Developed Countries

In an Insight late last week, we mentioned our rule of thumb that stocks cannot stomach more than 100-125bps tightening via a selloff in the 10-year US Treasury bond within a year. Applying this rule to the present-day suggests that equities will become turbulent should the 10-year US Treasury yield surpass 1.55% by March, 2.05% by June, and 1.75% by August. Today, we provide more color on this 100-125bps rule by looking at historical SPX drawdowns once yields sprint higher (please see chart on the next page). While the exact timing and the size of the drawdown varies from episode to episode, it is generally consistent with a roughly 10% pullback in the S&P 500 albeit with a 1-2 month lag following the trigger in our rule. We chose to examine data from 2009 onward thus only covering the QE era, which would increase the applicability of our analysis. Speaking of applicability, the 2009-2011 iterations provide the closest parallels as to what will likely take root this cycle as those iterations occurred in a post recessionary environment, which is similar to today. (We have drawn a number of parallels between circa 2010 and today in previous Insights, please see here, here and here). The 2009-2011 period also best aligns with the main reason for having this rule of thumb in the first place: to gauge the risk of interest rates undermining the market by weighing on the forward multiple component of price and/or via an economic slowdown because of tightening in monetary conditions. Before we conclude, a quick note on the taper tantrum and the 2016 iterations. During those periods the S&P 500 actually fell at the same time as yields rose (not after the rule was triggered), so technically we should not have counted that as a valid iteration on our chart. Bottom Line: Were the 10-year US Treasury yield to surpass 1.55% by March, 2.05% by June, and 1.75% by August, then the equity market will likely suffer a pullback especially given the absence of a valuation cushion.

  The Fed has telegraphed that they will not be backing down from QE and their ZIRP policy. The FOMC is not even thinking about thinking about tapering asset purchases despite a looming inflation spike in the coming months due to base effects that they vehemently deem transitory. Importantly, Charts 1 & 2 show that both the ISM’s manufacturing prices paid index and a sideways move in retail gasoline prices predict a surge in headline CPI in the April/May time frame as we first showed in a recent Special Report. Tack on a plethora of anecdotes regarding shortages and price hikes in a slew of industries and an inflationary spurt is already here. This week’s retail sales report also caused a jump in the Atlanta Fed’s GDPNow forecast for Q1 near double digit real GDP growth. More blow out output quarters are in the offing courtesy of the inoculation of the population and reopening of the economy and persistent government largesse. Thus, trust in the Fed’s ultra dovishness represents the biggest equity market risk in the coming months and there are high odds that the bond market will really test the Fed’s resolve. Chart 1 Chart 2 Our sense is that the Fed will initially ignore the spike in inflation at least until the summer, thus refraining from removing the proverbial “punch bowl”. However, if the market detects any signs of a “less dovish” Fed, especially if high inflation prints persist for whatever reason, risk premia will get repriced a lot higher.  Finally, staying on the topic of interest rates, we have a long-held rule of thumb that stocks cannot stomach more than 100-125bps tightening via a selloff in the 10-year US Treasury bond on a year-over-year basis. In other words, were the 10-year US Treasury yield to surpass 1.55% by March, 2.05% by June, and 1.75% by August, then the equity market will likely suffer a pullback especially given the absence of a valuation cushion.  Bottom Line: A marginally less dovish Fed represents a key risk for the broad equity market as inflation rears its ugly head in the coming months.  

Highlights A rise in global bond yields has rarely been a reliable precursor of a stronger dollar. This is because the dollar reacts to interest-rate differentials, rather than the level of global yields. Changes in the dollar correlate with both the level and the rate of change in relative yields. A definitive shift to a bullish dollar stance will require a rise in relative US real rates in the order of 50-to-75 bps. Meanwhile, negative/low interest rates could have caused a swing in the currency/yield correlation, especially at the short end of the curve. In aggregate, the dollar responds to relative rates of return. This includes not only fixed income flows, but equity flows as well. As such, the US equity market also needs to outperform foreign bourses to make the case for a stronger dollar. The dollar is oversold and remains ripe for a countertrend bounce. This noise could be confused for a durable bullish signal. Feature Chart I-1No Rise In Real Yields Global bond yields are on the rise, driven by the long end of the curve. This has included US yields, where the 10-year rate has bounced from a low of 36 bps last March to 130 bps today. Rising yields have important ramifications for equity prices (through the discount rate) and exchange rates. A rise in yields can be driven by prospects of either better growth, higher inflation expectations, or a combination of the two. This could bring forward expectations that the central bank will tighten monetary policy faster. In the case of the US and Eurozone, the culprit behind higher yields has been higher inflation expectations (Chart I-1). What does this mean for exchange rates? Are rising yields positive or negative for the dollar? Also, does it matter which component is driving yields higher – growth or inflation expectations? Finally, which currencies have historically benefited the most from an uptick in global yields?     Correlation Between Yields And Exchange Rates Chart I-2Bond Yields And Currencies Often Diverge The historical evidence is that there is little correlation between the dollar and the level or direction of global bond yields. Since the end of the Bretton Woods system in the 1970s, the trade-weighted dollar has appreciated while global bond yields have collapsed (Chart I-2). More important has been the path of relative interest rates. For example, the ebb and flow of EUR/USD has tracked the yield differential between Bund and Treasury yields since the 1970s (bottom panel Chart I-2). Currencies react more to the path of relative real rates than nominal rates. In theory, rising inflation is negative for a currency since its purchasing power is reduced. In a globally competitive system, the currency adjusts lower to equalize prices across borders. However, rising growth expectations allow policy rates to catch up with a higher neutral rate. This improves the relative rate of return for bond investors, allowing for capital inflows. Across the G10, there has been a longstanding relationship between real interest rate differentials and the path of the currency (Chart I-3A and Chart I-3B). Chart I-3ACurrencies Move With Relative Real Rates Chart I-3BCurrencies Move With Relative Real Rates Importantly, US real rates have not risen much against the rest of the world with the latest uptick in global bond yields. In fact, compared to countries such as Australia, the UK, Switzerland, and New Zealand, they have declined. This is negative for the dollar on the margin. While the direction of relative real rates is important, the absolute level of real yield spreads also matters for currency and bond investors. Chart I-4 shows that the dollar tends to respond to the level of real rates in the US, compared to the rest of the world. When US real rate differentials are positive, the dollar tends to appreciate on a year-over-year basis. Looking at a snapshot of global real yields, the US sits below the median (Chart I-5). Commodity-producing countries fare much better. So do Japan and Switzerland. Based on the historical precedent, US real rates will have to improve by about 50-to-100 bps to set the dollar up for structural upside. Chart I-4US Real Rates Are ##br##Still Low Chart I-5US Real Rates Need 50-75 Bps Upside To Make Them Attractive Bonds Versus Equities There are multiple drivers of exchange rates. Bond yields are just one of them. Equity flows also matter. One way to square the circle on whether the level of US real rates makes a difference for the dollar is through flow data. Foreign inflows into US Treasuries remain negative. This suggests that despite the rise in US nominal rates since March of last year, foreign investors are still not convinced they are sufficiently high to compensate for the rising US twin deficits. Rather, inflows into equities have been rather strong. This raises the prospect that the equity market has become an important driver of currency returns and will become the dominant driver going forward (Chart I-6). Importantly, the correlation between bond yields and exchange rates at very low rates is not straightforward. Bond investors span the duration spectrum, and 1-year, 2-year and even 5-year yield differentials are not meaningfully different across countries (Chart I-7). This is particularly the case if hedging costs are taken into consideration. It explains why currencies have not moved much in light of the violent moves at the long end of the yield curve, as shown in Chart I-3A and Chart I-3B. At times, the moves have been opposite to what economic theory would suggest. Chart I-6Foreign Investors Like US Equities, ##br##Not Bonds Chart I-7A Regime Shift For Interest Rates And Currencies? Chart I-8The CAD Is Not Driven By Relative Interest Rates, But Terms Of Trade If a central bank explicitly targets a bond yield, that makes it difficult for that same yield to send a reliable signal about the economy. That is why at very low rates, markets start to gravitate to other indicators of growth. These include, but are not limited to, differences in PMI surveys or even commodity prices. For example, the performance of the Canadian dollar can be perfectly explained by the rise in Canadian terms of trade, even though real interest rate differentials between Canada and the US have not done much (Chart I-8). Rising oil prices are usually bullish for Canadian national income, on a relative basis. They are also bullish for Canadian equities that are more resource based. Inflows into these sectors tend to be positive for the currency. In the case of Europe, the euro has rolled over on the drop in relative real rates, but the gap in economic data surprises with the US has provided a far better explanation of euro underperformance in recent weeks. With domestic European economies in various lockdowns, economic data is becoming relatively weaker (Chart I-9). This is curbing growth, inflation, and interest rate expectations. Chart I-9Economic Divergences Explain EUR/USD, Rather Than Real Interest Rates This brings up a bigger point. Flows tend to gravitate to capital markets with the highest expected returns, and this is certainly the case when cyclical versus defensive style tilts are concerned. This is important for currency strategy, since sector composition can drive a country’s equity returns. Higher yields tend to be beneficial for cyclical stocks, especially banks. In the case of Europe, the bourses are heavily weighted toward banks, industrials, and consumer discretionary sectors. Not only do these sectors need to do well for the equity market to outperform, they are also strongly tied to the performance of the domestic economy. That is why for the most part, both equity and currency relative performances tend to be in sync (Chart I-10). The bottom line is, to get the USD call right, investors should broaden their scope from relative bond yields to other drivers of currency returns. With most developed market interest rates near zero at the short end, relative bond yields matter less. More importantly, flows will be dictated by investors’ perceptions of where to find higher relative rates of return. This, in turn, will be based on relative growth fundamentals. Our bias is as follows: The US equity market has become very tech-heavy. Rising interest rates tend to hurt higher duration sectors such as tech and health care. At the margin, this hurts the relative performance of US equities. As such, rising rates will negatively impact the US equity market more, and will not derail our bearish dollar view (Chart I-11). Chart I-10The Dollar And Relative Stock Markets Chart I-11Global Defensives And Interest Rates The Signal And The Noise Chart I-12The Dollar Could Be Seasonally Strong There are a few conclusions from the insights made above. First, US real interest rates have not meaningfully improved relative to the rest of the world. Second, a rise in US real rates of 50bps above the rest of the world would be required in order to seriously question our bearish dollar view, from a fixed income angle. Finally, sector performance matters a great deal, which means that the current rise in global bond yields is bearish for US stocks compared to non-US bourses. This places the US dollar at a very critical juncture. On the one hand, the dollar is still very oversold. Every time the dollar bounces from these oversold levels, the bulls rage forward, taking it as vindication that the uptrend has resumed. As we have highlighted, the DXY could hit 94 before working off oversold conditions. February and March tend to be excellent months for a rise in the DXY (Chart I-12). On the other hand, a rise in the dollar could be genuine confirmation that the US is leading the recovery both in terms of rates and equity performance. Weakness in the euro will not be particularly surprising, given the lopsided level of optimism. We remain bullish until the euro hits 1.35. The reality is that no one knows the trajectory of global growth in 2021, let alone how the relative growth profile between countries will play out. The euro area is heavily levered to global growth, hence we remain bullish EUR/USD. However, this view will change if the facts change. Meanwhile, in a higher inflationary environment, the outperformers tend to be the Norwegian krone and commodity currencies. This makes sense since commodity prices (and ultimately producer prices) tend to outperform in a period of rising inflation. It dovetails nicely with our high-conviction view to heavily overweight the Scandinavian currencies (Chart I-13). Chart I-13Rising Inflation Is Bullish For The NOK   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been rather robust: Inflation expectations are well anchored. The February 5-10 year survey from the University of Michigan pinned inflation expectations at 2.7% year-on-year. Core PPI came in at 2% year-on-year in January, blowing out expectations of a 1.1% rise. Retail sales galloped above expectations. The control group printed 6% month-on-month in January compared to expectations of a 1% rise. Housing starts declined month-on-month in January, but building permits rose so it’s a wash if rising rates are affecting cyclical spending in the US.     The DXY index rose by around 30 bps this week. There is a clear tug-of-war in markets, with the Fed signaling that policy will remain easy as far as the eye can see, but bond markets pushing up longer-term rates. Our bias is that any pickup in inflation will prove transitory, vindicating Fed policy in 2021.  Report Links: Are Rising Bond Yields Bullish For The Dollar? - February 19, 2021 Portfolio And Model Review - February 5, 2021 Sizing A Potential Dollar Bounce - January 15, 2021 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data from the euro area remain weak: The trade surplus widened to €27.5 billion in December. 4Q GDP slowed by 5% year-on-year, in line with expectations. The ZEW survey was a very positive surprise. The expectations component for February jumped from 58.3 to 69.6. The euro fell by 0.4% against the US dollar this week. The markets will keep oscillating between how deep the euro area slowdown will be for now, and the magnitude of any potential rebound.  We are bullish on euro area growth, especially given tentative signs of a revival in animal spirits (proxied by the expectations component of the surveys). Report Links: Portfolio And Model Review - February 5, 2021 On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data from Japan has been positive: 4Q GDP surprised to the upside, rising an annualized 12.7% quarter-on-quarter. Exports are booming, rising 6.4% year-on-year in December. The rise in machinery orders by 11.8% in December corroborated the positive contribution from CAPEX to GDP. The Japanese yen fell by 0.9% against the US dollar this week. As Japanese data surprised to the upside, inflation expectations also rose and depressed real rates. The drop in the yen signals the market might be pricing in that the BoJ will not fight strength in economic data with more tapering. We are long the yen as a portfolio hedge, but that view has been shaken by recent weakness. Report Links: On Japanese Inflation And The Yen - January 29, 2021 The Dollar Conundrum And Protection - November 6, 2020 The Near-Term Bull Case For The Dollar - February 28, 2020 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data out of the UK have been in line: 4Q GDP in the UK was slightly better than expected at 1% quarter-on-quarter. Core CPI for January came in at 1.4%, in line with expectations. House prices are soaring, rising 8.5% in December on a year-on-year basis. The pound was the best performing currency this week, rising about 1%. Our short EUR/GBP trade has benefited from faster vaccination in the UK (that could give way to a faster reopening of the economy) and a nice valuation starting point. We are tightening stops this week to protect profits.  Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 Revisiting Our High-Conviction Trades - September 11, 2020 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The most important data this week from Australia was the employment report: There were 29.1K new jobs in January, in line with expectations. More importantly, there were 59K new full-time jobs, while part-time jobs fell by 29.8K. The unemployment rate declined from 6.6% to 6.4%. The Aussie was flat this week. When it comes to Covid-19, Australia ranks extremely well on a global scale. The number of new cases are low, the government has secured enough vaccines for the entire population and economic activity has rebounded given very close ties to China. We like the AUD, and are long versus the NZD. However, we expect that any positive surprises in the rest of the world will hurt AUD relative to the Americas. As such, we are short AUD/MXN. Report Links: Portfolio And Model Review - February 5, 2021 Australia: Regime Change For Bond Yields & The Currency? - January 20, 2021 An Update On The Australian Dollar - September 18, 2020 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week: Net migration remained at a very low level of 415 individuals in December. The New Zealand dollar fell by 0.3% against the US dollar this week. The kiwi has catapulted itself to the most expensive currency in our PPP models. According to our attractiveness ranking, it is also the worst. We are already long AUD/NZD but are looking for more opportunities to short the kiwi at the crosses. Stay tuned.  Report Links: Portfolio And Model Review - February 5, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data from Canada was positive: Housing starts rose by 282.4K, well above expectations for a January level of 228.3 K. Foreigners continued to by C$5 billion of securities in December. CPI was in line with expectations. The core median came in at 1.4% but the core trim was 1.8%, a nudge below the BoC range of 1-3%. The Canadian dollar was flat against the US dollar this week. The path of the CAD will be dictated by two factors – 1) relative economic growth between the US and the rest of the world (CAD benefits more from better US growth); and 2) the path of commodity prices, especially oil. Both remain positive for the CAD, as we alluded to last week. Report Links: Will The Canadian Recovery Lead Or Lag The Global Cycle? - February 12, 2021 Currencies And The Value-Versus-Growth Debate - July 10, 2020 More On Competitive Devaluations, The CAD And The SEK - May 1, 2020 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data out of Switzerland have been flat: Core CPI came in at 0% in January, suggesting Switzerland has tentatively exited deflation (the print was -0.4% in December). January exports rebounded, even as watch sales remained quite weak. The Swiss franc fell by 0.7% against the US dollar this week. Safe-haven currencies were laggards, with only the Swiss franc lagging the Japanese yen. This is clearly a signal that the market remains very much in risk-on mode. We are long EUR/CHF on this basis, but short USD/JPY purely as portfolio insurance. Report Links: Portfolio And Model Review - February 5, 2021 The Dollar Conundrum And Protection - November 6, 2020 On The DXY Breakout, Euro, And Swiss Franc - February 21, 2020 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The data out of Norway has been robust: 4Q mainland GDP came in at 1.9% quarter-on-quarter. Expectations were for a 1.3% rise. The trade balance exploded to NOK 23.1 billion in January. The Norwegian krone was flat against the US dollar this week, but outperformed the euro. The NOK is the perfect example of a currency on a coiled spring – cheap valuations, a liquidity discount, and primed to benefit from the global economic rebound. We are long the NOK against the euro, loonie, and USD. Report Links: Portfolio And Model Review - February 5, 2021 Revisiting Our High-Conviction Trades - September 11, 2020 A New Paradigm For Petrocurrencies - April 10, 2020 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The most important data from Sweden this week was the CPI: The headline measure for January came in at 1.6%, in line with expectations. The core measure at 1.8% was also in line with expectations. The Swedish krona was flat against the US dollar this week. The Swedish COVID-19 experiment is coming home to roost. On the one hand, much higher cases compared to Norway have dampened economic activity as people voluntarily try to avoid infection. Sweden chose to keep its economy largely open. On the other hand, Sweden is a highly levered play on the global cycle. We think the latter will dominate, and so are positive on the krona. Report Links: Revisiting Our High-Conviction Trades - September 11, 2020 Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Both the US and Iran have the intention and capability of restoring the 2015 nuclear deal so investors should presume that an escalation in tensions will conclude with a new arrangement by August this year. However, the deal that the Iranians will offer, and that Biden can accept, may be unacceptable to the Israeli government, depending on Israel’s March 23 election. Moreover if a deal is not clinched by August, the timeframe will stretch out for most of Biden’s term and strategic tensions will escalate. Major Middle Eastern conflicts and crises tend to occur at the top of the business cycle when commodity prices are soaring rather than in the early stages where we stand today. But regional instability is possible regardless, especially if the US-Iran talks fall apart. Maintain gold and safe-haven assets as the Iranian question can lead to near-term escalation even if a deal is the end-game. Feature Geopolitics is far from investors’ concerns today, so it could create some nasty surprises. Two urgent tests await the Biden administration – China/Taiwan and Iran – and provide a basis for investors to add some safe-haven assets and hedges amidst an exuberant stock rally in which complacency is very high. The past week’s developments underscore these two tests. First, Chinese officials flagged that they would cut off rare earth elements to the US, implying that they would retaliate if Biden refuses to issue waivers for US export controls on semiconductors to China.1 Second, Biden spoke on the phone with Benjamin Netanyahu for the first time. The delay signaled Biden’s distance from Netanyahu and intention to normalize ties with Israel’s arch-enemy Iran. In both the Taiwan Strait and the Persian Gulf, the base case is not a full-fledged military conflict in the short run. This is positive for the bull market. But major incidents short of war are likely in the near term and major wars cannot be ruled out. In this report we update our view of the Iran risk. A long-term solution to the nuclear threat is not at hand, which means that Israel could in the worst-case take military action on its own. Meanwhile tensions and attacks will escalate until a deal is agreed. Iranian-backed forces in Iraq have already attacked a US base near Erbil, killing an American military contractor.2 In the event of an Iranian diplomatic crisis, the stock market selloff will be short. The macro backdrop is highly reflationary and investors will buy on the dips. In the event of full-scale war, the US dollar will suffer for a longer period. Oil Price A Boon But Middle East Regimes Still Vulnerable Chart 1Oil Recovery A Boon For Middle East Markets Brent crude oil prices have rebounded to $65 per barrel on the global economic recovery. Middle Eastern equities are rallying in absolute terms, though not relative to other emerging markets (Chart 1). This underperformance is fitting given that the region suffers from poor governance, obstacles to doing business, resource dependency, insufficient technology and capital, and high levels of political and geopolitical risk. Non-oil producers and non-oil sectors in the Middle East have generally lagged the global economic recovery (Chart 2). The continuation of the recovery is essential to these regimes because most of them lack the fiscal room to provide large fiscal relief packages. The global average in fiscal support over the past year has been 7.4% but most Middle Eastern governments have provided 2% or less (Chart 3). Current account deficits have plagued oil producers since the commodity bust of 2014 and twin deficits have become a feature of the region, limiting the fiscal response to the global pandemic. Chart 2Middle East Economy Starts To Recover Chart 3Middle Eastern Regimes Fiscally Constrained The good news is that the recovery is likely to continue on the back of vaccines and fiscal pump-priming in all of the major economies. The bad news is that a black cloud hangs over the Middle East in the form of geopolitics. Given the underperformance of regional equities, global investors are not ignoring these risks – but they are a persistent factor until the Biden administration survives its initial tests in the region to create a new equilibrium. The unfinished geopolitical business in the region centers on the role of the US and the question of Iran. It is widely understood that the US has less and less interest in the region due to its newfound energy independence on the back of the shale revolution (Chart 4). This is why the US can afford to sign and break deals as it pleases under different administrations, namely the 2015 Iranian nuclear deal, otherwise known as the Joint Comprehensive Plan of Action (JCPA). The Obama administration spent two terms concluding the deal while the Trump administration spent one term nullifying it, leaving the central geopolitical question of the region in limbo. Israel and Arab governments feel increasingly insecure in light of the US’s apparent lack of foreign policy coherence and declining interest in the region. The US has not truly abandoned the region – if anything the Biden administration is looking to maintain or increase US international involvement.3 Washington still sees the need to preserve a strategic balance between Iran and the Arab states, prevent Iran from gaining nuclear weapons, and maintain security in the critical oil chokepoint of the Persian Gulf and Strait of Hormuz (Chart 5). But Washington’s appetite for commitment and sacrifice is obviously waning. The American public is openly hostile to the idea of Middle Eastern entanglements, and three presidents in a row have been elected on the assurance that they would scale down America’s “forever wars.” A decisive majority of Americans, including military veterans and Republicans, believe the wars in Afghanistan and Iraq were not worth fighting.4 And only 6% of Americans view Iran as the top threat to their country. Chart 4Waning US Interest In Middle East Chart 5Strait Of Hormuz Critical To Global Stability America’s lack of concern about the Iranian threat marks a difference from the early 2000s and especially from its critical Middle Eastern ally Israel. Naturally Israelis have a much greater fear of Iran, and 58% see it as the nation’s top threat (Chart 6). Israel and the Gulf Arab states are drawing together, under the framework of the Trump administration’s Abraham Accords, in case the US abandons the region. A deal normalizing relations with Iran would enable Iran to expand its power and influence and, if unchecked by the US, would pose a long-lasting threat to US allies. Chart 6No US Appetite For War With Iran – Israel A Different Story Chart 7China/Asia, Not Iran, The Strategic Priority For The US The US’s reason for dealing with Iran is that it needs to devote more attention to its strategy in the western Pacific in countering China (Chart 7). But China is also a reason for the US to stay involved in the Middle East. China’s role is expanding because of resource dependency and the desire to expand economic integration. Beijing wants to deepen its global investments, open up new markets, and create closer links with Europe (Chart 8). Chart 8AChina's Expanding Role In Middle East Chart 8BChina's Expanding Role In Middle East Chart 9Unresolved US-Iran Deal A Geopolitical Risk The opening of the Iranian economy would give the US (and EU) a greater role in Iran’s development, where China has a special advantage as long as Iran is a pariah. The US would add economic leverage to its military leverage in a region that provides China with its energy. The Chinese are not yet as capable of projecting power into the region but that is changing rapidly. There is a possible strategic balance to be established between these simultaneous foreign policy revolutions: the US-Iran détente, the Israeli-Arab détente, and the rise of Mideast-China ties. But balance is an ideal and not yet a reality. In the meantime these foreign policy revolutions must actually take place – and revolutions are rarely bloodless. It is possible for a meltdown to occur in light of the region’s profound changes. In particular, the US-Iran détente is incomplete and faces Israeli/Arab opposition, Iranian paranoia, and US foreign policy incoherence. At the moment it is premature to declare an end to the bull market in US-Iran tensions. That will come when a deal is actually sealed, and then tested and enforced. In the meantime Iranian incidents will occur (Chart 9). Geopolitical risks threaten to reduce global oil supply. Different regimes and their militant proxies will strike out against each other to establish red lines. But a US-Iran deal is highly likely – and once that occurs, the risk to oil supply shifts to the upside, as Iran’s economy will open up. Not only will Iran start exporting again but Gulf Arab producers will want to preserve their market share, which means they will pump more oil. Iran’s Regime Hardens Its Shell Ahead Of Leadership Succession The COVID-19 crisis has weakened regimes in the Middle East, much like the Great Recession sowed the seeds for the Arab Spring and many other sweeping changes in the region. But unlike the Arab Spring, the regimes most at risk today are majority Shia Muslim – with Lebanon, Iran, and Iraq all teetering on the verge of chaos (Chart 10). Chart 10Iranian Sphere De-Stabilized Amid COVID Chart 11Iranian Economy Weak (Despite Green Shoots) Chart 12Jobless Iranian Youth The Iranian economy is starting to show the faintest green shoots but it is far too soon to give the all-clear signal. US sanctions have shut off access to oil export revenues. Domestic demand is weak and imports are still contracting, albeit much less rapidly. The country has seen a double dip recession over the past ten years (Chart 11). Unemployment is rife, especially among the youth. The working-age population makes up 60% of total and periodically rises up in protest (Chart 12). Inflation is soaring and the currency is still wallowing in deep depreciation (Chart 13). All of these points suggest Iran is weaker than it looks and will seek to negotiate a deal with the Biden administration. But Iran cannot trust the US so it will simultaneously prepare for the worst outcome – no deal, sanctions, and eventually war. Chart 13Iran Still Ripe For Social Unrest Chart 14Iranian Regime Turning HawkishIran’s response to the US’s withdrawal from the 2015 nuclear deal and imposition of maximum pressure sanctions has been to adopt a siege mentality and fortify the regime for a potential military confrontation. The country is preparing for a highly uncertain and vulnerable transition from Supreme Leader Ali Khamenei to a future leader or group of leaders. The government fixed the 2020 parliamentary elections so that hardliners or “principlists” rose to prominence at the expense of independents and especially the so-called reformists. The reformists have been humiliated by the US betrayal of the deal and re-imposition of sanctions, which exploded the economic reforms of President Hassan Rouhani, who will step down in August (Chart 14). The Timeline Of Biden’s Iran Deal Still, it is likely that the US and Iran will return to some form of the 2015 nuclear deal. Lame duck Rouhani is politically capable of returning to the deal: President Rouhani is a lame duck president whose popularity has cratered. If he can restore the deal before August then he can salvage his legacy and provide a pathway for Iran out of economic ruin by removing sanctions. It is manifestly in Iran’s interests to restore the deal – one reason why it has never left the deal and has only made incremental and reversible infractions against it. If Rouhani falls on his sword he provides the Supreme Leader and the next administration with a convenient scapegoat to enable the deal to be restored. Freshman President Biden has enough political capital to return to the deal: Biden is capable of restoring the deal, as he clearly intends to do judging by his statements, cabinet appointments, and diplomatic actions thus far. He has demanded that Iran enter back into full compliance with the deal before he eases sanctions but even this demand can be fudged. After all, it was the US that exited the deal in the first place, and Iran remains in partial compliance, so it stands to reason that the US should make the first concession to bring Iran back into compliance. None of the signatories have nullified the deal other than the US, and it was an executive (not legislative) deal, so President Biden can ultimately rejoin it by fiat. This would not be a popular move at home but the US public is preoccupied. Biden would achieve a foreign policy objective early in his term. The timeline is critical – an early deal is our base case. But if it falls through, then it could take the rest of Biden’s term in office, or longer, to forge a deal. Tensions would skyrocket over that period. The timeline is shown in Table 1. The US has identified April or May as the time when Iran will reach “breakout” capability, i.e. produce enough highly enriched uranium to make a nuclear bomb. The Israelis, for their part, estimate that breakout phase will be reached in August – the same month Rouhani is set to step down. Both the US and Israel view breakout as a red line, though there is some room for interpretation. Table 1Can Lame Duck Rouhani Salvage US Deal For Legacy By August? The option of rejoining the old deal with Rouhani as a scapegoat will end when Rouhani exits in August. The next Iranian president is unlikely to repeat Rouhani’s mistake of pinning his administration on a promise from the Americans that could be revoked as early as January 20, 2025. The next Iranian president will be a nationalist or hardliner. Opinion shows that the public looks most favorably upon the firebrand ex-President Mahmoud Ahmadinejad or the hardline candidate from 2017 Ebrahim Raisi. Another possible candidate is Hossein Dehghan, a brigadier general. The least favorable political figures are the reformists like Rouhani (Chart 15). Chart 15Iran’s Next President Will Be Hawkish We cannot vouch for the quality of these opinion polls but they are corroborated by other polls we have seen and they make sense with what we know and have observed in recent years. Apparently the public has turned its back on the dream of greater economic opening, with self-sufficiency making a comeback in the face of US sanctions (Chart 16). The regime will promote this attitude in advance of the leadership transition as it must be prepared to conduct a smooth succession even under the worst-case scenario of sanctions or war. Chart 16Iran Preparing For Supreme Leader’s Succession Chart 17Nuclear Bomb Key To Regime Survival The hitch is that Iran is interested in rejoining the deal it signed in 2015, not a grander deal. It will not sign an expanded deal that covers its regional militant proxies and ballistic missile program or requires irreversible denuclearization. The Supreme Leader has witnessed that an active nuclear weapon program and ballistic missile program provide the surest guarantees of regime survival over the long haul. The contrasting cases of Libya and North Korea illustrate the point (Chart 17). Libya gave up its nuclear program and weapons of mass destruction in the wake of the US invasion of Iraq in 2003 only to see the regime collapse in 2011 and leader Muammar Gaddafi die under NATO military pressure. By contrast, North Korea refused to give up its nuclear and missile programs and repeatedly cut deals with the US that served only to buy time and ease sanctions, and today North Korea possesses an estimated 30-45 nuclear weapons deliverable through multiple platforms. Leader Kim Jong Un has used this leverage to bargain with the great powers. The lesson for Iran could not be clearer: a short-term deal with the Americans may buy time and a reprieve from sanctions. But total, verifiable, and irreversible denuclearization means regime suicide. The Biden administration would prefer to create a much more robust deal rather than suffer the criticism of rejoining the 2015 deal, given its flaws and that the first set of deadlines in 2025 is only four years away. But Biden cannot possibly reconstruct the P5+1 coalition of countries to force Iran into a grander bargain in the context of US-Russia and US-China tensions. The sacrifices that would be necessary to bring Russia and China on board would not be worth it. Therefore Biden’s solution will be to rejoin the existing deal plus an Iranian promise to enter negotiations on a more comprehensive deal in future. The Iranians can accept this option since it serves their purpose of buying time without making irreversible concessions on their nuclear and missile programs. Israel then becomes the sticking point, as Iranian officials have said that the US rejoining the original 2015 deal would be a “calamity” and unacceptable. The Israeli government is studying options for military action in the event that Iran reaches nuclear breakout. However, the Israeli election on March 23 will determine the fate of Benjamin Netanyahu and his government’s hawkish approach to Iran. A change of government in Israel would likely bring the US and Israel into line on concluding a deal with Iran so as to avoid military conflict for the time being. If Netanyahu wins, yet the US and Iran fall back into compliance with the 2015 deal (Table 2), then Iran is still limiting its nuclear capabilities through 2025, obviating the need for a unilateral Israeli strike in the near term. Israel will not launch a unilateral strike except as a last resort, as it fears permanent alienation from its greatest security guarantor, the United States. Table 2Iran’s Compliance (And Non-Compliance) With The Joint Comprehensive Plan Of Action If a deal cannot be put together by the time Rouhani steps down then the risk of conflict will increase as there will not be a prospect of a short-term fix. A much longer diplomatic arc will be required as Iran would draw out negotiations and the US would have to court allies to pressure Iran. The US and/or Israel could conduct sabotage or air strikes to set back the Iranian nuclear program. It is possible that the Iranian leadership or the increasingly powerful Iranian Revolutionary Guard Corps could overplay their hand in the belief that the US has no stomach for waging war. While it is true that the US public is war-weary, it is also true that that attitude would change overnight in the event of a national humiliation or attack. Investment Takeaways The Trump administration drew a hard line on nuclear proliferation. Trump’s defeat marks a softening in the US line regarding proliferation. This does not mean that the Biden administration will be ineffective – it could be even more effective with a more flexible approach – but it does mean that nuclear aspirants currently feel less pressure to make major concessions. This will hold at least until Biden demonstrates that he too can impose maximum pressure. Hence nuclear and missile tests will go up in the near term – as will various countries’ demonstrations of credible threats and red lines. The global economic recovery will strengthen oil producers by giving them greater government revenues with which to stabilize their domestic politics and restart foreign policy initiatives. The global oil price is reasonably correlated with international conflicts involving oil producers (Chart 18). With rising oil revenues, Russia, Saudi Arabia, Iran, Iraq, and others will be emboldened to pursue their national interests. Chart 18Oil Price And Global Conflict Go Hand In Hand While the Biden administration’s end-game is a nuclear deal with Iran, the period between now and the conclusion of a deal will see an increase rather than a decrease in tensions and tit-for-tat military strikes across the region. Unexpected cutoffs of oil supplies and a risk premium in the oil price will be injected first, as we have argued. When a deal is visible on the horizon then oil prices face a downside risk, due to the resumption of Iranian oil exports and any loss of OPEC 2.0 discipline. It is possible that this moment is already upon us. This report shows a clear path to a US-Iran deal by August. US Secretary of State Anthony Blinken is reaching out to the Iranians. Saudi Arabia has recently announced that it will not continue with large production cuts. Russian oil officials have argued that the global market is balanced and production cuts are no longer necessary.5 But given that the Russians and Saudis fought an oil market share war as recently as last year, it is not clear that a collapse in OPEC 2.0 discipline is imminent. What will be the market impact if hostilities revive in anticipation of a deal? Or worse, if a deal cannot be achieved and a much longer period of US-Iran conflict opens up for Biden’s term in office? Table 3 provides a list of major geopolitical incidents and crises in the Middle East since the Yom Kippur war. We look at the S&P500’s peak and trough within the three months before and after each crisis. The median drawdown is 8% and the market has usually recovered within one month. Twelve months later the S&P is up by 12%. Table 3Stock Market Reaction To Middle East Geopolitical Crises Table 4 shows a shortened list of the same incidents with the impact on the trade-weighted dollar, which is notable in the short run but is only persistent in the long run in the case of full-fledged wars like the first and second Persian Gulf wars. Table 4US Dollar Falls On Middle East Geopolitical Crises The stock market impact can last for a year if the crisis coincides with a bear market and recession. Middle Eastern crises tend to occur at the height of business cycles when economic activity is running hot, inflationary pressures are high, and governments feel confident enough in their economic foundation to take foreign policy risks. The Yom Kippur war and first oil shock initiated a recession in 1973. The first Iraq war also coincided with the onset of a recession. The terrorist attack on the USS Cole occurred near the height of the Dotcom bubble and was followed by the 2001 recession. The 2019 Iranian attack on Saudi Arabia’s Abqaiq refinery also occurred at the peak of the cycle. More analogous to the situation today are crises that occurred in the early stages of the global cycle. The Arab Spring and related events in 2011 coincided with a period of market weakness that lasted for most of the year as the aftershocks of the Great Recession rippled across the emerging world. This scenario is relevant in 2021 and especially 2022, as global stimulus wears off and governments strive to navigate the deceleration in growth. Middle Eastern instability could compound that problem. The chief risk in the coming years would be a failure to resolve the Iranian question followed by a US-Iran or Israel-Iran conflict that generates instability across the Middle East. Such a catastrophe could cause major energy supply shock that would short-circuit the global economy. History shows this risk is more likely to come late in the cycle rather than early but the above analysis indicates that a failure of the Biden administration to conclude a deal this year could lead to a multi-year escalation in strategic tensions with a new hawkish Iranian president. That path, in turn, could bring forward the time frame of a major war and supply shock. The Iranians have taken a hawkish turn, are fortifying their regime for the future, and will reject total denuclearization. The US is fundamentally less interested in the region and thus susceptible to continued foreign policy incoherence. The Israelis are just capable of taking military action on their own in the event of impending Iranian nuclear weaponization. These points suggest that the risk of war with Iran is non-trivial, even though a US-Iran deal is the base case.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Sun Yu and Demetri Sevastopulo, "China targets rare earth export curbs to hobble US defence industry," Financial Times, February 15, 2021, ft.com. 2 For the US response to the Erbil attack see Jim Garamone, "Austin Pleased With Discussions With NATO Leaders," Department of Defense News, February 17, 2021, defense.gov. 3 For example, Biden is unlikely to withdraw precipitously from the region, including Afghanistan, as Trump intended, especially as long as he is in a high-stakes negotiation with Iran. 4 Ruth Igielnik and Kim Parker, "Majorities of U.S. veterans, public say the wars in Iraq and Afghanistan were not worth fighting," Pew Research, July 10, 2019, pewresearch.org. 5 See Benoit Faucon and Summer Said, "Saudi Arabia Set to Raise Oil Output Amid Recovery in Prices," Wall Street Journal, February 17, 2021, wsj.com; Yuliya Fedorinova and Olga Tanas, "Global Oil Markets Are Now Balanced, Russia’s Novak Says," Bloomberg, February 14, 2021, Bloomberg.com.