中東
Expect the Middle East to create new and unexpected energy supply disruptions on top of the Russian energy shock.
Investors should go long US treasuries and stay overweight defensive versus cyclical sectors, large caps versus small caps, and aerospace/defense stocks. Regionally we favor the US, India, Southeast Asia, and Latin America, while disfavoring China, Taiwan, Hong Kong, eastern Europe, and the Middle East.
Executive Summary The US inflation surprise increases the odds of both congressional gridlock and recession, which increases uncertainty over US leadership past 2024 and reduces the US’s ability to lower tensions with China and Iran. Despite the mainstream media narrative, the Xi-Putin summit reinforces our view that China cannot reject Russia’s strategic partnership. The potential for conflict in Taiwan forces China to accept Russia’s overture. For the same reason the US and China cannot re-engage their economies sustainably, even if Biden and Xi somehow manage to reduce tensions after the midterm elections and twentieth national party congress. Russia could reduce oil exports as well as natural gas, intensifying the global energy shock. Ukraine’s counter-offensive and Europe’s energy diversification increase the risk of Russian military and economic failure. The Middle East will destabilize anew and create a new source of global energy supply disruptions. US-Iran talks are faltering as expected. Russian Oil Embargo Could Deliver Global Shock Asset Initiation Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 19.1% Bottom Line: Stay long US stocks, defensive sectors, and large caps. Avoid China, Taiwan, eastern Europe, and the Middle East. Feature Several notable geopolitical developments occurred over the past week while we met with clients at the annual BCA Research Investment Conference in New York. In this report we analyze these developments using our geopolitical method, which emphasizes constraints over preferences, capabilities over intentions, reality over narrative. We also draw freely from the many valuable insights gleaned from our guest speakers at the conference. China Cannot Reject Russia: The Xi-Putin Summit In Uzbekistan Presidents Xi Jinping and Vladimir Putin are meeting in Uzbekistan as we go to press and Putin has acknowledged China’s “questions and concern” about the war in Ukraine.1 They last met on February 4 when Xi gave Putin his blessing for the Ukraine invasion, promising to buy more Russian natural gas and to pursue a “no limits” strategic partnership (meaning one that includes extensive military cooperation). The meeting’s importance is clear from both leaders’ efforts to make it happen. Putin is leaving Russia despite rising domestic criticism over his handling of the Ukraine war and European energy war. Ukraine is making surprising gains in the battlefield, particularly around Kharkiv, threatening Russia’s ability to complete the conquest of Donetsk and the Donbas region. Meanwhile Xi is leaving China for the first time since the Covid-19 outbreak, despite the fact that he is only one month away from the most important political event of his life: the October 16 twentieth national party congress, where he hopes to clinch another five, ten, or fifteen years in power, expand his faction’s grip over the political system, and take over Mao Zedong’s unique title as chairman of the Communist Party. We do not yet know the full outcome of the Uzbek summit but we do not see it as a turning point in which China turns on Russia. Instead the summit reinforces our key point to investors all year: China cannot reject Russia. Russia broke energy ties with Europe and is fighting a proxy war with NATO. The Putin regime has lashed Russia to China’s side for the foreseeable future. China may not have wanted to move so quickly toward an exclusive relationship but it is not in a position to reject Russia’s diplomatic overture and leave Putin out to dry. The reason is that China is constrained by the US-led world order and like Russia is attempting to change that order and carve a sphere of influence to improve its national security. Beijing’s immediate goal is to consolidate power across the critical buffer territories susceptible to foreign interests. It has already consolidated Tibet, Xinjiang, Hong Kong, and to some extent the South China Sea, the critical approach to Taiwan. Taiwan is the outstanding buffer space that needs to be subjugated. Xi Jinping has taken it upon himself to unify China and Taiwan within his extended rule. But Taiwanese public opinion has decisively shifted in favor of either an indefinite status quo or independence. Hence China and Taiwan are on a collision course. Regardless of one’s view on the likelihood of war, it is a high enough chance that China, Taiwan, the US, and others will be preparing for it in the coming years. Chart 1US Arms Sales To Taiwan The US is attempting to increase its ability to deter China from attacking Taiwan. It believes it failed to deter Russia from invading Ukraine – and Taiwan is far more important to US economy and security than Ukraine. The US is already entering discussions with Taiwan and other allies about a package of severe economic sanctions in the event that China attacks – sanctions comparable to those imposed on Russia. The US Congress is also moving forward with the Taiwan Policy Act of 2022, which will solidify US support for the island as well as increase arms sales (Chart 1).2 Aside from China's military preparation – which needs to be carefully reviewed in light of Russia’s troubles in Ukraine and the much greater difficulty of invading Taiwan – China must prepare to deal with the following three factors in the event of war: 1. Energy: China is overly exposed to sea lines of communication that can be disrupted by the United States Navy. Beijing will have to partner with Russia to import Russian and Central Asian resources and attempt to forge an overland path to the Middle East (Chart 2). Unlike Russia, China cannot supply its own energy during a war and its warfighting capacity will suffer if shortages occur or prices spike. 2. Computer Chips: China has committed at least $200 billion on a crash course to build its own semiconductors since 2013 due to the need to modernize its military and economy and compete with the US on the global stage. But China is still dependent on imports, especially for the most advanced chips, and its dependency is rising not falling despite domestic investments (Chart 3). The US is imposing export controls on advanced microchips and starting to enforce these controls on third parties. The US and its allies have cut off Russia’s access to computer chips, leading to Russian shortages that are impeding their war effort. Chart 2China’s Commodity Import Vulnerability Chart 3China's Imports Of Semiconductors 3. US Dollar Reserves: China is still heavily exposed to US dollar assets but its access will be cut off in the event of war, just as the US has frozen Russian, Iranian, Venezuelan, and Cuban assets over the years. China is already diversifying away from the dollar but will have to move more quickly given that Russia had dramatically reduced its exposure and still suffered severely when its access to dollar reserves was frozen this year (Chart 4). Where will China reallocate its reserves? To developing and importing natural resources from Russia, Central Asia, and other overland routes. Chart 4China's US Dollar Exposure Russia may be the junior partner in a new Russo-Chinese alliance but it will not be a vassal. Russia has resources, military power, and regional control in Central Asia that China needs. Of course, China will maintain a certain diplomatic distance from Russia because it needs to maintain economic relations with Europe and other democracies as it breaks up with the United States. Europe is far more important to Chinese exports than Russia. China will play both sides and its companies will develop parallel supply chains. China will also make gestures to countries that feel threatened by Russia, including the Central Asian members of the Shanghai Cooperation Organization (SCO). But the crucial point is that China cannot reject Russia. If the Putin regime fails, China will be diplomatically isolated, it will lose an ally in any Taiwan war, and the US will have a much greater advantage in attempting to contain China in the coming years and decades. Russo-Chinese Alliance And The US Dollar Many investors speculate that China’s diversification away from the US dollar will mark a severe downturn for the currency. This is of course possible, given that Russia and China will form a substantial anti-dollar bloc. Certainly there can be a cyclical downturn in the greenback, especially after the looming recession troughs. But it is harder to see a structural collapse of the dollar as the leading global reserve currency. The past 14 years have shown how global investors react to US dysfunction, Russian aggression, and Chinese slowdown: they buy the dollar! The implication is that a US wage-price spiral, a Russian détente with Europe, and a Chinese economic recovery would be negative for the dollar – but those stars have not yet aligned. Related Report Geopolitical StrategyThe Geopolitical Consequences Of The Ukraine War The reason China needs to diversify is because it fears US sanctions when it invades Taiwan. Hence reducing its holdings of US treasuries and the dollar signals that it expects war in future. But will other countries rush into the yuan and yuan-denominated bonds if Xi is following in Putin’s footsteps and launching a war of choice, with damaging consequences for the economy? A war over Taiwan would be a global catastrophe and would send other countries plunging into the safe-haven assets, including US assets. Nevertheless China will diversify and other countries will probably increase their yuan trade over time, just as Russia has done. This will be a cyclical headwind for the dollar at some point. But it will not knock the US off the premier position. That would require a historic downgrade in the US’s economic and strategic capability, as was the case with the United Kingdom after the world wars. China will continue to stimulate the economy after the party congress. A successful Chinese and global economic rebound next year – and a decision to pursue “jaw jaw” with the US and Taiwan rather than “war war” – would be negative for the dollar. Hence we may downgrade our bullish dollar view to neutral on a cyclical basis before long … but not yet and not on a structural basis. Bottom Line: Favor the US dollar and the euro over the Chinese renminbi and Taiwanese dollar. Underweight Chinese and Taiwanese assets on a structural basis. Ukraine’s Counter-Offensive And A Russian Oil Embargo Ukraine launched a counter-offensive against Russia in September and achieved significant early victories. Russians fell back away from Kharkiv, putting Izyum in Ukrainian hands and jeopardizing Russia’s ability to achieve its war aim of conquering the remaining half of Donetsk province and thus controlling the Donbas region of eastern Ukraine. Russian positions also crumbled west of the Dnieper river, which was always an important limit on Russian capabilities (Map 1). Map 1Status Of Russia-Ukraine War: The Ukrainian Counter-Offensive (September 15, 2022) Some commentators, such as Francis Fukuyama in the Washington Post, have taken the Ukrainian counter-offensive as a sign that the Ukrainians will reconquer lost territory and Russia will suffer an outright defeat in this war.3 If Russia cannot conquer the Donbas, its control of the “land bridge” to Crimea will be unsustainable, and it may have to admit defeat. But we are very skeptical. It will be extremely difficult for Ukrainians to drive the Russians out of all of their entrenched positions. US military officials applauded Ukraine’s counter-offensive but sounded a cautious note. The chief problem is that neither President Putin nor the Russian military can afford such a defeat. They will have to double down on the Donbas and land bridge. The war will be prolonged. Ultimately we expect stalemate, which will be a prelude to ceasefire negotiations. But first the fighting will intensify and the repercussions for global economy and markets will get worse. Russia’s war effort is also flagging because Europe is making headway in finding alternatives for Russian natural gas. Russia has cut off flows through the Nord Stream pipeline to Germany, the Yamal pipeline to Poland, and partially to the Ukraine pipeline system, leaving only Turkstream operating normally. Yet EU gas storage is in the middle of its normal range and trending higher (Chart 5). Chart 5Europe Handling Natural Gas Crisis Well … So Far Of course, Europe’s energy supply is still not secure. Cold weather could require more heating than expected. Russia has an incentive to tighten the gas flow further. Flows from Algeria or Azerbaijan could be sabotaged or disrupted (Chart 6). Chart 6Europe’s NatGas Supply Still Not Secure Chart 7Europe Tipping Into Recession Anyway Russia’s intention is to inflict a recession on Europe so that it begins to rethink its willingness to maintain a long-term proxy war. Recession will force European households to pay the full cost of the energy breakup with Russia all at once. Popular support for war will moderate and politicians will adopt more pragmatic diplomacy. After all they do not have an interest in prolonging the war to the point that it spirals out of control. Clearly the economic pain is being felt, as manufacturing expectations and consumer confidence weaken (Chart 7). Europe’s resolve will not collapse overnight. But the energy crisis can get worse from here. The deeper the recession, the more likely European capitals will try to convince Ukraine to negotiate a ceasefire. However, given Ukraine’s successes in the field and Europe’s successes in diversification, it is entirely possible that Russia faces further humiliating setbacks. While this outcome may be good for liberal democracies, it is not good for global financial markets, at least not in the short run. If Russia is backed into a corner on both the military and economic fronts, then Putin’s personal security and regime security will be threatened. Russia could attempt to turn the tables or lash out even more aggressively. Already Moscow has declared a new “red line” if the US provides longer-range missiles to Ukraine. A US-Russia showdown, complete with nuclear threats, is not out of the realm of possibility. Russia could also start halting oil exports, as it has threatened to do, to inflict a major oil shock on the European economy. Investors will need to be prepared for that outcome. Bottom Line: Petro-states have geopolitical leverage as long as global commodity supplies remain tight. Investors should be prepared for the European embargo of Russian oil to provoke a Russian reaction. A larger than expected oil shock is possible given the risk of defeat that Russia faces (Chart 8). Chart 8Russian Oil Embargo Could Deliver Global Shock US-Iran Talks Falter Again This trend of petro-state geopolitical leverage was one of our three key views for 2022 and it also extends to the US-Iran nuclear negotiations, which are faltering as expected. Tit-for-tat military action between Iran and its enemies in the Persian Gulf will pick up immediately – i.e. a new source of oil disruption will emerge. If global demand is collapsing then this trend may only create additional volatility for oil markets at first, but it further constrains the supply side for the foreseeable future. It is not yet certain that the talks are dead but a deal before the US midterm looks unlikely. Biden could continue working on a deal in 2023-24. The Democratic Party is likely to lose at least the House of Representatives, leaving him unable to pass legislation and more likely to pursue foreign policy objectives. The Biden administration wants the Iran deal to tamp down inflation and avoid a third foreign policy crisis at a time when it is already juggling Russia and China. The overriding constraints in this situation are that Iran needs a nuclear weapon for regime survival, while Israel will attack Iran as a last resort before it obtains a nuclear weapon. Yes, the US is reluctant to initiate another war in the Middle East. But public war-weariness is probably overrated today (unlike in 2008 or even 2016) and the US has drawn a hard red line against nuclear weaponization. Iran will retaliate to any US-Israeli aggression ferociously. But conflict and oil disruptions will emerge even before the US or Israel decide to launch air strikes, as Iran will face sabotage and cyber-attacks and will need to deter the US and Israel by signaling that it can trigger a region-wide war. Chart 9If US-Iran Talks Fail, Iraq Will Destabilize Further Recent social unrest in Iraq, where the nationalist coalition of Muqtada al-Sadr is pushing back against Iranian influence, is only an inkling of what can occur if the US-Iran talks are truly dead, Iran pushes forward with its nuclear program, and Israel and the US begin openly entertaining military options. The potential oil disruption from Iraq presents a much larger supply constraint than the failure to remove sanctions on Iran (Chart 9). A new wave of Middle Eastern instability would push up oil prices and strengthen Russia’s hand, distracting the US and imposing further pain on Europe. It would not strengthen China’s hand, but the risk itself would reinforce China’s Eurasian strategy, as Beijing would need to prepare for oil cutoffs in the Persian Gulf. Iran’s attempts to join the Shanghai Cooperation Organization should be seen in this context. Ultimately the only factor that could still possibly convince Iran not to make a dash for the bomb – the military might of the US and its allies – is the same factor that forces China and Russia to strengthen their strategic bond. The emerging Russo-Chinese behemoth, in turn, acts as a hard constraint on any substantial reengagement of the US and Chinese economies. The US cannot afford to feed another decade of Chinese economic growth and modernization if China is allied with Russia and Central Asia. Of course, we cannot rule out the possibility that the Xi and Biden administrations will try to prevent a total collapse of US-China relations in 2023. If China is not yet ready to invade Taiwan then there is a brief space for diplomacy to try to work. But there is no room for long-lasting reengagement – because the US cannot simply cede Taiwan to China, and hence China cannot reject Russia, and Russia no longer has any options. Bottom Line: Expect further oil volatility and price shocks. Sell Middle Eastern equities. Favor North American, Latin American, and Australian energy producers. Investment Takeaways Recession Risks Rising: The inflation surprise in the US in August necessitates more aggressive Fed rate hikes in the near term, which increases the odds of rising unemployment and recession. US Policy Uncertainty Rising: A recession will greatly increase the odds of US political instability over the 2022-24 cycle and reduce the incentive for foreign powers like Iran or China to make concessions or agreements with the US. European Policy Uncertainty Rising: We already expected a European recession. Russia’s setbacks make it more likely that it will adopt more aggressive military tactics and economic warfare. Chinese Policy Uncertainty Rising: China will continue stimulating next year but its economy will suffer from energy shocks and its stimulus is less effective than in the past. It will likely increase economic and military pressure on Taiwan, while the US will increase punitive measures against China. It is not clear that it will launch a full scale invasion of Taiwan – that is not our base case – but it is possible so investors need to be prepared. Long US and Defensives: Stay long US stocks over global stocks, defensive sectors over cyclicals, and large caps over small caps. Buy safe-havens like the oversold Japanese yen. Long Arms Manufacturers: Buy defense stocks and cyber-security firms. Short China and Taiwan: Favor the USD and EUR over the CNY. Favor US semiconductor stocks over Taiwanese equities. Favor Korean over Taiwanese equities. Favor Indian tech over Chinese tech. Favor Singaporean over Hong Kong stocks. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Tessa Wong and Simon Fraser, “Putin-Xi talks: Russian leader reveals China's 'concern' over Ukraine,” BBC, September 15, 2022, bbc.com. 2 US Senate Foreign Relations Committee, “The Taiwan Policy Act of 2022,” foreign.senate.gov. 3 Greg Sargent, “Is Putin facing defeat? The ‘End of History’ author remains confident,” Washington Post, September 12, 2022, washingtonpost.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix
Executive Summary US Military Constraint: Strait Of Hormuz A US-Iran deal would make for a notable improvement in the geopolitical backdrop during an otherwise gloomy year. It would remove the risk of a major new oil shock. We maintain our 40% subjective odds of a deal, which is well below consensus. The risk of failure is underrated. Our conviction level is only moderate because President Biden can make concessions to clinch a deal – and Supreme Leader Khamenei may want to earn some money and time. Yet we have high conviction in our view that the US will ultimately fail to provide Iran with sufficient security guarantees while Iran will pursue a nuclear deterrent. Hence the Middle East will present a long-term energy supply constraint. In the short term, global growth and recession risk will drive oil prices, not any Iran deal. Asset Initiation Date Return LONG GLOBAL AEROSPACE & DEFENSE / BROAD MARKET EQUITIES 2020-11-27 9.3% Bottom Line: Any US-Iran deal will be marginally positive for risky assets. However, the failure of a deal would sharply increase the odds of oil supply disruptions in the short run. Feature Negotiations over Iran’s nuclear program remain in a critical phase. Rumors suggest Iran has agreed to rejoin the 2015 Joint Comprehensive Plan of Action (JCPA) with the United States. But these rumors are unconfirmed, while the International Atomic Energy Agency (IAEA) just announced that Iran has started operating more advanced centrifuges at its Natanz nuclear site.1 In this report we provide a tactical update on the topic. A US-Iran nuclear deal is one item on our checklist for global macro and geopolitical stability (Table 1). We are pessimistic about a deal but it would be a positive outcome for markets. Table 1Not A Lot Of Positive Catalysts In H2 2022 A decision could come at any moment so investors should bear in mind our key conclusions about a deal: Chart 1Oil Volatility: The Only Certainty Of Iran Saga 1. Any deal will be a short-term, stop-gap measure to delay a crisis until 2024 or beyond. This is not a small point because a crisis could lead to a large military conflict. 2. The short-run implication of any deal is oil volatility, not a drop in oil prices (Chart 1). Global demand is wobbly and OPEC could cut oil production in reaction to a deal. 3. Over the long run, global supply and demand balances will remain tight even if a deal is agreed. 4. If there is no deal, then a major new source of global supply constraint will emerge immediately due to a new spiral of conflict in the Middle East. Iran’s nuclear program will continue which will prompt threats from Israel and the Gulf Arab states and Iranian counter-threats. We are sticking with our subjective 40/60 odds that a deal will occur – i.e. our conviction level is medium, not high. The Biden administration wants a deal and has the executive authority to conclude a deal. Iran wants sanctions lifted and can buy time with a short-term deal. Our pessimism stems from the fact that neither side can trust the other, the US can no longer give credible security guarantees, and Iran has a strategic interest in obtaining nuclear weapons. A deal can happen but its durability depends on the 2024 US election. Status Of Negotiations Table 2Iran’s Three Demands Of US For Rejoining 2015 Nuclear Deal Ostensibly there were three outstanding Iranian demands over the month of August that needed to be met to secure a deal (Table 2). Iran reportedly dropped the first demand: that the US remove the Iranian Revolutionary Guard Corps from the US State Department’s list of Designated Foreign Terrorist Organizations. This concession prompted the news media to become more optimistic about a deal. This leaves two outstanding demands. Iran wants the IAEA conclude a “safeguards” investigation into unexplained uranium traces found at unauthorized sites in Iran, indicating nuclear activity that has not been accounted for. The IAEA will be very reluctant to halt such a probe on a political, not technical, basis. But it could happen under US pressure. Related Report Geopolitical StrategyRoulette With A Five-Shooter Iran also wants the US to provide a “guarantee” that future presidents will not renege on the nuclear deal and reimpose sanctions like President Trump did in 2019. President Biden cannot give any credible guarantee because the JCPA is an executive action, not a formal treaty, so a different president could reverse it. (The deal always lacked sufficient support in the Senate, even from top Democrats.) Iran is demanding certain diplomatic concessions and/or an economic indemnity in the event of another American reversal. Aside from attempting to incarcerate former President Trump, Biden can only offer empty promises on this front. In what follows we review the critical constraints facing the US and Iran. The US’s Constraints The first constraint on the US is the stagflationary economy. High inflation and oil prices pose a threat to President Biden and the Democrats not only in this year’s midterm elections but also in the 2024 presidential election. A recession is not at all unlikely by that time, given the inverted yield curve (Chart 2). If the US can help maintain stability in the Middle East, then the odds of another major oil supply shock (on top of Russia) will be reduced. Lifting sanctions on Iran will free up around 1 million barrels of oil to feed global demand. With Europe and the US imposing an oil and oil shipping embargo on Russia, the world is likely to lose around two million barrels of crude per day that the Gulf Arab states can only partially make up for, according to our Chief Commodity Strategist Bob Ryan (Table 3). This is a notable material constraint – and the main reason that Bob is more optimistic about an Iran deal than we are. Chart 2US Economic Constraint: Stagflation Table 3The Oil Math Behind Any Iran Deal However, Saudi Arabia would be alienated by a US-Iran détente. The American view is that Iranian production would threaten Saudi market share and force the Saudis to produce more. But the Saudis are seeing weakening global demand and have signaled that they will cut production. There is still an economic basis for an Iran deal but it is not clear that it will lower prices, especially in the short run. Over the long run the Saudis are a more reliable oil producer than Iran for both economic and geopolitical reasons. The second constraint is political. The US public is primarily concerned about the economy. Stagflation or recession could ultimately bring down the Biden administration. However, in the short run, American voters are much more concerned about domestic social issues (such as abortion access) than they are about foreign policy. In the long run, American voters are likely to maintain their long-held negative view of Iran (Chart 3). So the Biden administration has an incentive to prevent geopolitical events from hurting the economy but not to join arms with Iran in a major diplomatic agreement. The third constraint is military. Americans are not as war-weary today as they were in 2008 or 2016 but they are still averse to any new military conflicts in the Middle East. An Iranian nuclear bomb could change that view – but until a bomb is tested it will persist. Chart 3US Political Constraint: Americans Ignore Foreign Policy, Dislike Iran Chart 4US Military Constraint: Strait Of Hormuz If Iran freezes its nuclear program then it will reduce the odds of a Middle Eastern war and large-scale oil supply disruptions. If Iran does not freeze its nuclear program, then Israel will have to demonstrate a credible military threat against nuclear weaponization, and then Iran will have to demonstrate its region-wide militant capabilities, including the ability to shut down the Strait of Hormuz (Chart 4). The Biden administration wants to delay this downward spiral or avoid it altogether. Chart 5US Strategic Constraint: Avoid Mideast Quagmires The fourth constraint is strategic. The Biden administration wants to avoid conflict if possible because it is attempting to reduce America’s burden in the Middle East so that it can focus on emerging great power competition in Eastern Europe and East Asia. The original motivation for the Iran deal was to enable the US to “pivot to Asia” and counter China. Iranian hegemony in the Middle East is less of a threat than Chinese hegemony in East Asia (Chart 5). This logic is sound if Iran can really be brought to halt its nuclear program. The Europeans need to stabilize and open up the Middle East to create an alternative energy supply to Russia. The Americans need to avoid a nuclear arms race and war in the Middle East that distracts them from China. However, if Iran continues to pursue a nuclear weapon, then the US suffers strategically for doing a short-term deal that provides Iran with time and access to funds. Ultimately the only thing that can dissuade Iran from going nuclear is American power projection in the Middle East – and this capability is also one of the US’s greatest advantages over China. Bottom Line: The US has a strategic, military, and economic interest in concluding a deal that freezes Iran’s nuclear program. It arguably has an interest in a deal even if Iran violates the deal and pursues nuclear weaponization, since that will provide a legitimate basis for what would then become a necessary military intervention. The Biden administration faces some political blowback for a deal but will suffer more if failure to get a deal leads to a Middle Eastern oil shock. For all these reasons Biden administration is attempting to clinch a deal. But Iran is the sticking point. Iran’s Constraints Our reasons for pessimism regarding the nuclear talks hinge on Iran, not the United States. Supreme Leader Ayatollah Ali Khamenei’s goal is to secure the regime and arrange for a stable succession in the coming years. A deal with the Americans made sense in that context. But going forward, if dealing with the Americans does not bring credible security guarantees and yet makes the economy vulnerable again to a future snapback of sanctions, then the justification for the deal falls apart. We cannot read Khamenei’s mind any more than we can read Biden’s mind, so we will look at the material limitations. Chart 6Iran's Economic Constraint: Stagflation First, the economic constraint: The Iranian economy suffered a huge negative shock from the reimposition of sanctions in 2019 (Chart 6). However, the economy has sputtered through this shock and the Covid-19 shock without collapsing. Social unrest is an ever-present risk but it has not spiraled out of control. There has not been an attempted democratic revolution like in 2009. The upswing in the global commodity cycle has reinforced the regime. Sanctions do not prevent exports entirely. There is still a huge monetary incentive to let the Biden administration lift sanctions if it wants to do so: a deal is estimated to free up $100 billion dollars per year in revenue for the regime for ten years.2 Realistically this should be understood as more than $275 billion for two years since the longevity of the deal is in question. The problem is that Iran’s economy would be fully exposed to sanctions again if the US changed its mind. The bottom line is that the economic constraint does not force Iran to accept a deal but it is enticing. Second comes the political constraint. President Ebrahim Raisi hopes to become supreme leader someday and is loath to put his name on a deal with weak foundations. He originally opposed the deal, was vindicated, and does not now want to jeopardize his political future by making the same mistake as his hapless predecessor, Hassan Rouhani. Opinion polls may not be reliable in putting Raisi as the most popular politician in Iran but they probably are reliable in showing Rouhani at the bottom of the heap (Chart 7). There is a significant political constraint against rejoining the deal. Chart 7Iran’s Political Constraint: Risk Of American Betrayal Chart 8Iran’s Military Constraint: Outgunned, Unsure Of Allies Third comes the military constraint. While Iran is extremely vulnerable to Israeli and American military attack, it is also a fortress of a country, nestled in mountains, and airstrikes may not succeed in destroying the entire nuclear program or bringing down the regime. An attack by Israel could convert an entirely new generation to the Islamic revolution. And Iran may believe that the US lacks the popular support for military action in the wake of Iraq and Afghanistan. Iran may also believe that China and Russia will provide military and economic support (Chart 8). Ultimately, America has demonstrated a willingness to attack rogue states and Iran will try to avoid that outcome, since it could succeed in toppling the regime. But if Iran believes it can acquire a deliverable nuclear weapon in a few short years, then it may make a dash for it, since this solution would be a permanent solution: a nuclear deterrent against western attack, as opposed to temporary diplomatic promises. We often compare Iran’s strategic predicament to that of Ukraine, Libya, and North Korea. Ukraine gave up its Soviet nuclear weapons after the 1994 Budapest Memorandum, which promised that Russia, the US, the UK, France, and China would guarantee its security. Yet Russia ended up invading 20 years later – and none of the others prevented it or sent troops to halt the Russian advance. Separately Libya gave up its nuclear program in 2003 but NATO attacked and toppled the regime in 2011 anyway. Meanwhile North Korea played the diplomatic game with the US, ever inching along on the path toward nuclear weapons, and today has achieved nuclear-armed status and greater regime security. The outflow of refugees from the various regimes shows why Iran will emulate North Korea (Chart 9). Chart 9Iran’s Strategic Constraint: The Need For A Nuclear Deterrent Bottom Line: Iran has a short-term economic incentive to agree to a deal and a long-term military incentive. But ultimately the US cannot provide ironclad security guarantees that would justify halting the quest for a nuclear deterrent. A nuclear deterrent would overcome the military constraint. Therefore Iran will continue on that path. Any deal will be a ruse to buy time. Final Assessment The 2015 deal occurred in a context of Iranian strategic isolation, when American implementation was credible, oil prices were weak, and Iran had not achieved nuclear breakout capacity. Today Iran is not isolated (thanks to US quarrels with Russia and China), American guarantees are not credible (thanks to the polarization of foreign policy), oil prices are not weak (thanks to Russia), and Iran has already achieved nuclear breakout (Table 4). Table 4Iran’s Nuclear Program Status Check, Aug. 31, 2022 The US’s strategic aim is to create a balance of power in the region but Iran’s strategic aim is to ensure regime survival. The US’s emerging balancing coalition (Israel and the Gulf Arab states) increases the strategic threat to Iran and hence its need for a nuclear deterrent. While Russia and China formally support the 2015 deal, they each see Iran as a valuable asset in a great power struggle with the United States. Iran sees them the same way. Russia needs Iran as a partner to bypass western sanctions. Regardless, it benefits from Middle Eastern instability, which could entangle the United States. China must develop a deep long-term partnership with Iran for its own strategic reasons and does not look forward to a time when the US divests from that region to impose tougher strategic containment on China. China can survive a US conflict with Iran – and such a conflict could reduce the US ability to defend Taiwan. While neither Russia nor China positively desire Iran to obtain nuclear weapons, neither power stopped North Korea from obtaining the bomb – far from it. Russia assumes that Israel and the US will take military action to prevent weaponization, which would be catastrophic for the region but positive for Russia. China also assumes Israel and the US will act, which reinforces its need to diversify energy options so that it can access Russian, Central Asian, and Middle Eastern oil via pipeline. Investment Takeaways Our negative view on the global economy and geopolitical backdrop is once again being priced into global financial markets as equities fall anew. An Iran deal would delay a notable geopolitical risk for roughly the next 24 months and hence remove a major upside risk for oil prices. This would be marginally positive for global equities, although it will not be the driver. Europe’s and China’s economic woes are the drivers. The failure of a deal would bring major upside risks for oil into the near term and as such would be negative for equities – and could even become the global driver, as Middle Eastern oil disruptions will follow promptly from any failure of the deal. We continue to recommend that investors overweight US equities relative to global, defensive sectors relative to cyclicals, and large caps relative to small caps. We are overweight aerospace and defense stocks, India and Southeast Asia within emerging markets, and underweight China and Taiwan. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Iran International, “Exclusive: Ex-IAEA Official Says US And Iran To Sign Deal Soon,” August 30, 2022, iranintl.com. See also Francois Murphy, “Iran enriching uranium with more IR-6 centrifuges at Natanz -IAEA,” Reuters, August 31, 2022, reuters.com. 2 See Saeed Ghasseminejad, “Tehran’s $1 Trillion Deal: An Updated Forecast of Iran’s Financial Windfall From a New Nuclear Agreement,” Foundation for Defense of Democracies, August 19, 2022, fdd.org. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix
Executive Summary China's Unemployment Over the past week we have been visiting clients along the US west coast. In this report we hit some of the highlights from the most important and frequently asked questions. Xi Jinping is seizing absolute power just as the country’s decades-long property boom turns to bust. He will stimulate the economy but Chinese stimulus is less effective than it used to be. The US and Israel are underscoring their red line against Iranian nuclear weaponization. If Iran does not freeze its nuclear program, the Middle East will begin to unravel again. The UK’s domestic instability is returning, with Scotland threatening to leave the union. Brexit, the pandemic, and inflation make a Scottish referendum a more serious risk than in the past. Shinzo Abe’s assassination makes him a martyr for a vision of Japan as a “normal country” – i.e. one that is not pacifist but capable of defending itself. Japan’s rearmament, like Germany’s, points to the decline of the WWII peace settlement and the return of great power competition. Bottom Line: Investors need a new global balance to be achieved through US diplomacy with Russia, China, and Iran. That is not forthcoming, as the chief nations face instability at home and a stagflationary global economy. Feature The world is becoming less stable as stagflation combines with great power competition. Global uncertainty is through the roof. From a macroeconomic perspective, investors need to know whether central banks can whip inflation without triggering a recession. From a geopolitical perspective, investors need to know whether Russia’s conflict with the West will expand, whether US-China and US-Iran tensions will escalate in a damaging way, and whether domestic political rotations in the US and China this fall will lead to more stable and productive economies. China: What Will Happen At The Communist Party Reshuffle? General Secretary Xi Jinping will cement another five-to-10 years in power while promoting members of his faction into key positions on the Politburo and Politburo Standing Committee. By December Xi will roll out a pro-growth strategy for 2023 and the government will signal that it will start relaxing Covid-19 restrictions. But China’s structural problems ensure that this good news for global growth will only have a fleeting effect. China’s governance is shifting from single-party rule to single-person rule. It is also shifting from commercially focused decentralization to national security focused centralization. Xi has concentrated power in himself, in the party, and in Beijing at the expense of political opponents, the private economy, and outlying regions like Hong Kong, the South China Sea, and Xinjiang. The subordination of Taiwan is the next major project, ensuring that China will ally with Russia and that the US and China cannot repair or deepen their economic partnership. Related Report Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Xi and the Communist Party began centralizing political power and economic control shortly after the Great Recession. At that time it became clear that a painful transition away from export manufacturing and close relations with the United States was necessary. The transition would jeopardize China’s long-term economic, social, political, and geopolitical stability. The Communist Party believed it needed to revive strongman leadership (autocracy) rather than pursuing greater liberalization that would ultimately increase the odds of political revolution (democratization). The Xi administration has struggled to manage the country’s vast debt bubble, given that total debt standing has surged to 287% of GDP. The global pandemic forced the government to launch another large stimulus package, which it then attempted to contain. Corporate and household deleveraging ensued. The property and infrastructure boom of the past three decades has stalled, as the regime has imposed liquidity and capital requirements on banks and property developers to try to avoid a financial crisis. Regulatory tightening occurred in other sectors to try to steer investment into government-approved sectors and reduce the odds of technological advancement fanning social dissent. China’s draconian “zero Covid” policy sought to limit the disease’s toll, improve China’s economic self-reliance, and eliminate the threat of social protest during the year of the twentieth party congress. But it also slammed the brakes on growth. China is highly vulnerable to social instability for both structural and cyclical reasons. Chinese social unrest was our number one “Black Swan” for this year and it is now starting to take shape in the form of angry mortgage owners across the country refusing to make mortgage payments on houses that were pre-purchased but not yet built and delivered (Chart 1). Chart 1China: Mortgage Payment Boycott The mortgage payment boycott is important because it is stemming from the outstanding economic and financial imbalance – the property sector – and because it is a form of cross-regional social organization, which the Communist Party will disapprove. There are other social protests emerging, including low-level bank runs, which must be monitored very closely. Local authorities will act quickly to stop the spread of the mortgage boycott. But unhappy homeowners will be a persistent problem due to the decline of the property sector and industry. China’s property sector looks uncomfortably like the American property sector ahead of the 2006-08 bust. Prices for existing homes are falling while new house prices are on the verge of falling (Chart 2). While mortgages only make up 15% of bank assets, and household debt is only 62% of GDP, households are no longer taking on new debt (Chart 3). Chart 2China's Falling Property Prices Chart 3China's Property Crisis Chart 4China's Unemployment Most likely China’s property sector is entering the bust phase that we have long expected – if not, then the reason will be a rapid and aggressive move by authorities to expand monetary and fiscal stimulus and loosen economic restrictions. That process of broad-based easing – “letting 100 flowers bloom” – will not fully get under way until after the party congress, say in December. Unemployment is rising across China as the economy slows, another point of comparison with the United States ahead of the 2008 property collapse (Chart 4). Unemployment is a manipulated statistic so real conditions are likely worse. There is no more important indicator. China’s government will be forced to ease policy, creating a positive impact on global growth in 2023, but the impact will be fleeting. Bottom Line: The underlying debt-deflationary context will prevail before long in China, weighing on global growth and inflation expectations on a cyclical basis. Middle East: Why Did Biden Go And What Will He Get? President Biden traveled to Israel and now Saudi Arabia because he wants Saudi Arabia and the Gulf Arab members of OPEC to increase oil production to reduce gasoline prices at the pump for Americans ahead of the midterm elections (Chart 5). Chart 5Biden Goes To Israel And Saudi Arabia True, fears of recession are already weighing on prices, but Biden embarked on this mission before the growth slowdown was fully appreciated and he is not going to lightly abandon the anti-inflation fight before the midterm election. Biden also went because one of his top foreign policy priorities – the renegotiation of the 2015 nuclear deal with Iran – is falling apart. The Iranians do not want to freeze their nuclear program because they want regime survival and security. While Biden is offering a return to the 2015 deal, the conditions that produced the deal are no longer applicable: Russia and China are not cooperating with the US and EU to isolate Iran. Russia is courting Iran, oil prices are high and sanction enforcement is weak (unlike 2015). The Iranians now know, after the Trump administration, that they cannot trust the Americans to give credible security guarantees that will last across parties and administrations. The war in Ukraine also underscores the weakness of diplomatic security guarantees as opposed to a nuclear deterrent. Hence the joint US and Israeli declaration that Iran will never be allowed to obtain nuclear weapons. The good news is that this kind of joint statement is precisely what needed to occur – the underscoring of the red line – to try to change Ayatollah Ali Khamenei’s calculus regarding his drive to achieve nuclear breakout. In 2015 Khamenei gave diplomacy a chance to try to improve the economy, stave off social unrest, prepare the way for his eventual leadership succession process, and secure the Islamic Republic. The bad news is that Khamenei probably cannot make the same decision this time, as the hawkish faction now runs his government, the Americans are unreliable, and Russia and China are offering an alternative strategic orientation. The Saudis will pump more oil if necessary to save the global business cycle but not at the beck and call of a US president. The drop in oil prices reduces their urgency. The Americans can reassure the Saudis and Israel as long as the deal with Iran is not going forward. That looks to be the case. But then the US and Israel will have to undertake joint actions to underline their threat to Iran – and Iran will have to threaten to stage attacks across the region so as to deter any attack. Bottom Line: If a US-Iran deal does not materialize at the last minute, Middle Eastern instability will revive and a new source of oil supply constraint will plague the global economy. We continue to believe a US-Iran deal is unlikely, with only 40% odds of happening. Europe: Will Russia Turn Back On The Natural Gas? Russia’s objective in cutting off European natural gas is to inflict a recession on Europe. It wants a better bargaining position on strategic matters. Therefore we assume Russia will continue to squeeze supplies from now through the winter, when European demand rises and Russian leverage will peak. If Russia allows some flow to return, then it will be part of the negotiating process and will not preclude another cutoff before winter. It is possible that Russia is merely giving Europe a warning and will revert back to supplying natural gas. The problem is that Russia’s purpose is to achieve a strategic victory in Ukraine and in negotiations over NATO’s role in the Nordic countries. Russia has not achieved these goals, so natural gas cutoff will likely continue. Russia also hopes that by utilizing its energy leverage – while it still has it – it will bring forward the economic pain of Europe’s transition away from reliance on Russian energy. In that case European countries will experience recession and households will begin to change their view of the situation. European governments will be more likely to change their policies, to become more pragmatic and less confrontational toward Russia. Or European governments will be voted out of power and do the same thing. Other states could join Hungary in saying that Europe should never impose a full natural gas embargo on Russia. Russia would be able to salvage some of its energy trade with Europe over the long run, despite the war in Ukraine and the inevitable European energy diversification. In recent months we highlighted Italy as the weakest link in the European chain and the country most likely to see such a shift in policy occur. Italy’s national unity coalition had lost its reason for being, while the combination of rising bond yields and natural gas prices weighed on the economy. The Italian bond spread over German bunds has long served as our indicator of European political stress – and it is spiking now, forcing the European Central Bank to rush to plan an anti-fragmentation strategy that would theoretically enable it to tighten monetary policy while preventing an Italian debt crisis (Chart 6). The European Union remains unlikely to break up – Russian aggression was always one of our chief arguments for why the EU would stick together. But Italy will undergo a recession and an election (due by June 2023 but that could easily happen this fall), likely producing a new government that is more pragmatic with regard to Russia so as to reduce the energy strain. Chart 6Italy's Crisis Points To EU Divisions On Russia Italy’s political turmoil shows that European states are feeling the energy crisis and will begin to shift policies to reduce the burden on households. Households will lose their appetite for conflict with Russia on behalf of Ukrainians, especially if Russia begins offering a ceasefire after completing its conquest of the Donetsk area. If Russia expands its invasion, then Europe will expand sanctions and the risk of further strategic instability will go up. But most likely Russia will seek to quit while it is ahead and twist Europe’s arm into foisting a ceasefire onto Ukraine. Bottom Line: A change of government in Italy will increase the odds that the EU will engage in diplomacy with Russia in the coming year, if Russia offers, so as to reach a new understanding, restore natural gas flows, and salvage the economy. This would leave NATO enlargement unresolved but a shift in favor of a ceasefire in Ukraine in 2023 would be less negative for European assets and the euro. UK: Who Will Replace Boris Johnson? Last week UK Prime Minister Boris Johnson fell from power and now the Conservative Party is engaging in a leadership competition to replace him. We gave up on Johnson after he survived his no-confidence vote and yet it became clear that he could not recover in popular opinion. The inflation outburst destroyed his premiership and wiped away whatever support he had gained from executing Brexit. In fact it reinforced the faction that believed Brexit was the wrong decision. Going forward the UK will be consumed with domestic political turmoil as the cost of stagflation mounts, and geopolitical turmoil as Scotland attempts to hold a second independence referendum, possibly by October 2023. Global investors should focus primarily on Scotland’s attempt to secede, since the breakup of the United Kingdom would be a momentous historical event and a huge negative shock for pound sterling. While only 44.7% of Scots voted for independence in 2014, now they have witnessed Brexit, Covid-19, and stagflation, producing tailwinds for the Scots nationalist vote (Chart 7). Chart 7Forget Bojo's Exit, Watch Scotland There are still major limitations on Scotland exiting, since its national capabilities are limited, it would need to join the European Union, and Spain and possibly others will threaten to veto its membership in the European Union for fear of feeding their own secessionist movements. But any new referendum – including one done without the approval of Westminster – should be taken very seriously by investors. Bottom Line: Johnson’s removal will only marginally improve the Tories’ ability to manage the rebellion brewing in the north. A snap election that brings the Labour Party back into power would have a greater chance of keeping Scotland in the union, although it is not clear that such a snap election will happen in time to affect any Scottish decision. The UK faces economic and political turmoil between now and any referendum and investors should steer clear of the pound. (Though we still favor GBP over eastern European currencies). Britain will remain aggressive toward Russia but its ability to affect the Russian dynamic will fall, leaving the US and EU to decide the fate of Russian relations. Japan: What Is The Significance Of Shinzo Abe’s Assassination? Former Japanese Prime Minister Shinzo Abe was assassinated by a lone fanatic with a handmade gun. The significance of the incident is that Abe will become a martyr for a certain vision of Japan – his vision of Japan, which is that Japan can become a “normal country” that moves beyond the shackles of the guilt of its imperial aggression in World War II. A normal country is one that is economically stable and militarily capable of defending itself – not a pacifist country mired in debt-deflation. Abe stood for domestic reflation and a proactive foreign policy, along with the normalization of the Japanese Self-Defense Forces (JSDF). True, economic policy can become less dovish if necessary to deal with inflation. Some changes at the Bank of Japan may usher in a less dovish shift in monetary policy in particular. But monetary policy cannot become outright hawkish like it was before Abe. And Abe’s fiscal policy was never as loose as it was made out to be, given that he executed several hikes to the consumption tax. Japan’s structural demographic decline and large debt burden will continue to weigh on economic activity whenever real rates and the yen rise. The government will be forced to reflate using monetary and fiscal policy whenever deflation threatens to return. Debt monetization will remain an option for future Japanese governments, even if it is restrained during times of high inflation. Chart 8Shinzo Abe's Legacy This is not only because Japanese households will become depressed if deflation is left unchecked but also because economic growth must be maintained in order to sustain the nation’s new and growing national defense budgets. Japan’s growing need for self defense stems from China’s strategic rise, Russia’s aggression, and North Korea’s nuclearization, plus uncertainty about the future of American foreign policy. These trends will not change anytime soon. Indeed the Liberal Democratic Party’s popularity has increased under Abe’s successor, Prime Minister Fumio Kishida, who will largely sustain Abe’s vision. The Diet still has a supermajority in favor of constitutional revision so as to enshrine the self-defense forces (Chart 8). And the de facto policy of rearmament continues even without formal revision. Bottom Line: Any Japanese leader who attempts to promote a hawkish BoJ, and a dovish JSDF, will fail sooner rather than later. The revolving door of prime ministers will accelerate. As Japan’s longest-serving prime minister, Shinzo Abe opened up the reliable pathway, which is that of a dovish BoJ and a hawkish foreign policy. This is important for the world, as well as Japan, because a more hawkish Japan will increase China’s fears of strategic containment. The frozen conflicts in Asia will continue to thaw, perpetuating the secular rise in geopolitical risk. We remain long JPY-KRW, since the BoJ may adjust in the short term and Chinese stimulus is still compromised, but that trade is on downgrade watch. Investment Takeaways Russia’s energy cutoff is aimed at pushing Europe into recession so as to force policy changes or government changes in Europe that will improve Russia’s position at the negotiating table over Ukraine, NATO, and other strategic disputes. Hence Russia is unlikely to increase the natural gas flow until it believes it has achieved its strategic aims and multiple veto players in the EU will prevent the EU from ever implementing a full-blown natural gas embargo. Chinese stimulus cannot be fully effective until it relaxes Covid-19 restrictions, likely beginning in December or next year when Xi Jinping uses his renewed political capital to try to stabilize the economy. However, China’s government powers alone are insufficient to prevent the debt-deflationary tendency of the property bust. The Middle East faces rising geopolitical tensions that will take markets by surprise with additional energy supply constraints. The implication is continued oil volatility given that global growth is faltering. Once global demand stabilizes, the Middle East’s turmoil will add to existing oil supply constraints to create new price pressures. The odds are not very high of the Federal Reserve achieving a “soft landing” in the context of a global energy shock and a stagflationary Europe and China. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar
Executive Summary EU Embargoes Russian Oil The EU imposed an embargo on 90% of Russian oil imports, which will provoke retaliation. Russia will squeeze Europe’s economy ahead of critical negotiations over the coming 6-12 months. Russian gains on the battlefield in Ukraine point to a ceasefire later, but not yet – and Russia will need to retaliate against NATO enlargement. The Middle East and North Africa face instability and oil disruptions due to US-Iran tensions and Russian interference. China’s autocratic shift is occurring amid an economic slowdown and pandemic. Social unrest and internal tensions will flare. China will export uncertainty and stagflation. Inflation is causing disparate effects in South Asia – instability in Pakistan and Sri Lanka, and fiscal populism in India. Asset Initiation Date Return Long Brazilian Financials / Indian Equities (Closed) Feb 10/22 22.5% Bottom Line: Markets still face three geopolitical hurdles: Russian retaliation; Middle Eastern instability; Chinese uncertainty. Feature Global equities bounced back 6.1% from their trough on May 12 as investors cheered hints of weakening inflation and questioned the bearish consensus. BCA’s Global Investment Strategy correctly called the equity bounce. However, as BCA’s Geopolitical Strategy service, we see several sources of additional bad news. Throughout the Ukraine conflict we have highlighted two fundamental factors to ascertain regarding the ongoing macroeconomic impact: Will the war cut off the Russia-EU energy trade? Will the war broaden beyond Ukraine? Chart 1Russian-Exposed Assets Will Suffer More In this report we update our views on these two critical questions. The takeaway is that the geopolitical outlook is still flashing red. The US dollar will remain strong and currencies exposed to Russia and geopolitical risk will remain weak (Chart 1). In addition, China’s politics will continue to produce uncertainty and negative surprises this year. Taken together, investors should remain defensive for now but be ready to turn positive when the market clears the hurdles we identify. The fate of the business cycle hangs in the balance. Energy Ties Eroding … Russia Will Retaliate Over Oil Embargo Chart 2AEU Embargoes Russian Oil Europe is diversifying from Russian oil and natural gas. The European Union adopted a partial oil embargo on Russia that will cut oil imports by 90% by the end of 2022. It also removed Sberbank from the SWIFT banking communications network and slapped sanctions on companies that insure shipments of Russian crude. The sanctions will cut off all of Europe’s seaborne oil imports from Russia as well as major pipeline imports, except the Southern Druzhba pipeline. The EU made an exception for landlocked eastern European countries heavily dependent on Russian pipeline imports – namely Hungary, Slovakia, the Czech Republic, and Bulgaria (Chart 2A). Focus on the big picture. Germany changed its national policy to reduce Russian energy dependency for the sake of national security. From Chancellors Willy Brandt to Angela Merkel, Germany pursued energy cooperation and economic engagement as a means of lowering the risk of war with Russia. Ostpolitik worked in the Cold War, so when Russia seized Crimea in 2014, Merkel built the Nord Stream 2 pipeline. But Merkel’s policy failed to persuade Russia that economic cooperation is better than military confrontation – rather it emboldened President Putin, who viewed Europe as divided and corruptible. Chart 2BRussia Squeezes EU’s Natural Gas Russia’s regime is insecure and feels threatened by the US and NATO. Russia believed that if it invaded Ukraine, the Europeans would maintain energy relations for the sake of preserving overall strategic stability. Instead Germany and other European states began to view Russia as irrational and aggressive and hence a threat to their long-term security. They imposed a coal ban, now an oil ban the end of this year, and a natural gas ban by the end of 2027, all formalized under the recently announced RePowerEU program. Russia retaliated by declaring it would reduce natural gas exports to the Netherlands and probably Denmark, after having already cut off Finland, Poland, and Bulgaria (Chart 2B). As a pretext Russia points to its arbitrary March demand that states pay for gas in rubles rather than in currencies written in contracts. This ruble payment scheme is being enforced on a country-by-country basis against those Russia deems “unfriendly,” i.e. those that join NATO, adopt new sanctions, provide massive assistance to Ukraine, or are otherwise adverse. Chart 3Russia Actively Cutting Gas Flows Russia and Ukraine are already reducing natural gas exports through the Ukraine and Turkstream pipelines while the Yamal pipeline has been empty since May – and it is only a matter of time before flows begin to fall in the Nord Stream 1 pipeline to Germany (Chart 3). German government and industry are preparing to ration natural gas (to prioritize household needs) and revive 15 coal plants if necessary. Europe is attempting to rebuild stockpiles for the coming winter, when Russian willingness and capability to squeeze natural gas flows will reach a peak. The big picture is demonstrated by game theory in Diagram 1. The optimal situation for both Russia and the EU is to maintain energy exports for as long as possible, so that Russia has revenues to wage its war and Europe avoids a recession while transitioning away from Russian supplies (bottom right quadrant, each side receives four points). The problem is that this solution is not an equilibrium because either side can suffer a sudden shock if the other side betrays the tacit agreement and stops buying or selling (bottom left and top right quadrants). Diagram 1EU-Russia Standoff: What Does Game Theory Say? The equilibrium – the decision sets in which both Russia and the EU are guaranteed to lose the least – is a situation in which both states reduce energy trade immediately. Europe needs to cut off the revenues that fuel the Russian war machine while Russia needs to punish and deter Europe now while it still has massive energy leverage (top left quadrant, circled). Once Europe diversifies away, Russia loses its leverage. If Europe does not diversify immediately, Russia can punish it severely by cutting off energy before it is prepared. Russian energy weaponization is especially useful ahead of any ceasefire talks in Ukraine. Russia aims for Ukrainian military neutrality and a permanently weakened Ukrainian state. To that end it is seizing territory for the Luhansk and Donetsk People’s Republics, seizing the southern coastline and strategic buffer around Crimea, and controlling the mouth of the Dnieper river so that Ukraine is forever hobbled (Map 1). Once it achieves these aims it will want to settle a ceasefire that legitimizes its conquests. But Ukraine will wish to continue the fight. Map 1Russian Invasion Of Ukraine, 2022 Russia will need leverage over Europe to convince the EU to lean on Ukraine to agree to a ceasefire. Something similar occurred in 2014-15 when Russia collaborated with Germany and France to foist the Minsk Protocols onto Ukraine. If Russia keeps energy flowing to EU, the EU not only gets a smooth energy transition away from Russia but also gets to keep assisting Ukraine’s military effort. Whereas if Russia imposes pain on the EU ahead of ceasefire talks, the EU has greater interest in settling a ceasefire. Finally, given Russia’s difficulties on the battlefield, its loss of European patronage, and potential NATO enlargement on its borders, Moscow is highly likely to open a “new front” in its conflict with the West. Josef Stalin, for example, encouraged Kim Il Sung to invade South Korea in 1950. Today Russia’s options lie in the Middle East and North Africa – the regions where Europe turns for energy alternatives. Not only Libya and Algeria – which are both inherently fertile ground for Russia to sow instability – but also Iran and the broader Middle East, where a tenuous geopolitical balance is already eroding due to a lack of strategic understanding between the US and Iran. Russia’s capabilities are limited but it likely retains enough influence to ignite existing powder kegs in these areas. Bottom Line: Investors still face a few hurdles from the Ukraine war. First, the EU’s expanding energy embargo and Russian retaliation. Second, instability in the Middle East and North Africa. Hence energy price pressures will remain elevated in the short term and kill more demand, thus pushing the EU and the rest of the world toward stagflation or even recession. War Contained To Ukraine So Far … But Russia To Retaliate Over NATO Enlargement At present Russia is waging a full-scale assault on eastern and southern Ukraine, where about half of Donetsk awaits a decision (Map 2). If Russia emerges victorious over Donetsk in the summer or fall then it can declare victory and start negotiating a ceasefire. This timeline assumes that its economic circumstances are sufficiently straitened to prevent a campaign to the Moldovan border.1 Map 2Russia May Declare Victory If It Conquers The Rest Of Donetsk There are still ways for the Ukraine war to spill over into neighboring areas. For example, the Black Sea is effectively a Russian lake at the moment, which prevents Ukrainian grain from reaching global markets where food prices are soaring. Eventually the western maritime powers will need to attempt to restore freedom of navigation. However, Russia is imposing a blockade on Ukraine, has more at stake there than other powers, and can take greater risks. The US and its allies will continue to provide Ukraine with targeting information against Russian ships but this assistance could eventually provoke a larger naval conflict. Separately, the US has agreed to provide Ukraine with the M142 High Mobility Artillery Rocket System (HIMARS), which could lead to attacks on Russian territory that would prompt a ferocious Russian reaction. Even assuming that the Ukraine war remains contained, Russia’s strategic conflict with the US and the West will remain unresolved and Moscow will be eager to save face. Russian retaliation will occur not only on account of European energy diversification but also on account of NATO enlargement. Finland and Sweden are attempting to join NATO and as such the West is directly repudiating the Putin regime’s chief strategic demand for 22 years. Finland shares an 830 mile border with Russia, adding insult to injury. The result will be another round of larger military tensions that go beyond Ukraine and prolong this year’s geopolitical risk and uncertainty. Russia’s initial response to Finland’s and Sweden’s joint application to NATO was to dismiss the threat they pose while drawing a new red line. Rather than forbidding NATO enlargement, Russia now demands that no NATO forces be deployed to these two states. This demand, which Putin and other officials expressed, may or may not amount to a genuine Russian policy change. Russia’s initial responses should be taken with a grain of salt because Turkey is temporarily blocking Finland’s and Sweden’s applications, so Russia has no need to respond to NATO enlargement yet. But the true test will come when and if the West satisfies Turkey’s grievances and Turkey moves to admit the new members. If enlargement becomes inevitable, Russia will respond. Russia will feel that its national security is fundamentally jeopardized by Sweden overturning two centuries of neutrality and Finland reversing the policy of “Finlandization” that went so far in preventing conflict during the Cold War. Chart 4Military Balances Stacking Up Against Russia Russia’s military options are limited. Russia has little ability to expand the war and fight on multiple fronts judging by the army’s recent performance in Ukraine and the Red Army’s performance in the Winter War of 1939. This point can be illustrated by taking the military balance of Russia and its most immediate adversaries, which add up to about half of Russian military strength even apart from NATO (Chart 4). Russian armed forces already demonstrated some pragmatism in April by withdrawing from Kyiv and focusing on more achievable war aims. Unless President Putin turns utterly reckless and the Russian state fails to restrain him, Russia will opt for defensive measures and strategic deterrence rather than a military offensive in the Baltics. Hence Russia’s military response will come in the form of threats rather than outright belligerence. However, these threats will probably include military and nuclear actions that will raise alarm bells across Europe and the United States. President Dmitri Medvedev has already warned of the permanent deployment of nuclear missiles in the Kaliningrad exclave.2 This statement points to only the most symbolic option of a range of options that will increase deterrence and elevate the fear of war. Otherwise Russia’s retaliation will consist of squeezing global energy supply, as discussed above, including by opening a new front in the Middle East and North Africa. Instability should be expected as a way of constraining Europe and distracting America. Higher energy prices may or may not convince the EU to negotiate better terms with Russia but they will sow divisions within and among the allies. Ultimately Russia is highly unlikely to sacrifice its credibility by failing to retaliate for the combination of energy embargo and NATO enlargement on its borders. Since its military options are becoming constrained (at least its rational ones), its economic and asymmetrical options will grow in importance. The result will be additional energy supply constraints. Bottom Line: Even assuming that the war does not spread beyond Ukraine – likely but not certain – global financial markets face at least one more period of military escalation with Russia. This will likely include significant energy cutoffs and saber-rattling – even nuclear threats – over NATO enlargement. China’s Political Situation Has Not Normalized China continues to suffer from a historic confluence of internal and external political risk that will cause negative surprises for investors. Temporary improvements in government policy or investor sentiment – centered on a relaxation of “Zero Covid” lockdowns in major cities and a more dovish regulatory tone against the tech giants – will likely be frustrated, at least until after a more dovish government stance can be confirmed in the wake of the twentieth national party congress in October or November this year. At that event, Chinese President Xi Jinping is likely to clinch another ten years in power and complete the transformation of China’s governance from single-party rule to single-person rule. This reversion to autocracy will generate additional market-negative developments this year. It has already embedded a permanently higher risk premium in Chinese financial assets because it increases the odds of policy mistakes, international aggression, and ultimately succession crisis. The most successful Asian states chose to democratize and expand free markets and capitalism when they reached a similar point of economic development and faced the associated sociopolitical challenges. But China is choosing the opposite path for the sake of national security. Investors have seen the decay of Russia’s economy under Putin’s autocracy and would be remiss not to upgrade the odds of similarly negative outcomes in China over the long run as a result of Xi’s autocracy, despite the many differences between the two countries. China’s situation is more difficult than that of the democratic Asian states because of its reviving strategic rivalry with the United States. US Secretary of State Antony Blinken recently unveiled President Biden’s comprehensive China policy. He affirmed that the administration views China as the US’s top strategic competitor over the long run, despite the heightened confrontation with Russia.3 The Biden administration has not eased the Trump administration’s tariffs or punitive measures on China. It is unlikely to do so during a midterm election year when protectionist dynamics prevail – especially given that the Xi administration will be in the process of reestablishing autocracy, and possibly repressing social unrest, at the very moment Americans go to the polls. Re-engagement with China is also prohibited because China is strengthening its strategic bonds with Russia. President Biden has repeatedly implied that the US would defend Taiwan in any conflict with China. These statements are presented as gaffes or mistakes but they are in fact in keeping with historical US military actions threatening counter-attack during the three historic Taiwan Strait crises. The White House quickly walks back these comments to reassure China that the US does not support Taiwanese independence or intend to trigger a war with China. The result is that the US is using Biden’s gaffe-prone personality to reemphasize the hard edge (rather than the soft edge) of the US’s policy of “strategic ambiguity” on Taiwan. US policy is still ambiguous but ambiguity includes the possibility that a president might order military action to defend Taiwan. US attempts to increase deterrence and avoid a Ukraine scenario are threatening for China, which will view the US as altering the status quo and penalizing China for Russia’s actions. Beijing resumed overflights of Taiwan’s air defense identification zone in the wake of Biden’s remarks as well as the decision of the US to send Senator Tammy Duckworth to Taiwan to discuss deeper economic and defense ties. Consider the positioning of US aircraft carrier strike groups as an indicator of the high level of strategic tensions. On January 18, 2022, as Russia amassed military forces on the Ukrainian border – and the US and NATO rejected its strategic demands – the US had only one publicly acknowledged aircraft carrier in the Mediterranean (the USS Harry Truman) whereas it had at least five US carriers in East Asia. On February 24, the day of Russia’s invasion of Ukraine, the US had at least four of these carriers in Asia. Even today the US has at least four carriers in the Pacific compared to at least two in Europe – one of which, notably, is in the Baltics to deter Russia from attacking Finland and Sweden (Map 3). The US is warning China not to take advantage of the Ukraine war by staging a surprise attack on Taiwan. Map 3Amid Ukraine War, US Deters China From Attacking Taiwan Of course, strategic tensions are perennial, whereas what investors are most concerned about is whether China can secure its economic recovery. The latest data are still disappointing. Credit growth continues to falter as the private sector struggles with a deteriorating demographic and macroeconomic outlook (Chart 5). The credit impulse has entered positive territory, when local government bonds are included, reflecting government stimulus efforts. But it is still negative when excluding local governments. And even the positive measure is unimpressive, having ticked back down in April (Chart 6). Chart 5Credit Growth Falters Amid Economic Transition Chart 6Silver Lining: Credit Impulse Less Negative Bottom Line: Further monetary and fiscal easing will come in China, a source of good news for global investors next year if coupled with a broader policy shift in favor of business, but the effects will be mixed this year due to Covid policy and domestic politics. Taken together with a European energy crunch and Middle Eastern oil supply disruptions, China’s stimulus is not a catalyst for a sustainable global equity market rally this year. South Asia: Inflation Hammers Sri Lanka And Pakistan Since 2020 we have argued that the global pandemic would result in a new wave of supply pressures and global social unrest. High inflation is blazing a trail of destruction in emerging markets, notably in South Asia, where per capita incomes are low and political institutions often fragile. Chart 7South Asia: Surging Inflation Sri Lanka has been worst affected (Chart 7). Inflation surged to an eye-watering 34% in April and is expected to rise further. Surging inflation has affected Sri Lanka disproportionately because its macroeconomic and political fundamentals were weak to begin with. The tourism-dependent Sri Lankan economy suffered a body blow from terrorist attacks in 2019 and the pandemic in 2020-21. Then 2022 saw a power struggle between Sri Lanka’s President Gotabaya Rajapaksa and members of the national assembly including Prime Minister (PM) Mahinda Rajapaksa. The crisis hit a crescendo when the country defaulted on external debt obligations last month. These events weigh on Sri Lanka’s ability to transition from a long civil war (1983-2009) to a path of sustained economic development. While the political crisis has seemingly stabilized following the appointment of new Prime Minister Ranil Wickremesinghe, we remain bearish on a strategic time horizon. This is mainly because the new PM is unlikely to bring about structural solutions for Sri Lanka’s broken economy. Moreover, Sri Lanka holds more than $50 billion of foreign debt, or 62% of GDP. Another country that has been dealing with political instability alongside high inflation in South Asia is Pakistan, where inflation hit a three-year high in April (see Chart 7 above). The latest twist in Pakistan’s never-ending cycle of political uncertainty comes from the ousted Prime Minister Imran Khan. The former PM, who commands an unusual popular support group due to his fame as a cricketer prior to entering politics, is demanding fresh elections and otherwise threatening to hold mass protests. Pakistan’s new coalition government and Prime Minister Shehbaz Sharif, who came to power amid parliamentary intrigues, are refusing elections and ultimatums. From a structural perspective Pakistan is characterized by a weak economy and an unusually influential military. Now it faces high inflation and rising food prices – indeed it is one of the countries that is most dangerously exposed to the Russia-Ukraine war as it depends on these two for over 70% of its grain imports. Bottom Line: MSCI Sri Lanka has underperformed the MSCI EM index by 58.3% this year to date. Pakistan has underperformed the same index by 41.6% over the same period. Against this backdrop, we remain strategic sellers of both bourses. Instability in these countries is also one of the factors behind our strategic assessment of India as a country with a growing domestic policy consensus. South Asia: India’s Fiscal Populism And Geopolitics Inflation is less rampant in India, although still troublesome. Consumer prices nearly jumped to an 8-year high in April (see Chart 7). With a loaded state election calendar due over the next 12-18 months, the jump in inflation naturally triggered a series of mitigating policy responses. Ban On Wheat Exports: India produces 14% of the world’s wheat and 11% of grains, and exports 5% and 7%, respectively. India’s exports could make a large profit in the context of global shortages. But Prime Minister Narendra Modi is entering into the political end of the business cycle, with key state elections due that will have an impact on the ruling party’s political standing two years before the next federal election. He fears political vulnerability if exports continue amid price pressures at home. The emphasis on food security is typical but also bespeaks a lack of commitment to economic reform. Chart 8India's Real Interest Rates Fall Surprise Rate Hikes: The Reserve Bank of India (RBI) increased the policy repo rate by 40 basis points at an unscheduled meeting on May 4, thereby implementing its first rate hike since August 2018. With real rates in India lower than those in China or Brazil (Chart 8), the RBI will be forced to expedite its planned rate hikes through 2022. Tax Cuts On Fuel: India’s central government also announced steep cuts in excise duty on fuel. This is another populist measure that reduces political pressures but fails to encourage the private sector to adjust. These measures will help rein in inflation but the rate hikes will weigh on economic growth while the tax cuts will add to India’s fiscal deficit. Indeed, India is resorting to fiscal populism with key state elections looming. Geopolitical risk is less of a concern for India – indeed the Ukraine war has strengthened its bargaining position. In the short run, India benefits from the ability to buy arms and especially cheap oil from Russia while the EU imposes an embargo. But over the long run its economy and security can be strengthened by greater interest from the US and its allies, recently highlighted by the fourth meeting of the Quadrilateral Security Dialogue (Quad) and the launch of the US’s Indo-Pacific Economic Framework (IPEF). These initiatives are modest but they highlight the US’s need to replace China with India and ASEAN over time, a trend that no US administration can reverse now because of the emerging Russo-Chinese strategic alliance. At the same time, the Quad underscores India’s maritime interests and hence the security benefits India can gain from aligning its economy and navy with the other democracies. Bottom Line: Fiscal populism in the context of high commodity prices is negative for Indian equities. However, our views on Russia, the Middle East, and China all point to a sharper short-term spike in commodity prices that ultimately drives the world economy deeper into stagflation or recession. Therefore we are booking a 22.5% profit on our tactical decision to go long Brazilian financials relative to Indian equities. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Chart 9Russia: GeoRisk Indicator Chart 10Other Measures Of Russian Geopolitical Risk Chart 11China: GeoRisk Indicator Chart 12United Kingdom: GeoRisk Indicator Chart 13Germany: GeoRisk Indicator Chart 14France: GeoRisk Indicator Chart 15Italy: GeoRisk Indicator Chart 16Canada: GeoRisk Indicator Chart 17Spain: GeoRisk Indicator Chart 18Australia: GeoRisk Indicator Chart 19Taiwan: GeoRisk Indicator Chart 20Korea: GeoRisk Indicator Chart 21Turkey: GeoRisk Indicator Chart 22South Africa: GeoRisk Indicator Chart 23Brazil: GeoRisk Indicator Footnotes 1 Recent diplomatic flaps between core European leaders and Ukrainian President Volodymyr Zelensky reflect Ukraine’s fear that Europe will negotiate a “separate peace” with Russia, i.e. accept Russian territorial conquests in exchange for economic relief. 2 Dmitri Medvedev explicitly states ‘there can be no more talk of any nuclear-free status for the Baltic - the balance must be restored’ in warning Finland and Sweden joining NATO. Medvedev is suggesting that nuclear weapons will be placed in this area where Russia has its Kaliningrad exclave sandwiched between Poland and Lithuania. Guy Faulconbridge, ‘Russia warns of nuclear, hypersonic deployment if Sweden and Finland join NATO’, April 14, 2022, Reuters. 3 See Antony J Blinken, Secretary of State, ‘The Administration’s Approach to the People’s Republic of China’, The George Washington University, Washington D.C., May 26, 2022, state.gov. Additionally, see President Joe Biden’s remarks on China and getting involved military to defend Taiwan in a joint press conference with Japan’s Prime Minister Kishida Fumio. ‘Remarks by President Biden and Prime Minister Kishida Fumio of Japan in Joint Press Conference’, Akasaka Palace, Tokyo, Japan, May 23, 2022, whitehouse.gov. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar
Executive Summary Allies Still Have Faith In USD The Biden administration’s use of sanctions has prompted market speculation about the longevity of the dollar. Yet the DXY has hit 100 and could break out, in the context of rising interest rates and safe-haven demand. The US’s increasingly frequent recourse to economic sanctions is a sign of growing foreign policy challenges. US rivals will continue to diversify away from dollar-denominated reserves. However, from a big picture point of view, there is no clear case that the dollar suffers from US sanctions. When global growth reaccelerates, the dollar can weaken. But until then it will remain resilient. Recommendation (Tactical) Inception Level Inception Date Return Long DXY 96.19 23-FEB-22 5.8% Bottom Line: Tactically stay long DXY and defensives over cyclicals. Feature The US’s aggressive use of sanctions against Russia, in response to its invasion of Ukraine, has prompted market speculation about the future of the global financial and monetary system. Related Report US Political StrategyBiden's Foreign Policy And The Midterms It is helpful to begin with facts – what we really know – before launching into grandiose predictions for the future. For example, while some analysts are predicting the demise of the US dollar’s position as the leading reserve currency, so far global investors have bid up the dollar in the face of rising policy uncertainty (Chart 1). In this report we conduct a short overview of US sanctions policy and draw a few simple investment conclusions. Chart 1US Political Risk And The Dollar US Extra-Territorialism Not Yet Hurting The USD The DXY is now trading at 101.2, above the psychological threshold of 100, suggesting that it could break out above its 2016 102.2 peak. The drivers are an expected sharp rise in real interest rates, in both absolute and relative terms, as the Federal Reserve starts on a rate hike cycle that is expected to add 225 basis points to the Fed funds rate this year alone to combat core inflation of 6.5%. This monetary backdrop must be combined with extreme global political and economic instability to explain the dollar’s potential breakout. The global situation is growing less stable, as EU-Russia energy trade breaks down while China imposes lockdowns to stop the spread of Covid-19. Over the past twenty years, the US has struggled to maintain its global leadership. Washington became distracted by wars in the Middle East and South Asia, a national property market crash and financial crisis, and a spike in political polarization and populism. The US public grew war-weary, while the US faced growing challenges from large and powerful nations that it could not confront militarily. Therefore US policymakers turned to economic tools to try to achieve their objectives: namely sanctions but also tariffs and export controls. Many economists and political scientists have warned that the US’s expanding use of economic sanctions – and broader trend of international, extra-territorial, law enforcement – would drive other countries to sell the US dollar and buy other assets, so as to reduce their vulnerability to US tools. This reasoning is sound, as we can see with Russia, which has reduced its dollar-denominated foreign exchange reserves from 41% to 16% since 2016, while increasing its gold holdings from 15% to 22% over the same period. Other major countries vulnerable to US sanctions could follow in Russia’s footsteps. However, so far, the dollar is not suffering excessively from such moves. On the contrary it is rising. The US started using sanctions aggressively with North Korea in 2005, Iran in 2010, and Russia since 2012. The dollar has fluctuated based on other factors, namely rising when the global commodity and industrial cycle was falling (Chart 2). Chart 2TWUSD And DXY Since 2000 Sanctions are a limited prism through which to examine the dollar. But if there is any observable effect of the US’s turn toward sanctions against major players like Russia in 2012 and China in 2018, it is that it has boosted the dollar rather than hurt it. Obviously that trend could change someday. But for now, as the Ukraine war dramatically heightens the US struggle with its rivals, investors should observe that the dollar is on the verge of a breakout. If the dollar continues to rise, it suggests that the US’s structural turn toward more aggressive economic and financial sanctions is not negative for the dollar. It may be neutral or positive. Cyclically the trade-weighted dollar is nowhere near its 2020 peak and could still fall short of that peak, especially if global tensions subside. But the collapse in the euro has caused the DXY to break above its 2020 peak already. Bottom Line: Stay tactically long DXY while watching whether it can break sustainably above 100 to determine whether our cyclically neutral view should be upgraded. US Sanctions On North Korea In this century, the US began to turn more aggressive in its use of sanctions when it confronted the “Axis of Evil” following the terrorist attacks on September 11, 2001. North Korea withdrew from the Nuclear Non-Proliferation Treaty in 2003 and began to pursue a nuclear and ballistic missile program more intently. The US responded by levying serious sanctions on that state beginning in 2005. Gradually tougher US sanctions never caused a change in the North Korean regime or foreign policy. On the contrary North Korea achieved nuclear weaponization and is today outlining an expansive nuclear doctrine. US sanctions on North Korea were never going to drive global macro trends. However, they could have had an impact on South Korean trends. Initially none of the US sanctions reversed the dollar’s decline against the Korean won. After the global financial crisis in 2008, when the dollar began an uptrend against the won, we observe periods of significant new sanctions in which the won rises and the dollar falls (Chart 3, top panel). The same can be said for the outperformance of US equities relative to South Korean equities – if sanctions had any impact, they simply reinforced the flight to US assets in a globally disinflationary context. The trend was mirrored within the US equity market by the rise of tech versus industrials (Chart 3, bottom panel). Chart 3US Sanctions On North Korea Since Covid-19, the outperformance of US tech is now being overturned by high inflation, which has triggered a vicious selloff in tech. In 2022, global growth is slowing, stagflation is taking shape, and the odds of a recession are rising. Stagflation is negative for both industrials and tech, but more so tech. However, South Korea is still suffering from a deteriorating global macro and geopolitical backdrop, as globalization falters, US-China competition rises, and the US fails to contain North Korean ambitions. Sanctions are a symptom rather than a cause. Bottom Line: US sanctions on North Korea pose no threat to the US dollar. Tactically US industrials can continue to outperform tech but both sectors will suffer in a stagflationary context. US Sanctions On Venezuela The US has slapped sanctions on Venezuela since the early 2000s but these sanctions kicked into high gear in 2015 after President Nicolas Maduro took power and eliminated the last vestiges of democratic and constitutional order. The US recognized the opposition as the legitimate government so sanctions relief will not be easy or convenient. Sanctions have not changed the regime’s behavior, but the regime has all but collapsed and major changes could happen sooner than people expect. Moreover any short-term sanction relief prompted by high oil prices will not be sustainable: the Republican Party will oppose it, hence private US corporations will doubt its durability, and Venezuela’s failing oil industry cannot be revived quickly anyway (Chart 4, top panel). The US has strong relations with Venezuela’s neighbor Colombia. Yet Colombia faces the greatest economic and security risks from Venezuelan instability. The US dollar vastly outstripped the Colombian peso over the past decade, consistent with the US energy sector’s underperformance (Chart 4, bottom panel). Chart 4US Sanctions On Venezuela With Covid-19, this trend reversed because of the global energy squeeze and inflationary environment. The implication was positive for the Colombian peso as well as global (and US) energy sector relative performance. But the peso only marginally improved against the dollar, while US energy outperformance is now stretched. Bottom Line: Energy sector still enjoys macro tailwinds but it is no longer clear that US energy stocks will outperform the broad market for much longer. Favor energy by staying long US energy small caps versus large caps. Also stay long oil and gas transportation and storage sub-sector relative to the broad market. The Biden administration is unlikely to give sanction relief to Venezuela. If it does, it will be ineffective at reducing oil prices in the short term. Either way, there will be little impact on the US dollar. US Sanctions On Iran US policy toward Iran is critical to global stability and energy prices in 2022 and the coming years. US sanctions did not change Iran’s behavior alone, but in league with the P5+1 (the UK, France, China, Russia, plus Germany) sanctions forced Iran to accept limit on its nuclear program in 2015. However, the Trump administration withdrew from that agreement and imposed “maximum pressure” sanctions on Iran in 2018, leading to a sharp depreciation in the market exchange rate of the Iranian toman (Chart 5, top panel). The Saudi Arabian riyal, by contrast, is pegged to the dollar and remains steady except when oil prices collapse (Chart 5, middle panel). The Saudis still rely on the Americans for national security so they are unlikely to abandon the dollar, though they may marginally diversify their foreign exchange reserves. The Biden administration wants to rejoin the 2015 deal but first is trying to extract concessions from Iran. Iran feels limited pressure: while its currency is still weak and inflation high, Iran has not succumbed to social unrest. Iranian oil production and exports are rising amid global high prices (Chart 5, bottom panel). Ultimately Iran wants to continue to advance its nuclear program in line with the North Korean strategy. Hence Biden can rejoin the deal unilaterally if he wants to avoid Middle Eastern instability ahead of the midterm elections. But it would be a short-term, stop-gap agreement and the reduction in oil prices would be fleeting. By contrast, if Biden fails to lift Iran’s sanctions, then the risk of oil disruptions from the Middle East goes way up. Tactically investors should expect upside risks to the oil price, but that would kill more demand and weigh on global growth. Over the past decade the outperformance of US equities relative to Saudi and Emirati equities falls in line with the outperformance of US tech relative to energy sectors. As mentioned, this trend has largely run its course, although it can go further in the short run. But there is a broader trend related to growth versus value styles. The UAE’s stock market is heavily weighted toward financials, while the US is heavily weighted toward tech. The US tech sector has collapsed relative to financials (Chart 6). Chart 5US Sanctions On Iran Chart 6US Sanctions On Iran Bottom Line: US energy and financials sectors can fare reasonably well in a stagflationary context but their outperformance relative to tech is largely priced from a cyclical point of view. US maximum pressure sanctions on Iran never hurt the US dollar. US Sanctions On Russia The US’s extraordinary sanctions against Russia in 2022 – including freezing its dollar-denominated foreign exchange reserves – have sparked market fears that countries will divest from US dollars to protect themselves from any future US sanctions. To be clear, the US has confiscated foreign enemies’ property and foreign exchange reserves in the past. True, Russia is qualitatively different from other countries, such as Iran, because it is one of the world’s great powers. Yet the US closed off all economic and financial linkages with Russia from 1949-1991 because of the Cold War, the very period when the US dollar rose to prominence as the global reserve currency. In 2022, sanctions on Russia have primarily hurt the Russian ruble, not the US dollar (Chart 7). The Russians divested from the dollar after invading Ukraine in 2014 to reduce the impact of sanctions. But they were not able to divest fast enough to prevent the 2022 sanctions from pummeling their financial system and economy. Chart 7US Sanctions On Russia Going forward Russia will be much more insulated from the US dollar but at a terrible cost to long-term productivity. The lesson for other US rivals may be to diversify away from the dollar – but that will be a secondary lesson. The primary lesson will be to take economic stability into account when making strategic security decisions. Economic stability requires ongoing engagement in the global financial system and US dollar system. US sanctions on Russia have benefited US equities and dollar relative to Russian assets as one would expect. Russia’s invasion of Ukraine exacerbated the trend. The takeaway for US investors is that the energy sector’s outperformance sector’s outperformance can continue in the short run but is becoming stretched from a cyclical perspective. Bottom Line: Investors should expect oil and the energy sector to remain strong in the short run, while tech will suffer in an inflationary and stagflationary environment. But energy may not outperform tech for much longer. US Sanctions On China US policy toward China is the critical question today. China holds $1 trillion in dollar-denominated exchange reserves and must recycle around $200 billion in current account surpluses every year into global assets. The US has imposed sweeping sanctions on Iran since 2010, Russia since 2012, and China since 2018. China began diversifying away from dollar-denominated foreign exchange reserves in 2011 in the wake of the Great Recession. The US-initiated trade war in 2018 solidified the change in China’s foreign reserve strategy. The US sanctions against Russia will further solidify it. There are some signs that US punitive measures affected the USD-CNY exchange rate but global economic cycles are far more powerful. The yuan appreciated from 2005 until the global financial crisis, during the height of US-China economic and diplomatic engagement. It depreciated through the manufacturing slowdown of 2015 and the US-China trade war. It appreciated again with the pandemic stimulus and global trade rebound. The yuan was affected by US sanctions and tariffs on the margin amid these larger macro swings (Chart 8, top panel). Still, the overarching trend since 2014 points to a rising dollar and falling yuan. Globalization is in retreat and US-China strategic competition is heating up. As with South Korea, these trends are negative for Chinese assets. US sanctions are a symptom rather than a cause of the underlying macro and geopolitical dynamics. The same point can be made with regard to US equity performance relative to Chinese – and hence US tech outperformance relative to US industrial stocks (Chart 8, bottom panel). However, as with Korea, the cyclical takeaway is to favor industrials over technology in a stagflationary environment. Chart 8US Sanctions On China Bottom Line: Tactically favor US industrials over tech until the world’s stagflationary trajectory is corrected. US-China relations are one area where US sanction policy can hurt the dollar, as China will seek to diversify over time. But so far the evidence is scant. US Sanctions And Foreign Holdings Of Treasuries Having examined US sanctions on a country-by-country basis, we should now turn toward holdings of US dollars and Treasury securities. Are US economic sanctions jeopardizing the willingness of states to hold US assets? First, Americans hold 74% of outstanding treasuries. Foreigners hold the remaining 26% (Chart 9, top panel). This is a large degree of foreign ownership that reflects the US’s openness as an economy, as well as the size of the treasury market, which makes it attractive to foreign savers who need a place to store their wealth. Of this 26%, defense allies hold about 36%. Theoretically up to 17% of treasuries stand at risk of rapid liquidation by non-allied states afraid of US sanctions. But a conservative estimate would be 6%. Notably the share of foreign-held treasuries held by non-allies has fallen from 40% in 2009 to 23% today. Non-allies are reducing their share fairly rapidly (Chart 9, middle panel). What this really means is that China and Hong Kong are reducing their share – from 26% in 2008 to 16% today. Brazil and India have maintained a steady 6% of foreign-held treasuries. Notably the offshore financial centers see a growing share, suggesting that trust in the dollar remains strong even among states and entities that wish to hide their identity. Some of the divestment that has occurred from non-allied states may be overstated due to rerouting through these third parties. Looking at the data in absolute terms, only China – and arguably Brazil – can be said with any certainty to be pursuing a dedicated policy of divesting from US dollar reserves (Chart 10). This makes sense, as China, like Russia, is engaged in geopolitical competition with the US and therefore must take precautions against future US punitive measures. But these measures are not so far generating a worldwide flight from the dollar, either at the micro level or the macro level. Chart 9Foreign Purchases Of US Treasuries Chart 10Foreigners With Large Treasury Holdings In fact, the biggest competitor to the US dollar is the euro. This is clear from looking at the share of global currency reserves – the two are inversely proportional (Chart 11). And yet it is the European Union, not the US, that could suffer a long-term loss of security, productivity, and stability as a result of Russia’s invasion of Ukraine. The euro is losing status as a reserve currency and the war could exacerbate that trend. Chart 11Global Reserve Currency Basket Europe does not provide protection from US sanctions. The EU, like the US, utilizes economic sanctions and the two entities share many similar foreign policy objectives. Europe is also allied with the US through NATO. When the US withdrew from the Iran nuclear deal, the EU did not withdraw, yet EU entities enforced the sanctions, as their economic linkages with the US were much more valuable than those with Iran. In the case of Russia, the two have imposed sanctions in league, as they will likely do toward other small or great powers that attempt to reshape the global order through military force. The next competitors to the dollar and euro are grouped together in Chart 11 above because they are the US’s “maritime allies,” such as Japan, the United Kingdom, and Australia. These countries will pursue a similar foreign policy to the United States and they do not offer protection from US sanctions during times of conflict or war. The true competitor is the Chinese renminbi. The renminbi will grow as a share of global reserves. But it faces serious obstacles from China’s economic policy, currency controls, closed capital account, and geopolitical competition with the United States. Washington’s sanctions have already targeted China yet the US dollar has remained resilient. Bottom Line: The US’s erratic foreign policy in recent decades has potentially weighed on the US’s commanding position as a global reserve currency, with its share of reserves falling from 71% in 2000 to 59% today. But US allies have mostly picked up the slack. And the dollar’s top competitor, the euro, is likely to suffer more than the dollar from the Ukraine war. Still it is true that US sanctions are alienating China, which will continue to diversify away from the dollar. Investment Takeaways Tactically stay long the US dollar (DXY). The combination of monetary policy tightening and foreign policy challenges is driving a dollar rally that could result in a breakout. US sanctions policy is not a convincing reason to sell the dollar in today’s context. Over the medium term dollar diversification poses a risk, although the dollar will still remain the single largest reserve currency over a long-term, strategic horizon. For further discussion see the Special Report by our Foreign Exchange Strategy and Geopolitical Strategy, “Is The Dollar’s Reserve Status Under Threat?” Given US domestic policy uncertainty in an election year, and foreign policy challenges, stay long defensive sectors, namely health care, over cyclical sectors. Tactically our renewable energy trade has dropped sharply. But cyclically it remains attractive, as our recent Special Report with our US Equity Strategy team demonstrates. If Congress fails to succeed in promoting its new climate and energy bill, then this trade could suffer bad news in the near term. Tactically US industrials can continue to outperform the tech sector, given the stagflationary context that is developing. Energy’s outperformance, especially relative to tech, is becoming stretched, at least from a cyclical point of view. But geopolitical trends suggest oil risks are still to the upside tactically. For now, maintain exposure to high energy prices by staying long energy small caps versus large caps and O&G transportation and storage. Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets