the decay of the post-WWII international order and the return of the centuries-long struggle for global supremacy among Great Powers. The US and European political establishments fear the collapse of the WWII settlement in the face of eroding legitimacy at home and rising challenges from abroad. The 1945 peace settlement gave rise to both a Cold War and a diplomatic system, including the United Nations Security Council, for resolving differences among the great powers. It also gave rise to European integration and various institutions of American “liberal hegemony.” It is this system of managing great power struggle, and not the post-Cold War system of American domination, that lies in danger of unraveling. This is evident from the following points: American preeminence only lasted fifteen years, or at best until the 2008 Georgia war and global financial crisis. The US has been an incoherent wild card for at least 13 years now, almost as long as it was said to be the global empire. Russian antagonism with the West never really ended. In retrospect the 1990s were a hiatus rather than a conclusion of this conflict. China’s geopolitical rise has thawed the frozen conflicts in Asia from the 1940s-50s – i.e. the Chinese civil war, the Hong Kong and Taiwan Strait predicaments, the Korean conflict, Japanese pacifism, and regional battles for political influence and territory. Europe’s inward focus and difficulty projecting power have been a constant, as has its tendency to act as a constraint on America. Only now is Europe getting closer to full independence (which helped trigger Brexit). Geopolitical pressures will remain historically elevated for the foreseeable future because the underlying problem is whether great power struggle can be contained and major wars can be prevented. Specifically the question is whether the US can accommodate China’s rise – and whether China can continue to channel its domestic ambitions into productive uses (i.e. not attempts to create a Greater Chinese and then East Asian empire). The Great Recession killed off the “East Asia miracle” phase of China’s growth. Potential GDP is declining, which undermines social stability and threatens the Communist Party’s legitimacy. The renminbi is on a downtrend that began with the Xi Jinping era. The sharp rally during the COVID crisis is over, as both domestic and international pressures are rising again (Chart 5). Chart 5Biden Administration Review Of China Policy: More China Bashing While the data for China’s domestic labor protests is limited in extent, we can use it as a proxy for domestic instability in lieu of official statistics that were tellingly discontinued back in 2005. The slowdown in credit growth and the cyclical sectors of the economy suggest that domestic political risk is underrated in the lead up to the 2022 leadership rotation (Chart 6). Chart 6China's Domestic Political Risk Will Rise Chart 7Steer Clear Of Taiwan Strait The increasing focus on China’s access to key industrial and technological inputs, the tensions over the Taiwan Strait, and the formation of a Russo-Chinese bloc that is excluded from the West all suggest that the risk to global stability is grave and historic. It is reminiscent of the global power struggles of the seventeenth through early twentieth centuries. The outperformance of Taiwanese equities from 2019-20 reflects strong global demand for advanced semiconductors but the global response to this geopolitical bottleneck is to boost production at home and replace Taiwan. Therefore Taiwan’s comparative advantage will erode even as geopolitical risk rises (Chart 7). The drop in geopolitical tensions during COVID-19 is over, as highlighted above. With the US, EU, and other countries launching probes into whether the virus emerged from a laboratory leak in China – contrary to what their publics were told last year – it is likely that a period of national recriminations has begun. There is a substantial risk of nationalism, xenophobia, and jingoism emerging along with new sources of instability. An Alliance Of Democracies The Biden administration’s attempt to restore liberal hegemony across the world requires a period of alliance refurbishment with the Europeans. That is the purpose of his current trip to the UK, Belgium, and Switzerland. But diplomacy only goes so far. The structural factor that has changed is the willingness of the West to utilize government in the economic sphere, i.e. fiscal proactivity. Infrastructure spending and industrial policy, at the service of national security as well as demand-side stimulus, are the order of the day. This revolution in economic policy – a return to Big Government in the West – poses a threat to the authoritarian powers, which have benefited in recent decades by using central strategic planning to take advantage of the West’s democratic and laissez-faire governance. If the West restores a degree of central government – and central coordination via NATO and other institutions – then Beijing and Moscow will face greater pressure on their economies and fewer strategic options. About 16 American allies fall short of the 2% of GDP target for annual defense spending – ranging from Italy to Canada to Germany to Japan. However, recent trends show that defense spending did indeed increase during the Trump administration (Chart 8). Chart 8NATO Boosts Defense Spending The European Union as a whole has added $50 billion to the annual total over the past five years. A discernible rise in defense spending is taking place even in Germany (Chart 9). The same point could be made for Japan, which is significantly boosting defense spending (as a share of output) after decades of saying it would do so without following through. A major reason for the American political establishment’s rejection of President Trump was the risk he posed to the trans-Atlantic alliance. A decline in NATO and US-EU ties would dramatically undermine European security and ultimately American security. Hence Biden is adopting the Trump administration’s hawkish approach to trade with China but winding down the trade war with Europe (Chart 10). Chart 9Europe Spending More On Guns Chart 10US Ends Trade War With Europe? A multilateral deal aimed at setting a floor in global corporate taxes rates is intended to prevent the US and Europe from undercutting each other – and to ensure governments have sufficient funding to maintain social spending and reduce income inequality (Chart 11). Inequality is seen as having vitiated sociopolitical stability and trust in government in the democracies. Chart 11‘Global’ Corporate Tax Deal Shows Return Of Big Government, Attempt To Reduce Inequality In The West Risks To Biden’s Diplomacy It is possible that Biden’s attempt to restore US alliances will go nowhere over the course of his four-year term in office. The Europeans may well remain risk averse despite their initial signals of willingness to work with Biden to tackle China’s and Russia’s challenges to the western system. The Germans flatly rejected both Biden and Trump on the Nord Stream II natural gas pipeline linkage with Russia, which is virtually complete and which strengthens the foundation of Russo-German engagement (more on this below). The US’s lack of international reliability – given the potential of another partisan reversal in four years – makes it very hard for countries to make any sacrifices on behalf of US initiatives. The US’s profound domestic divisions have only slightly abated since the crises of 2020 and could easily flare up again. A major outbreak of domestic instability could distract Biden from the foreign policy game.2 However, American incapacity is a risk, not our base case, over the coming years. We expect the US economic stimulus to stabilize the country enough that the internal political crisis will be contained and the US will continue to play a global role. The “Civil War Lite” has mostly concluded, excepting one or two aftershocks, and the US is entering into a “Reconstruction Lite” era. The implication is negative for China and Russia, as they will now have to confront an America that, if not wholly unified, is at least recovering. Congress’s impending passage of the Innovation and Competition Act – notably through regular legislative order and bipartisan compromise – is case in point. The Senate has already passed this approximately $250 billion smorgasbord of industrial policy, supply chain resilience, and alliance refurbishment. It will allot around $50 billion to the domestic semiconductor industry almost immediately as well as $17 billion to DARPA, $81 billion for federal research and development through the National Science Foundation, which includes $29 billion for education in science, technology, engineering, and mathematics, and other initiatives (Table 1). Table 1Peak Polarization: US Congress Passes Bipartisan ‘Innovation And Competition Act’ To Counter China With the combination of foreign competition, the political establishment’s need to distract from domestic divisions, and the benefit of debt monetization courtesy of the Federal Reserve, the US is likely to achieve some notable successes in pushing back against China and Russia. On the diplomatic front, the US will meet with some success because the European and Asian allies do not wish to see the US embrace nationalism and isolationism. They have their own interests in deterring Russia and China. Lack Of Engagement With Russia Russian leadership has dealt with the country’s structural weaknesses by adopting aggressive foreign policy. At some point either the weaknesses or the foreign policy will create a crisis that will undermine the current regime – after all, Russia has greatly lagged the West in economic development and quality of life (Chart 12). But President Putin has been successful at improving the country’s wealth and status from its miserably low base in the 1990s and this has preserved sociopolitical stability so far. Chart 12Russia's Domestic Political Risk It is debatable whether US policy toward Russia ever really changed under President Trump, but there has certainly not been a change in strategy from Russia. Thus investors should expect US-Russia antagonism to continue after Biden’s summit with Putin even if there is an ostensible improvement. The fundamental purpose of Putin’s strategy has been to salvage the Russian empire after the Soviet collapse, ensure that all world powers recognize Russia’s veto power over major global policies and initiatives, and establish a strong strategic position for the coming decades as Russia’s demographic decline takes its toll. A key component of the strategy has been to increase economic self-sufficiency and reduce exposure to US sanctions. Since the invasion of Ukraine in 2014, Putin has rapidly increased Russia’s foreign exchange reserves so as to buffer against shocks (Chart 13). Chart 13Russia Fortified Against US Sanctions Putin has also reduced Russia’s reliance on the US dollar to about 22% (Chart 14), primarily by substituting the euro and gold. Russia will not be willing or able to purge US dollars from its system entirely but it has been able to limit America’s ability to hurt Russia by constricting access to dollars and the dollar-based global financial architecture. Russian Finance Minister Anton Siluanov highlighted this process ahead of the Biden-Putin summit by declaring that the National Wealth Fund will divest of its remaining $40 billion of its US dollar holdings. Chart 14Russia Diversifies From USD In general this year, Russia is highlighting its various advantages: its resilience against US sanctions, its ability to re-invade Ukraine, its ability to escalate its military presence in Belarus and the Black Sea, and its ability to conduct or condone cyberattacks on vital American food and fuel supplies (Chart 15). Meanwhile the US is suffering from deep political divisions at home and strategic incoherence abroad and these are only starting to be mended by domestic economic stimulus and alliance refurbishment. Chart 15Cyber Security Stocks Recover Europe’s risk-aversion when it comes to strategic confrontation with Russia, and the lack of stability in US-Russia relations, means that investors should not chase Russian currency or financial assets amid the cyclical commodity rally. Investors should also expect risk premiums to remain high in developing European economies relative to their developed counterparts. This is true despite the fact that developed market Europe’s outperformance relative to emerging Europe recently peaked and rolled over. From a technical perspective this outperformance looks to subside but geopolitical tensions can easily escalate in the near term, particularly in advance of the Russian and German elections in September (Chart 16). Chart 16Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Europe trades in line with EUR-RUB and these pair trades all correspond closely to geopolitical tensions with Russia (Chart 17). A notable exception is the UK, whose stock market looks attractive relative to eastern Europe and is much more secure from any geopolitical crisis in this region (Chart 17, bottom panel). The pound is particularly attractive against the Czech koruna, as Russo-Czech tensions have heated up in advance of October’s legislative election there (Chart 18). Chart 17Long UK Versus Eastern Europe Chart 18Long GBP Versus CZK Meanwhile Russia and China have grown closer together out of strategic necessity. Germany’s Election And Stance Toward Russia Germany’s position on Russia is now critical. The decision to complete the Nord Stream II pipeline against American wishes either means that the Biden administration can be safely ignored – since it prizes multilateralism and alliances above all things and is therefore toothless when opposed – or it means that German will aim to compensate the Americans in some other area of strategic concern. Washington is clearly attempting to rally the Germans to its side with regard to putting pressure on China over its trade practices and human rights. This could be the avenue for the US and Germany to tighten their bond despite the new milestone in German-Russia relations. The US may call on Germany to stand up for eastern Europe against Russian aggression but on that front Berlin will continue to disappoint. It has no desire to be drawn into a new Cold War given that the last one resulted in the partition of Germany. The implication is negative for China on one hand and eastern Europe on the other. Germany’s federal election on September 26 will be important because it will determine who will succeed Chancellor Angela Merkel, both in Germany and on the European and global stage. The ruling Christian Democratic Union (CDU) is hoping to ride Merkel’s coattails to another term in charge of the government. But they are likely to rule alongside the Greens, who have surged in opinion polls in recent years. The state election in Saxony-Anhalt over the weekend saw the CDU win 37% of the popular vote, better than any recent result, while Germany’s second major party, the Social Democrats, continued their decline (Table 2). The far-right Alternative for Germany won 21% of the vote, a downshift from 2016, while the Greens won 6% of the vote, a slight improvement from 2016. All parties underperformed opinion polling except the CDU (Chart 19). Table 2Saxony-Anhalt Election Results Chart 19Germany: Conservatives Outperform In Final State Election Before Federal Vote, But Face Challenges Chart 20Germany: Greens Will Outperform in 2021 Vote The implication is still not excellent for the CDU. Saxony-Anhalt is a middling German state, a CDU stronghold, and a state with a popular CDU leader. So it is not representative of the national campaign ahead of September. The latest nationwide opinion polling puts the CDU at around 25% support. They are neck-and-neck with the Greens. The country’s left- and right-leaning ideological blocs are also evenly balanced in opinion polls (Chart 20). A potential concern for the CDU is that the Free Democratic Party is ticking up in national polls, which gives them the potential to steal conservative votes. Betting markets are manifestly underrating the chance that Annalena Baerbock and the Greens take over the chancellorship (Charts 21A and 21B). We still give a subjective 35% chance that the Greens will lead the next German government without the CDU, a 30% that the Greens will lead with the CDU, and a 25% chance that the CDU retains power but forms a coalition with the Greens. A coalition government would moderate the Greens’ ambitious agenda of raising taxes on carbon emissions, wealth, the financial sector, and Big Tech. The CDU has already shifted in a pro-environmental, fiscally proactive direction. Chart 21AGerman Greens Will Recover Chart 21BGerman Greens Still Underrated No matter what the German election will support fiscal spending and European solidarity, which is positive for the euro and regional equities over the next 12 to 24 months. However, the Greens would pursue a more confrontational stance toward Russia, a petro-state whose special relations with the German establishment have impeded the transition to carbon neutrality. Latin America’s Troubles A final aspect of Biden’s agenda deserves some attention: immigration and the Mexican border. Obviously this one of the areas where Biden starkly differs from Trump, unlike on Europe and China, as mentioned above. Vice President Kamala Harris recently came back from a trip to Guatemala and Mexico that received negative media attention. Harris has been put in charge of managing the border crisis, the surge in immigrant arrivals over 2020-21, both to give her some foreign policy experience and to manage the public outcry. Despite telling immigrants explicitly “Do not come,” Harris has no power to deter the influx at a time when the US economy is fired up on historic economic stimulus and the Democratic Party has cut back on all manner of border and immigration enforcement. From a macro perspective the real story is the collapse of political and geopolitical risk in Mexico. From 2016-20 Mexico faced a protectionist onslaught from the Trump administration and then a left-wing supermajority in Congress. But these structural risks have dissipated with the USMCA trade deal and the inability of President Andrés Manuel López Obrador to follow through with anti-market reforms, as we highlighted in reports in October and April. The midterm election deprived the ruling MORENA party of its single-party majority in the Chamber of Deputies, the lower house of the legislature (Chart 22). AMLO is now politically constrained – he will not be able to revive state control over the energy and power sectors. Chart 22Mexican Midterm Election Constrained Left-Wing Populism, Political Risk Chart 23Buy Mexico (And Canada) On US Stimulus American monetary and fiscal stimulus, and the supply-chain shift away from China, also provide tailwinds for Mexico. In short, the Mexican election adds the final piece to one of our key themes stemming from the Biden administration, US populism, and US-China tensions: favor Mexico and Canada (Chart 23). A further implication is that Mexico should outperform Brazil in the equity space. Brazil is closely linked to China’s credit cycle and metals prices, which are slated to turn down as a result of Chinese policy tightening. Mexico is linked to the US economy and oil prices (Chart 24). While our trade stopped out at -5% last week we still favor the underlying view. Brazilian political risk and unsustainable debt dynamics will continue to weigh on the currency and equities until political change is cemented in the 2022 election and the new government is then forced by financial market riots into undertaking structural reforms. Chart 24Brazil's Troubles Not Truly Over - Mexico Will Outperform Elsewhere in Latin America, the rise of a militant left-wing populist to the presidency in a contested election in Peru, and the ongoing social unrest in Colombia and Chile, are less significant than the abrupt slowdown in China’s credit growth (Charts 25A and 25B). According to our COVID-19 Social Stability Index, investors should favor Mexico. Turkey, the Philippines, South Africa, Colombia, and Brazil are the most likely to see substantial social instability according to this ranking system (Table 3). Chart 25AMexico To Outperform Latin America Chart 25BChina’s Slowdown Will Hit South America Table 3Post-COVID Emerging Market Social Unrest Only Just Beginning Investment Takeaways Close long emerging markets relative to developed markets for a loss of 6.8% – this is a strategic trade that we will revisit but it faces challenges in the near term due to China’s slowdown (Chart 26). Go long Mexican equities relative to emerging markets on a strategic time frame. Our long Mexico / short Brazil trade hit the stop loss at 5% but the technical profile and investment thesis are still sound over the short and medium term. Chart 26China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets Chart 27Relative Uncertainty And Safe Havens China’s sharp fiscal-and-credit slowdown suggests that investors should reduce risk exposure, take a defensive tactical positioning, and wait for China’s policy tightening to be priced before buying risky assets. Our geopolitical method suggests the dollar will rise, while macro fundamentals are becoming less dollar-bearish due to China. We are neutral for now and will reassess for our third quarter forecast later this month. If US policy uncertainty falls relative to global uncertainty then the EUR-USD will also fall and safe-haven assets like Swiss bonds will gain a bid (Chart 27). Gold is an excellent haven amid medium-term geopolitical and inflation risks but we recommend closing our long silver trade for a gain of 4.5%. Disfavor emerging Europe relative to developed Europe, where heavy discounts can persist due to geopolitical risk premiums. We will reassess after the Russian Duma election in September. Go long GBP-CZK. Close the Euro “laggards” trade. Go long an equal-weighted basket of euros and US dollars relative to the Chinese renminbi. Short the TWD-USD on a strategic basis. Prefer South Korea to Taiwan – while the semiconductor splurge favors Taiwan, investors should diversify away from the island that lies at the epicenter of global geopolitical risk. Close long defense relative to cyber stocks for a gain of 9.8%. This was a geopolitical “back to work” trade but the cyber rebound is now significant enough to warrant closing this trade.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Trump’s policy toward Russia is an excellent example of geopolitical constraints. Despite any personal preferences in favor of closer ties with Russia, Trump and his administration ultimately reaffirmed Article 5 of NATO, authorized the sale of lethal weapons to Ukraine, and deployed US troops to Poland and the Czech Republic. 2 As just one example, given the controversial and contested US election of 2020, it is possible that a major terrorist attack could occur. Neither wing of America’s ideological fringes has a monopoly on fanaticism and violence. Meanwhile foreign powers stand to benefit from US civil strife. A truly disruptive sequence of events in the US in the coming years could lead to greater political instability in the US and a period in which global powers would be able to do what they want without having to deal with Biden’s attempt to regroup with Europe and restore some semblance of a global police force. The US would fall behind in foreign affairs, leaving power vacuums in various regions that would see new sources of political and geopolitical risk crop up. Then the US would struggle to catch up, with another set of destabilizing consequences.

Highlights President Biden has called for the US intelligence community to investigate the origins of COVID-19 and one of Biden’s top diplomats has stated the obvious: the era of “engagement” with China is over. This clinches our long-held view that any Democratic president would be a hawk like President Trump. The US-China conflict – and global geopolitical risk – will revive and undermine global risk appetite. China faces a confluence of geopolitical and macroeconomic challenges, suggesting that its equity underperformance will continue. Domestic Chinese investors should stay long government bonds. Foreign investors should sell into the bond rally to reduce exposure to any future sanctions. The impending agreement of a global minimum corporate tax rate has limited concrete implications that are not already known but it symbolizes the return of Big Government in the western world. Our updated GeoRisk Indicators are available in the Appendix, as well as our monthly geopolitical calendar. Feature In our quarterly webcast, “Geopolitics And Bull Markets,” we argued that geopolitical themes matter to investors when they have a demonstrable relationship with the macroeconomic backdrop. When geopolitics and macro are synchronized, a simple yet powerful investment thesis can be discerned. The US war on terror, Russia’s resurgence, the EU debt crisis, and Brexit each provided cases in which a geopolitically informed macro view was both accessible and actionable at an early stage. Investors generally did well if they sold the relevant country’s currency and disfavored its equities on a relative basis. Chart 1China's Decade Of Troubles Of course, the market takeaway is not always so clear. When geopolitics and macroeconomics are desynchronized, the trick is to determine which framework will prevail over the financial markets and for how long. Sometimes the market moves to its own rhythm. The goal is not to trade on geopolitics but rather to invest with geopolitics. One of our key views for this year – headwinds for China – is an example of synchronization. Two weeks ago we discussed China’s macroeconomic challenge. In this report we discuss China’s foreign policy challenge: geopolitical pressure from the US and its allies. In particular we address President Biden’s call for a deeper intelligence dive into the origins of COVID-19. The takeaway is negative for China’s currency and risk assets. The Great Recession dealt a painful blow to the Chinese version of the East Asian economic miracle. By 2015, China’s financial turmoil and currency devaluation should have convinced even bullish investors to keep their distance from Chinese stocks and the renminbi. If investors stuck with this bearish view despite the post-2016 rally, on fear of trade war, they were rewarded in 2018-19. Only with China’s containment of COVID-19 and large economic stimulus in 2020 has CNY-USD threatened to break out (Chart 1). We expect the renminbi to weaken anew, especially once the Fed begins to taper asset purchases. Our cyclical view is still bullish but US-China relations are unstable so we remain tactically defensive. Forget Biden’s China Review, He’s A Hawk Chinese financial markets face a host of challenges this year, despite the positive factors for China’s manufacturing sector amid the global recovery. At home these challenges consist of a structural economic slowdown, a withdrawal of policy stimulus, bearish sentiment among households, and an ongoing government crackdown on systemic risk. Abroad the Democratic Party’s return to power in Washington means that the US will bring more allies to bear in its attempt to curb China’s rise. This combination of factors presents a headwind for Chinese equities and a tailwind for government bonds (Chart 2). This is true at least until the government should hit its pain threshold and re-stimulate. Chart 2Global Investors Still Wary New stimulus may not occur in 2022. The Communist Party’s leadership rotation merely requires economic stability, not rapid growth. While the central government has a record of stimulating when its pain threshold is hit, even under the economically hawkish President Xi Jinping, a financial market riot is usually part of this threshold. This implies near-term downside, particularly for global commodities and metals, which are also facing a Chinese regulatory backlash to deter speculation. In this context, President Biden’s call for a deeper US intelligence investigation into the origin of COVID-19 is an important confirming signal of the US’s hawkish turn toward China. Biden gave 90 days for the intelligence community to report back to him. We will not enter into the debate about COVID-19’s origins. From a geopolitical point of view it is a moot point. The facts of the virus origin may never be established. According to Biden’s statement, at least one US intelligence agency believes the “lab leak theory” is the most likely source of the virus (while two other agencies decided in favor of animal-to-human transmission). Meanwhile Chinese government spokespeople continue to push the theory that the virus originated at the US’s Fort Detrick in Maryland or at a US-affiliated global research center. What is certain is that the first major outbreak of a highly contagious disease occurred in Wuhan. Both sides are demanding greater transparency and will reject each other’s claims based on a lack of transparency. If the US intelligence report concludes that COVID originated from the Wuhan Institute of Virology, the Chinese government and media will reject the report. If the report exonerates the Wuhan laboratory, at least half of the US public will disbelieve it and it will not deter Biden from drawing a hard line on more macro-relevant policy disputes with China. The US’s hawkish bipartisan consensus on China took shape before COVID. Biden’s decision to order the fresh report introduces skepticism regarding the World Health Organization’s narrative, which was until now the mainstream media’s narrative. Previously this skepticism was ghettoized in US public discourse: indeed, until Biden’s announcement on May 26, the social media company Facebook suppressed claims that the virus came from a lab accident or human failure. Thus Biden’s action will ensure that a large swathe of the American public will always tend to support this theory regardless of the next report’s findings. At the same time Biden discontinued a State Department effort to prove the lab leak theory, which shows that it is not a foregone conclusion what his administration will decide. The good news is that even if the report concluded in favor of the lab leak, the Biden administration would remain highly unlikely to demand that China pay “reparations,” like the Trump administration demanded in 2020. This demand, if actualized, would be explosive. The bad news is that a future nationalist administration could conceivably use the investigation as a basis to demand reparations. Nationalism is a force to be reckoned with in both countries and the dispute over COVID’s origin will exacerbate it. Traditionally the presidents of both countries would tamp down nationalism or attempt to keep it harnessed. But in the post-Xi, post-Trump era it is harder to control. The death toll of COVID-19 will be a permanent source of popular grievance around the world and a wedge between the US and China (Chart 3). China’s international image suffered dramatically in 2020. So far in 2021 China has not regained any diplomatic ground. Chart 3Death Toll Of COVID-19 The US is repairing its image via a return to multilateralism while the Europeans have put their Comprehensive Agreement on Investment with China on hold due to a spat over sanctions arising from western accusations of genocide (a subject on which China pointedly answered that it did not need to be lectured by Europeans). Notably Biden’s Department of State also endorsed its predecessor’s accusation of genocide in Xinjiang. Any authoritative US intelligence review that solidifies doubts about the WHO’s initial investigation – even if it should not affirm the lab leak theory – would give Biden more ammunition in global opinion to form a democratic alliance to pressure China (for example, in Europe). An important factor that enables the US to remain hawkish on China is fiscal stimulus. While stimulus helps bring about economic recovery, it also lowers the bar to political confrontation (Chart 4). Countries with supercharged domestic demand do not have as much to fear from punitive trade measures. The Biden administration has not taken new punitive measures against China but it is clearly not worried about Chinese retaliation. Chart 4Large Fiscal Stimulus Lowers The Bar To Geopolitical Conflict China’s stimulus is underrated in this chart (which excludes non-fiscal measures) but it is still true that China’s policy has been somewhat restrained and it will need to stimulate its economy again in response to any new punitive measures or any global loss of confidence. At least China is limited in its ability to tighten policy due to the threat of US pressure and western trade protectionism. Simultaneous with Biden’s announcement on COVID-19, his administration’s coordinator for Indo-Pacific affairs, Kurt Campbell, proclaimed in a speech that the era of “engagement” with China is officially over and the new paradigm is one of “competition.” By now Campbell is stating the obvious. But this tone is a change both from his tone while serving in President Obama’s Department of State and from his article in Foreign Affairs last year (when he was basically auditioning for his current role in the Biden administration).1 Campbell even said in his latest remarks that the Trump administration was right about the “direction” of China policy (though not the “execution”), which is candid. Campbell was speaking at Stanford University but his comments were obviously aimed for broader consumption. Investors no longer need to wait for the outcome of the Biden administration’s comprehensive review of policy toward China. The answer is known: the Biden administration’s hawkishness is confirmed. The Department of Defense report on China policy, due in June, is very unlikely to strike a more dovish posture than the president’s health policy. Now investors must worry about how rapidly tensions will escalate and put a drag on global sentiment. Bottom Line: US-China relations are unstable and pose an immediate threat to global risk appetite. The fundamental geopolitical assessment of US-China relations has been confirmed yet again. The US is seeking to constrain China’s rise because China is the only country capable of rivaling the US for supremacy in Asia and the world. Meanwhile China is rejecting liberalization in favor of economic self-sufficiency and maintaining an offensive foreign policy as it is wary of US containment and interference. Presidents Biden and Xi Jinping are still capable of stabilizing relations in the medium term but they are unlikely to substantially de-escalate tensions. And at the moment tensions are escalating. China’s Reaction: The Example Of Australia How will China respond to Biden’s new inquiry into COVID’s origins? Obviously Beijing will react negatively but we would not expect anything concrete to occur until the result of the inquiry is released in 90 days. China will be more constrained in its response to the US than it has been with Australia, which called for an international inquiry early last year, as the US is a superior power. Australia was the first to ban Chinese telecom company Huawei from its 5G network (back in 2018) and it was the first to call for a COVID probe. Relations between China and Australia have deteriorated steadily since then, but macro trends have clearly driven the Aussie dollar. The AUD-JPY exchange rate is a good measure for global risk appetite and it is wavering in recent weeks (Chart 5). Chart 5Australian Dollar Follows Macro Trends, Rallies Amid China Trade Spat Tensions have also escalated due to China’s dependency on Australian commodity exports at a time of spiking commodity prices. This is a recurring theme going back to the Stern Hu affair. The COVID spat led China to impose a series of sanctions against Australian beef, barley, wine, and coal. But because China cannot replace Australian resources (at least, not in the short term), its punitive measures are limited. It faces rising producer prices as a result of its trade restrictions (Chart 6). This dependency is a bigger problem for China today than it was in previous cycles so China will try to diversify. Chart 6Constraints On China's Tarrifs On Australia By contrast, China is not likely to impose sanctions on the US in response to Biden’s investigation, unless Biden attacks first. China’s imports from the US are booming and its currency is appreciating sharply. Despite Beijing’s efforts to keep the Phase One trade deal from collapsing, Biden is maintaining Trump’s tariffs and the US-China trade divorce is proceeding (Chart 7). Bilateral tariff rates are still 16-17 percentage points higher than they were in 2018, with US tariffs on China at 19% (versus 3% on the rest of the world) while Chinese tariffs on the US stand at 21% (versus 6% on the rest of the world). The Biden administration timed this week’s hawkish statements to coincide with the first meeting of US trade negotiators with China, which was a more civil affair. Both countries acknowledged that the relationship is important and trade needs to be continued. However, US Trade Representative Katherine Tai’s comments were not overly optimistic (she told Reuters that the relationship is “very, very challenging”). She has also been explicit about maintaining policy continuity with the Trump administration. We highly doubt that China’s share of US imports will ever surpass its pre-Trump peaks. The Biden administration has also refrained so far from loosening export controls on high-tech trade with China. This has caused a bull market in Taiwan while causing problems for Chinese semiconductor stocks’ relative performance (Chart 8). If Biden’s policy review does not lead to any relaxation of export controls on commercial items then it will mark a further escalation in tensions. Chart 7US Tarrifs Reduce China In Trade Deficit Bottom Line: Until Presidents Biden and Xi stabilize relations at the top, the trade negotiations over implementing the Phase One trade deal – and any new Phase Two talks – cannot bring major positive surprises for financial markets. Chart 8US Export Controls Amid Chip Shortage Congress Is More Hawkish Than Biden Biden’s ability to reduce frictions with China, should he seek to, will also be limited by Congress and public opinion. With the US deeply politically divided, and polarization at historically high levels, China has emerged as one of the few areas of agreement. The hawkish consensus is symbolized by new legislation such as the Strategic Competition Act, which is making its way through the Senate rapidly. Congress is also trying to boost US competitiveness through bills such as the Endless Frontier Act. These bills would subject China to scrutiny and potential punitive measures over a broad range of issues but most of all they would ignite US industrial policy , STEM education, and R&D, and diversify the US’s supply chains. We would highlight three key points with regard to the global impact of this legislation: Global supply chains are shifting regardless: This trend is fairly well established in tech, defense, and pharmaceuticals. It will continue unless we see a major policy reversal from China to try to court western powers and reduce frictions. The EU and India are less enthusiastic than the US and Australia about removing China from supply chains but they are not opposed. The EU Commission has recommended new defensive economic measures that cover supply chains in batteries, cloud services, hydrogen energy, pharmaceuticals, materials, and semiconductors. As mentioned, the EU is also hesitating to ratify the Comprehensive Agreement on Investment with China. Hence the EU is moving in the US’s direction independently of proposed US laws. After all, China’s rise up the tech value chain (and its decision to stop cutting back the size of its manufacturing sector) ultimately threatens the EU’s comparative advantage. The EU is also aligned with the US on democratic values and network security. India has taken a harder stance on China than usual, which marks an important break with the past. India’s decision to exclude Huawei from its 5G network is not final but it is likely to be at least partially implemented. A working group of democracies is forming regardless. The Strategic Competition Act calls for the creation of a working group of democracies but the truth is that this is already happening through more effective forums like the G7 and bilateral summits. Just as the implementation of the act would will ultimately depend on President Biden, so the willingness of other countries to adopt the recommendations of the working group would depend on their own executives. Allies have leeway as Biden will not use punitive measures against them: Any policy change from the EU, UK, India, and Australia will be independent of the US Congress passing the Strategic Competition Act. These countries will be self-directed. The US would have to devote diplomatic energy to maintaining a sustained effort by these states to counter China in the face of economic costs. This will be limited by the fact that the Biden administration will be very reluctant to impose punitive measures on allies to insist on their cooperation. The allies will set the pace of pressure on China rather than the United States. This gives the EU an important position, particularly Germany. And yet the trends in Germany suggest that the government will be more hawkish on China after the federal elections in September. Bottom Line: The Biden administration is unlikely to use punitive measures against allies so new US laws are less important than overall US diplomacy with each of the allies. Some allies will be less compliant with US policies given their need for trade with China. But so far there appears to be a common position taking shape even with the EU that is prejudicial to China’s involvement in key sectors of emerging technologies. If China does not respond by reducing its foreign policy assertiveness, then China’s economic growth will suffer. That drag would have to be offset by new supply chain construction in Southeast Asia and other countries. Investment Takeaways The foregoing highlights the international risks facing China even at a time when its trend growth is slowing (Chart 9) and its ongoing struggle with domestic financial imbalances is intensifying. China’s debt-service costs have risen sharply and Beijing is putting pressure on corporations and local governments to straighten out their finances (Chart 10), resulting in a wave of defaults. This backdrop is worrisome for investors until policymakers reassure them that government support will continue. Chart 9China's Growth Potential Slowing Chart 10China's Leaders Struggle With Debt China’s domestic stability is a key indicator of whether geopolitical risks could spiral out of control. In particular we think aggressive action in the Taiwan Strait is likely to be delayed as long as the Chinese economy and regime are stable. China has rattled sabers over the strait this year in a warning to the United States not to cross its red line (Chart 11). It is not yet clear how Biden’s policy continuity with the Trump administration will affect cross-strait stability. We see no basis yet for changing our view that there is a 60% chance of a market-negative geopolitical incident in 2021-22 and a 5% chance of full-scale war in the short run. Chart 11China PLA Flights Over Taiwan Strait Putting all of the above together, we see substantial support for two key market-relevant geopolitical risks: Chinese domestic politics (including policy tightening) and persistent US-China tensions (including but not limited to the Taiwan Strait). We remain tactically defensive, a stance supported by several recent turns in global markets: The global stock-to-bond ratio has rolled over. China is a negative factor for global risk appetite (Chart 12). Global cyclical equities are no longer outperforming defensives. There is a stark divergence between Chinese cyclicals and global cyclicals stemming from the painful transition in China’s bloated industrial economy (Chart 13). Global large caps are catching a bid relative to small caps (Chart 14). Chart 12Global Stock-To-Bond Ratio Rolled Over Chart 13Global Cyclicals-To-Defensives Pause Chart 14Global Large Caps Catch A Bid Versus Small Caps Cyclically the global economic recovery should continue as the pandemic wanes. China will eventually relax policy to prevent too abrupt of a slowdown. Therefore our strategic portfolio reflects our high-conviction view that the current global economic expansion will continue even as it faces hurdles from the secular rise in geopolitical risk, especially US-China cold war. Measurable geopolitical risk and policy uncertainty are likely to rebound sooner rather than later, with a negative impact on high-beta risk assets. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Coda: Global Minimum Tax Symbolizes Return Of Big Government On Thursday, the US Treasury Department released a proposal to set the global minimum corporate tax rate at 15%. The plan is to stop what Treasury Secretary Janet Yellen has referred to as a global “race to the bottom” and create the basis for a rehabilitation of government budgets damaged by pandemic-era stimulus. Although the newly proposed 15% rate is significantly below President Biden’s bid to raise the US Global Intangible Low-Taxed Income (GILTI) rate to 21% from 10.5%, it is the same rate as his proposed minimum tax on corporate book income. Biden is also raising the headline corporate tax rate from 21% to around 25% (or at highest 28%). Negotiators at the OECD were initially discussing a 12.5% global minimum rate. The finance ministers of both France and Germany – where the corporate income tax rates are 32.0% and 29.9%, respectively – both responded positively to the announcement. However, Ireland, which uses low corporate taxes as an economic development strategy, is obviously more comfortable with a minimum closer to its own 12.5% rate. Discussions are likely to occur when G7 finance ministers meet on June 4-5. Countries are hoping to establish a broad outline for the proposal by the G20 meeting in early July. It is highly likely that the OECD will come to an agreement. However, it is not a truly “global” minimum as there will still be tax havens. Compliance and enforcement will vary across countries. A close look at the domestic political capital of the relevant countries shows that while many countries have the raw parliamentary majorities necessary to raise taxes, most countries have substantial conservative contingents capable of preventing stiff corporate tax hikes (Table 1, in the Appendix). Our Geopolitical strategists highlight that the Biden administration’s compromise on the minimum rate reflects its pragmatism as well as emphasis on multilateralism. Any global deal will be non-binding but the two most important low-tax players are already committed to raising corporate rates well above this level: Biden’s plan is noted above, while the UK’s budget for March includes a jump in the business rate to 25% in April 2023 from the current 19%. Ireland and Hungary are the only outliers but they may eventually be forced to yield to such a large coalition of bigger economies (Chart 15). Chart 15Global Minimum Corporate Tax Impact Is Symbolic Rather Than Concrete Thus a nominal minimum corporate tax rate is likely to be forged but it will not be truly global and it will not change the corporate rate for most countries. The reality of what companies pay will also depend on loopholes, tax havens, and the effective tax rate. Bottom Line: On a structural horizon, the global minimum corporate tax is significant for showing a paradigm shift in global macro policy: western governments are starting to raise taxes and revenue after decades of cutting taxes. The experiment with limited government has ended and Big Government is making a comeback. On a cyclical horizon, the US concession on global minimum tax is that the Biden administration aims to be pragmatic and “get things done.” Biden is also working with Republicans to pass bills covering some bipartisan aspects of his domestic agenda, such as trade, manufacturing, and China. The takeaway from a global point of view is that Biden may prove to be a compromiser rather than an ideologue, unlike his predecessors.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Roukaya Ibrahim Vice President Daily Insights RoukayaI@bcaresearch.com Footnotes 1 Kurt M. Campbell and Jake Sullivan, "Competition Without Catastrophe," Foreign Affairs, September/October 2019, foreignaffairs.com. Section II: Appendix Table 1OECD: Which Countries Are Willing And Able To Raise Corporate Tax Rates? GeoRisk Indicator China Russia UK Germany France Italy Canada Spain Taiwan – Province Of China Korea Turkey Brazil Australia Section III: Geopolitical Calendar

ハイライト グローバル株式は大きな調整に非常に脆弱である。しかし景気循環的には米連邦準備制度（FRB）はインフレの上振れを容認する姿勢を取っており、世界経済は回復している。 中国の財政・信用インパルスが急低下しており、これによりグローバルの景気循環株およびコモディティは下押しを受けやすい。 短期を越えれば、中国の政治的安定の必要性が過度な政策引き締めを防ぐはずだ。リスクは前倒しになっている。 中国の国勢調査は当社のメガテーマの一つを裏付けている：中国の国内政治は不安定であり、ネガティブなサプライズをもたらし得る。 インドの州選挙は大規模なCOVID-19の波の最中に実施されたが、与党が2024年にも依然有利であることを示唆している。これは政策の継続を意味する。 景気循環派の強気バイアスを維持するが、中国が政策ミスを犯した場合には方針転換する準備をしておくこと。 特集 チャート 1 インフレ再浮上 インフレが頭をもたげる インフレが頭をもたげる 今週、米国のコアインフレが強く出たことと、長く眠っていたインフレが再び頭をもたげることへの幅広い懸念を受けて、グローバル市場は震撼した（チャート 1）。 景気循環的には、世界経済の回復に伴い投資家は米国株から国際株へローテーションし、米ドルは下落すると引き続き見ている（チャート 2）。しかしこの見方は、新興国株が先進国株に対してアウトパフォームし始めるべきだということも含んでおり、今年これまでのところはそれが実現していない。新興市場はテクノロジーに偏っており、米国の長期金利上昇に脆弱なだけでなく、中国の景気刺激がピークに達した今、さらに困難に直面している。 チャート 2 株式市場の動揺 株式市場が動揺 株式市場が動揺 チャート 3 世界経済とセンチメントの回復 世界経済とセンチメントは回復しつつある 世界経済とセンチメントは回復しつつある チャート 4 景気循環株対ディフェンシブの揺らぎ グローバルのシクリカル株とディフェンシブ株が揺らいでいる グローバルのシクリカル株とディフェンシブ株が揺らいでいる 我々が頼れる一つの事実は、COVID-19ワクチンの展開が続くことで世界的な成長回復を後押しするという点である（チャート 3）。米ドルもそれを示唆している。ドルは第1四半期に米国の相対的成長優位で反発したが、その後は下落に転じている。ドル安はディフェンシブに対して景気循環株にとってポジティブだが、景気循環株は短期的にはリフレーショントレードが過熱していることを示している（チャート 4）。 中国の成長が今や重要な焦点になる。中国の政策ミスは強気の景気循環見通しを覆すだろう。中国の金融・財政政策の引き締めは、今年我々が強調してきた主要なグローバルな政策リスクであり、今まさに顕在化している。しかし我々は引き締めの制約も指摘してきた。現時点で中国は我々のベンチマークによれば過度な引き締めの瀬戸際に立っている。さらなる引き締めが行われれば、我々は本質的によりディフェンシブな見方に転じるだろう。 本レポートではまた、中国の国勢調査の結果と、最新の大波のCOVID-19感染のもとで行われたインドの最近の州選の含意を検討する。我々はまだインドに対する強気見解を変更していないが、注視している。 中国：過度引き締めリスク 中国の問題は、対外貿易依存から内需依存への経済モデルの継続的な変化に起因している。これは習近平国家主席の台頭以前に共産党が採った戦略的決定であり、習はそれを体現し、戦略的ビジョンと米国との対立を通じて強化してきた。 北京の目標は滑らかで安定した移行を管理することだった。2015年の金融混乱や2018-19年の貿易戦争はその目標を危うくしたが、政策当局は最終的に持ちこたえた。そこへCOVID-19が発生し、1970年代以来の本格的な経済縮小をもたらした。中国はウイルスを抑え込み、貿易戦争開始から2021年のピークまでにGDP比13.8%に上る別の大規模な刺激で回復したが、今やさらに困難な移行に直面している。 チャート 5 中国の上昇する貯蓄傾向 中国の貯蓄傾向の高まり 中国の貯蓄傾向の高まり 潜在GDPが鈍化していることを考えると生活水準の改善の必要性は一層切迫している。債務の大幅な増加に鑑みると体系的な金融リスクを抑制する必要性も一層切迫している。米国が中国に対抗する民主諸国の連合を形成している今、経済の多角化の必要性も高まっている。長期預金比率などで測られる中国の家計・企業の「限界貯蓄性向」の急上昇は、国が困難に直面しアニマルスピリッツが抑えられていることの兆候である（チャート 5）。 2018-21年の大規模拡大の後、中国の財政・信用インパルスは低下に転じている。政策当局は昨年以降、緊急的な刺激を引き揚げるシグナルを出しており、その影響はハードデータに現れている。中国のマネー、クレジット、そして財政とクレジットを合わせたインパルスはいずれも、6〜9か月のラグの後に経済成長と相関する。これは中国のマネーとクレジットサイクルや経済活動を測る指標がどれであれ当てはまる（チャート 6Aおよびチャート 6B）。中国の経済モメンタムはピークに達しており、世界がワクチンと経済再開の追い風を享受しているにもかかわらず、今年後半から2022年にかけて世界経済にとって逆風となるだろう。 チャート 6A 中国の財政・信用インパルスが急落 … 中国の財政・信用インパルスが急落… 中国の財政・信用インパルスが急落… チャート 6B … マネー・アンド・クレジットのインパルスも同様に低下 ... マネー・アンド・クレジットのインパルスも同様である ... マネー・アンド・クレジットのインパルスも同様である 財政・信用インパルスのダウンシフトは、特に国内消費向けに中国が輸入するコモディティ、マテリアル、およびその他財の需要の鈍化を予示している（中国の輸出向け製造に投入される部品や中間財の輸入は、世界の回復とともに比較的健全に見える）。このシフトは、スウェーデン株などの中国関連プレイや急騰している金属価格が調整なしに上昇を続けることを困難にするだろう（チャート 7）。投機筋のポジショニングは現時点でコモディティに偏っている。中国とそれが支配する金属市場との乖離は短期的には耐え難いように見える（チャート 8）。 チャート 7 中国のリフレーショントレードはピーク付近 中国のリフレーショントレードはピーク付近 中国のリフレーショントレードはピーク付近 チャート 8 マネーサイクルとコモディティ価格の衝突 マネーサイクルとコモディティ価格の衝突 マネーサイクルとコモディティ価格の衝突 世界的なグリーンや再生可能エネルギーシステムへの移行（すなわち脱炭素化）は銅をはじめ金属にとって強気だが、短期的には中国の需要減を補うことはできないことを、我々のエマージング・マーケッツ・ストラテジーが示している。中国の建設・産業向けの銅の国内需要は世界総需要の約56.5%を占める一方、グリーンエネルギー競争（太陽光パネル、風力発電、電気自動車の生産等）は世界需要の約3.5%にすぎない。 この数値は既存のシステムや構造の再調整やレトロフィット（例：電力網）も見込まれているためグリーン計画をやや過小評価している面はある。しかし要点は、米国および欧州の消費が大幅に増加しても、中国の銅消費が減少すればそれに逆行することだ。特に米国のインフラ計画が早くても2022年まで本格的に始動しないことを考えれば、今後12か月で中国の影響で世界の銅需要は減速するだろう。 中国の政策当局はまだ過度な引き締めを懸念している、あるいは新たに政策を緩和する意思を示したわけではない。4月末の政治局会議は12月の中央経済工作会議や3月の政府活動報告から大きな政策変更を含んでいなかった（表 1）。しかしもし差異があるとすれば、昨年の緊急感をさらに後退させつつも、地方政府幹部を隠れ債務に対して説明責任を負わせるような何らかの仕組みを示唆した点にある。含意は引き続き引き締め的な政策であり、したがって過度の引き締めリスクは依然として大きい。 表 1 中国の最近のマクロ経済政策表明：刺激の縮小 中国は過度な金融引き締めの瀬戸際にある 中国は過度な金融引き締めの瀬戸際にある チャート 9 中国の政策引き締めのベンチマーク 中国の政策引き締めのベンチマーク 中国の政策引き締めのベンチマーク 確かに4月会議の「お茶の葉」は様々に読み取ることができる。4月の声明はマクロ経済政策指針から「必要な政策支援を維持する」という文言を外しており、これは経済への支援を減らすことを意味する可能性がある。しかし同時に、マネーサプライ（M2）とクレジット成長（社会融資総量）を名目GDP成長に合わせるという目標も外れており、これはクレジット成長の新たな上振れを許容するものと見なすこともできる。とはいえ中国人民銀行は第1四半期の金融政策報告書でこのクレジット目標を維持しており、確信は持てない。このルーブリックによれば、中国は我々がリスクを測るために用いる「過度引き締め」の瀬戸際にあることに注意されたい（チャート 9）。 過去20年の中国の政策運営に基づけば、我々は重大な転換点の発表は4月ではなく7月の政治局会議で行われると予想する。したがって4月は先の会合からの大きな変更とは見なしていないし、我々のチャイナ・インベストメント・ストラテジーも同様に見ていない。従って過度な政策引き締めは今後12か月で中国および世界経済に対する現実的なリスクであり、我々の過度引き締めチェックリストはこの点を強調している（表 2）。 表 2 中国の政策引き締めチェックリスト 中国、過度の引き締め寸前 中国、過度の引き締め寸前 中国の財政・信用のダウンシフトは、第20回党大会を控えて進行している。党大会は2022年を通じて行われ、秋に最高指導部（政治局常務委員）の交代で頂点に達する。共産党の100周年に当たる今年7月1日に向けて経済は十分に刺激されているため、政策当局は過剰を防ぐことに集中している。金融リスクの予防、反独占規制、不動産バブルの抑制が当面の命題である。企業および政府の債務不履行や破産の増加は、指導部が経済構造改革と改革を推し進める意志を裏付けており、近年これが確認されている（チャート 10）。 チャート 10 中国における創造的破壊 中国、過度な引き締め寸前 中国、過度な引き締め寸前 投資家は党大会があるからといって指導部が政策を緩和するだろうと想定してはならない。2017年の党大会の前にはむしろその逆のことが起きた。しかし、投資家はまた、中国が重要なイベントの前に自国経済を沈めるほど過度に引き締めるとも安易に想定してはならない。安定が目標となるだろう（2017年や以前の党大会でもそうであったように）──これは現行の引き締めが財政的・経済的にあまりにも痛みを伴う場合には政策緩和がいつか行われることを意味する。政策当局が転換点に達するまでは、中国関連資産は短期的に脆弱である。 ちなみに、第20回党大会の接近は政治的な暗闘や衝撃的な出来事を引き寄せるだろう。最高指導者は通常、党大会前に派閥の勢力を示すために有力なライバルを解任する。政府はまたメディア統制を強化し、事件の周辺で声を上げるか抗議するかもしれない反体制派を取り締まる。しかし2022年はその利害が一層高い。 習主席は当初2022年に退任すると見られていたが、今は退任しない見込みであり、これは少なくとも一部の反対を喚起するだろう。さらに習政権下で中国は三つの歴史的な政策革命を遂げた：強力な指導者モデルを採用し、前二代の集団指導モデルを損なったこと、経済の自給自足を重視して自由化と開放を犠牲にしたこと、そして大国としての地位を強調し米国や同盟国との協調を犠牲にしていることだ。 まとめ：中国の政策引き締めにより、グローバル株式、コモディティ、そして「中国プレイ」は大幅な調整リスクに直面している。当社のベースケースは中国が過度な引き締めを回避するというものだが、最新のマネーおよびクレジットの数値はその見方を変更する閾値に達している。これらの指標がさらに急落すれば見解を変更する必要がある。 中国の消えゆく労働力 最終的に過度な引き締めを抑制する制約の一つは、労働年齢人口の縮小による中国の潜在GDP成長の低下である。中国の第7回国勢調査が今週公表され、国とその経済に影響する深い構造変化を裏付けた。 過去10年の人口増加率は5.4%に鈍化し、1953年の最初の国勢調査以降で最低となった。出生率は2020年に1.3まで下落し、2.1の人口置換水準や2016年に一人っ子政策を緩和した際の目標1.8を下回っている。出生率は世界銀行の推計（2019年で1.7）や日本の数値よりも低い。人口1000人当たりの出生数も減少し、2020年の新生児数は1961年（大飢饉の年）以来の低水準となった。出生率は高所得国の水準に収束しており、経済発展が中国でも出産抑制の同じ効果をもたらしていることを示唆しているが、中国はこれらの国より発展段階が低い。 チャート 11 1990年代の日本より速く減少する中国の労働人口 中国、過度な金融引き締めの瀬戸際に立つ 中国、過度な金融引き締めの瀬戸際に立つ 最年少コホートの比率は16.6%から17.95%に上昇し、最年長コホートは2010年の8.9%から現在13.5%へ上昇、働き手層は75.3%から68.6%に低下した。労働年齢人口は2010年にピークに達し、過去10年で6.79ポイント減少した。対照的に日本の労働年齢人口は1992年にピークを迎え、その後の10年で2.18ポイント低下した（チャート 11）。 言い換えれば、中国は1990年代初頭に日本が経験した人口転換を経験しているが、中国の労働年齢人口はさらに速く減少する可能性がある。中国は日本が達したより低い1人当たり所得水準でこの大規模な社会経済的変化を経験している。 人口動態の課題は中国の社会経済的および政治的システムに圧力をかけるだろう。中国の奇跡は、他のアジアの奇跡と同様に、輸出製造により大量の貯蓄を生み出し、それを国家開発に再投資することを前提としていた。労働年齢人口の減少は経済発展と重なり、長期的には貯蓄率の低下をもたらすだろう。これはチャート 12に示されたように、二つの異なる中国の労働人口の図と国民貯蓄率を並べたものである。扶養比率が上昇するにつれて貯蓄率は低下し、再目的化に使える資金が減少する。資本コストは上昇し、経済構造改革は加速するだろう。 日本の場合、人口変化は1990年の金融危機と全国的な経済行動の変化と同時に起きた。貯蓄率は経済の変化とともに低下したが、生成された貯蓄は依然として投資を上回っており、これは民間需要の不足と大きな債務負担の圧力によるものであった。企業は投資と生産の拡大よりも債務圧縮に注力した（チャート 13）。これらは外部環境が良好だったときに起きたが、中国は地政学的緊張による経済的圧力が高まる文脈で同様の人口問題に直面している。 チャート 12 希少化する中国の労働者 中国の労働者が希少になりつつある 中国の労働者が希少になりつつある チャート 13 高貯蓄が債務拡大を可能にするが、やがて債務が圧倒する 高い貯蓄が借入拡大を促し、債務が耐え難くなるまで続く 高い貯蓄が借入拡大を促し、債務が耐え難くなるまで続く 中国はこれまで破滅的な金融危機や不動産価格の崩壊を回避しており、深刻な流動性の罠に陥る事態は避けている。中国当局は不動産バブルの危険を痛感しており、したがって金融の過剰を防ぎバブル的活動を抑制することに注力している。これが過度の引き締めリスクを重大なものにしている。しかしどちらか一方の誤りはデフレへの滑落を招き得る。習政権は活動が過度に減速したり金融の不安定性が手に負えなくなりそうな時は経済を刺激してきたが、これは難しいバランス行為であり、故に我々は過度引き締めリスクを綿密に監視している。 中国の国勢調査からのその他の注目点は以下の通りである： 二人っ子政策は現時点では成功していない。 COVID-19は出生率に悪影響を与えた可能性はあるが、タイミングの点で出生数を大きく歪めるほどではない。したがってトレンドはパンデミックだけで説明できない。 急速な都市化が続いており、都市化率は64%に達し、2010年から14ポイント上昇した。 政策議論は定年年齢の引き上げ、出産に対する財政的インセンティブの提供、子育てをより手頃にするための各種価格統制（特に不動産バブルの抑制）、および地方からの移住が続く中で中小都市の不動産価格が急落しないようにする措置を強調している。 中国の少数民族人口は総人口の9%を占め、過去10年で9%成長したのに対し、漢民族は91%で5%成長にとどまった。少数民族は一人っ子（二人っ子）政策の免除対象である。しかし、新疆のような自治区では民族間緊張が発生しており、中国の少数民族政策に対する国際的な監視が強まっている。 中国の人口動態上の課題は広く知られているが、最新の国勢調査はその規模を再確認させる。中国の潜在成長率は低下しており、上昇する扶養比率は政府に対する要求を強める社会変化を示している。より大きな財政・社会支出の必要は困難な経済的トレードオフと不人気な政治的決定を必要とするだろう。経済変化と人の移動は地域間および富の格差を深めるだろう。 これらすべての点は、我々の一貫したジオポリティカル・ストラテジーのメガテーマの一つを裏付けている：中国の国内政治リスクは過小評価されている。 まとめ：中国の2020年国勢調査は、中国の上昇する社会経済的・政治的課題の根底にある人口減少を強く裏付けるものである。中国は強力な中央政府を持ち、単一支配政党の下で権力が集約され、近年様々な課題を管理してきた実績はあるが、それでも現在進行中の変化の規模は圧倒的であり、ネガティブな経済的・政治的サプライズを招くだろう。 インド：州選はモディに対する転換点ではない インドで第2波のCOVID-19がピークにあった時期に、5州で選挙が行われた。中でも西ベンガル州の結果が最も重要だった。西ベンガルは大きな州であり、インド国会の議員のほぼ10分の1を占めている。ナレンドラ・モディ首相の与党バラティヤ・ジャナタ党（BJP）は294議席中約70%を獲得するとの目標を公言していた。 実際には、西ベンガルは地域政党であるオール・インディア・トリナムール会議（AITMC）の圧勝となった。AITMCは2期の反イナカム任期に直面していたにもかかわらず、議席数は過去最高を記録した。多くの予測を上回る結果であり、多くの世論調査が予想していなかったことが示された。 投資家はこの重要州でのBJPの敗北をどう受け止めるべきか。これはモディのパンデミック対応への反発か。2024年の総選挙で政権交代や国家政策の変更を予告するものか。そうとは言えない。ここで我々は三つの主要な示唆を挙げる： 示唆その1：BJPの成果は注目に値する チャート 14 インド：西ベンガルで足がかりを得たBJP 中国、過度な引き締めの瀬戸際 中国、過度な引き締めの瀬戸際 BJPは西ベンガルで目標には届かなかったが、この州はBJPの地盤ではない。BJPは英語で言えばヒンディー語圏で自然な支持基盤を持つとされ、西ベンガルは非ヒンディー語圏であり、伝統的にBJPは「外部勢力」と見なされてきた。またこの州は変化を受け入れにくいことで知られている。例えばAITMC以前は左派が34年という記録的な長期政権を維持していた。このような状況下で、BJPが2021年に77議席に増やしたことは注目に値する（2016年は3議席）（チャート 14）。 この成果によりBJPは西ベンガルで主要な野党となった。これはBJPが時間をかければ伝統的な強みを持たない州でも足場を築けることを示している。歴史的に弱い州でこの成果を上げたことは、BJPが依然として無視できない勢力であることの表れだ。 示唆その2：BJPの人気は後退したが、2024年に政権を維持する見込みは依然強い BJPに対する不満はCOVID-19対応の不手際とそれに伴う経済的困窮により高まっているが、国家レベルでBJPに代わる現実的な選択肢は存在しない。 最近の州選は、西ベンガルだけでなく、野党のインド国民会議（INC）がまだ体制を整えていないことを確認した。コングレスは西ベンガルで44議席から0議席に崩壊した。より重要なのは、コングレスが大衆にアピールする内部指導者を任命・選出する必要性と、識別可能な政策アジェンダを策定する必要性という二つの重要課題をまだ解決していない点である。 コングレスの弱さは、BJPの議席数が2019年のピークから減少する可能性があっても、我々の2024年のベースケースは依然としてBJP主導の政権がインドの政権を維持するというものであることを意味する。政策の継続性とある程度の構造改革の可能性がベースケースだ。 示唆その3：インドの地域政党の台頭 過去10年のBJPの台頭は、コングレスと地域政党の議席減少と同時に進んだ。しかし最近の州選は、BJPが地域政党の議席シェアを劇的に圧縮できないことを示している。例えば西ベンガルではBJPは単独で77議席を獲得したが、これはこの州で支配的なAITMCの犠牲になって得たものではない。一方、同月に選挙が行われた別の大州であるタミル・ナードゥでは二大地域政党の間で支配が揺れ続けている。 チャート 15 インド：BJPは2019年にピークを迎えたが2024年にも有力 中国は過度な引き締めの瀬戸際にある 中国は過度な引き締めの瀬戸際にある 2019年の総選挙では地域政党（BJPとコングレスを除く全党）のシェアは約40%から35%に低下した（チャート 15）。2024年の選挙では、BJPのピーク議席数が2019年の高水準から低下することにより、地域政党の議席シェアがやや上昇する可能性がある。 インドの地域政党の今後の台頭は単純な力学に根ざしている。BJPが2024年に二期目の現職となる可能性があるので、全国レベルでBJPに対する代替がない限り、有権者は差分的に地域政党を支持する選択をするだろう。 BJPは2024年に単独最大党として過半数を超える議席を獲得するポジションに留まるだろう。しかし与党が過半数を確保するために地域政党を取り込むシナリオも十分にあり得る。ただし2024年までは長い時間がある。COVID-19とその経済的影響への対応が、BJPが2019年の成果を超えることを難しくするだろう。次の重要な州選は2022年2月に予定されており、インド最大の州ウッタル・プラデーシュで選挙が行われる。ここでの結果は、BJPがパンデミックと経済ショックによる反イナカム効果をいかに緩和できるかを示すだろう。 結論：インドにおけるBJPの人気は揺らいでいるが劇的に崩れたわけではない。BJPは依然として2024年に過半数を超える単独最大政党になる位置にある可能性が高い。したがって当面この新興市場で政権不安は懸念されない。 中国の国内政治リスクとインドの政治的継続性を踏まえ、当面インド向けのトレードを維持する（チャート 16Aおよびチャート 16B）。ただし我々はインド全体のレビューを進めており、今後の特別レポートで顧客に結論を共有する予定である。 チャート 16A 新興国に対してインド債をロングで保有 インド債券を新興国（EM）に対してロングで維持する インド債券を新興国（EM）に対してロングで維持する チャート 16B インドロング／中国ショートを堅持 インドをロング、中国をショートで貫く インドをロング、中国をショートで貫く 投資上の示唆 短期的な安全資産トレードを維持する。天然ガス先物のロングは19.8%の利得でクローズ。 景気循環（12か月）の強気ポジションを維持し、グロースよりバリューを優先する。レアアースを含むコモディティおよび新興市場のロングを維持する。ただし、中国が我々のベンチマークに従って過度の引き締めを行った場合にはこれらのトレードをカットする準備をすること。 当面は新興国同業と比較してインドのローカル通貨建て債をオーバーウェイトし、インド株を中国株に対してロングする。だがインドに対する強気姿勢は精査中である。 チャート 17 テック売りの中で回復するサイバーセキュリティ株 サイバーセキュリティ株がテック株の暴落の中で反発 サイバーセキュリティ株がテック株の暴落の中で反発 サイバーセキュリティ株はロングで保有を継続すべきだが、地政学的「職場復帰」トレードとしてはサイバーよりも航空宇宙・防衛を引き続き好む。先週の一般的なテック売りの中でサイバーセキュリティ株はテックセクターに対して持ち直した。米国で発生した大規模なColonial Pipelineのランサムウェア攻撃は、東海岸の燃料供給の約45%を支える主要ネットワークを一時的に停止させた（チャート 17）。それでも重要インフラに対する攻撃はサイバーセキュリティが長期的なテーマであることを浮き彫りにしており、投資家はエクスポージャーを維持すべきである。サイバー株はワクチン発見以降、テック全体をアウトパフォームしている（チャート 18）。 チャート 18 サイバーセキュリティは構造的テーマである サイバーセキュリティは長期的なテーマである サイバーセキュリティは長期的なテーマである Matt Gertken バイスプレジデント 地政学ストラテジー mattg@bcaresearch.com Yushu Ma リサーチ・アソシエイト yushu.ma@bcaresearch.com Ritika Mankar, CFA 編集者／ストラテジスト Ritika.Mankar@bcaresearch.com