Emerging Markets

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

Highlights Oil demand expectations remain high. Realized demand continues to disappoint. This means OPEC 2.0's production-management strategy – i.e., keeping the level of supply below demand – will continue to dictate oil-price levels. US producers will remain focused on consolidation via M&A and on returning capital to shareholders, in line with the Kingdom of Saudi Arabia's (KSA) expectation. Going forward, shale producers will focus on protecting and growing profit margins. The durability of OPEC 2.0's tactical advantage arising from its enormous spare capacity – ~ 7mm b/d – is difficult to gauge: Tightening global oil markets now in anticipation of Iran's return as a bona fide exporter benefits producers globally, and could accelerate the return of US shales if that return is delayed or re-opening boosts demand more than expected. We are raising our average Brent forecast for 2021 to $66.50 vs. $63/bbl earlier, with 2H21 prices averaging $70/bbl. We are moving our 2022 and 2023 forecasts up slightly to $74 and $81/bbl (Chart of the Week). WTI will trade $2-$3/bbl lower. We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to further steepen backwardations in forward curves. Feature While the forecasted rebound in global oil demand continues to drive expectations for higher prices, it is the production discipline of OPEC 2.0 and capital discipline imposed on US shale producers that has and will continue to super-charge the recovery of prices. Continued monetary accommodation and fiscal stimulus notwithstanding, realized global oil demand has mostly flatlined at ~ 96mm b/d following its surge in February, as uncertainty over COVID-19 containment keeps governments hesitant about reopening their economies too quickly. Stronger demand in Asia, led by China, has been offset by weaker demand in India and Japan, where COVID-19 remains a deterrent to re-opening and recovery. The recovery in DM demand generally stalled over this period even as vaccine availability increased (Chart 2). Chart of the WeekOPEC 2.0 Comfortable With Higher Prices Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Chart 2Global Demand Recovery Stalled Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices That likely will change in 2H21, but it is not a given: The UK, which has been among the world leaders in COVID-19 containment and vaccinations, delayed its full reopening by a month – to July 19 – in an effort to gain more time to bolster its efforts against the Delta variant first identified in India. In the US, New York state lifted all COVID-19-induced restrictions and fully re-opened this week. Still, even in the US, unintended inventory accumulation in the gasoline market – just as the summer driving season should be kicking into high gear – suggests consumers remain cautious (Chart 3). Chart 3Unintended Inventory Accumulation in US Gasoline Market Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices We continue to expect the re-opening of the US and Europe (including the UK) will boost DM demand in 2H21, and wider vaccine availability will boost EM oil demand later in the year and in 2022. For all of 2021, we have lifted our demand-growth estimate slightly to 5.3mm b/d from 5.2mm b/d last month. We expect global demand to grow 4.1mm b/d next year and 1.6mm b/d in 2023. Our 2021 estimates are in line with those of the US EIA and the IEA. OPEC is more bullish on demand recovery this year, expecting growth of 6mm b/d. We continue to believe the risk on the demand side remains to the upside; however, given continued uncertainty around global COVID-19 containment, we remain circumspect. Supply-Side Discipline Drives Oil Prices OPEC 2.0 remains committed to its production-management strategy that is keeping the level of supply below demand. Compliance with production cuts in May reportedly was at 115%, following a 114% rate in April.1 Core OPEC 2.0 – i.e., states with the capacity to increase production – is holding ~ 7mm b/d of spare capacity, according to the IEA, which will allow it to continue to perform its role as the dominant supplier in our modeling (Chart 4). Earlier this year, KSA's Energy Minister Abdulaziz bin Salman correctly recognized the turn in the market that likely ensures OPEC 2.0's dominance for the foreseeable future – i.e., the shift in focus of the US shale-oil producers from production for the sake of production to profitability.2 This is a trend that has been apparent for years as capital markets all but abandoned US shale-oil producers. Chart 4OPEC 2.0 Remains Dominant Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Producers outside OPEC 2.0 – what we refer to as the "price-taking cohort" – have prioritized shareholder interests as a result of this market pressure, and remain focused on sometimes-forced consolidation via M&A, which we have been expecting.3 The significance of this evolution of shale-oil production is difficult to overstate, particularly as the survivors of this consolidation will be firms with strong balance sheets and a focus on profitability, as is the case with any well-run manufacturing firm. We also expect large producers to opportunistically shed production assets to reduce their carbon footprints, so as to come into compliance with court-ordered emission reductions and shareholder demands to reduce pollution.4 With the oil majors like Shell, Equinor and Oxy divesting themselves of shale properties, production increasingly will be in the hands of firms driven by profitability.5 We expect US shale-oil production to end the year at 9.86mm b/d and to average 9.57mm b/d next year; however, as the shales become the marginal global supply, production could become more volatile (Chart 5). The consolidation of US production also will alter the profitability of firms continuing to operate in the shales. We expect breakeven costs to fall as acquired production by stronger firms results in high-grading of assets – only the most profitable will be produced given market-pricing dynamics – while less profitable acreage will be mothballed until prices support development(Chart 6). Chart 5US Producers Focus On Profitability Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Chart 6Shale Breakevens Likely Fall As Consolidation Picks Up Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Supply-Demand Balances Tightening The current round of M&A consolidation and OPEC 2.0's continued discipline lead us to expect continued tightening of global oil supply-demand balances this year and next (Chart 7). This will allow inventories to continue to draw, which will keep forward oil curves backwardated (Chart 8). Chart 7Supply-Demand Balances Will Continue To Tighten Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Chart 8Tighter Markets, Lower Stocks Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices The critical factor here will be OPEC 2.0's continued calibration of supply in line with realized demand and the return of Iran as a bona fide exporter, which we expect later this year. OPEC 2.0's restoration of ~ 2mm b/d of supply will be done by the beginning of 3Q21, when we expect Iran to begin restoring production and visible exports (i.e., in addition to its under-the-radar sales presently). The return of Iranian supply – and a possible increase in Libyan output – will present some timing difficulties for OPEC 2.0's overall strategy, but they will be short-lived. We continue to monitor output to assess the evolution of balances (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Investment Implications Oil demand will increase over the course of 2H21, as vaccines become more widely distributed globally, and the massive fiscal and monetary stimulus deployed worldwide kicks economic activity into high gear. On the supply side, markets will tighten on the back of continued restraint until Iranian barrels return to the market. The balance of risk is to the upside, particularly if the US and Iran are unable to agree terms that restore Iran as a bona fide exporter. In that case, the market tightening now under way will result in sharply higher prices. That said, realized demand growth has stalled over the past three months, which can be seen in unintended inventory accumulation in the US gasoline markets just as the summer driving season opens. We are raising our average Brent forecast for 2021 to $66.50 vs. $63/bbl earlier, with 2H21 prices averaging $70/bbl. We are moving our 2022 and 2023 forecasts up slightly as well to $74 and $81/bbl (Chart of the Week). WTI will trade $2-$3/bbl lower. We remain long the S&P GSCI Dynamic Roll Index ETF (COMT) and the S&P GSCI, expecting tight supply-demand balances to further steepen backwardations in forward curves. The big risk, as highlighted above, remains an acceleration of COVID-19 infections, hospitalizations and deaths, which force governments to delay re-opening or impose localized lockdowns once again. In this regard, KSA's strategy of calibrating its output to realized – vice forecasted – demand likely will remain in place.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish China's refinery throughput surged 4.4% to 14.3mm b/d in May, a record high that surpassed November 2020's previous record of 14.26mm b/d, according to S&P Platts Global. The increased runs were not unexpected, and were largely accounted for by state-owned refiners, which operated at 80% of capacity after coming out of turnaround season. Turnarounds will fully end in July. In addition, taxes on niche refined-product imports are due to increase, which will bolster refinery margins as inventories are worked down. China's domestic crude oil production was just slightly more than 4mm b/d. Base Metals: Bullish China's Standing Committee approved the release an undisclosed amount of its copper, aluminum and zinc stockpiles via an auction process in the near future, according to reuters.com. The government disclosed its intent on the website of National Food and Strategic Reserves Administration on Wednesday; however, specifics of the auction – volumes and auction schedule, in particular – were not disclosed. Prices had fallen ~ 9% from recent record highs in the lead-up to the announcement, which we flagged last month.6 Prices rallied from lows close to $4.34/lb on the COMEX Wednesday (Chart 9). Precious Metals: Bullish After a worse-than-expected US employment report, we do not expect the Federal Reserve to lift nominal interest rates in Wednesday’s Federal Open Market Committee (FOMC) meeting. The Fed will only raise rates once the US economy reaches a level consistent with its definition of "maximum employment." Wednesday’s interest rate decision will be crucial to gold prices. If the Fed does not mention asset tapering or an interest-rate hike, citing current inflation as a transitory phenomenon, gold demand and prices will rise. On the other hand, if the Fed indicates an interest rate hike sooner than the previously stated 2024, this will weigh on gold prices (Chart 10). Ags/Softs: Neutral As of June 13, 96% of the US corn crop had emerged vs. the five-year average of 91%, according to the USDA. 68% of the crop was rated in good to excellent condition, slightly below the five-year average. In the bean market, 94% of the crop was planted as of 13 June, vs. the five-year average of 88%. The Department reported 86% of the crop had emerged vs. the five-year average of 74%. According to the USDA, 52% of the bean crop was in good-to-excellent condition vs the five-year average of 72%. Chart 9 Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices Chart 10 Balance Of Risks Tilts To Higher Oil Prices Balance Of Risks Tilts To Higher Oil Prices   Footnotes 1     Please see OPEC+ complies with 115% of agreed oil curbs in May - source published by reuters.com on June 11, 2021. 2     Please see Saudis raise U.S. and Asian crude prices for April delivery published by worldoil.com on March 8, 2021. 3    Please see US shale consolidation continues as Independence scoops up Contango Oil & Gas published by S&P Global Platts on June 8, 2021. 4    We discuss this in A Perfect Energy Storm On The Way, published on June 3, 2021.  Climate activism will become increasingly important to the evolution of oil and natural gas production, and likely will lead to greater concentration of supply in the hands of OPEC 2.0 and privately held producers that do not answer to shareholders. 5    Please see Interest in Shell's Permian assets seen as a bellwether for shale demand published by reuters.com on June 15, 2021. 6    Please see Less Metal, More Jawboning, which we published on May 27, 2021.  It is available at ces.bcaresearch.com. Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

Dear Client, Next week, in lieu of our regular weekly report, I will be hosting two webcasts where I will discuss the outlook for China’s economy and financial markets, a year into policy normalization. The webcasts will be held on Tuesday, June 22 at 10:00 am EDT (English), and Thursday, June 24 at 9:00 am HKT (Mandarin). We will return to our regular publishing schedule on Wednesday, June 30. Best regards, Jing Sima, China Strategist   Feature China’s onshore stocks rebounded in the past two months on the back of a rapidly appreciating RMB versus the US dollar and accelerating foreign capital inflows (Chart 1). However, in our view, China’s domestic policy backdrop and economic fundamentals do not support a sustained rally in Chinese stocks in the next six months. The RMB’s rise vis-à-vis the US dollar will likely falter in the second half of the year as China’s growth weakens. A narrowing in real yields later this year between China’s government bonds and US Treasuries will also discourage foreign flows into Chinese assets. Performance of Chinese cyclical stocks versus defensives failed to decisively breakout in both the onshore and offshore equity markets. An underperformance in cyclical stocks relative to defensives has historically pointed to waning market sentiment towards the Chinese economy (Chart 2). Chart 1Rapid Appreciation In The RMB Buoyed A Recent Rebound In A-Shares Rapid Appreciation In The RMB Buoyed A Recent Rebound In A-Shares Rapid Appreciation In The RMB Buoyed A Recent Rebound In A-Shares Chart 2Cyclical Stocks Continued To Underperform Defensives Cyclical Stocks Continued To Underperform Defensives Cyclical Stocks Continued To Underperform Defensives The number of onshore stocks with prices rising versus falling remains low, even though there has been a slight improvement this year from Q4 2020. The narrow breath in the equity market implies that recent rebound in A-share stocks has been largely driven by a handful of companies (Chart 3). Such narrow breadth suggests that the rebound in Chinese stock prices will not sustain (Chart 4). Chart 3A Narrow-Based Market Rally in A-Shares A Narrow-Based Market Rally in A-Shares A Narrow-Based Market Rally in A-Shares Chart 4Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks Narrowing Market Breadth Has Historically Led To Price Pullbacks A tightened monetary and credit environment has created obstacles for Chinese equities since early this year. Credit numbers released last week show that credit growth deceleration has gathered speed in May, raising the risk of policy overtightening, i.e. credit growth undershooting the government’s 2021 targets. We could see some moderation in the credit growth deceleration into 2H21. A delay in the rollout of local government (LG) bonds and LG special purpose bonds (SPBs) in the first five months of the year means the pace of LG bond issuance between June and October will escalate, which will help to stabilize credit growth. However, weak corporate bond net financing and contracting shadow banking will cap the upside in credit expansion. Chart 5The Economy Could Surprise The Market To The Downside In Q3 The Economy Could Surprise The Market To The Downside In Q3 The Economy Could Surprise The Market To The Downside In Q3 Additionally, if more LG bonds come onto the market in Q3, then we could see tighter interbank liquidity conditions and higher bond yields. This, in turn, would partially offset the positive effects on the economy and equity market from a slower pace in credit growth deceleration. For the next six months, we continue to hold an underweight position in Chinese onshore and investable stocks, in both absolute terms and within a global equity portfolio. Policy tightening has not reversed course and there is an escalating risk that economic data will surprise the market to the downside in Q3 (Chart 5). Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com     Macro Policy Conditions Are Still Unfavorable For Risk Assets A further deterioration in the credit impulse in May reflects Chinese authorities’ efforts to reduce local government leverage and shadow banking activities. Net corporate bond financing contracted for the first time since early 2018, driven by shrinking local government financing vehicle (LGFV) bonds (Chart 6). Meanwhile, the pace of contraction in shadow-bank loans climbed. At this rate of deceleration, credit growth will undershoot the government’s 2021 target, which is expected to be in line with this year’s nominal GDP growth. The pace in credit expansion on a year-over-year basis has dropped to its previous cycle’s trough (Chart 7). Moreover, the speed of the deceleration in credit growth has outpaced the 2017/18 tightening cycle. It has been seven months since Chinese credit growth peaked (October 2020), which is significantly less than the 13 months it took for credit to decline from top to bottom in 2017/18. Chart 6Contraction In Net Corporate Bond Financing And Shadow Banking Dragged Down Credit Growth In May Contraction In Net Corporate Bond Financing And Shadow Banking Dragged Down Credit Growth In May Contraction In Net Corporate Bond Financing And Shadow Banking Dragged Down Credit Growth In May Chart 7Credit Growth Has Decelerated To Its Trough Reached In 2017/18 Tightening Cycle Credit Growth Has Decelerated To Its Trough Reached In 2017/18 Tightening Cycle Credit Growth Has Decelerated To Its Trough Reached In 2017/18 Tightening Cycle Chart 8Most Of LG Bonds Issued In The First Five Months Are Refinancing Bonds The Stars Are Not Yet Aligned For Chinese Stocks The Stars Are Not Yet Aligned For Chinese Stocks So far this year, LG bond issuance is also behind schedule. About 63% of LG bonds issued in the first five months are refinancing bonds (Chart 8). The new LG bonds and LG SPBs issued to date account for only 21% and 16.5%, respectively, of their 2021 quotas. A delay in LG bond issuance in the first five months means that much more bonds will be on the market between June and October, which may help to stabilize credit growth in Q3. However, weak corporate bond financing and an acceleration in contracting shadow banking activities will cap the upside on broad credit. We do not expect a reversal in policy tightening. Instead, credit growth will likely hover near current levels for the rest of the year. In the past, Chinese policymakers eased when the global manufacturing backdrop faltered. Given that global growth is robust, Chinese policymakers will not feel any urgency to reverse policy setting and will likely use the strong external environment as an opportunity for domestic deleveraging. Chinese Exports Will Face Challenges In The Second Half Of The Year Chart 9A Broad-Based Moderation In China's Exports to DMs A Broad-Based Moderation In China's Exports to DMs A Broad-Based Moderation In China's Exports to DMs Export growth slowed in May with a broad-based moderation in the country’s exports to developed markets (DMs), albeit from a very elevated level (Chart 9). The easing in exports reflects an ongoing demand shift in the DMs away from goods to services as economic activity normalizes (Chart 10). China’s robust exports, which have been driven by strong and partly pandemic-induced global demand for goods, will likely gradually lose strength in the second half of the year. China’s weakening new export orders component in the May manufacturing PMI reflects this trend (Chart 11). Chart 10Global Consumption Recovery In Services Will Likely Outpace Goods Global Consumption Recovery In Services Will Likely Outpace Goods Global Consumption Recovery In Services Will Likely Outpace Goods Chart 11China's Softening New Export Orders Signal Further Export-Sector Weakness China's Softening New Export Orders Signal Further Export-Sector Weakness China's Softening New Export Orders Signal Further Export-Sector Weakness An appreciating RMB versus the US dollar is also a headwind for Chinese exports. The USD/CNY historically has led Chinese new export orders by around six months, with the exception of the pandemic-hit outlier in 2020 (Chart 12).  The recent sharp RMB appreciation is starting to weight on Chinese exports. Moreover, BCA’s Geopolitical strategists do not expect that China will principally benefit from US President Biden’s $2.4 trillion infrastructure and green energy plan . US explicitly aims to diminish China’s role as a supplier of US goods and materials. The widening divergence between US’s trade deficit with China and the rest of world already shows evidence (Chart 13). Chart 12The RMB's Rapid Rise Creates Headwinds For Chinese Exports The RMB's Rapid Rise Creates Headwinds For Chinese Exports The RMB's Rapid Rise Creates Headwinds For Chinese Exports Chart 13China's Exports May Not Benefit From Biden's Infrastructure Plan China's Exports May Not Benefit From Biden's Infrastructure Plan China's Exports May Not Benefit From Biden's Infrastructure Plan Still No Inflation Pass-Through Chart 14Chinese Producers Are Unable To Pass Rising Input Costs On To Consumers Chinese Producers Are Unable To Pass Rising Input Costs On To Consumers Chinese Producers Are Unable To Pass Rising Input Costs On To Consumers Chinese surging producer prices overstate domestic inflationary pressures. Inflation in the Producer Price Index (PPI) surged by 9.0% year-over-year in May, jumping to its highest level since 2009. High PPI inflation reflects rising commodity prices and a low base effect. Meanwhile, inflationary pressures are much more muted for consumer goods and services. The gap between producer and consumer prices widened to the highest level since 1990, highlighting the absence of price inflation pass-through from producers to consumers (Chart 14). We expect soaring PPI inflation to be transitory; it will ease when low-base factors from last year and global supply constraints are removed later this year. CPI inflation will remain tame through the year. As such, Chinese authorities are unlikely to tighten monetary policy in response to high PPI readings. Instead, Beijing will continue to use regulatory measures to curb speculation in the commodity market and window-guide industries to readjust material inventories to help ease the pace of rising commodity prices. Historically, PPI inflation’s impact on consumer prices has been weak when prices on producer goods were pushed up by supply shocks rather than mounting domestic demand. The sharp uptick in the PPI during the 2017/18 cycle was mostly due to China’s supply-side reforms and a rapid consolidation in the upstream industries. Global supply constraints linked to the pandemic have also resulted in a sharp upturn in the Chinese PPI since mid-2020. Moreover, Chart 15 shows that the pass-through from PPI inflation to consumers is closely correlated to household income growth. The pass-through has weakened significantly since 2011 when household income growth subdued along with a declining Chinese working population (Chart 16). Chart 15Subdued Household Income Growth Since 2011 Has Suppressed CPI Inflation Subdued Household Income Growth Since 2011 Has Suppressed CPI Inflation Subdued Household Income Growth Since 2011 Has Suppressed CPI Inflation Chart 16Income Growth Decelerated After China's Working Population Peaked Income Growth Decelerated After China's Working Population Peaked Income Growth Decelerated After China's Working Population Peaked Chart 17Profits Diverged Between Upstream And Mid & Downstream Industries The Stars Are Not Yet Aligned For Chinese Stocks The Stars Are Not Yet Aligned For Chinese Stocks Lacking inflation pass-through from producers to consumers has led to a bifurcated profit recovery between upstream and mid & downstream industries. Since late last year, the share of upstream industries in total profits increased sharply at the expense of mid and downstream businesses (Chart 17). A deterioration in the profits of mid and downstream industries will weigh on the outlook for their capex, which in turn, will reduce the demand for upstream goods.     Domestic Demand Remains China’s Weakest Link Investments and household demand remain the weakest links in China’s economy. Sluggish household consumption reflects a fragile post-pandemic recovery in manufacturing and services employment, and a rising propensity for precautionary savings (Chart 18). A PBoC survey shows that households’ preference for more saving deposits soared in 2020 (Chart 19). Although it has slightly diminished since late 2020, the reading is still much higher than its pre-pandemic level and will likely persist to year-end on the back of a subdued outlook for employment and income. Chart 18Weak Employment In Both Manufacturing And Service Industries Weak Employment In Both Manufacturing And Service Industries Weak Employment In Both Manufacturing And Service Industries Chart 19Propensity For Precautionary Savings Is Still Elevated Propensity For Precautionary Savings Is Still Elevated Propensity For Precautionary Savings Is Still Elevated Manufacturing investment continued its rebound in April, but the growth has not rallied to its pre-pandemic state and the recovery was more than offset by falling old-economy infrastructure and real estate investment growth (Chart 20). Although a pickup in LG SPB issuance in Q3 will provide some support to infrastructure expenditures, the effect on aggregate infrastructure investment probably will be muted. China’s Ministry of Finance has raised the requirements for approvals of new investment projects, which have decreased notably since early this year (Chart 21). Hence, growth in infrastructure investment may not significantly improve in 2H21 without a harmonized policy impetus for more bank loans and loosened regulations on local government spending. Chart 20Recovery In Manufacturing Investment Was More Than Offset By Falling Infrastructure And Real Estate Investment Growth Recovery In Manufacturing Investment Was More Than Offset By Falling Infrastructure And Real Estate Investment Growth Recovery In Manufacturing Investment Was More Than Offset By Falling Infrastructure And Real Estate Investment Growth Chart 21Falling New Projects Approval Falling New Projects Approval Falling New Projects Approval Real Estate Sector: Mounting Deleverage Pressure Property developers face challenges from heightened government scrutiny on bank loans and limits on the sector’s leverage ratio, along with curtailed off-balance sheet funding due to Asset Management Regulation (AMR) . Bank loans to real estate developers and household mortgages have tumbled to historical lows and will likely slow further in the next few months (Chart 22, top panel). The tightened financing policies have started to cool demand in the real estate market (Chart 22, bottom panel). Softer housing demand will start to drag down property developers’ capital spending and real estate construction activities (Chart 23). Chart 22Deteriorating Financing Starting To Cool The Property Market Deteriorating Financing Starting To Cool The Property Market Deteriorating Financing Starting To Cool The Property Market Chart 23Real Estate Investments And Construction Activities May Slow Further Real Estate Investments And Construction Activities May Slow Further Real Estate Investments And Construction Activities May Slow Further   Table 1China Macro Data Summary The Stars Are Not Yet Aligned For Chinese Stocks The Stars Are Not Yet Aligned For Chinese Stocks Table 2China Financial Market Performance Summary The Stars Are Not Yet Aligned For Chinese Stocks The Stars Are Not Yet Aligned For Chinese Stocks   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Note: An update on Peru is available on page 10. Highlights The longer it takes the Colombian government to drastically expand fiscal policy and increase social benefits, the higher the risk that next year’s presidential election will result in a win for the left. The government will be slow or reluctant to act and, hence, odds of a left-wing government in one year’s time is increasing. We are not forecasting that radical left-wing candidate Gustavo Petro will win next year’s presidential elections. Our point is that rising odds of a victory will be sufficient to undermine Colombia’s financial markets as the nation’s macro risk premium widens. We are downgrading Colombian equities from neutral to underweight and local currency bonds and sovereign credit from overweight to neutral relative to their respective EM benchmarks. Short the Colombian peso versus the US dollar. Feature Colombia has entered a critical moment in its history. The country was once seen as a beacon of political stability, fiscal orthodoxy, and market friendly policies. However, recent large-scale protests have raised the question as to whether Colombia will move toward the left, as has occurred in Mexico, Argentina and more recently in Peru with the election of Pedro Castillo. The nationwide protests in Colombia were triggered by the government’s attempt to raise taxes amidst a recession. What’s more, these protests are a manifestation of deep-rooted popular anger about poor social security benefits, income inequality and unaffordability of education and health care for a large chunk of the population. Further, angst relating to organized crime and government corruption has boiled over as the government has failed to address these systemic issues. In a nutshell, years of market-friendly conservative policies have widened the gap between “haves” and “have nots”. The recent recession has only exaggerated this income disparity and has unleashed public anger toward the government. Critically, social transfers in Colombia amid the pandemic were among the lowest in the world (Chart 1). Chart 1Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? The main risk to the nation’s financial markets is not that President Duque drastically increases fiscal spending to calm down protests, but rather the rising odds of a left-wing victory in the May 2022 presidential elections. Unfortunately, the current government’s reluctance to let go of traditional economic conservatism could eventually backfire and inadvertently swing the country to the far left.  As a result, we are downgrading our stance on Colombian equities from neutral to underweight and are downgrading local and sovereign bonds from overweight to neutral in their respective EM portfolios. Underlying Motives For Popular Discontent There are fundamental grounds for Colombia’s popular discontent. This year’s protests against President Duque echo the sentiment of previous demonstrations that occurred in 2019 and 2020: weak income growth, high income inequality, low government support for social programs, and unsuccessful policies to reduce corruption and organized crime. These issues have not been resolved even as Colombia emerged as one of the most successful economies in the region. In essence, wealth and development have not been felt by the entire population. According to the Gini coefficient, Colombia is the most unequal country among Latin American and OECD nations, even after accounting for taxes and transfers (Chart 2). Colombia suffers from a stubbornly high official unemployment rate which has seldom fallen below double-digit levels in the past two decades (Chart 3). Chart 2Colombia Is One Of The Most Unequal Countries In The World Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Chart 3Colombia’s Unemployment: High And No Improvement Yet Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming?   Government cash transfers and spending on pensions and education remain among the lowest of developed and developing nations (Chart 4). Voters are frustrated with the government’s failure to tackle crime and insurgent paramilitary groups, especially given that Duque ran on an anti-crime platform. According to data from Transparency International, Colombian’s perception of government corruption has risen dramatically since 2018 (Chart 5). Chart 4The Government’s Social Spending In Colombia Is Small Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Chart 5Corruption Perception Has Been Rising Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming?   Bottom Line: Even though Colombia’s GDP growth has been solid, especially relative to its Latin American peers, the benefits have not been widely distributed across all social groups. The severe recession has highlighted Colombia’s challenges and unleashed popular anger toward the government. When Too Much Economic Orthodoxy Backfires Colombia’s right-wing government has provoked massive public discontent due to its insistence on tightening fiscal policy during the worst recession in the country’s history. In essence, the government tried to pass a tax reform bill which would raise taxes on utilities, consumer goods, and business income at the height of the second wave of the COVID-19 pandemic and amid a massive nominal and real GDP contraction (Chart 6). Chart 6Colombia: The First Nominal GDP Contraction On Record Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? What followed were not only protests but also a broad-based backlash against the government from all corners, including political parties. President Duque has become isolated and is quickly turning into a lame duck president. Duque’s economic policies, his failure to reduce violence from insurgent paramilitary groups in recent years, and his own militant response to protests have made him lose the confidence of voters. Moreover , his failure to control the political upheaval from the outset has made him lose the confidence of international investors. Going forward, the major risk to financial markets will be rising odds that a left-wing candidate might win next year’s presidential elections. Chart 7 illustrates that leftist Gustavo Petro leads other potential contenders by a wide margin. Petro is a former member of a guerilla organization and was the frontrunner in the 2018 presidential election. Chart 7Growing Risks Of A Left-Wing Presidency In 2022 Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? If he were to win, it would mark a major pivot from an orthodox/conservative approach to a considerably leftist model of economic policy. Some of his proposals include nationalizing mining companies, de-investing from fossil fuels, government confiscation of land for agriculture, reducing central bank independence, and import substitution policies for the industrial sector.  In order to reduce Petro’s odds of winning the election, the current government must splurge on public spending and dramatically reform the country’s social security policies to appease a wide portion of the population. Nevertheless, we believe the government’s response will be too little, too late. Not only is the government reluctant to open the fiscal taps, but it also has no intention of revamping social security, health care and education policies. In fact, talks with protesters have yet to go anywhere after more than a month of a national strike. The current government’s failure to address Colombians’ concerns may boost the popularity of left-wing politicians. As a result, the market could soon start pricing in rising odds of a left-wing presidency in Colombia. This is negative for financial assets. Bottom Line: Investors will soon start realizing that there is a risk that a left-wing government could upend Colombia’s structural backdrop in a year’s time. To reiterate, we are not forecasting that radical left-wing presidential candidate Gustavo Petro will win next year’s presidential elections. Rather, our point is that rising odds of his victory will be sufficient to undermine Colombia’s financial markets as the nation’s macro risk premium widens. Implications For Financial Markets 1. Downgrade equities from neutral to underweight within an EM equity portfolio. A lingering pandemic, dwindling consumer and business confidence, and a broken monetary policy transmission mechanism are major headwinds for the economy and for corporate profits: Various sectors of the economy are struggling to recover, and our proxy for the marginal propensity to spend is suggesting that the economy will underwhelm (Chart 8). Nominal income growth is very weak. One of the reasons is very low inflation – core CPI measures remain below the central bank’s target range (Chart 9). Chart 8Growth Will Surprise To The Downside Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Chart 9Colombia: Inflation Is Nowhere To Be Seen Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming?   Commercial banks are not expanding credit and will not do so any time soon. Credit growth is negative, and provisions and non-performing loans will continue rising, reaching historical highs (Chart 10). Given that banks make up a large part of Colombia’s bourse, this will weigh heavily on Colombian equity indexes. Notably, lending rates are higher than warranted by economic conditions. This will make it very difficult for borrowers to service debt. While the central bank (Banrep) has cut rates to a historical low of 1.75%, the nominal prime lending rate is at 8.1% and real (deflated by core inflation) lending rates remain elevated at 6% (Chart 11).  Rolling economic lockdowns will impede the economic normalization process. Colombia is still suffering from a deadly second wave of COVID-19 infections. New daily cases and deaths are at all-time highs, and the country’s vaccination drive is falling behind most DM countries and large regional peers. This will further cap economic growth. Chart 10Bank Credit Is Very Weak Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Chart 11Colombian Lending Rates Are Elevated Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming?     2. Short the Colombian peso versus the US dollar. The basis is that the current account deficit remains wide at 3.8% of GDP while foreign capital inflows – both FDI and portfolio flows – will wane due to political volatility and rising odds of a left-wing government next year (Chart 12).  3. Downgrade Local Currency Bonds and Sovereign Credit to Neutral Domestic Bonds: While local yields seem quite attractive, currency depreciation risks are too high. The yield curve is incredibly steep and swap rates are pricing in about 75 basis points in rate hikes over the next 12 months (Chart 13). Yet, economic conditions warrant lower not higher interest rates. This makes long-term bond yields attractive, barring the election of a left-wing government next year. Chart 12Balance Of Payments Will Weigh On The Currency Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Chart 13Colombian Local Bonds: Value Or A Value Trap? Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming?   Despite very attractive yields and low inflation, the risk-reward tradeoff of overweighting Colombian local bonds is no longer attractive. We are also closing the position of receiving 10-year swap rates. Sovereign credit: The nation’s sovereign credit spreads will widen if and as international agencies downgrade Colombia’s rating. The nation’s sovereign credit spreads are tight because its governments have been known for orthodox macroeconomic policies and prudent debt management. With political pressures for more social spending, sharply rising public debt and growing odds of a left-wing victory in the next presidential elections, sovereign credit might be repriced.  We will monitor the situation and if the government fails to appease protesters with higher fiscal spending, we will downgrade our allocation to local currency bonds and sovereign credit further to underweight within their respective EM benchmarks. A Word On The Peruvian Elections The election of left-wing candidate Pedro Castillo in Peru is all but confirmed. While right-wing presidential candidate Keiko Fujimori is alleging signs of fraud and is demanding a recount of hundreds of thousands of votes, it is unlikely that this will change the outcome of the election. Fujimori lost the popular vote by an even smaller margin in 2016 but conceded victory after days of uncertainty. Chart 14Peruvian Stocks Are On The Edge Of A Breakdown Colombia: Is A Political Shift To The Left Coming? Colombia: Is A Political Shift To The Left Coming? Nevertheless, next week will prove to be volatile as the electoral tribunal makes a decision on Fujimori’s appeal. We expect uprisings from voters on both sides: Castillo supporters will defend his triumph and Fujimori supporters will voice their anger at what they perceive to be an unfair election. We continue to recommend an underweight allocation on Peruvian equities within an EM-dedicated equity portfolio. In the short term, Peruvian share prices will suffer from socio-political volatility. In the medium to long term, Castillo’s populist and anti-market policies will undermine business and investor confidence. Chart 14 shows that Peruvian equities have reached critical levels, displaying a tapering wedge technical profile. If they relapse further, it would qualify as a major breakdown. A significant gap down is likely to follow. We also recommend investors maintain a neutral allocation to Peruvian local bonds and downgrade sovereign credit to underweight. While public debt remains low at 22.6% of GDP, an overhaul of orthodox macroeconomic policies requires a re-rating of Peruvian sovereign credit. Juan Egaña Research Analyst juane@bcaresearch.com

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