South Asia
ハイライト
グローバル株式は大きな調整に非常に脆弱である。しかし景気循環的には米連邦準備制度（FRB）はインフレの上振れを容認する姿勢を取っており、世界経済は回復している。
中国の財政・信用インパルスが急低下しており、これによりグローバルの景気循環株およびコモディティは下押しを受けやすい。
短期を越えれば、中国の政治的安定の必要性が過度な政策引き締めを防ぐはずだ。リスクは前倒しになっている。
中国の国勢調査は当社のメガテーマの一つを裏付けている：中国の国内政治は不安定であり、ネガティブなサプライズをもたらし得る。
インドの州選挙は大規模なCOVID-19の波の最中に実施されたが、与党が2024年にも依然有利であることを示唆している。これは政策の継続を意味する。
景気循環派の強気バイアスを維持するが、中国が政策ミスを犯した場合には方針転換する準備をしておくこと。
特集
チャート 1
インフレ再浮上
インフレが頭をもたげる
インフレが頭をもたげる
今週、米国のコアインフレが強く出たことと、長く眠っていたインフレが再び頭をもたげることへの幅広い懸念を受けて、グローバル市場は震撼した（チャート 1）。
景気循環的には、世界経済の回復に伴い投資家は米国株から国際株へローテーションし、米ドルは下落すると引き続き見ている（チャート 2）。しかしこの見方は、新興国株が先進国株に対してアウトパフォームし始めるべきだということも含んでおり、今年これまでのところはそれが実現していない。新興市場はテクノロジーに偏っており、米国の長期金利上昇に脆弱なだけでなく、中国の景気刺激がピークに達した今、さらに困難に直面している。
チャート 2
株式市場の動揺
株式市場が動揺
株式市場が動揺
チャート 3
世界経済とセンチメントの回復
世界経済とセンチメントは回復しつつある
世界経済とセンチメントは回復しつつある
チャート 4
景気循環株対ディフェンシブの揺らぎ
グローバルのシクリカル株とディフェンシブ株が揺らいでいる
グローバルのシクリカル株とディフェンシブ株が揺らいでいる
我々が頼れる一つの事実は、COVID-19ワクチンの展開が続くことで世界的な成長回復を後押しするという点である（チャート 3）。米ドルもそれを示唆している。ドルは第1四半期に米国の相対的成長優位で反発したが、その後は下落に転じている。ドル安はディフェンシブに対して景気循環株にとってポジティブだが、景気循環株は短期的にはリフレーショントレードが過熱していることを示している（チャート 4）。
中国の成長が今や重要な焦点になる。中国の政策ミスは強気の景気循環見通しを覆すだろう。中国の金融・財政政策の引き締めは、今年我々が強調してきた主要なグローバルな政策リスクであり、今まさに顕在化している。しかし我々は引き締めの制約も指摘してきた。現時点で中国は我々のベンチマークによれば過度な引き締めの瀬戸際に立っている。さらなる引き締めが行われれば、我々は本質的によりディフェンシブな見方に転じるだろう。
本レポートではまた、中国の国勢調査の結果と、最新の大波のCOVID-19感染のもとで行われたインドの最近の州選の含意を検討する。我々はまだインドに対する強気見解を変更していないが、注視している。
中国：過度引き締めリスク
中国の問題は、対外貿易依存から内需依存への経済モデルの継続的な変化に起因している。これは習近平国家主席の台頭以前に共産党が採った戦略的決定であり、習はそれを体現し、戦略的ビジョンと米国との対立を通じて強化してきた。
北京の目標は滑らかで安定した移行を管理することだった。2015年の金融混乱や2018-19年の貿易戦争はその目標を危うくしたが、政策当局は最終的に持ちこたえた。そこへCOVID-19が発生し、1970年代以来の本格的な経済縮小をもたらした。中国はウイルスを抑え込み、貿易戦争開始から2021年のピークまでにGDP比13.8%に上る別の大規模な刺激で回復したが、今やさらに困難な移行に直面している。
チャート 5
中国の上昇する貯蓄傾向
中国の貯蓄傾向の高まり
中国の貯蓄傾向の高まり
潜在GDPが鈍化していることを考えると生活水準の改善の必要性は一層切迫している。債務の大幅な増加に鑑みると体系的な金融リスクを抑制する必要性も一層切迫している。米国が中国に対抗する民主諸国の連合を形成している今、経済の多角化の必要性も高まっている。長期預金比率などで測られる中国の家計・企業の「限界貯蓄性向」の急上昇は、国が困難に直面しアニマルスピリッツが抑えられていることの兆候である（チャート 5）。
2018-21年の大規模拡大の後、中国の財政・信用インパルスは低下に転じている。政策当局は昨年以降、緊急的な刺激を引き揚げるシグナルを出しており、その影響はハードデータに現れている。中国のマネー、クレジット、そして財政とクレジットを合わせたインパルスはいずれも、6〜9か月のラグの後に経済成長と相関する。これは中国のマネーとクレジットサイクルや経済活動を測る指標がどれであれ当てはまる（チャート 6Aおよびチャート 6B）。中国の経済モメンタムはピークに達しており、世界がワクチンと経済再開の追い風を享受しているにもかかわらず、今年後半から2022年にかけて世界経済にとって逆風となるだろう。
チャート 6A
中国の財政・信用インパルスが急落 …
中国の財政・信用インパルスが急落…
中国の財政・信用インパルスが急落…
チャート 6B
… マネー・アンド・クレジットのインパルスも同様に低下
... マネー・アンド・クレジットのインパルスも同様である
... マネー・アンド・クレジットのインパルスも同様である
財政・信用インパルスのダウンシフトは、特に国内消費向けに中国が輸入するコモディティ、マテリアル、およびその他財の需要の鈍化を予示している（中国の輸出向け製造に投入される部品や中間財の輸入は、世界の回復とともに比較的健全に見える）。このシフトは、スウェーデン株などの中国関連プレイや急騰している金属価格が調整なしに上昇を続けることを困難にするだろう（チャート 7）。投機筋のポジショニングは現時点でコモディティに偏っている。中国とそれが支配する金属市場との乖離は短期的には耐え難いように見える（チャート 8）。
チャート 7
中国のリフレーショントレードはピーク付近
中国のリフレーショントレードはピーク付近
中国のリフレーショントレードはピーク付近
チャート 8
マネーサイクルとコモディティ価格の衝突
マネーサイクルとコモディティ価格の衝突
マネーサイクルとコモディティ価格の衝突
世界的なグリーンや再生可能エネルギーシステムへの移行（すなわち脱炭素化）は銅をはじめ金属にとって強気だが、短期的には中国の需要減を補うことはできないことを、我々のエマージング・マーケッツ・ストラテジーが示している。中国の建設・産業向けの銅の国内需要は世界総需要の約56.5%を占める一方、グリーンエネルギー競争（太陽光パネル、風力発電、電気自動車の生産等）は世界需要の約3.5%にすぎない。
この数値は既存のシステムや構造の再調整やレトロフィット（例：電力網）も見込まれているためグリーン計画をやや過小評価している面はある。しかし要点は、米国および欧州の消費が大幅に増加しても、中国の銅消費が減少すればそれに逆行することだ。特に米国のインフラ計画が早くても2022年まで本格的に始動しないことを考えれば、今後12か月で中国の影響で世界の銅需要は減速するだろう。
中国の政策当局はまだ過度な引き締めを懸念している、あるいは新たに政策を緩和する意思を示したわけではない。4月末の政治局会議は12月の中央経済工作会議や3月の政府活動報告から大きな政策変更を含んでいなかった（表 1）。しかしもし差異があるとすれば、昨年の緊急感をさらに後退させつつも、地方政府幹部を隠れ債務に対して説明責任を負わせるような何らかの仕組みを示唆した点にある。含意は引き続き引き締め的な政策であり、したがって過度の引き締めリスクは依然として大きい。
表 1
中国の最近のマクロ経済政策表明：刺激の縮小
中国は過度な金融引き締めの瀬戸際にある
中国は過度な金融引き締めの瀬戸際にある
チャート 9
中国の政策引き締めのベンチマーク
中国の政策引き締めのベンチマーク
中国の政策引き締めのベンチマーク
確かに4月会議の「お茶の葉」は様々に読み取ることができる。4月の声明はマクロ経済政策指針から「必要な政策支援を維持する」という文言を外しており、これは経済への支援を減らすことを意味する可能性がある。しかし同時に、マネーサプライ（M2）とクレジット成長（社会融資総量）を名目GDP成長に合わせるという目標も外れており、これはクレジット成長の新たな上振れを許容するものと見なすこともできる。とはいえ中国人民銀行は第1四半期の金融政策報告書でこのクレジット目標を維持しており、確信は持てない。このルーブリックによれば、中国は我々がリスクを測るために用いる「過度引き締め」の瀬戸際にあることに注意されたい（チャート 9）。
過去20年の中国の政策運営に基づけば、我々は重大な転換点の発表は4月ではなく7月の政治局会議で行われると予想する。したがって4月は先の会合からの大きな変更とは見なしていないし、我々のチャイナ・インベストメント・ストラテジーも同様に見ていない。従って過度な政策引き締めは今後12か月で中国および世界経済に対する現実的なリスクであり、我々の過度引き締めチェックリストはこの点を強調している（表 2）。
表 2
中国の政策引き締めチェックリスト
中国、過度の引き締め寸前
中国、過度の引き締め寸前
中国の財政・信用のダウンシフトは、第20回党大会を控えて進行している。党大会は2022年を通じて行われ、秋に最高指導部（政治局常務委員）の交代で頂点に達する。共産党の100周年に当たる今年7月1日に向けて経済は十分に刺激されているため、政策当局は過剰を防ぐことに集中している。金融リスクの予防、反独占規制、不動産バブルの抑制が当面の命題である。企業および政府の債務不履行や破産の増加は、指導部が経済構造改革と改革を推し進める意志を裏付けており、近年これが確認されている（チャート 10）。
チャート 10
中国における創造的破壊
中国、過度な引き締め寸前
中国、過度な引き締め寸前
投資家は党大会があるからといって指導部が政策を緩和するだろうと想定してはならない。2017年の党大会の前にはむしろその逆のことが起きた。しかし、投資家はまた、中国が重要なイベントの前に自国経済を沈めるほど過度に引き締めるとも安易に想定してはならない。安定が目標となるだろう（2017年や以前の党大会でもそうであったように）──これは現行の引き締めが財政的・経済的にあまりにも痛みを伴う場合には政策緩和がいつか行われることを意味する。政策当局が転換点に達するまでは、中国関連資産は短期的に脆弱である。
ちなみに、第20回党大会の接近は政治的な暗闘や衝撃的な出来事を引き寄せるだろう。最高指導者は通常、党大会前に派閥の勢力を示すために有力なライバルを解任する。政府はまたメディア統制を強化し、事件の周辺で声を上げるか抗議するかもしれない反体制派を取り締まる。しかし2022年はその利害が一層高い。
習主席は当初2022年に退任すると見られていたが、今は退任しない見込みであり、これは少なくとも一部の反対を喚起するだろう。さらに習政権下で中国は三つの歴史的な政策革命を遂げた：強力な指導者モデルを採用し、前二代の集団指導モデルを損なったこと、経済の自給自足を重視して自由化と開放を犠牲にしたこと、そして大国としての地位を強調し米国や同盟国との協調を犠牲にしていることだ。
まとめ：中国の政策引き締めにより、グローバル株式、コモディティ、そして「中国プレイ」は大幅な調整リスクに直面している。当社のベースケースは中国が過度な引き締めを回避するというものだが、最新のマネーおよびクレジットの数値はその見方を変更する閾値に達している。これらの指標がさらに急落すれば見解を変更する必要がある。
中国の消えゆく労働力
最終的に過度な引き締めを抑制する制約の一つは、労働年齢人口の縮小による中国の潜在GDP成長の低下である。中国の第7回国勢調査が今週公表され、国とその経済に影響する深い構造変化を裏付けた。
過去10年の人口増加率は5.4%に鈍化し、1953年の最初の国勢調査以降で最低となった。出生率は2020年に1.3まで下落し、2.1の人口置換水準や2016年に一人っ子政策を緩和した際の目標1.8を下回っている。出生率は世界銀行の推計（2019年で1.7）や日本の数値よりも低い。人口1000人当たりの出生数も減少し、2020年の新生児数は1961年（大飢饉の年）以来の低水準となった。出生率は高所得国の水準に収束しており、経済発展が中国でも出産抑制の同じ効果をもたらしていることを示唆しているが、中国はこれらの国より発展段階が低い。
チャート 11
1990年代の日本より速く減少する中国の労働人口
中国、過度な金融引き締めの瀬戸際に立つ
中国、過度な金融引き締めの瀬戸際に立つ
最年少コホートの比率は16.6%から17.95%に上昇し、最年長コホートは2010年の8.9%から現在13.5%へ上昇、働き手層は75.3%から68.6%に低下した。労働年齢人口は2010年にピークに達し、過去10年で6.79ポイント減少した。対照的に日本の労働年齢人口は1992年にピークを迎え、その後の10年で2.18ポイント低下した（チャート 11）。
言い換えれば、中国は1990年代初頭に日本が経験した人口転換を経験しているが、中国の労働年齢人口はさらに速く減少する可能性がある。中国は日本が達したより低い1人当たり所得水準でこの大規模な社会経済的変化を経験している。
人口動態の課題は中国の社会経済的および政治的システムに圧力をかけるだろう。中国の奇跡は、他のアジアの奇跡と同様に、輸出製造により大量の貯蓄を生み出し、それを国家開発に再投資することを前提としていた。労働年齢人口の減少は経済発展と重なり、長期的には貯蓄率の低下をもたらすだろう。これはチャート 12に示されたように、二つの異なる中国の労働人口の図と国民貯蓄率を並べたものである。扶養比率が上昇するにつれて貯蓄率は低下し、再目的化に使える資金が減少する。資本コストは上昇し、経済構造改革は加速するだろう。
日本の場合、人口変化は1990年の金融危機と全国的な経済行動の変化と同時に起きた。貯蓄率は経済の変化とともに低下したが、生成された貯蓄は依然として投資を上回っており、これは民間需要の不足と大きな債務負担の圧力によるものであった。企業は投資と生産の拡大よりも債務圧縮に注力した（チャート 13）。これらは外部環境が良好だったときに起きたが、中国は地政学的緊張による経済的圧力が高まる文脈で同様の人口問題に直面している。
チャート 12
希少化する中国の労働者
中国の労働者が希少になりつつある
中国の労働者が希少になりつつある
チャート 13
高貯蓄が債務拡大を可能にするが、やがて債務が圧倒する
高い貯蓄が借入拡大を促し、債務が耐え難くなるまで続く
高い貯蓄が借入拡大を促し、債務が耐え難くなるまで続く
中国はこれまで破滅的な金融危機や不動産価格の崩壊を回避しており、深刻な流動性の罠に陥る事態は避けている。中国当局は不動産バブルの危険を痛感しており、したがって金融の過剰を防ぎバブル的活動を抑制することに注力している。これが過度の引き締めリスクを重大なものにしている。しかしどちらか一方の誤りはデフレへの滑落を招き得る。習政権は活動が過度に減速したり金融の不安定性が手に負えなくなりそうな時は経済を刺激してきたが、これは難しいバランス行為であり、故に我々は過度引き締めリスクを綿密に監視している。
中国の国勢調査からのその他の注目点は以下の通りである：
二人っ子政策は現時点では成功していない。
COVID-19は出生率に悪影響を与えた可能性はあるが、タイミングの点で出生数を大きく歪めるほどではない。したがってトレンドはパンデミックだけで説明できない。
急速な都市化が続いており、都市化率は64%に達し、2010年から14ポイント上昇した。
政策議論は定年年齢の引き上げ、出産に対する財政的インセンティブの提供、子育てをより手頃にするための各種価格統制（特に不動産バブルの抑制）、および地方からの移住が続く中で中小都市の不動産価格が急落しないようにする措置を強調している。
中国の少数民族人口は総人口の9%を占め、過去10年で9%成長したのに対し、漢民族は91%で5%成長にとどまった。少数民族は一人っ子（二人っ子）政策の免除対象である。しかし、新疆のような自治区では民族間緊張が発生しており、中国の少数民族政策に対する国際的な監視が強まっている。
中国の人口動態上の課題は広く知られているが、最新の国勢調査はその規模を再確認させる。中国の潜在成長率は低下しており、上昇する扶養比率は政府に対する要求を強める社会変化を示している。より大きな財政・社会支出の必要は困難な経済的トレードオフと不人気な政治的決定を必要とするだろう。経済変化と人の移動は地域間および富の格差を深めるだろう。
これらすべての点は、我々の一貫したジオポリティカル・ストラテジーのメガテーマの一つを裏付けている：中国の国内政治リスクは過小評価されている。
まとめ：中国の2020年国勢調査は、中国の上昇する社会経済的・政治的課題の根底にある人口減少を強く裏付けるものである。中国は強力な中央政府を持ち、単一支配政党の下で権力が集約され、近年様々な課題を管理してきた実績はあるが、それでも現在進行中の変化の規模は圧倒的であり、ネガティブな経済的・政治的サプライズを招くだろう。
インド：州選はモディに対する転換点ではない
インドで第2波のCOVID-19がピークにあった時期に、5州で選挙が行われた。中でも西ベンガル州の結果が最も重要だった。西ベンガルは大きな州であり、インド国会の議員のほぼ10分の1を占めている。ナレンドラ・モディ首相の与党バラティヤ・ジャナタ党（BJP）は294議席中約70%を獲得するとの目標を公言していた。
実際には、西ベンガルは地域政党であるオール・インディア・トリナムール会議（AITMC）の圧勝となった。AITMCは2期の反イナカム任期に直面していたにもかかわらず、議席数は過去最高を記録した。多くの予測を上回る結果であり、多くの世論調査が予想していなかったことが示された。
投資家はこの重要州でのBJPの敗北をどう受け止めるべきか。これはモディのパンデミック対応への反発か。2024年の総選挙で政権交代や国家政策の変更を予告するものか。そうとは言えない。ここで我々は三つの主要な示唆を挙げる：
示唆その1：BJPの成果は注目に値する
チャート 14
インド：西ベンガルで足がかりを得たBJP
中国、過度な引き締めの瀬戸際
中国、過度な引き締めの瀬戸際
BJPは西ベンガルで目標には届かなかったが、この州はBJPの地盤ではない。BJPは英語で言えばヒンディー語圏で自然な支持基盤を持つとされ、西ベンガルは非ヒンディー語圏であり、伝統的にBJPは「外部勢力」と見なされてきた。またこの州は変化を受け入れにくいことで知られている。例えばAITMC以前は左派が34年という記録的な長期政権を維持していた。このような状況下で、BJPが2021年に77議席に増やしたことは注目に値する（2016年は3議席）（チャート 14）。
この成果によりBJPは西ベンガルで主要な野党となった。これはBJPが時間をかければ伝統的な強みを持たない州でも足場を築けることを示している。歴史的に弱い州でこの成果を上げたことは、BJPが依然として無視できない勢力であることの表れだ。
示唆その2：BJPの人気は後退したが、2024年に政権を維持する見込みは依然強い
BJPに対する不満はCOVID-19対応の不手際とそれに伴う経済的困窮により高まっているが、国家レベルでBJPに代わる現実的な選択肢は存在しない。
最近の州選は、西ベンガルだけでなく、野党のインド国民会議（INC）がまだ体制を整えていないことを確認した。コングレスは西ベンガルで44議席から0議席に崩壊した。より重要なのは、コングレスが大衆にアピールする内部指導者を任命・選出する必要性と、識別可能な政策アジェンダを策定する必要性という二つの重要課題をまだ解決していない点である。
コングレスの弱さは、BJPの議席数が2019年のピークから減少する可能性があっても、我々の2024年のベースケースは依然としてBJP主導の政権がインドの政権を維持するというものであることを意味する。政策の継続性とある程度の構造改革の可能性がベースケースだ。
示唆その3：インドの地域政党の台頭
過去10年のBJPの台頭は、コングレスと地域政党の議席減少と同時に進んだ。しかし最近の州選は、BJPが地域政党の議席シェアを劇的に圧縮できないことを示している。例えば西ベンガルではBJPは単独で77議席を獲得したが、これはこの州で支配的なAITMCの犠牲になって得たものではない。一方、同月に選挙が行われた別の大州であるタミル・ナードゥでは二大地域政党の間で支配が揺れ続けている。
チャート 15
インド：BJPは2019年にピークを迎えたが2024年にも有力
中国は過度な引き締めの瀬戸際にある
中国は過度な引き締めの瀬戸際にある
2019年の総選挙では地域政党（BJPとコングレスを除く全党）のシェアは約40%から35%に低下した（チャート 15）。2024年の選挙では、BJPのピーク議席数が2019年の高水準から低下することにより、地域政党の議席シェアがやや上昇する可能性がある。
インドの地域政党の今後の台頭は単純な力学に根ざしている。BJPが2024年に二期目の現職となる可能性があるので、全国レベルでBJPに対する代替がない限り、有権者は差分的に地域政党を支持する選択をするだろう。
BJPは2024年に単独最大党として過半数を超える議席を獲得するポジションに留まるだろう。しかし与党が過半数を確保するために地域政党を取り込むシナリオも十分にあり得る。ただし2024年までは長い時間がある。COVID-19とその経済的影響への対応が、BJPが2019年の成果を超えることを難しくするだろう。次の重要な州選は2022年2月に予定されており、インド最大の州ウッタル・プラデーシュで選挙が行われる。ここでの結果は、BJPがパンデミックと経済ショックによる反イナカム効果をいかに緩和できるかを示すだろう。
結論：インドにおけるBJPの人気は揺らいでいるが劇的に崩れたわけではない。BJPは依然として2024年に過半数を超える単独最大政党になる位置にある可能性が高い。したがって当面この新興市場で政権不安は懸念されない。
中国の国内政治リスクとインドの政治的継続性を踏まえ、当面インド向けのトレードを維持する（チャート 16Aおよびチャート 16B）。ただし我々はインド全体のレビューを進めており、今後の特別レポートで顧客に結論を共有する予定である。
チャート 16A
新興国に対してインド債をロングで保有
インド債券を新興国（EM）に対してロングで維持する
インド債券を新興国（EM）に対してロングで維持する
チャート 16B
インドロング／中国ショートを堅持
インドをロング、中国をショートで貫く
インドをロング、中国をショートで貫く
投資上の示唆
短期的な安全資産トレードを維持する。天然ガス先物のロングは19.8%の利得でクローズ。
景気循環（12か月）の強気ポジションを維持し、グロースよりバリューを優先する。レアアースを含むコモディティおよび新興市場のロングを維持する。ただし、中国が我々のベンチマークに従って過度の引き締めを行った場合にはこれらのトレードをカットする準備をすること。
当面は新興国同業と比較してインドのローカル通貨建て債をオーバーウェイトし、インド株を中国株に対してロングする。だがインドに対する強気姿勢は精査中である。
チャート 17
テック売りの中で回復するサイバーセキュリティ株
サイバーセキュリティ株がテック株の暴落の中で反発
サイバーセキュリティ株がテック株の暴落の中で反発
サイバーセキュリティ株はロングで保有を継続すべきだが、地政学的「職場復帰」トレードとしてはサイバーよりも航空宇宙・防衛を引き続き好む。先週の一般的なテック売りの中でサイバーセキュリティ株はテックセクターに対して持ち直した。米国で発生した大規模なColonial Pipelineのランサムウェア攻撃は、東海岸の燃料供給の約45%を支える主要ネットワークを一時的に停止させた（チャート 17）。それでも重要インフラに対する攻撃はサイバーセキュリティが長期的なテーマであることを浮き彫りにしており、投資家はエクスポージャーを維持すべきである。サイバー株はワクチン発見以降、テック全体をアウトパフォームしている（チャート 18）。
チャート 18
サイバーセキュリティは構造的テーマである
サイバーセキュリティは長期的なテーマである
サイバーセキュリティは長期的なテーマである
Matt Gertken バイスプレジデント 地政学ストラテジー mattg@bcaresearch.com Yushu Ma リサーチ・アソシエイト yushu.ma@bcaresearch.com Ritika Mankar, CFA 編集者／ストラテジスト Ritika.Mankar@bcaresearch.com
Highlights The Biden administration is combining Trumpian nationalism with a renewed push for US innovation in a major infrastructure bill that is highly likely to become law. Populism and Great Power struggle with China and Russia are structural forces that give enormous momentum to this effort. Don’t bet against it. President Biden’s $2.4 trillion infrastructure and green energy plan has a subjective 80% chance of passing into law by the end of the year, as infrastructure is popular and Democrats control Congress. The net deficit increase will range from $700 billion to $1.3 trillion depending on the size of corporate tax hikes in the final bill. The second part of Biden’s plan, the roughly $2 trillion American Families Plan, has a much lower chance of passage – at best 50/50 – as the 2022 midterm elections will loom and fiscal fatigue will set in. While the US infrastructure package is a positive cyclical catalyst, it was largely expected, and the Biden administration still faces early stress-tests on China/Taiwan, Russia, Iran, and even North Korea. Game theory helps explain why financial markets cannot ignore the 60% chance of a crisis in the Taiwan Strait. A full-fledged war is still low-probability but Taiwan remains the world’s preeminent geopolitical risk. In emerging markets, stay short Russian and Brazilian currency and assets – and continue favoring Indian stocks over Chinese. Feature The “arsenal of democracy” is a phrase that President Franklin Delano Roosevelt used to describe the full might of US government, industry, and labor in assisting the western allies in World War II. The US is reviving this combination of productive forces today, with President Joe Biden’s $4 trillion-plus American Jobs and Families Plan unveiled in Pittsburgh on March 31. The context is once again a global struggle among the Great Powers, albeit not world war (at least not yet … more on that below). The US is reviving its post-WWII pursuit of global liberal hegemony – symbolized by its role, growing once again, as the world’s chief consumer and chief warrior (Chart 1). Biden promoted his plan to build up the US’s infrastructure and social safety net explicitly as a historic and strategic investment – “in 50 years, people are going to look back and say this was the moment that American won the future.”1 It is critical for investors to realize that they are not witnessing another round of COVID-19 fiscal relief. That task is already completed with the Republican spending of 2020 and Biden’s own $1.9 trillion American Rescue Plan Act (ARPA), which together with the vaccine rollout are delivering a jolt to growth (Chart 2). Chart 1America Pursues Hegemony Anew Chart 2Consensus Expects 6.5% US GDP Growth After American Rescue Plan Our own back-of-the-envelope estimates of growth suggest that there is considerable upside risk even under current law (Chart 3). The output gap is also guesstimated here, and it will tighten faster than expected, especially as the service sector revives on economic reopening. Chart 3Back-Of-Envelope: US GDP And Output Gap Show Upside Risk After American Rescue Plan Act (ARPA) A growth overshoot is even more likely considering that the first part of Biden’s proposal, the $2.4 trillion American Jobs Plan consisting mostly of infrastructure and green energy, is highly likely to pass Congress (by July at earliest and December at latest, most likely late fall). Our revised estimates for the US budget deficit show that this bill will add considerably to the deficit in the coming years, peaking in three or four years, thus averting the “fiscal cliff” in 2022-23 and adding to aggregate demand in the years after the short-term COVID-era cash handouts dry up (Chart 4). The net deficit increase will be $700 billion if Biden gets all of his tax hikes and $1.3 trillion if he only gets half of them, according to our sister US Political Strategy. Chart 4US Budget Deficit Will Remain Fat In Coming Years We give Biden’s $2.4 trillion American Jobs Plan an 80% chance of passing through Congress by the end of the year. Infrastructure is broadly popular – as President Trump’s own $2 trillion infrastructure campaign proposal revealed – and Democrats have just enough votes to push it through the Senate via budget reconciliation, which requires zero votes from Republicans. Biden’s political capital is still strong given that his approval rating will stay above 50% as long as Trump is the obvious alternative and the Republicans are deeply divided over their own future (Chart 5).2 The second part of his plan, the $1.95 trillion American Families Plan, is much less likely to pass before the 2022 midterm elections – we would say 50/50 odds at best, if the infrastructure deal passes quickly. Chart 5Biden’s Political Capital Is Sufficient To Pass Another Major Law Of course there are very important differences between Biden’s $2.4 trillion infrastructure plan and the similarly sized proposal that Trump would have unveiled this month had he been re-elected: Biden’s proposal is probably heavier on innovation and research and development, and certainly heavier on unionization and labor regulation, than Trump’s would have been. Biden’s plan integrates infrastructure with sustainability, renewable energy, and climate change initiatives that will help the US catch up with Europe and China on the green front. The plan will consist of direct government spending – rather than government seed money to promote private investment. It will be partially offset by repealing the corporate tax cuts in Trump’s signature Tax Cuts and Jobs Act. Most importantly – from a geopolitical point of view – Biden is making a bid for the US to resume its post-WWII quest for global liberal hegemony. He argued that the US stands at the crossroads of a global choice between “democracies and autocracies” and that rebuilding US infrastructure is ultimately about proving that democracies can create consensus and “deliver for their people.” Autocratic regimes, fairly or not, routinely call attention to the divisiveness of modern party politics in the West and the resulting policy gridlock which produces bad outcomes for many citizens, resulting in greater domestic dysfunction and “chaos.” It is important to note that this bid for hegemony will be more, not less, destabilizing for global politics as it will make the US economy more self-sufficient and insulated from the world. It will intensify the US-China and US-Russia strategic competition while making it more difficult for Biden to conduct bilateral diplomacy with these states given their differences in moral values and frequent human rights violations. What is happening now is the culmination of political shifts that pre-date the pandemic, but were galvanized by the pandemic, and it is of global, geopolitical significance for the coming decade and beyond.3 Biden and the establishment Democrats – embattled by populism on their right and left flanks – are shamelessly coopting President Trump’s “Make America Great Again” nationalism with a larger-than-life, infrastructure-and-manufacturing initiative that emphasizes productivity as well as “Buy American” protectionism. Biden explicitly argued that Americans need to boost innovation to “put us in a position to win the global competition with China in the upcoming years.” At Biden’s first press conference on March 25, he made a similar point about China: So I see stiff competition with China. China has an overall goal, and I don’t criticize them for the goal, but they have an overall goal to become the leading country in the world, the wealthiest country in the world, and the most powerful country in the world. That’s not going to happen on my watch because the United States are going to continue to grow and expand.4 The US trade deficit is set to widen a lot further under this massive domestic buildout. It aims to be the largest government investment program since Dwight Eisenhower’s building of the highways or the Kennedy-Johnson-Nixon space race. But it explicitly aims to diminish China’s role as a supplier of US goods and materials and the US trade deficit already shows evidence of economic divorce (Chart 6). The US is bound to have a larger trade deficit due to its own savings-and-investment imbalances but it has a powerful interest in redistributing this trade deficit to its allies and reducing over-dependency on China, which is itself pursuing strategic self-sufficiency and military modernization in anticipation of an ongoing rivalry this century. Chart 6Biden's Coopts Trump's Trade And Manufacturing Agenda Bottom Line: Biden’s $2.4 trillion American Jobs Plan has an 80% chance of passing Congress later this year with a net increase to the fiscal thrust of between $700 billion and $1.3 trillion, depending on how many and how high the corporate tax hikes. The other $2 trillion social spending part of Biden’s plan has only a 50/50 chance of passage. The infrastructure and green energy rebuild should be understood as a return of Big Government motivated by populism and Great Power competition – it is a geopolitical theme with enormous momentum. The result will be faster US growth and higher inflation expectations, with the upside risk of a productivity boom (or boomlet) from the combination of public and private sector innovation. Investors should not bet against the cyclical bull market even though any increase in long-term potential GDP is speculative. A Fourth Taiwan Strait Crisis And The Cuban Missile Crisis Biden’s American Jobs Plan reserves $50 billion for US semiconductor manufacturing, a vast sum, larger than expectations and far larger than the relatively small public investments that helped revolutionize the US chip industry in the 1980s. But it will take a long time for these investments to pay off in the form of secure and redundant supply chains, while a semiconductor shortage is raging today that is already entangled with the US-China rivalry and tensions over the Taiwan Strait. The risk of a diplomatic or military incident is urgent because the chip shortage exacerbates China’s vulnerabilities at a time when the Biden administration is about to make critical decisions regarding the tightness of new export controls that cut off China’s access to US semiconductor chips, equipment, and parts. If the Biden administration appears to pursue a full-fledged tech blockade, as the Trump administration seemed bent on doing, then China will retaliate economically or militarily. Before going further we should point out that there are still areas of potential US-China cooperation under the Biden administration that could reduce tensions this year (though not over the long run). Biden and Xi Jinping might meet virtually as early as this month to discuss carbon emission reduction targets. Meanwhile China is positioning itself to serve as power-broker on two major foreign policy challenges – Iran and North Korea. Biden expressly seeks Chinese and Russian assistance based on the mutual interest in nuclear non-proliferation. Notably, Beijing’s renewed strategic dealings with Iran over the past month highlight its confidence that Biden does not have the appetite to stick with Trump’s “maximum pressure” but rather will seek to reduce sanctions and restore the 2015 nuclear deal. Hence China will seek to parlay influence over Tehran in exchange for reduced US pressure on its trade and economy (Chart 7). Beijing is making a similar offer on North Korea. Chart 7China Holds The Key To Iran, As With North Korea? Ironically both Iranian and North Korean geopolitical tensions should skyrocket in the short term since high-stakes negotiations are beginning, even though they are ultimately more manageable risks than the mega-risk of US-China conflict over Taiwan. China cannot gain the advanced technology it needs to achieve a strategic breakthrough if the US should impose a total tech blockade, e.g. draconian export controls enforced on US allies. Yet it is highly unlikely to gain the tech by seizing Taiwan, since war would likely destroy the computer chip fabrication plants and provoke global sanctions that would crush its economy. The result is that China is launching a massive campaign of domestic production and indigenous innovation while circumventing US restrictions through cyber and other means. Still, a dangerous strategic asymmetry is looming because the US will retain access to the most advanced computer chips via its alliances and on-shoring, whereas China will remain vulnerable to a tech blockade via Taiwan. This brings us to our chief global geopolitical risk: a US-China showdown in the Taiwan Strait. Highlighting the urgency of the risk, Admiral John Aquilino, the nominee for Commander of the US Indo-Pacific Command, told the Senate Armed Services Committee that China might not wait six years to attack Taiwan: “My opinion is that this problem is much closer to us than most think and we have to take this on.”5 To illustrate the calculus of such a showdown – and our reasons for maintaining an alarmist tone and building up market hedges and safe-haven investments – we turn to game theory. Game theory is not a substitute for empirical analysis but a tool to formalize complex international systems with multiple decision-makers. An obvious yet fair analogy to a US-China-Taiwan crisis is the Cuban missile crisis of 1962.6 The standard construction of the Cuban missile crisis in game theory goes as follows: if the US maintains a blockade and the Soviets withdraw their missiles a compromise is achieved and war is averted; if the US conducts air strikes and the Soviets maintain or use their missiles then war ensues. The payouts to each player are shown in the matrix in Diagram 1. Diagram 1Cuban Missile Crisis, 1962 One concern about this construction is that the payouts may underestimate the costs of war since nuclear arms could be used. We insert a comment into the diagram highlighting that the payouts could be altered to account for nuclear war. Note that this alteration does not change the final outcome: the equilibrium scenario is still US blockade and Soviet withdrawal, which is what happened in reality. If we model a US-China-Taiwan conflict along similar lines, the US takes the role of the Soviet Union while China stands where the US stood in 1962 (Diagram 2). This is a theoretical scenario in which the US offers Taiwan a decisive improvement in its security or offensive military capabilities. However, because of the unique circumstances of the Chinese civil war, in which the victors established the People’s Republic of China in Beijing in 1949 and the defeated forces retreated to Taiwan, China’s regime legitimacy is at stake in any showdown over Taiwan. If Beijing suffered a defeat that secured Taiwan’s independence while degrading Beijing’s regime legitimacy and security, the Chinese regime might not survive the domestic blowback.7 Diagram 2Fourth Taiwan Strait Crisis – What Happens If The US Offers Game-Changing Military Support To Taiwan? Thus we reduce the Chinese payout in the case of American victory. In the top right cell of Diagram 2, the row player’s payout falls from two points (2ppt) in the first diagram to one point (1ppt) in this diagram. This seemingly slight change entirely alters the outcome of the game. Beijing now faces equally bad outcomes in the event of defeat, whereas victory remains preferable to a tie. Therefore as long as China believes that the US will not resort to nuclear weapons to defend Taiwan (a reasonable assessment) then it may make the mistake of opting for military force to ensure victory. Fortunately for global investors the US is not providing Taiwan with game-changing military capabilities, although it is ultimately up to China to decide what threatens its security and the US is in the process of upgrading Taiwan’s defense in an effort to deter Beijing from forceful reunification. Thus the exercise demonstrates why we do not expect immediate war – no game-changer yet – but at the same time it shows why war is much likelier than the consensus holds if the military or political status quo changes in a way that China deems strategically unacceptable. A lower-degree Taiwan crisis should be expected – i.e. one in which the US maintains tech restrictions, offers arms sales or military training that do not upend the military balance, or signs free trade agreements or other significant upgrades to the US-Taiwan relationship.8 We would give a 60% probability to some kind of crisis over the next 12-24 months. The global equity market could at least suffer a 10% correction in a standard geopolitical crisis and it could easily fall 20% if US-China war appears more likely. What would trigger a full-fledged Taiwan war? We would grow even more alarmed if we saw one of three major developments: Chinese internal instability giving rise to a still more aggressive regime; the US providing Taiwan with offensive military capabilities; or Taiwan seeking formal political independence. The first is fairly likely, the second lends itself to miscalculation, and the third is unlikely. But it would only take one or two of these to increase the war risk dramatically. Bottom Line: The Taiwan Strait is still the critical geopolitical risk and Biden’s policy on China is still unclear. Iranian and North Korean tensions will escalate in the short run but the fundamental crisis lies in Taiwan. Since some kind of showdown is likely and war cannot be ruled out we advise clients to accumulate safe-haven assets like the Japanese yen and otherwise not to bet headlong against the US dollar until it loses momentum. Emerging Markets Round-Up In this section we will briefly update some important emerging market themes and views: Chart 8Favor USMCA Over Putin's Russia Russia: US-Russia tensions are escalating in the face of Biden’s reassertion of the US bid for liberal hegemony, which poses a direct threat to Russia’s influence in eastern Europe and the former Soviet Union. Ukraine is expected to see a renewed conflict this spring. The top US and Russian military commanders spoke on the phone for the second time this year after Ukrainian military reports indicated that Russia is amassing forces on the border. We also assign a 50/50 chance that the US will use sanctions to prevent the completion of the NordStream II pipeline from Russia to Germany, an event that would shake up the German election as well as provoke a Russian backlash. The Russian ruble has suffered a long slide since Putin’s invasion of Georgia in 2008 and Crimea in 2014 and the country’s currency and equities have not staged much of a comeback amid the global cyclical upswing and commodity price rally post-COVID. We recommend investors favor the Canadian dollar and Mexican peso as oil plays in the context of American stimulus and persistent Russian geopolitical risk (Chart 8). We also favor developed market European stocks over emerging Europe, which will suffer from renewed US-Russia tensions. Brazil: Brazilian President Jair Bolsonaro’s domestic political troubles are metastasizing as expected – the rally-around-the-flag effect in the face of COVID-19 has faded and his popular approval rating now looks dangerously like President Trump’s did, relative to previous presidents, which is an ominous warning for the “Trump of the South,” who faces an election in October 2022 (Chart 9). The COVID-19 deaths are skyrocketing, with intensive care units reaching critical levels across the country. The president has reshuffling his cabinet, including all three heads of the military in an unprecedented disruption that compounds fears about his willingness to politicize the military.9 Meanwhile the judicial system looks likely (but not certain) to clear former President Luiz Inácio Lula da Silva to run against Bolsonaro for the presidency, a potent threat (Chart 10). Bolsonaro’s three pillars of political viability have cracked under the pandemic: the country remains disorderly, the systemic corruption and the “Car Wash” scandal under the former ruling party are no longer at the center of public focus, and fiscal stimulus has replaced structural reform. Chart 9Brazil: Will ‘Trump Of The South’ Face Trump’s Fate? Our Brazilian GeoRisk Indicator has reached a peak with Bolsonaro’s crisis – and likely breaking of the fiscal spending growth cap put in place at the height of the political crisis in 2016 – while Brazilian equities relative to emerging markets have hit a triple bottom (Chart 11). It is too soon for investors to buy into Brazil given that the political upheaval can get worse before it gets better and a Lula administration is no cure for Brazil’s public debt crisis, though a short-term technical rally is at hand. Chart 10Brazil’s Lula Looks To Be A Contender In 2022? Chart 11Brazil: Policy Risk Peaks, Equities Hit Triple-Bottom Versus EM India: A lot has happened since we last updated our views on India, South Asia, and the broader Indian Ocean basin. Farmer protests broke out in India, forcing Prime Minister Narendra Modi to temporarily suspend his much-needed structural reforms to the agricultural sector, while China-backed military coup broke out in Myanmar, and the US election set up a return to negotiations with Iran and the Taliban in Afghanistan. Perhaps the biggest surprise was the Indo-Pakistani ceasefire, despite boiling tensions over India’s decision to make Jammu and Kashmir a federal union territory. The ceasefire is temporary but it does highlight a changing geopolitical dynamic in the region. India and Pakistan ceased fire along the Line of Control where they have fought many times. The ceasefire does not resolve core problems – Pakistan will not stop supporting militant proxies and India will not grant Kashmir autonomy – but it does show their continued ability to manage the intensity of disputes while dealing with the global pandemic. An earlier sign of coordination occurred after the exchange of air strikes in early 2019, which preceded the Indian election and suggested that India and Pakistan had the ability to control their military encounters. India’s move to revoke the autonomy of Jammu and Kashmir in August 2019, along with various militant operations, created the basis for another major conflict this year. After all, the Kargil war in 1999 followed nuclear weaponization, while the 2008 conflict followed the Mumbai attack. But instead India and Pakistan have agreed to a temporary truce. A major India-Pakistan conflict would be a “black swan” as nobody is expecting it at this point. Not coincidentally, India and China also reduced tensions after the flare-up in their Himalayan territorial disputes in 2020. China may be reducing tensions now that it no longer has to distract its population from Trump and the US election. China is shifting its focus to the Myanmar coup, another area where it hopes to parlay its influence with a Biden administration preoccupied with democracy and human rights. Sino-Indian tensions will resume later, especially as China continues its infrastructure construction at the farthest reaches of its territory for the sake of economic stimulus, internal control, and military logistics. The Biden administration is adopting the Trump administration’s efforts to draw India into a democratic alliance. But more urgently it is trying to withdraw from Afghanistan and cut a deal with Iran, which means it will need Indian and Pakistani cooperation and will want India to play a supportive role. Typically India eschews alliances and it will disapprove of Biden’s paternalism. For both China and Pakistan, making a temporary truce with India discourages it from synching up relations with the US immediately. Still, we expect India to cooperate more closely with the US over time, both on economic and security matters. This includes a beefed up “Quad” (Quadrilateral Security Dialogue) with Japan and Australia, which already have strong economic ties with India. Biden’s attempt to frame US foreign policy as a global restoration of democracy and liberalism will not go very far if he alienates the largest democracy in the world and in Asia. Nor will his attempt to diversify the US economy away from China or counter China’s regional assertiveness. Therefore Biden will have to take a supportive role on US-India ties. We are sticking with our contrarian long India / short China equity trade (Chart 12). India cannot achieve its geopolitical goals without reforming its economy and for that very reason it will redouble its structural reform drive, which is supported by changing voting patterns in favor of accelerating nationwide economic development. India will also receive a tailwind from the US and its allies as they seek to diversify production sources and reduce supply chain dependency on China, at least for health, defense, and tech. Meanwhile China’s government is pursing import substitution, deleveraging, and conflict with its neighbors and the United States. While Chinese equities are much cheaper than Indian equities on a P/E basis, they are not as pricey on a P/B and P/S basis (Chart 13) – and valuation trends can continue under the current macro and geopolitical backdrop. Indian equities are more volatile but from a long-term and geopolitical point of view, India’s moment has arrived. Chart 12Contrarian Trade: Stick To Long India / Short China Bottom Line: Stay long Indian equities relative to Chinese and stay short Russian and Brazilian currencies and assets. These views are based on political and geopolitical themes that will remain relevant over the long run but are also seeing short-term confirmation. Chart 13Indian Stocks Not As Over-Priced On Price-To-Book, Price-To-Sales Investment Takeaways To conclude we want to highlight two investment takeaways. First, while the market has rallied in expectation of the US stimulus package, Biden must now get the package passed. This roller coaster process, combined with the inevitable European recovery once the vaccine rollout gets on its feet (Chart 14), will power an additional rally in cyclicals, value stocks, and commodities. This is true as long as China does not tighten monetary and fiscal policy too abruptly, a risk we have highlighted in previous reports. Chart 14Europe's Vaccination Problem While the US is pursuing “Buy American” provisions within its stimulus package, its growing trade deficit shows that it will be forced to import goods and services to meet its surging demand. This is beneficial for its nearest trade partners, Canada and Mexico, and Europe – as well as China substitutes further afield in some cases. Our European Investment Strategist Mathieu Savary has pointed out the opportunities lurking in Europe at a time when vaccine troubles and lockdowns are clouding the medium-term economic view, which is brightening. He recommends going long the “laggard” sectors and sub-sectors that have not benefited much relative to “leaders” that rallied sharply in the wake of last year’s stimulus, vaccine discovery, and defeat of President Trump (Chart 15). The laggard sectors are primed to outperform on rising US interest rates and decelerating Chinese economy as well (Chart 16). Therefore we recommend going long his basket of Euro Area laggards and short the leaders. Chart 15Europe’s Laggards And Leaders Chart 16Macro Forces Favor The Laggards over the Leaders Chart 17Will OPEC 2.0 Maintain Production Discipline To Keep Oil Supplies Tight? Commodities – especially base metals – will continue to benefit from the global and European reopening as well as the US infrastructure buildout, assuming that China does not shoot its economy in the foot. Our Commodity & Energy Strategy highlights that global oil prices should remain in a $60-$80 per barrel range over the coming years on the back of tight supply/demand balances and ongoing OPEC 2.0 production management (Chart 17). We continue to see upside oil price risks in the first half of the year but downside risks in the second half. The US pursuit of a deal with Iran may trigger sparks initially – i.e. unplanned supply outages – but this will be followed by increased supply from Iran and/or OPEC 2.0 as a deal becomes evident. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 White House, "Remarks by President Biden on the American Jobs Plan," Pittsburgh, Pennsylvania, March 31, 2021, whitehouse.gov. 2 A bipartisan bill is conceivably, barely, since Republicans face pressure to join with such a popular bill, but they cannot accept the corporate tax hikes, unionization, or green boondoggles that will inevitably occur. 3 The pandemic and President Trump’s hands-off attitude toward it helped galvanize this revival of Big Government, but the revival was already well on its way prior to the pandemic. 4 White House, "Remarks by President Biden in Press Conference," March 25, 2021, whitehouse.gov. 5 Again, "the most dangerous concern is that of a military force against Taiwan," though he implied that Beijing would wait until after the February 2022 Winter Olympics before taking action. He requested that the US urgently increase regional military defense. See Senate Armed Services Committee, "Nomination – Aquilino," March 23, 2021, armed-services.senate.gov. 6 At that time the Soviet Union stationed nuclear missiles in Cuba that threatened the US homeland directly and sent a convoy to make the missile installation permanent. The US imposed a blockade. A showdown ensued, at great risk of war, until the Soviets withdrew and the Americans made some compromises regarding missiles in Turkey. 7 Note that this was not the case for the US in 1962: Cuba did not have special significance for the legitimacy of the American republic and the American regime would have survived a defeat in the showdown, although its security would have been greatly compromised. 8 Taiwan is proposing to buy a missile segment enhancement for its Patriot Advanced Capability-3 missile defense system for delivery in 2025, though this is not yet confirmed by the Biden administration. See for example Yimou Lee, "Taiwan To Buy New U.S. Air Defence Missiles To Guard Against China," Reuters, March 31, 2021, reuters.com. 9 See Monica Gugliano, "I Will Intervene! The Day Bolsonaro Decided To Send Troops To The Supreme Court," Folha de São Paulo, August 2020, piaui.folha.uol.com.br.
Highlights China and India periodically fight each other on their fuzzy Himalayan border with zero market consequences. A major conflict is possible in the current environment – but it would present a buying opportunity. Chinese escalation with India would not have a negative impact on global trade and economy, unlike escalation with the US or its East Asian allies. If China gets into a major conflict with India, it is less likely to stage major military actions in the South China Sea or Taiwan Strait. It would reduce much more significant geopolitical risks. Go strategically long Indian pharmaceuticals. Feature India and China have engaged in their first deadly military clash since 1967. An Indian colonel and at least 20 troops died in fighting on June 15 in the Galwan Valley, Ladakh, where territorial disputes have heated up over the past month.At least 50 Chinese troops are estimated dead.1 Chart 1Regional Equities May Not Shrug Off War In Himalayas ... At First It was a minor incident. No shots were fired. Combatants used stones and knives and threw each other off cliffs. However, the occasion of the battle was a negotiation to de-escalate tensions, and talks have gone on since June 3. So that bodes ill. Prime Minister Narendra Modi’s government has not responded but China’s foreign ministry is making conciliatory remarks. Normally India-China border clashes occur during the summer, when weather permits, and do not last long and do not impact the rest of the world, either politically or financially. However, the structural and cyclical drivers of the conflict suggest it could escalate over the summer. A major escalation between nuclear powers is unlikely but could conceivably cause volatility in global financial markets. Global equity investors are focused on other things (COVID-19, global stimulus), but recent volatility suggests that Chinese, Indian, and Pakistani bourses could be vulnerable to any major military escalation (Chart 1). However, a Himalayan-inspired selloff would be short-lived and would present a buying opportunity. India-China tensions are far less relevant to global financial markets than China’s disputes with the United States in East Asia. If the US uses India as a pretext for tougher actions on China, then that is a different story. But it is unlikely for reasons explained below. Our base case strategic assessment of India remains the same: Chinese expansionism will pressure India to speed up economic development to gain greater influence in South Asia. India will also pursue better trade and defense relations with the United States and its allies in East Asia and the Pacific. We are tactically cautious on global equities, but strategically we expect equities to beat bonds and cyclicals to beat defensives. Selloffs stemming from Himalayan conflict will create buying opportunities for emerging market equities, especially India. The Drivers Of The Ladakh Skirmish India and China have a 2,170-mile border in the Himalayan mountains that is disputed in India’s northwest (Aksai Chin) and northeast (Sikkim; Arunachal Pradesh). These border disputes have simmered for decades and occasionally flare into violent incidents, usually meaningless. An India-China border war could occur, but is unlikely. Today’s clashes are mostly taking place in eastern Ladakh, as with disputes in 2013-14. Minor incidents have also occurred in India’s northeast (Naku La, Sikkim). These may be unrelated, but they may also suggest a broad India-China border conflict is in the works (Map 1). Map 1India And China Often Fight Over Undefined Himalayan Border When Ice Melts There is always a local spark for clashes along the Line of Actual Control. These tend to be triggered by infrastructure construction or military patrols that cross the countries’ various border claims. Typically China triggers the incident as it is always pouring more money and concrete into new structures to solidify its territorial claims, whereas India’s resources are more limited. However, in recent years India has grown more capable. Both sides may also be surging infrastructure spending amid the recession (Chart 2). Chart 2China No Longer Alone In Nation-Building In Himalayas Chart 3China's Slower Growth Jeopardizes Communist Party Legitimacy In the current dispute both sides claim the other broke the peace. Indian builders supposedly violated China’s space while working on the Darbuk-Shayok-DBO road which connects to an airfield near Galwan Valley, the site of the clash. But the Indian side argues that Chinese military forces have ventured several miles from their usual outposts and amassed major forces on their side suggesting they are preparing for a bigger effort to expand their control of territory. 2 We may never know who “started” it. There is no clear border and even the Line of Actual Control is hard to define.3 Investors should not confuse the proximate cause of this conflict for the underlying cause. There are structural and cyclical factors at work on both sides: 1. China’s declining domestic stability and rising international assertiveness. The crises of 2008, 2015, 2018-19, and 2020 have caused a hard break in China’s economic model. Slower trend growth jeopardizes the Communist Party’s long-term monopoly on power (Chart 3). The Xi Jinping administration has responded to each crisis by tightening the party’s grip and reasserting central Beijing control. This is true at home, in peripheral territories like Xinjiang and Hong Kong, and abroad, as in the South China Sea and the Belt and Road Initiative. Territorial disputes have flared up across China’s borders. India is no exception, with incidents in 2013, 2014, 2017, and now 2020 marking the change (Table 1). Table 1China’s Territorial Assertiveness Triggers Clashes With India The China-Pakistan Economic Corridor strengthens the alliance between these two countries and deepens India’s insecurities. India perceives China’s Belt and Road Initiative as a threat of economic and eventually military encirclement. In 2017, the Doklam dispute between China, Bhutan, and India – which lasted over two months – served to distract the Chinese populace from a major increase in US pressure on China’s periphery. That was President Trump’s “fire and fury” campaign to intimidate North Korea into entering nuclear negotiations (Chart 4). In 2020, China faces its first recessionary environment since the mid-1970s as well as rocky relations with the United States over trade, technology, Hong Kong, North Korea again, and possibly even the Taiwan Strait. It is a convenient time to turn the public’s attention to the Himalayas. Chart 4China's Last Dispute With India Occurred During US-North Korea Tensions 2. India’s emerging national consensus and international coming-of-age. India’s rise as a global power has accelerated since the Great Recession, especially after oil prices fell in 2014. Prime Minister Modi has won two smashing general elections with single-party majorities, in 2014 and 2019. His movement also maintains the upper hand in state legislatures, which is important given that India’s weak federal government cannot simply force structural reforms onto the country (Map 2). Modi’s electoral success reflects a deeper national consensus on the need for stronger central leadership, faster economic development, deeper international trade and investment ties, and pro-efficiency reforms such as the creation of a single market. The policy retreat from globalization benefits insular and service-oriented economies like India at the expense of mercantilist trading powers such as China. America’s pivot to Asia and “Indo-Pacific” strategy create a chance for India to attract investment as multinational corporations diversify away from China (Chart 5). Map 2Modi’s Political Capital At State-Level Chart 5India Attracts Investment As Supply Chains Diversify From China Chart 6US And India Fiscal Stimulus Enable Supply Chain Shift Out Of China In August 2019, after Modi’s big election victory, he launched an ambitious agenda of state-building. He converted the autonomous region of Jammu and Kashmir into two union territories under New Delhi: Jammu and Kashmir, and Ladakh. This change of status quo angered China and Pakistan, which felt their own territory threatened. Chinese territorial pressure could be retribution for these administrative reforms. China and Pakistan will also want to undermine Modi’s party in upcoming elections for the state assembly of Jammu and Kashmir. China’s territorial encroachments reflect its desire to gain control of the entire Aksai Chin plateau. India does not want China to gain such a strategic advantage at the head of the Indus River and valley. The global pandemic and recession reinforced these structural and cyclical trends by pushing both India and China to use nationalist devices to divert their populations from domestic ills. The use of fiscal stimulus across the world enables leaders to pursue risky strategic policies (Chart 6). There is also a tactical issue: India took over the chairmanship of the World Health Assembly in May, while the US is lobbying on behalf of Taiwan’s long desire to be represented in the World Health Organization in the wake of COVID-19. China is resisting this call and could be using Ladakh as a pressure tactic.4 How Far Will Sino-Indian Conflict Escalate? Reports suggest that India and China have reinforced troops in and near Ladakh and have brought more firepower and airpower into range.5 Some of this activity, on both sides, consists of seasonal military drills. So it is not certain that a build-up is occurring. China is less constrained and more capable of escalation than India. If China continues pressing its territorial advance, or if India tries to reclaim territory or take other territory in compensation, then the fight will expand. The conflict is taking place in rocky recesses at a far remove from the rest of the world, so there is a temptation to believe that any escalation can be controlled.6 This may be false and lead to tit-for-tat escalation. Table 2Military Balance: India Versus China In Himalayas Which side faces greater constraints? China is least constrained and most capable of escalation. Over the short run, China can utilize improved military command and capabilities in the area and can control the media and political response at home. Besting India would demonstrate that all Asian territorial claimants should defer to China. However, over the long run, aggression would cement the balance-of-power alliance between the US and India. India is more constrained than China, less capable of escalation: Modi has considerable political capital, but his conventional military advantage in this area is eroding and China has the higher ground from which to stage attacks (Table 2). India’s loss in the 1962 Himalayan war with China was a national humiliation. A repeat of such an event could destroy much of Modi’s mystique as a strongman leader and national savior. In the worst-case scenario, China would demonstrate superior military capability while the US and its allies would remain utterly aloof, leaving India looking both weak and isolated. Therefore India will engage in tit-for-tat military response while seeking diplomatic de-escalation. The US lacks interest in the dispute: Trump has already offered to mediate, presumably to demonstrate his deal-making skills again before the election. But the US does not have a compelling interest in this dispute and India does not want US mediation. If Trump takes punitive measures against China it will be for other reasons. Serious punitive measures require the stock market and economy to relapse, since at the moment Trump’s average approval rating is 43% and he hopes financial and economic gains will help him recover (Diagram 1). Diagram 1Odds President Trump Will Hike Tariffs On China Before US Election The above points suggest that China can afford to escalate if it wants to show India and the rest of Asia that the US is toothless and that China’s territorial claims in Asia should not be opposed. Since COVID-19, China has been aggressive in the South China Sea and Taiwan Strait, despite the fact that these areas bring economic risks. The Himalayas do not. The implication is that China’s risk appetite is large, particularly in territorial disputes, and driven by social and economic pressure at home. Investment Takeaways Because India and China (and Pakistan) have nuclear arms, and because the US could get involved, it is possible that a major escalation could occur and cause volatility in global financial markets. But it would not last long and no parties will use nuclear arms over Himalayan territorial disputes. A major conflict that results in a Chinese victory would subtract from Prime Minister Modi’s political capital and hence weigh on Indian equities, which have broken down badly since COVID-19 (Chart 7). The reason is that strong political support for Modi would enable India to continue making structural economic reforms that increase productivity. Chart 7Indian Equities Underperforming Since COVID-19 Chart 8India’s Path To Regional Primacy Lies Through Economic Opening And Reform In the long run, a major conflict, especially a humiliating defeat, would accelerate India’s attempts to improve national economic prowess for the sake of strategic security. Since India cannot achieve its strategic objective of primacy in South Asia merely through military power, it will need to do so through a stronger economic pull (Chart 8). This is an impetus for structural economic reform even beyond Modi. Hence our secularly bullish outlook on India. Indian pharmaceutical equities offer an investment opportunity (Chart 9). In an attempt to address land acquisition, which is one of the biggest constraints faced by companies looking to invest in India, New Delhi has announced that it is developing an area the size of Luxembourg to attract businesses moving out of China. The government reached out to over 1,000 US companies in April with incentives for them to move their facilities to India, with a focus on industries in which India has a comparative advantage, such as medical equipment suppliers, food processing units, textiles, leather, and auto part makers. Chart 9US And Indian Stimulus Policies Will Boost Investment In Indian Pharma While India is not as economically competitive as China, it could be attractive for non-strategic industries that would not want to relocate to the US but are looking to reduce uncertainty from US-China tensions. The next round of US fiscal stimulus is also likely to contain significant provisions that will incentivize companies to relocate from China, particularly in the medical and health care sector. For global investors, while a major Sino-Indian escalation could lead to short-term volatility, it would ultimately be a positive development if Beijing vented its nationalism on a strip of earth that is not globally relevant, rather than on the seas, which are highly relevant. Conflict between the US and China in East Asia is a far greater risk than Sino-Indian conflict. Indeed Chinese and American actions over the Taiwan Strait, North Korea, or the South and East China Seas are still far more likely than Sino-Indian tensions to affect global trade and stability and financial markets this year. The US could impose sanctions on Chinese tech and trade, a military incident could occur in the Taiwan Strait, North Korea could provoke US President Donald Trump into a new round of “fire and fury” that triggers a showdown with China, or the US and China could fight a naval skirmish in the South or East China Sea. None of these options is low probability, especially surrounding the US election. Over the short run, global investors should prepare for greater equity volatility, primarily because of hiccups in delivering new stimulus in the US, EU, and China, plus US domestic political risks and US-China-Asia strategic tensions. Stay long JPY-USD. Over the long run, a global growth rebound driven by massive global fiscal and monetary stimulus will drive the US dollar to weaken, global equities to outperform bonds, and cyclicals to outperform defensives. We remain long China-sensitive plays as well as infrastructure, cyber-security, and defense stocks. Strategically, go long Indian pharmaceuticals relative to the emerging market benchmark. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The Guardian, "Soldiers fell to their deaths as India and China’s troops fought with rocks," June 17, 2020. 2 See Ashley J. Tellis, "Hustling in the Himalayas: The Sino-Indian Border Confrontation," Carnegie Endowment for International Peace, June 4, 2020. See also Mohan Guruswamy, "India-China Border Dispute: Is A Give And Take Possible Now?" South Asia Monitor, June 3, 2020. 3 The Treaty of Tingmosgang (1684) only specifies one checkpost, at the Lhari Stream near Demchok, leaving everything else to disputed Indian and Chinese claims. See Alexander Davis and Ruth Gamble, "The local cost of rising India-China tensions," June 1, 2020. 4 See Nayanima Basu, "India Isn’t Worried About Tension With China, Unlikely To Give In To US Pressure On Taiwan," May 13, 2020. 5 See Ren Feng and He Penglei, "PLA Xizang Military Command holds coordinated exercise in plateau region," China Military Online, June 15, 2020. See also "空降兵某旅积极探索远程兵力投送新模式 空地同步 奔赴高原". 6 The reason escalation is normally limited is because of the extreme difficulty of operating extended military operations and resupply at 13,000-feet altitude. Both sides have the ability to surge reinforcements and equalize the contest. The cost and difficulty of retaking lost territory is often prohibitive. And while India’s conventional military power may overbalance China in this region, China has the uphill advantage and has made leaps and bounds in operational capabilities in recent decades. In short, escalation is normally controllable. See Aidan Milliff, "Tension High, Altitude Higher: Logistical And Physiological Constraints On The Indo-Chinese Border," War On The Rocks, June 8, 2020.
Highlights So what? EM elections bring opportunities as well as risks. Why? Emerging market equities will benefit as long as China’s stimulus does not fizzle. Modi is on track to win India’s election – which is a positive – though risks lie to the downside. Thailand’s next cycle of political instability is beginning, but we are still cyclically overweight. Indonesia will defy the global “strongman” narrative – go overweight tactically. Populism remains a headwind to Philippine and Turkish assets. Wait for Europe to stabilize before pursuing Turkish plays. Feature Chart 1Risks of China's Stimulus Have Shifted To The Upside China’s official PMIs in March came at just the right time for jittery emerging market investors awaiting the all-important March credit data. EM equities, unlike the most China-sensitive plays, have fallen back since late January, after outperforming their DM peers since October (Chart 1). This occurred amid a stream of negative economic data and policy uncertainties: China’s mixed signals, prolonged U.S.-China trade negotiations, the Fed’s extended “pause” in rate hikes, the inversion of the yield curve, Brexit, and general European gloom. We have been constructive on EM plays since February 20, when we determined that the risks of China’s stimulus had shifted to the upside. However, several of the EM bourses that are best correlated with Chinese stimulus are already richly valued (the Philippines, Indonesia, Malaysia, etc). The good news is that a series of elections this spring provide a glimpse into the internal politics of several of these countries, which will help determine which ones will outperform if we are correct that global growth will find its footing by Q3. First, A Word On Turkey … More Monetary Expansion On The Way Local elections in Turkey on March 31 have dealt a black eye to President Recep Tayyip Erdogan. His ruling Justice and Development Party (AKP) has lost control of the capital Ankara for the first time since 2004. Erdogan has also (arguably) conceded the mayoralty of Istanbul, the economic center of the country, where he first rose to power in 1994. Other cities also fell to the opposition. Vote-counting is over and the aftermath will involve a flurry of accusations, investigations, and possibly unrest. Erdogan’s inability to win elections with more than a slim majority is a continual source of insecurity for him and his administration. This weekend’s local elections reinforce the point. The AKP alone failed to cross 45% in terms of popular votes. Combined with its traditional ally – the Nationalist Movement Party (MHP) – it received 51.6% of the total vote (in the 2015 elections, the two parties combined for over 60% of the vote). While losing the local elections will not upset the balance in parliament, it is a rebuke to Erdogan over his economic policy and a warning to the AKP for the future. Erdogan does not face general elections until 2023. But judging by his response to the first serious challenge to his rule – the Gezi Park protests of May 2013 – his reaction will be to double down on unorthodox, populist economic policy. Chart 2Erdogan Will Respond With Populist Politics Back in 2013, the government responded to the domestic challenge through expansive monetary policy. The central bank gave extraordinary liquidity provisions to the banking system. Chart 2 clearly shows that the liquidity injections began with the Gezi protests. These provisions only paused in 2016-17, when global growth rebounded on the back of Chinese stimulus and EM asset prices rose, supporting Turkey’s currency and enabling the central bank to hold off. Today, the severe contraction in GDP (by 3% in Q4 2018), with a negative global backdrop, will likely end Erdogan’s patience with tight monetary policy.1 To illustrate how tight policy has been, note that bank loan growth denominated in lira is contracting at a rate of 17% in real terms. Given the authorities’ populist track record, rising unemployment will likely lead to further “backdoor” liquidity easing. A new bout of unorthodox monetary policy will be negative for domestic bank equities, local-currency bonds, and the lira. As one of the first EM currencies and bourses to begin outperforming in September 2018, Turkey has been at the forefront of the EM mini-rally over the past six months. But with global growth still tepid, this mini-cycle is likely to come to an end for the time being. Watch for the bottoming in Chinese followed by European growth before seeking new opportunities in Turkish assets. Erdogan’s domestic troubles could also prompt him to renew his foreign combativeness, which raises tail risks to Turkish risk assets, such as through U.S. punitive measures. Last year, Erdogan responded to the economic downswing by toning down his belligerent rhetoric and mending fences with Europe and the U.S. However, a reversion to populism may require him to seek a convenient distraction. The U.S. is withdrawing from Syria and the Middle East, leaving Turkey in a position where it needs other relationships to pursue its interests. Russia is a key example. Currently Erdogan is bickering with the U.S. over the planned purchase of a missile defense system from Russia. But the consequence is that relations with the U.S. could deteriorate further, potentially leading to new sanctions. Bottom Line: Turkey is still in the grip of populist politics and will respond to the recession and domestic discontent with easier monetary policy which would bode ill for the lira and lira-denominated assets. The stabilization of the European economy is necessary before investors attempt to take advantage of the de-rating of Turkish assets. India: Focus On Modi’s Political Capital We have long maintained that Modi is likely to stay in power after India’s general election on April 11-May 19. His coalition has recovered in public opinion polling since the Valentine’s Day attack on Indian security forces in Indian Kashmir (Chart 3). The government responded to the attacks by ordering airstrikes on February 26 against Pakistani targets in Pakistani territory for the first time since 1974. The attack was theatrical but the subsequent rally-around-the-flag effect gave Modi and his Bharatiya Janata Party (BJP) a badly needed popular boost. The market rallied on the back of Modi’s higher chances of reelection. Modi is the more business-friendly candidate, as opposed to his chief rival, Rahul Gandhi of the Indian Congress Party. Nevertheless, election risks still lie to the downside: Modi and his party are hardly likely to outperform their current 58% share of seats in the lower house of parliament, since the conditions for a wave election – similar to the one that delivered the BJP a single-party majority in 2014 – do not exist today. While the range of outcomes is extremely broad (Chart 4), the current seat projections shown in Chart 3 put Modi’s coalition right on the majority line. Meanwhile his power is already waning in the state legislatures. Thus Modi’s reform agenda has lost momentum, at least until he can form a new coalition. This will take time and markets may ultimately be disappointed by the insufficiency of the tools at his disposal in his second term. Indian equities are the most expensive in the EM space, and only more so after the sharp rally in March on the back of the Kashmir clash and Modi’s recovering reelection chances (Chart 5). Additional clashes with Pakistan are not unlikely during the election season, despite the current appearance of calm. This is because Modi’s patriotic dividend in the polls could fade. Since even voters who lack confidence in Modi as a leader believe that Pakistan is a serious threat (Chart 6), he could be encouraged to stir up tensions yet again. This would be playing with fire but he may be tempted to do it if his polling relapses or if Pakistan takes additional actions. Chart 5...And Lofty Valuations Further escalation would be positive for markets only so long as it boosts Modi’s chances of reelection without triggering a wider conflict. Yet the standoff revealed that these two powers continue to run high risks of miscalculation: their signaling is not crystal clear; deterrence could fail. Thus, further escalation could become harder to control and could spook the financial markets.2 Even if Modi eschews any further jingoism, his lead is tenuous. First, the economic slowdown is taking a toll – even the official unemployment rate is rising (Chart 7) and the government has been caught manipulating statistics. There is no time for the economy to recover enough to change voters’ minds. Opinion polls show that even BJP voters are not very happy about the past five years. They care more about jobs and inflation than they do about terrorism, and a majority thinks these factors have deteriorated over Modi’s five-year term (Chart 8). Chart 7Manipulated Stats Can't Hide Deteriorating Economy If the polling does not change, Modi will win with a weak mandate at best. A minority government or a hung parliament is possible. A Congress Party-led coalition, which would be a market-negative event, cannot be ruled out. The latter especially would prompt a big selloff, but anything short of a single-party majority for Modi will register as a disappointment. Bottom Line: There may be a relief rally after Modi is seen to survive as prime minister, but his likely weak political capital in parliament will be disappointing for markets. The market will want additional, ambitious structural reforms on top of what Modi has already done, but he will struggle to deliver in the near term. While we are structurally bullish, in the context of this election cycle – which includes rising oil prices that hinder Indian equity outperformance – we urge readers to remain underweight Indian equities within emerging markets. Thailand: An Outperformer Despite Quasi-Military Rule A new cycle of political instability is beginning in Thailand as the country transitions back into civilian rule after five years under a military junta. However, this is not an immediate problem for investors, who should remain overweight Thai equities relative to other EMs on a cyclical time horizon. The source of Thai instability is inequality – both regional and economic. Regionally, 49% of the population resides in the north, northeast, and center, deprived of full representation by the royalist political and military establishment seated in Bangkok (Map 1). Economically, household wealth is extremely unevenly distributed. Thailand’s mean-to-median wealth ratio is among the highest in the world (Chart 9). Eventually these factors will drive the regional populist movement – embodied by exiled Prime Minister Thaksin Shinawatra and his family and allies – to reassert itself against the elites (the military, the palace, and the civil bureaucracy). New demands will be made for greater representation and a fairer distribution of wealth. The result will be mass street protests and disruptions of business sentiment and activity that will grab headlines sometime in the coming years, as occurred most recently in 2008-10 and 2013-14. Chart 10Social Spending Did Not Hinder Populism The seeds of the next rebellion are apparent in the results of the election on March 24. The junta has sought to undercut the populists by increasing infrastructure spending and social welfare (Chart 10), and controlling rice prices for farmers. Yet the populists have still managed to garner enough seats in the lower house to frustrate the junta’s plans for a seamless transition to “guided” civilian rule. The final vote count is not due until May 9 but unofficial estimates suggest that the opposition parties have won a majority or very nearly a majority in the lower house. This is despite the fact that the junta rewrote the constitution, redesigned the electoral system to be proportional (thus watering down the biggest opposition parties), and hand-picked the 250-seat senate. Such results point to the irrepressible population dynamics of the “Red Shirt” opposition in Thailand, which has won every free election since 2001. Nevertheless, the military and its allies (the “Yellow Shirt” political establishment) are too powerful at present for the opposition to challenge them directly. The junta has several tools to shape the election results to its liking in the short run.3 It would not have gone ahead with the election were this not the case. As a result, the cycle of instability is only likely to pick up over time. Investors should note the silver lining to the period of military rule: it put a halt to the spiral of polarization at a critical time for the country. The unspoken origin of the political crisis was the royal succession. The traditional elites could not tolerate the rise of a populist movement that flirted with revolutionary ideas at the same time that the revered King Bhumibol Adulyadej drew near to passing away. This combination threatened both a succession crisis and possibly the survival of the traditional political system, a constitutional monarchy backed by a powerful army. With the 2014 coup and five-year period of military rule (lengthy even by Thai standards), the military drew a stark red line: there is no alternative to the constitutional monarchy. The royalist faction had its bottom line preserved, at the cost of an erosion of governance and democracy. The result is that going forward, there is a degree of policy certainty. Chart 11Thai Confidence Has Bottomed Chart 12Strong Demand Sans Risk Of Being Overleveraged The long-term trend of Thai consumer confidence tells the story (Chart 11). Optimism surged with the election of populist Thaksin in the wake of the Asian Financial Crisis in 2001. The long national conflict that ensued – in which the elites and generals exiled Thaksin and ousted his successors, and the country dealt with a global financial crisis and natural disasters – saw consumer confidence decline. However, the coup of 2014 and the royal succession (to be completed May 4-6 with the new king’s coronation) has reversed this trend, with confidence trending upward since then. Revolution is foreclosed yet the population is looking up. Military rule is generally disinflationary in Thailand and this time around it initiated a phase of private sector deleveraging. Yet the economy has held up reasonably well. Private consumption has improved along with confidence and investment has followed, albeit sluggishly (Chart 12). The advantage is that Thailand has had slow-burn growth and has avoided becoming overleveraged again, like many EM peers. Chart 13Thailand Outperformed EM Despite Military Interference Furthermore, Thailand is not vulnerable to external shocks. It has a 7% current account surplus and ample foreign exchange reserves. It is not too exposed to China, either economically or geopolitically: China makes up only 12% of exports, while Bangkok has no maritime-territorial disputes with Beijing in the South China Sea. In fact, Thailand maintains good diplomatic relations with China and yet has a mutual defense treaty with the United States (the oldest such treaty in Asia). It is perhaps the most secure of any of the Southeast Asian states from the point of view of the secular U.S.-China conflict. Finally, if our forecast proves wrong and political instability returns sooner than we expect, it is important to remember that Thailand’s domestic political conflicts rarely affect equity prices in a lasting way. Global financial crises and natural disasters have had a greater impact on Thai assets over the past two decades than the long succession crisis. Thailand has outperformed both EM and EM Asia during the period of military interference, though democratic Indonesia has done better (Chart 13). Bottom Line: Thailand’s political risks are domestic and stem from regional and economic inequality, which will result in a revived opposition movement that will clash with the traditional military and political elite. This clash will eventually create policy uncertainty and political risk. But it will need to build up over time, since the military junta has strict control over the current environment. Meanwhile macro fundamentals are positive. Indonesia: Rejecting Strongman Populism We do not expect any major surprises from the Indonesian election. Instead, we expect policy continuity, a marginal positive for the country’s equities. However, stocks are overvalued, overexposed to the financial sector,4 and vulnerable if global growth does not stabilize. The most important trend since the near collapse of Indonesia in the late 1990s has been the stabilization of the secular democratic political system and peaceful transition of power. That trend looks to continue with President Joko Widodo’s likely victory in the election on April 17. President Jokowi defeated former general Prabowo Subianto in the 2014 election and has maintained a double-digit lead over his rival in the intervening years (Chart 14). Prabowo is a nationalist and would-be strongman leader who was accused of human rights violations during the fall of his father-in-law Suharto’s dictatorship in 1998. Emerging market polls are not always reliable but a lead of this size for this long suggests that the public knows Prabowo and does not prefer him to Jokowi. In fact he never polled above 35% support while Jokowi has generally polled above 45%. The incumbent advantage favors Jokowi. Household consumption is perking up slightly and consumer confidence is high (see Chart 11 above). Wages have received a big boost during Jokowi’s term and are now picking up again, in real as well as nominal terms and for rural as well as urban workers. Jokowi’s minimum wage law has not resulted in extravagant windfalls to labor, as was feared, and inflation remains under control (Chart 15). Government spending has been ramped up ahead of the vote (and yet Jokowi is not profligate). All of these factors support the incumbent. Real GDP growth is sluggish but has trended slightly upward for most of Jokowi’s term. Chart 15Favorable Economic Conditions Support Incumbent Jokowi Jokowi has been building badly needed infrastructure with success and has been attracting FDI to try to improve productivity (Chart 16). This is the most positive feature of his government and is set to continue if he wins. A coalition in parliament has largely supported him after an initial period of drift. The biggest challenge for Jokowi and Indonesia are lackluster macro fundamentals. For instance, twin deficits, which show a lack of savings and invite pressure on the currency, which has been very weak. The twin deficits have worsened since 2012 because China’s economic maturation has forced a painful transition on Indonesia, which it has not yet recovered from. There is some risk to governance as Jokowi has chosen Ma’ruf Amin, the top cleric of the world’s largest Muslim organization, as his running mate. Jokowi wants to counteract criticisms that he is not Islamic enough (or is a hidden Christian), which cost his ally the governorship of Jakarta in 2017. However, Jokowi is not a strongman leader like Erdogan in Turkey, whose combination of Islamism and populism has been disastrous for the country’s economy. As mentioned, Jokowi will be defeating the would-be strongman Prabowo, who has also allied with Islamism. In fact, Indonesia is a relatively secular and modern Muslim-majority country and Amin is the definition of an establishment religious leader. The security forces have succeeded in cracking down on militancy in the past decade, greatly improving Indonesia’s stability and security as a whole (Chart 17). Governance is weak on some measures in Indonesia, but Jokowi is better than the opposition on this front and neither his own policies nor his vice presidential pick signals a shift in a Turkey-like, Islamist, populist direction. Bottom Line: We should see Indonesian equities continue to outperform EM and EM Asia as long as China’s stimulus efforts do not collapse and global growth picks up as expected in the second half of the year. Peaceful democratic transitions and economic policy continuity have been repeatedly demonstrated in Indonesia despite the inherent difficulties of developing a populous, multi-ethnic archipelago. Nationalism is a constant risk but it would be more virulent under Jokowi’s opponent. The Philippines: Embracing Strongman Populism The May 13 midterm elections mark the three-year halfway point in President Rodrigo Duterte’s presidential term. Duterte is still popular, with approval ratings in the 75%-85% range. These numbers likely overstate his support, but it is clearly above 50% and superior to that of his immediate predecessors (Chart 18). Further, his daughter’s party, Faction for Change, has gained national popularity, reinforcing the signal that he can expand his power base in the vote. The senate is the root of opposition to Duterte. His supporters control nine out of 24 seats. But of the twelve senators up for election, only three are Duterte’s supporters. So he could make gains in the senate which would increase his ability to push through controversial constitutional reforms. (He needs 75% of both houses of parliament plus a majority in a national referendum to make constitutional changes.) In terms of the economy, we maintain the view that Duterte is a true “populist” – pursuing nominal GDP growth to the neglect of everything else. His fiscal policy of tax cuts and big spending have supercharged the economy but macro fundamentals have deteriorated (Chart 19). He has broken the budget deficit ceiling of 3%, up from 2.2% in 2017. His reflationary policies have turned the current account surplus into a deficit, weighing heavily on the peso, which peaked against other EM currencies when he came to power in 2016 (Chart 20). Inflation peaked last year but we expect it to remain elevated over the course of Duterte’s leadership. He has appointed a reputed dove, Benjamin Diokno, as his new central banker. Chart 19Reflationary Policies Created Twin Deficits... Chart 20...And Twin Deficits Weigh On The Peso Rule of law has deteriorated, as symbolized by the removal of the chief justice of the Supreme Court for questioning Duterte’s extension of martial law in Mindanao. Duterte also imprisoned his top critic in the senate, Leila de Lima, on trumped-up drug charges. He tried but failed to do so with Senator Antonio Trillanes, a former army officer and quondam coup ring-leader who has substantial support in the military. The army is pushing back against any prosecution of Trillanes, and against Duterte’s ongoing détente with China, prompting Duterte to warn of the risk of a coup. Duterte’s China policy is to attract Chinese investment while avoiding a conflict in the South China Sea. His administration has failed to downgrade relations with the U.S. thus far, but further attempts could be made. This strategy could make the Philippines a beneficiary of Chinese investment if it succeeds. However, China knows that the Philippine public is very pro-American (more so than most countries) and that Duterte could be replaced by a pro-U.S. president in as little as three years, so it is not blindly pouring money into the country. Pressure to finance the current account deficit will persist. If pro-Duterte parties gain seats in the senate the question will be whether he comes within reach of the 75% threshold required for constitutional changes. His desire to change the country into a federal system has not gained momentum so far. He claims he will stand down at the end of his single six-year term but he could conceivably attempt to use any constitutional change to stay in power longer. If the revision goes forward, it will be a hugely divisive and unproductive use of political capital. Bottom Line: The Philippine equity market is highly coordinated with China’s credit cycle and so should benefit from China’s stimulus measures this year (as well as the Fed’s backing off). Nevertheless, Philippine equities are overvalued and macro fundamentals and quality of governance have all deteriorated. Duterte’s emphasis on building infrastructure and human capital is positive, but the means are ill-matched to the ends: savings are insufficient and inflation will be a persistent problem. We would favor South Korea, Thailand, Indonesia, and Malaysia over the Philippines in the EM space. Investment Implications We expect China’s stimulus to be significant and to generate increasingly positive economic data over the course of the year. China is a key factor in the bottoming of global growth, which in turn will catalyze the conditions for a weaker dollar and outperformance of international equities relative to U.S. equities. Caveat: In the very near term, it is possible that China plays could relapse and EM stocks could fall further due to the fact that Chinese and global growth have not yet clearly bottomed. We are structurally bullish India, but recommend sitting on the sidelines until financial markets discount the disappointment of a Modi government with insufficient political capital to pursue structural reforms as ambitious as the ones undertaken in 2014-19. Go long Thai equities relative to EM on a cyclical basis. Stay long Thai local-currency government bonds relative to their Malaysian counterparts. Go long Indonesian equities relative to EM on a tactical basis. Maintain vigilance regarding Russian and Taiwanese equities: the Ukrainian election, Russia’s involvement in Venezuela, and the unprecedented Taiwanese presidential primary election reinforce our view that Russia and Taiwan are potential geopolitical “black swans” this year. Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 See BCA Emerging Markets Strategy, “Turkey: Brewing Policy Reversal?” March 21, 2019, available at www.bcaresearch.com. 2 See Sanjeev Miglani and Drazen Jorgic, “India, Pakistan threatened to unleash missiles at each other: sources,” Reuters, March 16, 2019, available at uk.reuters.com. 3 The junta can disqualify candidates and rerun elections in the same district without that candidate if the candidate is found to have violated a range of very particular laws on campaigning and use of social media. Also, the Election Commission is largely an instrument of the Bangkok establishment and can allocate seats according to the junta’s interests. 4 See BCA Emerging Markets Strategy, “Indonesia: It Is Not All About The Fed,” March 7, 2019, available at www.bcaresearch.com. Geopolitical Calendar
Highlights So What? Our best and worst calls of 2018 cast light on our methodology and 2019 forecasts. Why? Our clients took us to task for violating our own methodology on the Iranian oil sanctions. Sticking to our guns would have paid off with long Russian equities versus EM. We correctly called China’s domestic policy, the U.S.-China trade war, Europe, the U.S. midterms, and relative winners in emerging markets. Feature It has been a tradition for BCA’s Geopolitical Strategy, since our launch in 2012, to highlight our best and worst forecasts of the year.1 This will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 9, when we return to our regular publication schedule. We wish all of our clients a great Holiday Season. And especially all the very best in 2019: lots of happiness, health, and hefty returns. Good luck and good hunting. The Worst Calls Of 2018 A forecasting mistake is wasted if one learns nothing from the error. This is why we take our mistakes seriously and why we always begin the report card with our zingers. Our overall performance in 2018 was … one of our best. The successes below will testify to this. However, we made three notable errors. A Schizophrenic Russia View Our worst call of the year was to panic and close our long Russian equities relative to emerging markets trade in the face of headline geopolitical risks. In early March, we posited that Russia was a “buy” relative to the broad EM equity index due to a combination of cheap valuations, strong macro fundamentals, orthodox policy, and an end to large-scale geopolitical adventurism. This call ultimately proved to be correct (Chart 1). Chart 1Russian Stocks Outperformed In The End What went wrong? The main risk to our view, that the U.S. Congress would pursue an anti-Russia agenda regardless of any Russian sympathies in the Trump White House, materialized in the wake of the poisoning of former Russian military intelligence officer Sergei Skripal with a Novichok nerve agent in the United Kingdom. As fate would have it, the incident occurred just before our bullish report went to clients! The ensuing international uproar and sanctions caused a selloff. Our bullish thesis did not rest exclusively on geopolitics, but a thaw in West-Russia relations did form the main pillar of the view. Our Russia Geopolitical Risk Index, which had served us well in the past, was pricing as low of a level of geopolitical risk as one could hope for in the post-Crimea environment (Chart 2). Naturally the measure jumped into action following the Skripal incident. Chart 2Geopolitical Risk Was Low Prior To Skripal The timing of our call was therefore off, but we should have stuck with the overall view. The U.S. imposed preliminary sanctions that lacked teeth. While Washington accepted the U.K.’s assessment that Moscow was behind the poisoning, the weakness of the sanctions also signaled that the U.S. did not consider the incident worthy of a tougher position. There are now two parallel sanction processes under way. The first round of sanctions announced in August gave Russia 90 days to comply and adopt “remedial measures” regarding the use of chemical and biological weapons. On November 9, the U.S. State Department noted that Russia had not complied with the deadline. The U.S. is now expected to impose a second round of sanctions that will include at least three of six punitive actions: Opposition to development aid and assistance by international financial institutions (think the IMF and the World Bank); Downgrading diplomatic relations; Additional restrictions on exports to Russia (high-tech exports have already been barred by the first round of sanctions); Restrictions on imports from Russia; A ban on landing rights in the U.S. for Russian state-owned airlines; Prohibiting U.S. banks from purchasing Russian government debt. While the White House was expected to have such sanctions ready to go on the November 9 deadline, it has dragged its feet for almost two months now. This suggests that President Trump continues to hold out for improved relations with President Putin. A visit by President Putin to Washington remains possible in Q1 2019. As such, we would expect the White House to adopt some mix of the first five items on the above list, hardly a crushing response from Moscow’s perspective. The U.S. Congress, however, has a parallel process in the form of the Defending American Security from Kremlin Aggression Act of 2018 (DASKAA). Introduced in August by Senator Lindsey Graham, a Russia hawk, the legislation would put restrictions on Americans buying Russian sovereign debt and curb investments in Russian energy projects. The bill also includes secondary sanctions on investing in the Russian oil sector, which would potentially ensnare European energy companies collaborating with Russia in the energy sector. There was some expectation that Congress would take up the bill ahead of the midterm election, but nothing came of it. Even with the latest incident – the seizing of two Ukrainian naval vessels in the Kerch Strait – we have yet to see action. While we expect the U.S. to do something eventually, the White House approach is likely to be tepid while the congressional approach may be too draconian to pass into law. And with Democrats about to take over the House, and likely demand even tougher sanctions against Russia, the ultimate legislation may be too bold for President Trump to sign into legislation. The point is that Russia has acted antagonistically towards the West in 2018, but in small enough increments that the response has been tepid. Given the paucity of Russian financial and trade links with the U.S., Washington’s sanctions would only bite if they included the dreaded “secondary sanction” implications for third party sovereigns and firms – particularly European, which do have a lot of business in Russia. This is highly unlikely without major Russian aggression. We cannot completely ignore the potential for such aggression in 2019, especially with President Putin’s popularity in the doldrums (Chart 3) and a contentious Ukrainian election due for March 31. However, we outlined the constraints against Russia in 2014, amidst the Ukrainian crisis, and we do not think that these constraints have been reduced (they may have only grown since then). Chart 3Non-Negligible Risk Of Russian Aggression Regardless of the big picture for 2019, we could have faded the risks in 2018 and stuck to the fundamentals. Russia is up 17.2% against EM year-to-date. The lesson here, therefore, is to find re-entry points into a well-founded view despite market volatility. Chart 1 shows that Russian equities climbed the proverbial “wall of worry” relative to EM in 2018. Doubting Jair Bolsonaro Our list of mistakes keeps us in the EM universe where we underestimated Jair Bolsonaro’s chances of winning the presidency in Brazil. The answer to the question we posed in the title of our September report – “Brazil: Can The Election Change Anything?” – was a definitive “yes.” Since the publication of that report, BRL/USD is up 2.9% and Brazilian equities are up 18.5% relative to EM (Chart 4). Chart 4Bolsonaro Rally Losing Its Luster Already To our credit, the question of Bolsonaro’s electoral chances elicited passionate and pointed internal debate. But our clients did not see the internal struggle, just the incorrect external output! A bad call is a bad call, no matter how it is assembled on the intellectual assembly line. That said, we still think that our report is valuable. It sets out the constraints facing Bolsonaro in 2019. He has to convince the left-leaning median voter that meaningful pension reform is needed; bully a fractured Congress into painful structural reforms; and overcome an unforgiving macro context of tepid Chinese stimulus and a strong USD. If the Bolsonaro administration wastes the good will of the investment community over the next six months, we expect the market’s punishment to be swift and painful. In fact, Chart 4 notes that the initial Bolsonaro rally has already lost most of its shine. Brazilian assets are still up since the election, but the gentle slope could become a steep fall if Bolsonaro stumbles. The market is priced for political perfection. To be clear, we are not bearish on Bolsonaro. We believe that, relative to EM, he will be a positive for Brazil. However, the market is currently betting that he will win by two touchdowns, whereas we think he will squeak by with a last-second field goal. The difference between the two forecasts is compelling and we have expressed it by being long MXN/BRL.2 Not Sticking To Our Method In The Case Of Iran Throughout late-2017 and 2018 we pointed out that President Trump’s successful application of “maximum pressure” against North Korea could become a market-relevant risk if he were emboldened to try the same strategy against Iran. For much of the year, this view was prescient. As investors realized the seriousness of President Trump’s strategy, a geopolitical risk premium began to seep into oil prices, as illustrated in Chart 5 by the red bar. Every time we spoke to clients or published reports on this topic, we highlighted just how dangerous a “maximum pressure” strategy would be in the case of Iran. We stressed that Iran could wreak havoc across Iraq and other parts of the Middle East and even drive up oil prices to the point of causing a “geopolitical recession in 2019.” In other words, we stressed the extraordinary constraints that President Trump would face. To their credit many of our clients called us out on the inconsistency: our market call was über bullish oil prices, while our methodology emphasized constraints over preferences. We were constantly fielding questions such as: Why would President Trump face down such overwhelming constraints? We did not have a very good answer to this question other than that he was ideologically committed to overturning the Iranian nuclear deal. In essence, we doubted President Trump’s own ideological flexibility and realism. That was a mistake and we tip our hat to the White House for recognizing the complex constraints arrayed against it. President Trump realized by October how dangerous those constraints were and began floating the idea of sanction waivers, causing the geopolitical risk premium to drain from the market (Chart 6). To our credit, we highlighted sanction waivers as a key risk to our view and thus took profit on our bullish energy call early. Chart 6Sanction Waivers Caused A Collapse In Oil Prices That said, our clients have taken the argument further, pointing out that if we were wrong on Trump’s ideological flexibility with Iran, we may be making the same mistake when it comes to China. However, there is a critical difference. Americans are more concerned about conflict with North Korea than with Iran (Chart 7), while China is the major concern about trade (Chart 8). Second, railing against the Iran deal did not get President Trump elected, whereas his protectionist rhetoric – specifically regarding China – did (Chart 9). Getting anything less than the mother-of-all-deals with Beijing will draw down Trump’s political capital ahead of 2020 and open him to accusations of being “weak” and “surrendering to China.” These are accusations that the country’s other set of protectionists – the Democrats – will wantonly employ against him in the next general election. Chart 9Protectionism, Not Iran, Helped Trump Get Elected Ultimately, if we have to be wrong, we are at least satisfied that our method stood firm in the face of our own fallibility. We are doubly glad to see our clients using our own method against our views. This is precisely what we wanted to accomplish when we began BCA’s Geopolitical Strategy in March 2012: to revolutionize finance by raising the sophistication with which it approaches geopolitics. That was a lofty goal, but we do not pretend to hold the monopoly on our constraint-based methodology. In the end, our market calls did not suffer due to our error. We closed our long EM energy-producer equities / EM equities for a gain of 4.67% and our long Brent / short S&P 500 for a gain of 6.01%. However, our latter call, shorting the S&P 500 in September, was based on several reasons, including concerns regarding FAANG stocks, overstretched valuations, and an escalation of the trade war. Had we paired our S&P 500 short with a better long, we would have added far more value to our clients. It is that lost opportunity that has kept us up at night throughout this quarter. We essentially timed the S&P 500 correction, but paired it with a wayward long. The Best Calls Of 2018 BCA’s Geopolitical Strategy had a strong year. We are not going to list all of our calls here, but only those most relevant to our clients. Our best 2018 forecast originally appeared in 2017, when in April of that year we predicted that “Political Risks Are Understated In 2018.” Our reasoning was bang on: U.S. fiscal policy would turn strongly stimulative (the tax cuts would pass and Trump would be a big spender) and thus cause the Fed to turn hawkish and the USD to rally, tightening global monetary policy; Trump’s trade war would re-emerge in 2018; China would reboot its structural reform efforts by focusing on containing leverage, thus tightening global “fiscal” policy. In the same report we also predicted that Italian elections in 2018 would reignite Euro Area breakup risks, but that Italian policymakers would ultimately be found to be bluffing, as has been our long-running assertion. Throughout 2018, our team largely maintained and curated the forecasts expressed in that early 2017 report. We start the list of the best calls with the one call that was by far the most important for global assets in 2018: economic policy in China. The Chinese Would Over-Tighten, Then Under-Stimulate Getting Chinese policy right required us, first, to predict that policy would bring negative economic surprises this year, and second, once policy began to ease, to convince clients and colleagues that “this time would be different” and the stimulus would not be very stimulating. In other words, this time, China would not panic and reach for the credit lever of the post-2008 years (Chart 10), but would maintain its relatively tight economic, financial, environmental, and macro-prudential oversight, while easing only on the margin. Chart 10No Massive Credit Stimulus In 2018 This is precisely what occurred. BCA Foreign Exchange Strategy’s “China Play Index,” which is designed to capture any reflation out of Beijing, collapsed in 2018 and has hardly ticked up since the policy easing announced in July (Chart 11). Chart 11Weak Reflation Signal From China Our view was based on an understanding of Chinese politics that we can confidently say has been unique: From March 2017, we highlighted the importance of the 2017 October Party Congress, arguing that President Xi Jinping would consolidate his power and redouble his attempts to “reform” the economy by reining in dangerous imbalances. We explicitly characterized the containment of leverage as the most market-relevant reform to focus on. We stringently ignored the ideological debate about the nature of reform in China, focusing instead on the major policy changes afoot. We identified very early on how the rising odds of a U.S.-China conflict would embolden Chinese leadership to double-down on painful structural reforms. Will China maintain this disciplined approach in 2019? That is yet to be seen. But we are arming ourselves and clients with critical ways to identify when and whether Beijing’s policy easing transforms into a full-blown “stimulus overshoot”: First, we need to see a clear upturn in shadow financing to believe that the Xi administration has given up on preventing excess debt. Assuming that such a shift occurs, and that overall credit improves, it will enable us to turn bullish on global growth and global risk assets on a cyclical, i.e., not merely tactical, horizon (Chart 12). Chart 12A Shadow Lending Surge Would Mean A Big Policy Shift Second, our qualitative checklist will need to see a lot more “checks” in order to change our mind. Short of an extraordinary surge in bank and shadow bank credit, there needs to be a splurge in central and especially local government spending (Table 1). The mid-year spike in local governments’ new bond issuance in 2018 was fleeting and fell far short of the surge that initiated the large-scale stimulus of 2015. Frontloading these bonds in 2019 will depend on timing and magnitude. Table 1A Credit Splurge, Or Government Spending Splurge, Is Necessary For Stimulus To Overshoot Third, we would need to see President Xi Jinping make a shift in rhetoric away from the “Three Battles” of financial risk, pollution, and poverty. Having identified systemic financial risk as the first of the three ills, Xi needs to make a dramatic reversal of this three-year action plan if he is to clear the way for another credit blowout. Trade War Would Reignite In 2018 It paid off to stick with our trade war alarmism in 2018. We correctly forecast that the U.S. and China would collide over trade and that their initial trade agreement – on May 20 – was insubstantial and would not last. In the event it lasted three days. Our one setback on the trade front was to doubt the two sides would agree to a trade truce at the G20. However, by assigning a subjective 40% probability, we correctly noted the fair odds of a truce. We also insisted that any truce would be temporary, which ended up being the case. We may yet be vindicated if the March 1 deadline produces no sustainable deal, as we forecast in last week’s Strategic Outlook. That said, correct geopolitical calls do not butter our bread at BCA. Rather, we are paid to make market calls. To that end, we would point out that we correctly assessed the market-relevance of the trade conflict, fading S&P 500 risks and focusing on the effect on global risk assets. Will this continue into 2019? We think so. We do not see trade conflict as the originator of ongoing market turbulence (Chart 13) and would expect the U.S. to outperform global equities again over the course of 2019 (Chart 14). This view may appear wrong in Q1, as the market digests the Fed backing off from hawkish rhetoric, the ongoing trade negotiations, and the likely seasonal uptick in Chinese credit data in the beginning of the calendar year. Chart 13Yields, Not Trade War, Drove Stocks Chart 14U.S. Stocks Will Resume Outperformance However, any stabilization in equity markets would likely serve to ease financial conditions in the U.S., where economic and inflation conditions remain firmly in tightening territory (Chart 15). As such, the Fed pause is likely to last no more than a quarter, maybe two at best, leading to renewed carnage in global risk assets if our view on Chinese policy stimulus – tepid – remains valid through the course of 2019. Chart 15If Financial Conditions Ease, Tightening Will Be Back On Europe (All Of It… Again) In 2017, our forecasting track record for Europe was stellar. This continued in 2018, with no major setbacks: Populism in Italy: Our long-held view has been that Europe’s chief remaining risks lay in Italian populists coming to power. We predicted in 2016 that this would eventually happen and that they would then be proven to be bluffing. This is essentially what happened in 2018. Matteo Salvini’s Lega is surging in the polls because its leader has realized that a combination of hard anti-immigrant policy and the softest-of-soft Euroskepticism is a winning combination. We believe that investors can live with this combination. Our only major fault in forecasting European politics and assets this year was to close our bearish Italy call too early: we booked our long Spanish / short Italian 10-year government bond trade for a small loss in August, before the spread between the two Mediterranean countries blew out to record levels. That missed opportunity could have also made it on our “worst calls” list as well. Pluralism in Europe: To get the call on Italy right, we had to dabble in some theoretical work. In a somewhat academic report, we showed that political concentration was on the decline in the developed world (Chart 16), but especially in Europe (Chart 17). Put simply, lower political concentration suggests that a duopoly between the traditional center-left and center-right parties is breaking down. Contrary to the conventional wisdom, we argued that Europe’s parliamentary systems would enable centrist parties to adopt elements of the populist agenda, particularly on immigration, without compromising the overall stability of European institutions. As such, political pluralism, or low political concentration, is positive for markets. Immigration crisis is over: For centrist parties to be able to successfully adopt populist immigration policy, they needed a pause in the immigration crisis. This was empirically verifiable in 2018 (Chart 18). Chart 18European Migration Crisis Is Over Merkel’s time has run out: Since early 2017, we had cautioned clients that Angela Merkel’s demise was afoot, but that it would be an opportunity, rather than a risk, when it came. It finally happened in 2018 and it was not a market moving event. The main question for 2019 is whether German policymakers, and Europe as a whole, will use the infusion of fresh blood in Berlin to reaccelerate crucial reforms ahead of the next global recession. Brexit: Since early 2016, we have been right on Brexit. More specifically, we were corrent in cautioning investors that, were Brexit to occur, “the biggest loser would be the Conservative Party, not the EU.” As with the previous two Conservative Party prime ministers, it appears that the question of the U.K.’s relationship with the EU has completely drained any political capital out of Prime Minister Theresa May’s reign. We suspect that the only factor propping up the Tories in the polls is that Jeremy Corbyn is the leader of Her Majesty’s Most Loyal Opposition. We have also argued that soft Brexit would ultimately prove to be “illogical” and that “Bregret” would begin to seep in, as it now most clearly has. We parlayed these rising geopolitical risks and uncertainties by shorting cable in the first half of the year for a 6.21% gain. Malaysia Over Turkey And India Over Brazil Not all was lost for our EM calls this year. We played Malaysia against Turkey in the currency markets for a 17.44% gain, largely thanks to massively divergent governance and structural reform trajectories after Malaysia’s opposition won power for the first time in the country’s history. Second, we initiated a long Indian / short Brazilian equity view in March that returned 27.54% by August. This was a similar play on divergent structural reforms, but it was also a way to hedge our alarmist view on trade. Given India’s isolation from global trade and insular financial markets, we identified India as one of the EM markets that would remain aloof of protectionist risks. We could have closed the trade earlier for greater gain, but did not time the exit properly. Midterm Election: A Major Democratic Victory Our midterm election forecast was correct: Democrats won a substantial victory. Even our initial call on the Senate, that Democrats had a surprisingly large probability of picking up seats, proved to be correct, with Republicans eking out just two gains in a year when Democrats were defending 10 seats in states that Trump carried in 2016. What about our all-important call that the election would have no impact on the markets? That is more difficult to assess, given that the S&P 500 has in fact collapsed in the lead-up to and aftermath of the election. However, we see little connection between the election outcome and the stock market’s performance. Neither do our colleagues or clients, who have largely stopped asking about the Democrats’ policy designs. In 2019, domestic politics may play a role in the markets. Impeachment risk is low, but, if it rears its head, it could prompt President Trump to seek relevance abroad, as his predecessors have done when they lost control of domestic policy. In addition, the Democratic Party’s sweeping House victory may suggest a political pendulum swing to the left in the 2020 presidential election. We will discuss both risks as part of our annual Five Black Swans report in early 2019. U.S. domestic politics was a collection of Red Herrings during much of President Obama’s presidency, and has produced strong tailwinds under President Trump (tax cuts in particular). This may change in 2019, with considerable risk to investors, and asset prices, ahead. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 For our 2019 Outlook, please see BCA Geopolitical Strategy Strategic Outlook, “2019 Key Views: Balanced On A Knife’s Edge,” dated December 14, 2018, available at gps.bcaresearch.com. For our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 In part we like this cross because we also think that Mexico’s newly elected president, Andrés Manuel López Obrador, is priced to lose by two touchdowns, whereas he may merely lose by a last-second field goal.
Highlights So What? Global divergence will persist beyond the near term. Why? China’s stimulus will be disappointing unless things get much worse. U.S.-China trade war will reignite and strategic tensions will continue. European risks are limited short-term, but will surge without reform. U.S. assets will outperform; oil and the yen will rise; the pound is a long-term play; EM pain will continue. Feature The year 2019 will be one of considerable geopolitical uncertainty. Three issues dominate our Outlook, with low-conviction views on all three questions: Question 1: How much will China stimulate? Question 2: Will the trade war abate? Question 3: Is Europe a Black Swan or a Red Herring? The main story in 2018 was policy divergence. American policymakers ramped up stimulus – both through the profligate tax cuts and fiscal spending – at the same time that Chinese policymakers stuck to their guns on de-levering the economy. The consequence of this policy mix was that the synchronized global recovery of late 2016 and 2017 evolved into a massive outperformance by the U.S. economy (Chart 1). The Fed responded to the bullish domestic conditions with little regard for the global economy, causing the DXY to rally from a 2018 low of 88.59 in February to 97.04 today. While the policy divergence narrative appears to be macroeconomic in nature, it is purely political. There is nothing cyclical about the ‘U.S.’ economic outperformance in 2018. President Donald Trump campaigned on an economic populist agenda and then proceeded to deliver on it throughout 2017 and 2018. He faced little opposition from fiscal conservatives, mainly because fiscal conservativism melts away from the public discourse when budget deficits are low (Chart 2) and when the president is a Republican (Chart 3). Meanwhile, Chinese policymakers have decided to tolerate greater economic pain in an effort to escape the Middle Income Trap (Chart 4). They believe this trap will envelop them if they cannot grow the economy without expanding the already-massive build-up of leverage (Chart 5). Geopolitics is not just about “things blowing up somewhere in the desert.” In today’s world, emblematized by paradigm shifts, politicians are more than ever in the driver’s seat. While technocrats respond to macroeconomic factors, politicians respond to political and geopolitical constraints. Few investment narratives last much longer than a year and policy divergence is coming to a close. Will the Fed pause given the turn in global growth? Will China respond with effective stimulus in 2019? If the answer to both questions is yes, global risk assets could light up in the next quarter and potentially beyond. Already EM has outperformed DM assets for a month and some canaries in the coal mine for global growth – like the performance of Swedish economic indicators – signal that the outperformance is real. We are skeptical that the move is sustainable beyond a quarter or two (Chart 6). As our colleague Peter Berezin has highlighted, the market is pricing less than one hike in 2019 (Chart 7). Regardless, the impact on the U.S. dollar, remains muted, with the DXY at 97.04. This suggests that the backing off that the Fed may or may not have already done is still not enough from the perspective of weakening global growth (Chart 8). Global risk assets need more from the Fed than what the market is already pricing. And with U.S. inflationary pressures building (Chart 9), the BCA House View expects to see multiple Fed hikes in 2019, disappointing investors bullish on EM and global risk assets. With our Fed view set by the House View, we therefore turn to where we can add value. To this end, the most important question of 2018 largely remains the same in 2019: How much will China stimulate? Question 1: How Much Will China Stimulate In 2019? China is undoubtedly already stimulating, with a surge in local government bond issuance earlier this year and a bottoming in the broad money impulse (Chart 10). M2 is in positive territory. However, the effort can best be characterized as tepid, with a late-year collapse in bond issuance (Chart 11) and a still-negative total social financing (TSF) impulse (Chart 12). TSF is the broadest measure of private credit in China’s economy. We expect a surge in TSF in Q1, but this is a normal seasonal effect. A typical Q1 credit surge will not be enough to set global risk assets alight for very long, particularly if the market has already priced in as much of a “pause” from the Fed as we are going to get. Investors should specifically focus on new local government bond issuance and whether the “shadow financing” component of TSF gets a bid, since the primary reason for the weakness in TSF over the past year is the government’s crackdown on shadow lending. As Chart 13A & B shows, it was new local government bonds that led the way for stimulus efforts in 2015, followed by a surge in both bank lending and shadow lending in 2016. We would also expect further monetary policy easing, with extra RRR cuts or even a benchmark policy rate cut. However, monetary policy has been easy all year and yet the impact on credit growth has remained muted. This begs two important questions: Is the credit channel impaired? A slew of macroprudential reforms – which we have dubbed China’s “Preemptive Dodd-Frank” – may have impaired the flow of credit in the system. The official policy of “opening the front door, closing the back door” has seen bank loans pick up modestly but shadow lending has been curtailed (Chart 14A & B). This way of controlling the rise of leverage has its costs. For private enterprises – with poor access to the official banking sector – the shadow financial system was an important source of funding over the past several years. Is policy pushing on a string? An even more dire scenario would be if China’s credit channel is not technically, but rather psychologically, impaired. Multiple reasons may be to blame: a negative net return on the assets of state-owned enterprises (Chart 15); widespread trade war worries; mixed signals from policymakers; or a general lack of confidence in the political direction of the country. The rising M2/M1 ratio suggests that the overall economy’s “propensity to save” is rising (Chart 16). Why would Chinese policymakers keep their cool despite a slow pickup in credit growth? Are they not concerned about unemployment, social unrest, and instability? Of course, they are. But Chinese policymakers are not myopic. They also want to improve potential GDP over the long run. Table 1China: The Trend In Domestic Demand, And The Outlook For Trade, Is Negative So far, the economy has weathered the storm relatively well. First, eight out of ten of our China Investment Strategy’s housing price indicators (Table 1) are flat-to-up – although it is true that the October deterioration in floor space started and especially floor space sold (Chart 17) is cause for concern. If and when the housing market weakens further, stimulus will be used to offset it, despite the fact that the government is attempting to prevent a sharp increase in prices at the same time. With so much of China’s middle-class savings invested in the housing market, the key pillar of socio-economic stability is therefore real estate. Second, credit has fueled China’s “old economy,” but policymakers want to buoy “new China” (Chart 18). This means that measures to boost consumption and the service sector economy will be emphasized in new rounds of stimulus, as has occurred thus far (tax cuts, tariff cuts, deregulation, etc). This kind of stimulus is not great news for global risk assets leveraged to “old China,” such as EM and industrial metals. Third, policymakers are not exclusively focused on day-to-day stability but are also focused on the decades-long perseverance of China’s political model. And that means moving away from leverage and credit as the sole fuel for the economy. This is not just about the Middle Income Trap, it is also about national security and ultimately sovereignty. Relying on corporate re-levering for stimulus simply doubles-down on the current economic model, which is still export-oriented given that most investment is geared toward the export sector. But this also means that China will be held hostage to foreign demand and thus geopolitical pressures, a fact that has been revealed this year through the protectionism of the White House. As such, moving away from the investment-led growth model and towards a more endogenous, consumer-led model is not just good macro policy, it makes sense geopolitically as well. Will the trade war – or the current period of trade truce – change Chinese policymakers’ decision-making? We do not see why it would. First, if the trade truce evolves into a trade deal, the expected export shock will not happen (Chart 19) and thus major stimulative measures would be less necessary. Second, if we understand correctly why policymakers have cited leverage as an “ill” in the first place, then we would assume that they would use the trade war as an excuse for the pain that they themselves have instigated. In other words, the trade war with the U.S. gives President Xi Jinping the perfect excuse for the slowdown, one that draws attention from the real culprit: domestic rebalancing. Bottom Line: Since mid-2018, we have been asking clients to focus on our “Stimulus Overshoot” checklist (Table 2). We give the first item – “broad money and/or total credit growth spike” – a premier spot on the list. If a surge in total credit occurs, we will know that policymakers are throwing in the towel and stimulating in a major way. It will be time to turn super-positive on global risk assets, beyond a mere tactical trade, as a cyclical view at that point. Note that if one had gone long EM in early February 2016, when January data revealed a truly epic TSF splurge, one would not have been late to the rally. Table 2Will China’s Stimulus Overshoot In 2019? Our low-conviction view, at the moment, is that the increase in credit growth that we will see in Q1 will be seasonal – the usual frontloading of lending at the beginning of the year – rather than an extraordinary surge that would signal a policy change. A modest increase in credit growth will not be enough to spark a sustainable – year-long – rally in global risk assets. The Fed has already backed off as far as the market is concerned. As such, a pickup in Chinese credit could temporarily excite investors. But global stabilization may only embolden the Fed to refocus on tightening after a Q1 pause. Question 2: Will The Trade War Abate? The first question for investors when it comes to the trade war is “Why should we care?” Sure, trade policy uncertainty appears to have correlated with the underperformance of global equity indices relative to the U.S. (Chart 20). However, such market action was as much caused by our policy divergence story – being as it is deeply negative for EM assets – as by a trade war whose impact on the real economy has not yet been felt. Nonetheless, we do believe that getting the trade war “right” is a big call for 2019. First, while the impact of the U.S.-China trade war has been minimal thus far, it is only because China front-loaded its exports ahead of the expected tariffs, cut interbank rates and RRRs, accelerated local government spending, and allowed CNY/USD to depreciate by 10%. A restart of trade tensions that leads to further tariffs will make frontloading untenable over time, whereas further currency depreciation would be severely debilitating for EMs. We doubt the sustainability of the trade truce for three reasons: U.S. domestic politics: The just-concluded midterm election saw no opposition to President Trump on trade. The Democratic Party candidates campaigned against the president on a range of issues, but not on his aggressive China policy. Polling from the summer also shows that a majority of American voters consider trade with China unfair (Chart 21). In addition, President Trump will walk into the 2020 election with a wider trade deficit, due to his own stimulative economic policy (Chart 22). He will need to explain why he is “losing” on the one measure of national power that he campaigned on in 2016. Structural trade tensions: Ahead of the G20 truce, the U.S. Trade Representative Robert Lighthizer issued a hawkish report that concluded that China has not substantively changed any of the trade practices that initiated U.S. tariffs. Lighthizer has been put in charge of the current trade negotiations, which is a step-up in intensity from Treasury Secretary Steven Mnuchin, who was in charge of the failed May 2018 round. Geopolitical tensions: The G20 truce did not contain any substantive resolution to the ongoing strategic tensions between the U.S. and China, such as in the South China Sea. Beyond traditional geopolitics, tensions are increasingly involving high-tech trade and investment between the two countries and American allegations of cyber theft and spying by China. The recent arrest of Huawei’s CFO in Canada, on an American warrant, will likely deepen this high-tech conflict in the short term. Since the G20 truce with Xi, President Trump has seen no significant pickup in approval ratings (Chart 23). Given that the median American voter has embraced protectionism – against China at least – we would not expect any. Meanwhile, U.S. equities have sold off, contrary to what President Trump, or his pro-trade advisors, likely expected in making the G20 decision to delay tariffs. At some point, President Trump will realize that he risks considerable political capital on a trade deal with China that very few voters actually want or that the U.S. intelligence and defense community supports. Democrats did not oppose his aggressive China policy in the midterm election because they know that the median voter does not want it. As such, it is guaranteed that Trump’s 2020 Democratic Party opponent will accuse him of “surrender,” or at least “weakness.” If, over the next quarter, the economic and market returns on his gambit are paltry, we would expect President Trump to end the truce. Furthermore, we believe that a substantive, and long-lasting, trade deal is unlikely given the mounting tensions between China and the U.S. These tensions are not a product of President Trump, but are rather a long-run, structural feature of the twenty-first century that we have been tracking since 2012.1 Tensions are likely to rise in parallel to the trade talks on the technology front. We expect 2019 to be the year when investors price in what we have called Bifurcated Capitalism: the segmentation of capital, labor, and trade flows into geopolitically adversarial – and yet capitalist in nature – economic blocs. Entire countries and sectors may become off-limits to Western investors and vice-versa for their Chinese counterparts. Countries will fall into either the Tencent and Huawei bloc or the Apple and Ericsson bloc. This development is different from the Cold War. Note our emphasis on capitalism in the term Bifurcated Capitalism. The Soviet Union was obviously not capitalist, and clients of BCA did not have interests in its assets in the 1970s and 1980s. Trade between Cold War economic blocs was also limited, particularly outside of commodities. The closest comparison to the world we now inhabit is that of the nineteenth century. Almost all global powers were quite capitalist at the time, but they engaged in imperialism in order to expand their economic spheres of influence and thus economies of scale. In the twenty-first century, Africa and Asia – the targets of nineteenth century imperialism – may be replaced with market share wars in novel technologies and the Internet. This will put a ceiling on how much expansion tech and telecommunication companies can expect in the competing parts of Bifurcated Capitalism. The investment consequences of this concept are still unclear. But what is clear is that American policymakers are already planning for some version of the world we are describing. The orchestrated effort by the U.S. intelligence community to encourage its geopolitical allies to ban the use of Huawei equipment in their 5G mobile networks suggests that there are limits to the current truce ever becoming a sustainable deal. So does the repeated use of economic sanctions originally designed for Iran and Russia against Chinese companies. President Trump sets short- and medium-term policies given that he is the president. However, the intelligence and defense communities have “pivoted to Asia” gradually since 2012. This shift has occurred because the U.S. increasingly sees China as a peer competitor, for the time being confined in East Asia but with intentions of projecting power globally. To what extent could President Trump produce a trade deal with Xi that also encompasses a change in the U.S. perception of China as an adversary? We assign a low probability to it. As such, President Xi has little reason to give in to U.S. pressure on trade, as he knows that the geopolitical and technology pressure will continue. In fact, President Xi may have all the reason to double-down on his transformative reforms, which would mean more pain for high-beta global plays. Bottom Line: What may have appeared as merely a trade conflict has evolved into a broad geopolitical confrontation. President Trump has little reason to conclude a deal with China by March. Domestic political pressures are not pushing in the direction of the deal, while America’s “Deep State” is eager for a confrontation with China. Furthermore, with President Trump “blinking” on Iranian sanctions, his administration has implicitly acknowledged the constraints discouraging a deeper involvement in the Middle East. This puts the geopolitical focus squarely on China. Question 3: Is Europe a Black Swan or a Red Herring? The last two years have been a dud in Europe. Since the Brexit referendum in mid-2016, European politics have not been a catalyst for global markets, save for an Italy-induced sell-off or two. This could substantively change in 2019. And, as with the first two questions, the results could be binary. On one hand, there is the positive scenario where the stalled and scaled-back reforms on the banking union and Euro Area budget get a shot in the arm in the middle of the year. On the other hand, the negative scenario would see European-wide reforms stall, leaving the continent particularly vulnerable as the next global recession inevitably nears. At the heart of the binary distribution is the broader question of whether populism in Europe is trending higher. Most commentators and our clients would say yes, especially after the protests and rioting in Paris over the course of November. But the answer is more complicated than that. While populists have found considerable success in the ballot box (Chart 24), they have not managed to turn sentiment in Europe against the currency union (Chart 25). Even in Italy, which has a populist coalition government in power, the support for currency union is at 61%, the highest since 2012. This number has apparently risen since populists took over. What explains this divergence? Effectively, Europe’s establishment parties are being blamed for a lot of alleged ills, liberal immigration policy first amongst them. However, European integration remains favored across the ideological spectrum. Few parties that solely focus on Euroskepticism have any chance of winning power, something that both Lega and Five Star Movement found out in Italy. Italy’s Deputy Prime Minister Matteo Salvini confirmed his conversion away from Euroskepticism by stating that he wants to “reform the EU from the inside” and that it was time to give the “Rome-Berlin axis” another go.2 Salvini is making a bet – correct in our view – that by moderating Lega’s populism on Europe, he can capture the center ground and win the majority in the next Italian election, which could happen as soon as 2019. As such, we don’t think that the “rise of populism” in Europe is either dramatic or market-relevant. In fact, mainstream parties are quickly adopting parts of the anti-establishment agenda, particularly on immigration, in a bid to recoup lost voters. A much bigger risk for Europe than populism is stagnation on the reform front, a perpetual Eurosclerosis that leaves the bloc vulnerable in the next recession. What Europe needs is the completion of a backstop to prevent contagion. Such a backstop necessitates greatly enhancing the just-passed banking union reforms. The watered-down reforms did not include a common backstop to the EU’s single resolution fund nor a deposit union. A working group will report on both by June 2019, with a potential legislative act set for some time in 2024. What could be a sign that the EU is close to a grand package of reforms in 2019? We see three main avenues. First, a political shift in Germany. Investors almost had one, with conservative Friedrich Merz coming close to defeating Merkel’s hand-picked successor Annegret Kramp-Karrenbauer (also known as AKK) for the leadership of the ruling Christian Democratic Union (CDU). Merz combined a right-leaning anti-immigrant stance with staunch pro-European integration outlook. It is unclear whether AKK will be willing to make the same type of “grand bargain” with the more conservative factions of the CDU electorate. However, AKK may not have a choice, with both Alternative for Germany (AfD) and the Green Party nibbling at the heels of the right-of-center CDU and left-of-center Social-Democratic Party (SPD) (Chart 26). The rise of the Green party is particularly extraordinary, suggesting that a larger portion of the German electorate is radically Europhile rather than Euroskeptic. AKK may have to adopt Merz’s platform and then push for EU reforms. Second, French President Emmanuel Macron may have to look abroad for relevance. With his reform agenda stalled and political capital drained, it would make sense for Macron to spend 2019 and beyond on European reforms. Third, a resolution of the Brexit debacle. The longer the saga with the U.K. drags on, the less focus there will be in Europe on integration of the Euro Area. If the U.K. decides to extend the current negotiating period, it may even have to hold elections for the European Parliament. As such, we are not focusing on the budget crisis in Italy – our view that Rome is “bluffing” is coming to fruition –or a potential early election in Spain. And we are definitely not focusing on the EU Parliamentary election in May. These will largely be red herrings. The real question is whether European policymakers will finally have a window of opportunity for strategic reforms. And that will require Merkel, AKK, and Macron to expend whatever little political capital they have left and invest it in restructuring European institutions. Finally, a word on Europe’s role in the global trade war. While Europe is a natural ally for the U.S. against China – given its institutional connections, existing alliance, and trade surplus with the latter and deficit with the former (Chart 27) – we believe that the odds are rising of a unilateral tariff action by the U.S. on car imports. This is because the just-concluded NAFTA deal likely raised the cost of vehicle production in the trade bloc, necessitating import tariffs in order for the deal to make sense from President Trump’s set of political priorities. The Trump administration may not have the stomach for a long-term trade war with Europe, but it can shake up the markets with actions in that direction. Bottom Line: In the near term, there are no existential political risks in Europe in 2019. As such, investors who are bullish on European assets should not let geopolitics stand in the way of executing on their sentiment. We remain cautious for macroeconomic reasons, namely that Europe is a high-beta DM play that needs global growth to outperform in order to catch a bid. However, 2019 is a make-or-break year on key structural reforms in Europe. Without more work on the banking union – and without greater burden sharing, broadly defined – the Euro Area will remain woefully unprepared for the next global recession. Question 4: Will Brexit Happen? Given the volume of market-relevant geopolitical issues, we have decided to pose (and attempt to answer) five additional questions for 2019. We start with Brexit. Prime Minister Theresa May has asked for a delay to the vote in the House of Commons on the Withdrawal Treaty, which she would have inevitably lost. The defeat of the subsequent leadership challenge is not confidence-inspiring as the vote was close and a third of Tory MPs voted against her. May likely has until sometime in January to pass the EU Withdrawal Agreement setting out the terms of Brexit, given that all other EU member states have to get it through their parliaments before the Brexit date on March 29. The real question is whether any deal can get through Westminster. The numbers are there for the softest of soft Brexits, the so-called Norway+ option where the U.K. effectively gets the same deal as Norway, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to pay essentially for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election – which may usher the even less pro-Brexit Labour Party into power – or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the delay signals that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear: the median voter is turning forcefully towards Bremain (Chart 28). It will soon become untenable to delay the second referendum. And even if the House of Commons passes the softest of Soft Brexit deals, we expect that the Norway+ option will prove to be unacceptable when Westminster has to vote on it again in two or three year’s time. Is it time to buy the pound, particularly cable, which is cheap on a long-term basis (Chart 29)? It is a tough call. On one hand, our confidence that the U.K. ultimately has to remain in the EU is rising. However, to get there, the U.K. may need one last major dose of volatility, either in the form of a slow-burn crisis caused by Tory indecision or in the form of a far-left Labour government that tries its own hand at Brexit while pursuing a 1970s style left-wing economic agenda. Can any investor withstand this kind of volatility in the short and potentially long-ish term? Only the longest of the long-term investors can. Question 5: Will Oil Prices Rally Substantively In 2019? Several risks to oil supply remain for 2019. First, there is little basis for stabilization in Venezuelan oil production, and further deterioration is likely (Chart 30). Second, sectarian tensions in Iraq remain unresolved. Third, supply risks in other geopolitical hot spots – like Nigeria and Libya – could surprise in 2019. The most pressing geopolitical issue, however, is a decision on the Iranian sanction waivers. President Trump induced considerable market-volatility in 2019 by signaling that he would use “maximum pressure” against Iran. As a result, the risk premium contribution to the oil price – illustrated in Chart 31 by the red bar – rose throughout 2018, only to collapse as the White House offered six-month sanction waivers. Not only did the risk premium dissipate, but Saudi Arabia then scrambled to reverse the production surge it had instituted to offset the Iran sanctions. We agree with BCA’s Commodity & Energy Strategy that oil market fundamentals are tight and numerous supply risks loom. We also struggle to see why President Trump will seek to pick a fight with Iran in the summer of 2019. Our suspicion is that if President Trump was afraid of a gasoline-price spike right after the midterm election, why would he not “blink” at the end of the spring? Not only will the U.S. summer driving season be in full swing – a time of peak U.S. gasoline demand – but the 2020 election primaries will only be six months away. Furthermore, it is highly unlikely that OPEC and Russia will do the U.S. president’s bidding by turning on the taps to offset any unforeseen supply losses in 2019. They did not do so even when President Trump asked, very nicely, ahead of the just-concluded Vienna meeting. Once Trump prioritized domestic politics over Saudi geopolitical interests – by backing away from his maximum pressure tactic against Iran – he illustrated to Riyadh that his administration is about as reliable of an ally as the Obama White House. Meanwhile, his ardent defense of Riyadh in the Khashoggi affair, at a cost of domestic political capital, means that he lost the very leverage that he could have used to pressure Saudi Arabia. We therefore remain cautiously bullish on oil prices in 2019, but with the caveat that a big-bang surge in prices due to a U.S.-Iran confrontation – our main risk for 2019 just a few months ago – is now less likely. Question 6: Will Impeachment Become A Risk In 2019? While we have no way to forecast the Mueller investigation, it is undoubtedly clear that risks are rising on the U.S. domestic front. President Trump’s popularity among GOP voters is elevated and far from levels needed to convince enough senators to remove him from power (Chart 32). However, a substantive finding by Mueller may leave the moderate Democrats in the House with no choice but to pursue impeachment. This may rattle the market for both headline and fundamental reasons. The headline reasons are obvious. The fundamental reasons have to do with the looming stimulus cliff in 2020. A pitched battle between the House Democrats and the White House would make cooperation on another substantive stimulus effort less likely and thus a recession in 2020 more likely. The market may start pricing in such an outcome at some point in 2019. Furthermore, sentiment could be significantly impacted by a protracted domestic battle that impairs Trump’s domestic agenda. President Bill Clinton sought relevance abroad amidst his impeachment proceedings by initiating an air war against Yugoslavia. President Trump may do something similar. There is also an unclear relationship between domestic tensions and trade war. On one hand, President Trump may want a clear win and so hasten a deal. On the other hand, he may want to extend the trade war to encourage citizens to “rally around the flag” and show his geopolitical mettle amidst a distracting “witch hunt.” While we have faded these domestic risks in 2017 and 2018, we think that it may be difficult to do so in 2019. We stick by our view that previous impeachment bouts in the U.S. have had a temporary effect on the markets. But if market sentiment is already weakened by global growth and end of cycle concerns, a political crisis may become a bearish catalyst. Question 7: What About Japan? Japan faces higher policy uncertainty in 2019, after a period of calm following the 2015-16 global turmoil. We expect to see “peak Shinzo Abe” – in the sense that after this year, his political capital will be spent and all that will remain will be for him to preside over the 2020 Tokyo Olympics. The primary challenge for Abe is getting his proposed constitutional revisions passed despite economic headwinds. Assuming he goes forward, he must get a two-thirds vote in both houses of parliament plus a majority vote in a popular referendum. The referendum is unscheduled but could coincide with the July upper house elections. This will be a knife’s edge vote according to polling. If he holds the referendum and it passes, he will have achieved the historic goal of making Japan a more “normal” country, i.e. capable of revising its own constitution and maintaining armed forces. He will never outdo this. If he fails, he will become a lame duck – if he does not retire immediately like David Cameron or Matteo Renzi. And if he delays the revisions, he could miss his window of opportunity. This uncertain domestic political context will combine with China/EM and trade issues that entail significant risks for Japan and upward pressure on the yen. Hence government policy will resume its decidedly reflationary tilt in 2019. It makes little sense for Abe, looking to his legacy, to abandon his constitutional dream while agreeing to raise the consumption tax from 8% to 10% as expected in October. We would take the opposite side of the bet: he is more likely to delay the tax hike than he is to abandon constitutional revision. If Abe becomes a lame duck, whether through a failed referendum, a disappointing election, or a consumption tax hike amid a slowdown, it is important for investors to remember that “Abenomics” will smell just as sweet by any other name. Japan experienced a paradigm shift after a series of “earthquakes” from 2008-12. No leader is likely to raise taxes or cut spending aggressively, and monetary policy will remain ultra-easy for quite some time. The global backdrop is negative for Japan but its policy framework will act as a salve. Question 8: Are There Any Winners In EM? We think that EM and global risk assets could have a window of outperformance in early 2019. However, given the persistence of the policy divergence narrative, it will be difficult to see EM substantively outperforming DM over the course of 2019. Mexico Over Brazil That said, we do like a few EM plays in 2019. In particular, we believe that investors are overly bullish on Brazil and overly bearish on Mexico. In both countries, we think that voters turned to anti-establishment candidates due to concerns over violence and corruption. However, Brazilian President-elect Jair Bolsonaro has a high hurdle to clear. He must convince a traditionally fractured Congress to pass a complex and painful pension reform. In other words, Bolsonaro must show that he can do something in order to justify a rally that has already happened in Brazilian assets. In Mexico, on the other hand, Mexican President Andrés Manuel López Obrador (AMLO) remains constrained by the constitution (which he will be unable to change), the National Supreme Court of Justice, and political convention that Mexico is right-of-center on economic policy (an outwardly left-wing president has not won an election since 1924). In other words, AMLO has to show that he can get out of his constraints in order to justify a selloff that has already happened. To be clear, we are not saying that AMLO is a positive, in the absolute, for Mexico. The decision to scrap the Mexico City airport plans, to sideline the finance ministry from key economic decisions, and to threaten a return to an old-school PRI-era statism is deeply concerning. At the same time, we are not of the view that Bolsonaro is, in the absolute, a negative for Brazil. Rather, we are pointing out that the relative investor sentiment is overly bullish Bolsonaro versus AMLO. Especially given that both presidents remain constrained by domestic political intricacies and largely campaigned on the same set of issues that have little to do with their perceived economic preferences. They also face respective median voters that are diametrically opposed to their economic agendas – Bolsonaro, we think, is facing a left-leaning median voter, whereas the Mexican median voter is center-right. The macroeconomic perspective also supports our relative call. If our view on China and the Fed is correct, high-beta plays like Brazil will suffer, while an economy that is tied-to-the-hip of the U.S., like Mexico, ought to outperform EM peers. As such, we are putting a long MXN/BRL trade on, to capture this sentiment gap between the two EM markets. Investors will be receiving positive carry on Mexico relative to Brazil for the first time in a long time (Chart 33). The relative change in the current account balance also favors Mexico (Chart 34). Finally, the technicals of the trade look good as well (Chart 35). South Korea Over Taiwan Diplomacy remains on track on the Korean peninsula, despite U.S.-China tensions in other areas. Ultimately China believes that peace on the peninsula will remove the raison d’être of American troops stationed there. Moreover, Beijing has witnessed the U.S.’s resolve in deterring North Korean nuclear and missile tests and belligerent rhetoric. It will want to trade North Korean cooperation for a trade truce. By contrast, if Trump’s signature foreign policy effort fails, he may well lash out. We view deeply discounted South Korean equities as a long-term buy relative to other EMs. Taiwan, by contrast, is a similar EM economy but faces even greater short-term risks than South Korea. In the next 13-month period, the Tsai Ing-wen administration, along with the Trump administration, could try to seize a rare chance to upgrade diplomatic and military relations. This could heighten cross-strait tensions and lead to a geopolitical incident or crisis. More broadly, U.S.-China trade and tech tensions create a negative investment outlook for Taiwan. Thailand Over India Five state elections this fall have turned out very badly for Prime Minister Narendra Modi and his National Democratic Alliance (NDA). These local elections have a negative impact, albeit a limited one, on Modi’s and the NDA’s reelection chances in the federal election due in April (or May). Nevertheless, it is entirely possible to lose Chhattisgarh, Madhya Pradesh, and Rajasthan while still winning a majority in the Lok Sabha – this is what happened to the Indian National Congress in 2004 and 2009. So far federal election opinion polling suggests anything from a hung parliament to a smaller, but still substantial, BJP majority. Modi was never likely to maintain control of 20 out of 29 states for very long, nor to repeat his party’s sweeping 2014 victory. He was also never likely to continue his reform push uninhibited in the lead up to the general election. Nevertheless, the resignation of Reserve Bank of India Governor Urjit Patel on December 10 is a very worrisome sign. Given that Indian stocks are richly valued, and that we expect oil prices to drift upwards, we remain negative on India until the opportunity emerges to upgrade in accordance with our long-term bullish outlook. By contrast, we see the return to civilian rule in Thailand as a market-positive event in the context of favorable macro fundamentals. Thai elections always favor the rural populist “red” movement of the Shinawatra family, but presumably the military junta would not hold elections if it thought it had not sufficiently adjusted the electoral system in favor of itself and its political proxies. Either way, the cycle of polarization and social unrest will only reemerge gradually, so next year Thailand will largely maintain policy continuity and its risk assets will hold up better than most other EMs. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Special Report, “Power And Politics In East Asia: Cold War 2.0?” dated September 25, 2012, Global Investment Strategy Special Report, “Searing Sun: Japan-China Conflict Heating Up,” dated January 25, 2013, “Sino-American Conflict: More Likely Than You Think, Part II,” dated November 6, 2015, and “The South China Sea: Smooth Sailing?” dated March 28, 2017, available at gps.bcaresearch.com. 2 Yes. He literally said that. Geopolitical Calendar