戦争/紛争
Highlights So What? Tariffs and currency depreciation will likely lead to military saber-rattling in Asia Pacific. Why? President Trump is not immune to the market’s reaction to his trade war escalation. Yet China’s currency depreciation is a major escalation and the near-term remains fraught with danger for investors. Military shows of force and provocations could crop up across Asia Pacific, further battering sentiment or delaying trade talks. Remain short CNY-USD, short the Hang Seng index, long JPY-USD, and long gold. Overweight the U.S. defense sector relative to global stocks. Feature The Osaka G20 tariff ceasefire has collapsed; U.S. President Donald Trump is threatening tariffs on all Chinese imports; the People’s Bank of China has allowed the renminbi to depreciate beneath the important 7.0 exchange rate to the dollar; and the United States has formally labeled China a “currency manipulator.” What a week! The spike in volatility is likely to be accompanied by a rise in credit risk, as measured by the TED spread (Chart 1). Safe havens like gold, treasuries, and the Japanese yen are rallying in a classic risk-off episode, while messengers of global growth like copper, the Australian dollar, and the CRB raw industrials index are stumbling (Chart 2). Only green shoots in Chinese trade and German manufacturing have kept the selloff in check this week by improving the cyclical outlook despite elevated near-term risks. Chart 1So Much For The Osaka G20 Tariff Ceasefire! Chart 2Key Risk-On/Risk-Off Indicators Breaking Down While we anticipated the re-escalation of U.S.-China tensions, now is the time to take stock and reassess. President Trump is a political animal. While he has demonstrated a voracious risk appetite throughout the year, he is ultimately focused on reelection in November 2020. The United States will survive without a trade deal by then, but Trump may not. Presumably, Trump’s reason for increasing pressure on China throughout 2019 is to secure a deal by the end of the year. This would be to see China’s concessions translate into trade perks for the U.S. markets and economy in 2020 by the time he hits the campaign trail. The experience of Q4 2018 suggests that Trump changed his negotiating tack after U.S. equities fell by only 4% from their peak – but we consider an equity correction a clear pain threshold (Chart 3). Trump is closely associated with the economic fortunes of the country, even more so than the average president. Bear markets tend to coincide with recessions. Trump – beset by controversy and scandal at home – must assume that a recession will be the coup de grâce. Chart 3Where Is President Trump's Pain Threshold? Chart 4Will Huawei Ban Hit The Tech Sectors? Investors will get some clarity next week when the Commerce Department decides whether to renew the general temporary license for American companies to trade with Chinese telecoms giant Huawei. A full denial of the license would signal that Trump is unconcerned with recession and reelection probabilities and focusing exclusively on the national security threat from China. It would send technology sectors and the broader equity market into a plunge on both sides of the Pacific (Chart 4) and could significantly increase the risk that the global economy begins a downturn. Positive signals are scarce as we go to press: New tariff is on track: The U.S. Trade Representative is preparing a final list of $300 billion in goods to fall under a new 10% tariff, despite reports that Trump overrode USTR Robert Lighthizer in announcing the new tariff. This does not guarantee that the tariff will go into effect on September 1 but it does make it more likely than not. Huawei is under pressure: Office of Management and Budget has disqualified Huawei from any U.S. government contracts as of August 13 – a ban to be extended to any third parties contracting Huawei as of the same date next year. This is not encouraging for Huawei but it is a separate and more limited determination from that of the Commerce Department. Still, we expect the Trump administration to take some moves to offset the ongoing trade escalation. While we are inclined to think the new tariff will take effect, Huawei will likely get a reprieve in the meantime. This will help to ensure that the September trade talks in Washington, DC go forward. The administration has an interest in keeping the trade negotiations alive. Furthermore, there is some evidence that President Trump is recognizing the need to calm other “trade wars” to mitigate the impact of the central China trade war. In September the administration will attempt ratification of the USMCA in Congress – we still think this is slightly favored to go through. We also expect a U.S.-Japan trade agreement to materialize rapidly – likely at the UN General Assembly from September 17-30. Another positive sign is that the European Union has agreed to expand beef imports from the United States. Real movement on agriculture, while China cancels U.S. ag imports, implies that President Trump is less likely to impose car tariffs on Europe for national security reasons on November 13-14.1 The problem is that the fallout from China’s currency depreciation and the new tariffs will hit the market before anything else, which means we remain tactically bearish. Heightened trade tensions are also likely to spill into the strategic sphere in the near term. Saber-rattling – military shows of force and provocations – will increase the geopolitical risk premium across the globe, especially in East Asia. A frightening U.S.-China clash may ultimately encourage real compromises in the trade negotiations, but the market would get the negative news first. If Washington does not make any reassuring moves but expands the current policy assault on China – including through a Huawei ban – then we will consider shifting to a defensive posture cyclically as well as tactically. Bottom Line: We recognize that President Trump may be forced by the risk of a recession to relax the trade pressure and accept some kind of China deal – we may upgrade this 40% chance if and when the U.S. veers toward an equity bear market. In the meantime we expect further negative fallout from the past week’s aggressive maneuvers by both sides. Currency War Assuming that an equity correction is inevitable at some point and that Trump goes crawling back to the Chinese for trade talks: How will they respond? Will Xi Jinping, the strongman general secretary of a resurgent Communist Party, return to talks and reassure global markets at Trump’s beck and call? Or will he refuse, let the market do what it will, and let Trump hang? By letting the currency drop … Beijing is expressing open defiance. The renminbi’s depreciation – through PBoC inaction on August 5, then through action on August 8 – is a warning that Trump is approaching the point of no return. His initial grievance has always been Chinese “currency manipulation” but until now he has refrained from formally leveling this accusation (only using it on Twitter). By letting the currency drop well beneath the level at which Trump was inaugurated (6.8 CNY-USD), and beyond the global psychological threshold, Beijing is expressing open defiance and threatening essentially to break off negotiations. Chart 5China Sends Warning Via Currency Depreciation The effect of continued depreciation would be to offset the effect of tariffs and ease financial conditions in China. This is fully in keeping with our view that China has opted for stimulus over reform this year. China is likely to follow up with further cuts to banks’ reserve requirement ratios and a cut to the benchmark policy interest rate (Chart 5). The July Politburo statement showed a greater willingness to stimulate the economy and it occurred prior to Trump’s new volley of tariffs. Currency appreciation is the surest way to rebalance China’s economy toward household consumption and obviate a strategic conflict with the United States. By contrast, yuan depreciation will exacerbate the U.S. trade deficit and give Trump’s Democratic rivals convenient evidence that the “Art of the Deal” is counterfeit. How far will the renminbi fall? Chart 6 updates our back-of-the-envelope calculation of the implication from different tariff scenarios assuming that the equilibrium bilateral exchange rate depreciation will equal the tariffs collected as a share of total exports to the United States. (10% tariff on $259 billion = $25.9 billion, which is 5% of $509 billion total.) The yuan is now approaching Scenario D, 25% tariffs on the first half of imports and 10% on the second half, which points toward 7.6 CNY-USD. There are reasons to believe that this simple framework won’t apply, at least in terms of the magnitude of the impact, but it gives an indication of considerable downward pressure. Chart 6The Yuan Will Fall, But Not Freely Chester Ntonifor of our Foreign Exchange Strategy sees the yuan falling to around 7.3-7.4 if the new tariffs are applied based on the fact that the 25% tariff on $250 billion worth of goods produced a roughly 10% decline in the bilateral exchange rate. Our Emerging Markets Strategy also expects about a 5% drop in the CNY-USD. Having tightened capital controls during the last bout of depreciation in 2015-16, China is probably capable of controlling the pace of depreciation, preventing capital outflows from becoming a torrent, by selling foreign exchange reserves, further tightening capital controls, or utilizing foreign currency forward swaps. But Asian currencies, global trade revenues in dollars, and EM currencies and risk assets will suffer – and they have more room to break down from current levels.2 Meanwhile even a modest drop in the renminbi – amid a return to dovish monetary policy in global central banks – has revived concerns about a global currency war. A rising dollar is anathema to President Trump, who aims to reduce the trade deficit, encourage the on-shoring of manufacturing, and maintain easy financial conditions for the U.S. economy. Table 1U.S. Demands On China In Trade Talks Chart 7U.S. Allies' Share Of Treasuries Rises Trump’s decision to slap a sweeping new tariff on China – reportedly at the objection of all of his trade advisers except the ultra-hawkish Peter Navarro (Table 1) – was at least partly driven by his desire to see the Fed cut rates beyond the 25 basis point cut on July 31 and weaken the dollar. Yet the escalation of the trade war weighs on global trade and growth, which will push the dollar up. This reinforces the above argument that Trump will probably seek to offset the recent trade war escalation with some mitigating moves. Beyond inducing the Fed to cut further, it is difficult for President Trump to drive the dollar down. The Treasury Department can intervene in foreign exchange markets, but direct intervention does not have a successful track record. Interventions usually have to be sterilized (expansion of the money supply externally must be addressed at home by mopping up the new liquidity), which in the context of free-moving global capital means that any depreciation will be short-lived. An unsterilized intervention would be extremely unorthodox and is unlikely short of a major crisis and breakdown in institutional independence. The U.S. could attempt to engineer an internationally coordinated currency intervention, as we have highlighted in the past. But it is highly unlikely to succeed this time around. The U.S. is less dominant of a military and economic power than it was when it orchestrated the Smithsonian Agreement of 1971 and the Plaza Accord of 1985. Neither the European nor the Japanese economies are in a position to tighten monetary policy or financial conditions through currency appreciation. While China weans itself off treasuries, U.S. allies and others fill the void. Indeed, after a long period in which American allies declined as a share total holders of treasuries – as China and emerging markets increased their forex reserves and treasury holdings momentously – allies are now taking a greater share (Chart 7). Chart 8China Diversifies While It Depreciates China is driving down the yuan not by buying more treasuries but by buying other things – diversifying away from the USD into alternative reserve currencies and hard assets, such as gold and resources tied to the Belt and Road Initiative (Chart 8). As trade, globalization, and global growth have slowed down, and as China’s growth model and the U.S.-China special relationship expire, global dollar liquidity is shrinking. Dollar liquidity is the lifeblood of the global financial system and the consequence is to tighten financial conditions, including via equity markets (Chart 9). The solution would be a trade deal in which China agrees to reforms to pacify the U.S., including an appreciation renminbi, while the U.S. abandons tariffs, enabling global trade, growth, commodity prices, and dollar liquidity to recover. Yet China was never likely to agree to a new Plaza Accord because it is delaying reform to its economy in order to maintain overall political stability – and the financial turmoil of 2015-16 only hardened this position. Chart 9Dollar Liquidity A Risk To Global Equities Moreover Japan in 1985 was already a subordinate ally and had a security guarantee from the United States that was not in question. By contrast, China today is asserting its “equality” as a nation with the U.S., and has no guarantee that Americans are not demanding economic reforms so as to debilitate China’s political stability and strategic capability. After tariffs and currency war comes saber-rattling. Comparing China to Japan in the decades leading up to the Plaza Accord shows how remote of a possibility this solution is: China’s currency has been moving in precisely the opposite direction (Chart 10). Chart 10So Much For Plaza Accord 2.0 The Plaza Accord is a useful analogy for another reason: it marked the peak in Japanese market share in the U.S. economy. In Japan’s case, currency appreciation was the primary mover, while Japan also relocated production to the United States. Chart 11The Real Analogy With The Plaza Accord In China’s case, if currency appreciation is ruled out and production is not relocated due to a failure to secure a trade agreement, then U.S. protectionism will remain the primary means of capping China’s share of the market (Chart 11). The dollar will remain strong and this will continue to weigh on global markets. Bottom Line: China’s recent currency depreciation is a warning signal to the U.S. that the trade negotiations could be broken off. There is further downside if the U.S. implements the new tariffs or hikes tariff rates further. The renminbi is unlikely to enter a freefall, however, because China maintains tight capital controls and is stimulating its economy. It is doubtful that the Trump administration can engineer a depreciation of the dollar through a multilateral agreement. It lacks the geopolitical heft of the 1970s-80s, and it does not have a strategic understanding with China that would enable Beijing to make the same degree of concessions that Tokyo made in 1985. Saber-Rattling After tariffs and currency depreciation, the next likeliest manifestation of strategic tensions lies in the military sphere. While the U.S. threatens to cut off Chinese tech companies like Huawei, Beijing has signaled that countermeasures would include an embargo on U.S. imports of rare earth elements and products.3 When China implemented a partial rare earth export ban on Japan (Chart 12), the context was a maritime-territorial dispute in the East China Sea in which military and strategic tensions were also escalating. The threat to industry only amplified these tensions. There are several locations in East Asia where conditions are ripe for clashes and incidents that could add to negative global sentiment. Indeed, saber-rattling has already begun in Hong Kong, Taiwan, the Koreas, and the East and South China Seas. The following areas are the most likely to darken the outlook for U.S.-China negotiations: Direct U.S.-China tensions: The U.S. and China have experienced several minor clashes since the beginning of the Trump administration. The near-collision of a Chinese warship with the USS Decatur occurred in October 2018, after the implementation of the first sweeping tariff on $200 billion worth of goods – a period of tensions very similar to that of today.4 October 1 marks the 70th anniversary of the People’s Republic of China, an event that will be marked by outpourings of nationalism and a flamboyant military parade displaying advanced new weapons. The government in Beijing will be extremely sensitive in the lead-up to this anniversary, leading to tight domestic controls of news and media, hawkish rhetoric, and the potential for provocations on the high seas. Hong Kong and Taiwan: Chinese officials, including the People’s Liberation Army garrison commander in Hong Kong, the director of the Office of Hong Kong and Macao Affairs, and the city’s embattled Chief Executive Carrie Lam have warned in various ways that if unrest spirals out of control, it could result in mainland China’s intervention. A large-scale police exercise in Shenzhen, Guangdong, just across the water, has highlighted Beijing’s willingness to take forceful action. The deployment of mainland troops would likely lead to casualties and could trigger sanctions from western countries that would have common cause on this issue. The Tiananmen Square incident shows that such an event could lead to a non-negligible hit to domestic demand and foreign exports under sanctions (Chart 13). Hong Kong is obviously a much smaller share of total exports to China these days, but when combined with Taiwan – where there could also be a hit to sentiment from Hong Kong unrest and possibly separate economic sanctions – the impact could be substantial (Chart 14). Chart 13Mainland Intervention In Hong Kong Could Prompt Sanctions Chart 14HK/Taiwan A Significant Share Of Greater China Trade Why would Taiwan get worse as a result of Hong Kong? Unrest in Hong Kong has already galvanized opposition to the mainland’s policies in Taiwan, where the presidential election polling has shifted in incumbent President Tsai Ing-wen’s favor (Chart 15). Beijing has imposed new travel restrictions and held a number of intimidating military exercises, while the U.S. has increased freedom of navigation operations in the Taiwan Strait. These trends could worsen over the next year. Japan and the East China Sea: Japan’s top military official – General Koji Yamazaki – recently warned that Chinese military intrusions are increasing around the disputed Senkaku (Diaoyu) islands in the East China Sea. He called particular attention to China’s change of the Coast Guard from civilian to military control, which he said posed new risks of escalation in disputed waters. Japan itself may have an interest in a more confrontational stance over the coming year. The Japanese government has seen a rise in public opposition to its plan to revise the constitution to enshrine the Self-Defense Forces and thus move toward a more “normal” Japanese military and security posture (Chart 16). A revival of trouble in the South China Sea: China has not reduced its assertive foreign policy in order to win regional allies amid its conflict with the United States. On the contrary, it has continued asserting itself to the point of alienating governments that have largely sought to warm up to the Xi administration, including both Vietnam and the Philippines. The Vietnamese have engaged in a month-long standoff over alleged Chinese encroachments in its Exclusive Economic Zone. And a clash near Sandy Cay in the Spratly Islands is forcing Philippine President Rodrigo Duterte, who has otherwise avoided confrontation with China, to address President Xi over the international court decision in 2016 that ruled out China’s claims of sovereignty over the disputed islands. The South China Sea is important because it is a vital supply line for all of the countries in the region. Even if the United States washed its hands of Beijing’s efforts to control the sea lanes, U.S. allies would still face a security threat that would drive tensions in these waters. This is a formidable group of Asian nations that China fears will seek to undermine it (Chart 17). And of course the Americans are not washing their hands of the region but actually reasserting their interest in maintaining a western Pacific defense perimeter. The Korean peninsula: North Korea has resumed testing short-range missiles, causing another hiccup in U.S. attempts at diplomacy (Chart 18). These tensions have the potential to flare as the U.S.-China trade talks deteriorate, since Beijing has offered cooperation on North Korea’s missile and nuclear program as a concession. Chart 17U.S. Asian Allies Formidable Chart 18North Korean Provocations Still Low-Level Ultimately North Korea needs to be part of the U.S.-China solution, so as long as tensions rise it sends a negative signal regarding the status of talks. And vice versa. South Korea is another case in which China is not reducing its foreign policy aggressiveness in order to win friends. On July 23, a combined Russo-Chinese bomber exercise over the disputed Dokdo (Takeshima) islands in the Sea of Japan led to interception by both Korean and Japanese fighter jets and the firing of hundreds of warning shots. The incident reveals that South Korean President Moon Jae-in is not seeing an improvement in relations with these countries despite his more pro-China orientation and his attempt to engage with North Korea. It also shows that while South Korea’s trade spat with Japan can persist for some time, it may take a back seat to these rising security challenges. As long as North Korean tensions rise it sends a negative signal regarding U.S.-China talks. Chart 19Russia May Need To Distract From Domestic Unrest Russia, like China, is feeling immense domestic political pressure, including large protests, that may result in greater foreign policy aggression (Chart 19). And as China and Russia tighten their informal alliance in the face of a more aggressive U.S., American allies face new operational pressures and the potential for geopolitical crises will rise. Bottom Line: The whole panoply of East Asian geopolitical risks is heating up as U.S.-China tensions escalate. While the U.S. and China may engage in direct provocations or miscalculations, their East Asian neighbors are implicated in the breakdown of the regional strategic order. A crisis in any of these hotspots could jeopardize the already unfavorable context for any U.S.-China trade deal over the next year, especially during rough patches like the very near term. Investment Implications Chart 20A Strategic Investment The potential for saber-rattling in the near term – on top of a series of critical U.S. decisions that could mitigate or exacerbate the increase in tensions surrounding the new tariff hike – argues strongly against altering our tactically defensive positioning at the moment. In this environment we advise clients to stick with our two strategic defense plays – long the BCA global defense basket in absolute terms, and long S&P500 Aerospace and Defense equities relative to global equities. The U.S. Congress’s newly agreed bipartisan budget deal provides a substantially improved fiscal backdrop for American defense stocks, which are already breaking out amid positive fundamentals. A host of non-negligible geopolitical risks speaks to the long-term nature of this trade (Chart 20). Our U.S. Equity Strategy recently reaffirmed its bullish position on this sector. We maintain that the U.S. and China have a 40% chance of concluding a trade agreement by November 2020. Note, however, that even a “no deal” scenario does not entail endless escalation. Presidents Trump and Xi could agree to another tariff ceasefire; negotiations could even lead to some tariff rollback in 2020. That would be, after all, Trump’s easiest way to “ease” trade policy amid recession risks. Nevertheless, our highest conviction call is not about whether there will be a deal, but that any trade truce that is reached will be shallow – an attempt to mitigate the trade war’s damage, save face, and bide time for the next round in U.S.-China conflict. We give only a 5% chance of a “Grand Compromise” by November 2020 that greatly expands the U.S.-China economic and corporate earnings outlook over the long haul. In this sense the ultimate trade deal will be a disappointment for markets. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 At the signing ceremony President Trump reminded his European interlocutors that the risk of car tariffs is not yet off the table. He concluded the celebration saying, “Congratulations. And we’re working on deal where the European Union will agree to pay a 25 percent tariff on all Mercedes-Benz’s, BMWs, coming into our nation. So, we appreciate that. I’m only kidding. (Laughter.) They started to get a little bit worried. They started — thank you. Congratulations. Best beef in the world. Thank you very much.” 2 See Emerging Markets Strategy Weekly Report, “EM: Into A Liquidation Phase?” August 8, 2019, ems.bcaresearch.com. 3 The national rare earth association holding a special working meeting and pledging to support any countermeasures China should take against U.S. tariffs. See Tom Daly, “China Rare Earths Group Supports Counter-Measures Against U.S. ‘Bullying,’” Reuters, August 7, 2019. 4 Military tensions are already heating up as Beijing criticizes the U.S. over the new Defense Secretary Mark Esper’s claim during his Senate confirmation hearings that new missile defense may be installed in the region in the coming years. This comes in the wake of the U.S. withdrawal from the 1987 Intermediate-Range Nuclear Forces Treaty, partly due to China’s not being a signatory of the agreement. Missile defense is a long-term issue but these developments feed into the current negative atmosphere.
Highlights So What? Geopolitical risks are not about to ease. Why? Fiscal policy becomes less accommodative next year unless politicians act. Financial conditions give President Trump room to expand his tariff onslaught. Our Iran view is confirmed by rapid escalation of tensions – war risk is high. The odds of a no-deal Brexit have risen. Feature The AUD-JPY cross and copper-to-gold ratio – two market indicators that flag global growth and risk-on sentiment – are hovering over critical points at which a further breakdown would catalyze a renewed flight to quality (Chart 1). Chart 1Risk-On Indicators Breaking Down? Global sentiment remains depressed amid a rash of negative economic surprises and bonds continue to rally despite a more dovish outlook from the Fed (Chart 2). Chart 2Global Sentiment Remains Depressed The cavalry is on the way: European Central Bank President Mario Draghi oversaw a dramatic easing of monetary policy on June 18, driving the Italian-German sovereign bond spread down to levels not seen since before the populist election outcome of March 2018 (Chart 2, bottom panel). The Federal Reserve adjusted its policy rate projections to countenance an interest rate cut in the not-too-distant future. More needs to be done, however, to sustain the optimism that has propelled the S&P 500 and global equities upward since the volatility catalyzed by President Donald Trump’s announcement of a tariff rate hike on May 6. Political and geopolitical risks are higher, not lower, since that time as market-negative scenarios are playing out with U.S. policy, Iran, and Brexit, while we take a dim view of the end-game of the U.S.-China negotiations despite recent improvements. Fiscal And Trade Uncertainties This year’s growth wobbles have occurred in the context of expansive fiscal policy in the developed markets. Next year, however, the fiscal thrust (the change in the cyclically adjusted budget balance) is projected to decline in the U.S. and Japan and nearly to do so in Europe (Chart 3). We expect President Trump and the House Democrats to raise spending caps (or at least keep spending at current levels) and thus prevent the budget deficit from contracting in FY2020 – this is their only substantial point of agreement. But this at best neutralizes what would otherwise be a negative fiscal backdrop. Meanwhile it is not at all clear that Brussels will relax its scrutiny of member states seeking to cut taxes and boost spending, such as Italy. Japanese Prime Minister Abe Shinzo would need to arrange for the Diet to pass a new law to avoid the consumption tax hike from 8% to 10% on October 1. He can pull this off, especially if the U.S. trade war escalates – or if he decides to turn next month’s upper house election into a general election and needs to boost his popularity. But as things currently stand in law, the world’s third biggest economy will face a deep fiscal pullback next year (Chart 3, bottom panel). In short, DM fiscal policy will not really become contractionary in 2020, but this is a view and not yet a reality (Chart 4). Chart 3Fiscal Pullback Likely Next Year Chart 4Only The U.S. Is Profligate Meanwhile China’s stimulus is still in question – in fact it remains the major macro question this year. The efficacy of China’s stimulus is declining ... An escalating trade war will bring greater stimulus but also greater transmission problems. Since February we have argued that the Xi administration has shifted to sweeping fiscal-and-credit stimulus in the face of the unprecedented external threat posed by the Trump administration (Charts 5A and 5B). We expect China’s credit growth to continue its upturn in June and in H2. Ultimately, we think the whole package will be comparable to 2015-16 – and anything even close to that will prolong the global economic expansion. We do not see a massive 2008-style stimulus occurring unless relations with the U.S. completely collapse and a global recession occurs. Chart 5AStimulus Amid The Trade War The catch – as we have shown – is that the efficacy of China’s stimulus is declining over time because of over-indebtedness and bearish sentiment in China’s private sector. These tepid animal spirits stem from epochal changes: Xi’s reassertion of communism and America’s withdrawal of strategic support for China’s rise. An escalating trade war will bring greater stimulus but also greater transmission problems. The magnitude of the tariffs that President Trump is threatening to impose on China, Mexico, the EU, and Japan is mind-boggling. We illustrate this with a simple simulation of duties collected as a share of total imports under different scenarios (Chart 6). China and Mexico are fundamentally different from the EU and Japan and hence the threat of tariffs will continue to weigh on markets for Trump’s time in office – China because of a national security consensus and Mexico because of the Trump administration’s existential emphasis on curbing illegal immigration. But we still put the risk of auto tariffs (or other punitive measures) on Europe at 45% if Trump seals a China deal. The odds are lower for Japan but it is still at risk. Global supply chains are shifting – a new source of costs and uncertainty for companies – as a slew of recent news has highlighted. Already 40% of companies surveyed by the American Chamber of Commerce in China say they are relocating to Southeast Asia, Mexico, and elsewhere (Chart 7). If the G20 is a flop – or results in nothing more than a pause in tariffs for another three-month dialogue – relocations will gain steam, forcing companies’ bottom lines to take a hit. Even in the best case, in which the Trump-Xi summit produces a joint statement outlining a “deal in principle” accompanied by a rollback of the May 10 tariff hike, uncertainty will persist due to President Trump’s unpredictability, China’s incentive to wait until after the U.S. election, and Trump’s incentive to corner the “China hawk” platform prior to the election. We maintain that, by November 2020, there is a roughly 70% chance of further escalation. At least the U.S.-China conflict is nominally improving. The same cannot be said for other geopolitical risks discussed below: the U.S. and Iran are flirting with war; the U.S. presidential election is injecting a steady trickle of market-negative news; the chances of a no-deal Brexit are rising; and Trump may turn on Europe at a moment when it lacks leadership. This list assumes that Russia takes advantage of American distraction by improving domestic policy rather than launching into a new foreign adventure – say in Ukraine or Kaliningrad. If there is any doubt as to whether political risk can outweigh more accommodative monetary policy, remember that President Trump actually can remove Chairman Jerome Powell. Legally he is only allowed to do so “for cause” as opposed to “at will.” But the meaning of this term is a debate that would go to the Supreme Court in the event of a controversial decision. Meanwhile the stock market would dive. Now, this is precisely why Trump will not try. But the implication, as with Congress and the border wall, is that Trump is constrained on domestic policy and hence tariffs are his most effective tool to try to achieve policy victories. With an ebullient stock market and a Fed that is adjusting its position, Trump can try to kill two birds with one stone: wring concessions from trade partners while forcing the FOMC to keep responding to rising external risks. Bottom Line: Central banks are riding to the rescue, but there is only so much they can do if global leaders are tightening budgets and imposing barriers on immigration and trade. We remain tactically cautious. Oh Man, Oh Man, Oman Iran has swiftly responded to the Trump administration’s imposition of “maximum pressure” on oil exports. The shooting down of an American drone that Tehran claims violated its airspace on June 20 is the latest in a spate of incidents, including a Houthi first-ever cruise missile attack on Abha airport in Saudi Arabia. Two separate attacks on tankers near the Strait of Hormuz (Map 1) demonstrate that Iran is threatening to play its most devastating card in the renewed conflict with the U.S. Hormuz ushers through a substantial share of global oil demand and liquefied natural gas demand (Chart 8). The amount of spare pipeline capacity that the Gulf Arab states could activate in the event of a disruption is merely 3.9 million barrels per day, or 6 million if questionable pipelines like the outdated Iraqi pipeline in Saudi Arabia prove functional (Table 1). Table 1No Sufficient Alternatives To Hormuz A conflict with Iran could cause the biggest oil shock of all time. Even if this spare capacity were immediately utilized, a conflict could cause the biggest oil shock of all time – considerably bigger than that of the Iranian Revolution (Chart 9). We have shown in the past that Iran has the military capability of interrupting the flow of traffic in Hormuz for anywhere from 10 days to four months. A preemptive strike by Iran would be most effective, whereas a preemptive American attack would include targets to reduce Iran’s ability to retaliate via Hormuz. The impact on oil prices ranges from significant to devastating. Needless to say, blocking the Strait of Hormuz would initiate a war so Iran is attempting to achieve diplomatic goals with the threats themselves – it will only block the strait as a last resort, say if it is convinced that the U.S. is about to attack anyway. As the experience of President Jimmy Carter shows, Americans may rally around the flag during a crisis but they will also kick a president out of office for higher prices and an economic slowdown. President Trump cannot be unaware of this precedent. The intention of his Iran policy is to negotiate a “better deal” than the 2015 one – a deal that includes Iran’s regional power projection and ballistic missile capabilities as well as its nuclear program. The problem is that Trump has already been forced to deploy a range of forces to the region, including additional troops (albeit so far symbolic at 2,500) (Chart 10). He is also sending Special Representative for Iran, Brian Hook, to the region to rally support among Gulf Cooperation Council. The week after Hook will court Britain, Germany, and France, three of the signatories of the 2015 deal. Trump ran on a campaign of eschewing gratuitous wars in the Middle East – a popular stance among war-weary Americans (Chart 11) – but there is a substantial risk that he could get entangled in the region. First, he is adopting a more aggressive foreign policy to attempt to compensate for the lack of payoff in public opinion from the strong economy. Second, Iran is not shrinking from the fight, which could draw him deeper into conflict. Third, there is always a high risk of miscalculation when nations engage in such brinkmanship. Chart 10Is The 'Pivot To Asia' About To Reverse? The Iranian response has been, first, to reject negotiations. When Trump sent a letter to Rouhani via Japanese Prime Minister Abe Shinzo, Abe was rebuffed – and one of the tankers attacked near Oman was a Japanese flagged vessel, the Kokuka Courageous. This is a posture, not a permanent position, as the Iranian release of an American prisoner demonstrates. But the posture can and will be maintained in the near term – with escalation as the result. Second, Iran is increasing its own leverage in any future negotiation by demonstrating that it can sow instability across the region and bring the global economy grinding to a halt. Iran cannot assume that Trump means what he says about avoiding war but must focus on the United States’ actions and capabilities. Cutting off all oil exports is a recipe for extreme stress within the Iranian regime – it is an existential threat. Therefore, the Iranians have signaled that the cost of a total cutoff will be a war that will cause a global oil price shock. The Iranian leaders are also announcing that they are edging closer to walking away from the 2015 nuclear pact (Table 2). If so, they could quickly approach “breakout” capacity in the uranium enrichment – meaning that they could enrich to 20% and then in short order enrich to 90% and amass enough of this fuel to make a nuclear device one year thereafter. The Trump administration has reportedly reiterated that this one-year limit is the U.S. government’s “red line,” just as the Obama administration had done. Table 2Iran Threatens To Walk Away From 2015 Nuclear Deal This Iranian threat is a direct reaction to Trump’s decision in May not to renew the oil sanction waivers. Previously the Iranians had sought to preserve the 2015 deal, along with the Europeans, in order to wait out Trump’s first term. These developments push us to the brink of war. Iran is retaliating with both military force and a nuclear restart. This comes very close to meeting our conditions for an American (and Israeli) retaliation that is military in nature. Diagram 1 is an update of our decision tree that we have published since last year when Trump reneged on the 2015 deal. The window to de-escalate is closing rapidly. The Appendix provides a checklist for air strikes and/or the closure of Hormuz. Diagram 1Iran-U.S. Tensions Decision Tree At very least we expect to see the U.S. attempt to create a large international fleet to assert freedom of navigation in the Persian Gulf and Strait of Hormuz. While Iran may lay low during a large show of force, it will later want to demonstrate that it has not been cowed. And it has the capacity to retaliate elsewhere, including in Iraq, an area we have highlighted as a major geopolitical risk to oil supply. The U.S. government has already reacted to recent threats there from Iranian proxies by pulling non-essential personnel. Iran has several incentives to test the limits of conflict if the U.S. insists on the oil embargo. First, tactically, it seeks to deter President Trump, take advantage of American war-weariness, drive a wedge between the U.S. and Europe, and force a relaxation of the sanctions. This would also demonstrate to the region that Iran has greater resolve than the United States of America. This goal has not been achieved by the recent spate of actions, so there is likely more conflict to come. Second, President Hassan Rouhani’s government is also likely to maintain a belligerent posture – at least in the near term – to compensate for its loss of face upon the American betrayal of the 2015 nuclear deal. Rouhani negotiated the deal against the warnings of hardline revolutionaries. The 2020 majlis elections make this an important political goal for his more reform-oriented faction. Negotiations with Trump can only occur if Rouhani has resoundingly demonstrated his superiority in the clash of wills. Structurally, Iran faces tremendous regime pressures in the coming years and decades because of its large youth population, struggling economy, and impending power transition from the 80 year-old Supreme Leader Ali Khamanei. A patriotic war against America and its allies – while not desirable – is a risk that Khamenei can take, as an air war is less likely to trigger regime change than it is to galvanize a new generation in support of the Islamic revolution. For oil markets the outcome is volatility in the near term – reflecting the contrary winds of trade war and global growth fears with rising supply risks. Because we expect more Chinese stimulus, both as the trade talks extend and especially if they collapse, we ultimately share BCA’s Commodity & Energy Strategy view that the path of least resistance for oil prices is higher on a cyclical horizon, as demand exceeds supply (Chart 12). We remain long EM energy producers relative to EM ex-China. Chart 12Crude Oil Supply-Demand Balance Should Send Prices Higher Bottom Line: The risk of military conflict has risen materially. This also drastically elevates the risk of a supply shock in oil prices that would kill global demand. The U.S. Election Adds To Geopolitical Risk The 2020 U.S. election poses another political risk for the rising equity market. The Democratic Party’s first debate will be held on June 26-27. The leftward shift in the party will be on full display, portending a possible 180-degree reversal in U.S. policy if the Democrats should win the election, with the prospect of a rollback of Trump’s tax cuts and deregulation of health, finance, and energy. The uncertainty and negative impact on animal spirits will be modest if current trends persist through the debates. Former Vice President Joe Biden remains the frontrunner despite having naturally lost the bump to his polling support after announcing his official candidacy (Chart 13). Biden is a known quantity and a centrist, especially compared to the farther left candidates ranked second and third in popular support– Vermont Senator Bernie Sanders and Massachusetts Senator Elizabeth Warren. Biden is not only beating Sanders in South Carolina, which underscores the fact that he is competitive in the South and hence has a broader path to the White House, but also in New Hampshire, where the Vermont native should be ahead (Chart 14). These states hold the early primaries and caucuses and if Biden maintains his large lead then he will start to appear inevitable very early in the primary campaign next year. Hence a poor showing in the debate on June 27 is a major risk to Biden – he should be expected to be eschew the limelight and play the long game. Elizabeth Warren, by contrast, has the most to gain as she appears on the first night and does not share a stage with the other heavy hitters. If she or other progressive candidates outperform then the market will be spooked. The market could begin to trade off the polls. All of these candidates are beating Trump in current head-to-head polling – Biden is even ahead in Texas (Chart 15). This means that any weakness from Biden does not necessarily offer the promise of a Trump victory and policy continuity. The Democrats also have a powerful demographic tailwind. The just-released projections from the U.S. Census Bureau reveal how Trump’s narrow margins of victory in the swing states in 2016 are in serious jeopardy in 2020 as a result of demographics if he does not improve his polling among the general public (Chart 16). We still give Trump the benefit of the doubt as the incumbent president amid an expanding economy, but it is essential to recognize that his popular approval rating is reminiscent of a president during recession – i.e. one who is about to lose the White House for his party (Chart 17). Even if there is not a recession, an increase in unemployment is likely to cost him the election – and even a further decrease in unemployment cannot guarantee victory (Chart 18). This is why we see Trump making a bid to become a foreign policy president and seek reelection on the basis that it is unwise to change leaders amid an international crisis. We still give Trump the benefit of the doubt ... but his popular approval rating is reminiscent of a president during recession. The race for the U.S. senate is extremely important for the policy setting from 2021. If Republicans maintain control, they will be able to block sweeping Democratic legislation – which is particularly relevant if a progressive candidate should win the White House. However, if Democrats can muster enough votes to remove a sitting president with a strong economy – including a strong economy in the key senate swing races (Chart 19) – then they will likely win over the senate as well. Chart 19Hard To Win The Senate In 2020 While Key States Prosper Bottom Line: The 2020 election poses a double risk to the bull market. First, the Democratic primary campaign threatens sharp policy discontinuity, especially if and when developments cause Biden to drop in the polls (dealing a blow to centrism or the political establishment). Second, Trump’s vulnerability makes him more likely to act aggressive on the international stage, whether on trade, immigration, or national security, reinforcing the risks outlined above with regard to China, Iran, Mexico, and even Europe. Rising Odds Of A No-Deal Brexit Former Mayor of London and former foreign secretary Boris Johnson looks increasingly likely to seal the Conservative Party leadership contest in the United Kingdom. It is not yet a done deal, but the shift within the party in favor of accepting a “no deal” exit is clear. None of the remaining candidates is willing to forgo that option. The newest development advances us along our decision tree in Diagram 2, altering the conditional probabilities for this year’s events. We expect the next prime minister to try to push a deal substantially similar to outgoing Prime Minister Theresa May before attempting any kamikaze run as the October 31 deadline approaches. The attempt to leverage the EU’s economic weakness will not produce a fundamental renegotiation of the exit deal, but some element of diplomatic accommodation is possible as the EU seeks to maintain overall stability and a smooth exit if that is what the U.K. is determined to accomplish. Diagram 2Brexit Decision Tree Hence the prospect of passing a deal substantially similar to outgoing Prime Minister Theresa May’s deal is about 30%, roughly equal to the chance of a delay (28%). These options are believable as the new leader will have precious little time between taking the reins and Brexit day. The EU can accept a delay because it ultimately has an interest in keeping the U.K. bound into the union. Public opinion polling is not conducive to the new prime minister seeking a new election unless the change of face creates a massive shift in support for the Conservatives, both by swallowing the Brexit Party and outpacing Labour. If the purpose is to deliver Brexit, then the risk of a repeat of the June 2017 snap election would seem excessive. Nevertheless, the Tories’ working majority in parliament is vanishingly small, at five MPs, so a shift in polling could change the thinking on this front. The pursuit of a no-deal exit would create a backlash in parliament that we reckon has a 21% chance of ending in a no-confidence motion and new election. Bottom Line: The odds of a crash Brexit have moved up from 14% to 21% as a result of the leadership contest. The threat that the U.K. will crash out of the EU is not merely a negotiating ploy, although it will be a last resort even for the new hard-Brexit prime minister. Public opinion is against a no-deal Brexit, as is the majority of parliament, but the risk to the U.K. and EU economies will loom large over global risk assets in the coming months. Investment Conclusions Political and geopolitical risks to the late-cycle expansion are rising, not falling. U.S. foreign policy remains the dominant risk but U.S. domestic policy pre-2020 is an aggravating factor. Easing financial conditions give President Trump more ammunition to use tariffs and sanctions. Meanwhile our view that this summer will feature “fire and fury” between the U.S. and Iran has been confirmed by the tanker attacks in Oman. Tensions will likely escalate from here. Ultimately, we believe Trump is more likely to back off from the Iran conflict than the China conflict. This is part of our long-term theme that the U.S. really is pivoting to China and geopolitical risk will rotate from the Middle East to East Asia. But as highlighted above, the risk of entanglement is very high due to Trump’s approach and Iran’s incentives to raise the stakes. Oil prices will not resume their upward drift until Chinese stimulus is reconfirmed – and even then they will continue to be volatile. We remain cautious and are maintaining our safe-haven tactical trades of long gold and long JPY/USD. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix