Emerging Markets

Highlights The stock market can apparently ignore the intensifying US-China conflict as long as massive monetary and fiscal stimulus continues. Hence the ongoing “stimulus hiccup” is a big problem. Ultimately a stimulus bill will pass, but risks are rising that it will come too late or fall short in size. The longer the negotiations drag on, the more likely that the absence of fiscal support, the spiraling US-China conflict, US political instability, and other risks will take center stage and upset the equity rally. Assuming a new stimulus package will ultimately pass, it will fuel Trump’s tentative comeback in opinion polls, increasing the risk that the revolution in the global trading system gets a new lease on life. Thus volatility is likely to rise from here until the US succession is settled. Stay long JPY-USD and health stocks in the near term and bullion in the long term. Feature Two of the key views we have hammered since May are coming to fruition: Stimulus Hiccup: The White House and Congress are struggling to get a new relief bill passed. We have argued that the next round of fiscal stimulus would face execution risks that would cause equity volatility to rise again, which is now occurring (Chart 1). Ultimately we expect the Republican Senate to capitulate to a major new stimulus bill. But the very near term is murky and the negotiations pose a clear and present danger to an equity market that has now surpassed its pre-COVID-19 highs (Chart 2). Chart 1Volatility Is Bottoming, Will Rise Ahead Of US Election Volatility Is Bottoming, Will Rise Ahead Of US Election Volatility Is Bottoming, Will Rise Ahead Of US Election Chart 2Markets Recovered, Near-Term Risk To Downside Markets Recovered, Near-Term Risk To Downside Markets Recovered, Near-Term Risk To Downside US-China Conflict: The White House has revoked Chinese tech giant Huawei’s general license, leaving the company in thrall to periodic Commerce Department allowances that will impede business. It has also expanded punitive measures to a slew of subsidiaries and Chinese software companies like TikTok (ByteDance) and WeChat (Tencent). We have argued that President Trump’s electoral vulnerability and economic stimulus in both countries lowered the bar to conflict and decoupling. Both countries have an interest in reducing their interdependency and the COVID-19 crisis has given them an opportunity to make structural changes that were previously more difficult. Neither the US tech sector, nor China-exposed US stocks, nor Taiwanese equities are pricing this monumental geopolitical risk at present (Chart 3). Combining these two views results in a dangerous outlook for global risk assets in the near term. The reason we argued that US-China tensions would escalate to the point of disrupting markets this year was that we viewed domestic stimulus as lowering the economic and financial bar that prevented conflict. Hence US and Chinese confrontational steps could go farther than the market expected and eventually something would snap (Chart 4). Chart 3Market Ignores US-China Escalation Market Ignores US-China Escalation Market Ignores US-China Escalation Chart 4US And Global Stimulus Enable US-China Fight Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable Yet today tensions are escalating despite the failure to arrange a new jolt of domestic stimulus. This is true on both sides, as China is also seeing a deceleration in stimulus provision, mainly on the monetary side, that we also expect to be temporary but nevertheless has negative implications in the near term. The longer fresh stimulus is delayed, the more likely that markets will respond to the historic breakdown in US-China relations, US political instability, and other risks to corporate earnings and the economic recovery. Constraints On Politicians Support Cyclical Recovery To be sure, there is evidence that politicians are aware of their limits and already heading back to the negotiating table. Even with talks ongoing, the risks of delayed stimulus or Chinese retaliation are substantial. First, the White House, House Democrats, and Senate Republicans are continuing to negotiate despite being on recess while hosting national party conventions this week and next. House members are rushing back to Washington to vote on measures to boost the US postal service amid a controversy over how to handle mail-in voting for the election amid the pandemic. This has opened a pathway for stimulus talks to get back on track. It could result in a “skinny” stimulus bill quickly, or otherwise new developments could lead to the roughly $2.5 trillion blowout that we expect based on the two sides splitting the difference on most issues (Table 1). Table 1Stimulus Bill Will Hit $2.5 Trillion If Democrats And Republicans Split The Difference Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable Chart 5Trump’s Reelection Bid Stands On The Economy Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable Second, the US and China are arranging to keep talking. Ostensibly they are checking up on the status of the Phase One trade deal. The Trump administration cannot easily walk away from this deal– unless Trump irredeemably becomes a lame duck making a desperate bid to turn the tables on the Democrats. To do so would hurt Trump’s credibility on renegotiating US trade deals and likely trigger a selloff in the stock market that could set back the economic recovery and remove the last leg that his reelection bid stands on (Chart 5). The Chinese, for their part, have stuck with the deal despite US punitive measures because they do not want to provoke Trump, lest he attempt to inflict maximum damage on their economy in his final months or in a second presidential term. The renminbi is not depreciating relative to the dollar, suggesting that the tenuous truce is intact for now (Chart 6). Chart 6Renminbi Signals Phase One Trade Deal Intact ... For Now Renminbi Signals Phase One Trade Deal Intact ... For Now Renminbi Signals Phase One Trade Deal Intact ... For Now Yet The Market May Sell Before Politicians Soften Their Line Nevertheless in the very near term investors have very low visibility on what happens next. Congress could still fumble and cause greater doubts. It could easily fail to reach a new stimulus deal until after September 8 when the Senate returns or September 14 when the House returns. President Trump’s executive orders, and negotiating gestures from Republicans, are a tenuous bridge for markets as they fall far short of even the Republicans’ $1 trillion asking price. The stock market will plunge if the talks collapse, but it will also drop if the stimulus falls short. The market may have to sell off to force politicians to provide stimulus and temper strategic competition. Trump’s complicated attempt to extend relief via executive orders, and/or a skinny deal that does not include direct rebates to households and funding for state and local governments, would be inadequate for the needs of the economy (Chart 7). It is imperative for Senate Republicans to capitulate and come closer to the Democrats $2.4 trillion standing offer (down from $3.4 trillion) – but it is possible they could miscalculate and fail to compromise. Democrats will not cave because they ultimately benefit at the ballot box if stimulus flops and financial turmoil returns. Chart 7US Economy Needs Extended Period Of Fiscal Support US Economy Needs Extended Period Of Fiscal Support US Economy Needs Extended Period Of Fiscal Support On the China front, it is not guaranteed that China will refrain from retaliation against tech companies like Apple that depend on China for their operations. The market is betting that a rally entirely based on the tech sector can be sustained even in the face of an expanding tech war between the world’s biggest economies (Chart 8). Yet China suffers an economic and strategic blow from the US imposition of a technological cordon and Xi Jinping could decide to retaliate immediately. He could come to believe that the risk of not retaliating – which would entail continuing economic recovery and possibly Trump’s reelection on an anti-China platform – is greater than the risk of retaliation and financial turmoil. He has the ability to stimulate the domestic economy and benefits if he sets a precedent that American presidents lose if they attack China. China may not turn to Taiwan immediately, but since 2016 we have highlighted that Taiwan, not Hong Kong, is the major geopolitical risk stemming from the US-China crisis. Saber-rattling, cyber-rattling, and punitive economic measures are picking up in the Taiwan Strait and could lead to a global geopolitical crisis at any time. Here, too, the base case is that China will remain in a holding pattern until after the US election. It also should use economic sanctions long before it resorts to the final military option (Chart 9). But there is a large risk of miscalculation as the US seeks to cut off Taiwan semiconductor trade with China while Taiwan reduces its economic dependency on the mainland and tightens its defense relations with the United States. The Trump administration presents a window of opportunity so the risks are elevated in the lead up to and aftermath of the US election. Chart 8Tech Bubble Amid Tech War An Obvious Danger Tech Bubble Amid Tech War An Obvious Danger Tech Bubble Amid Tech War An Obvious Danger Chart 9China's Economic Card May Be Only Thing Preventing War China's Economic Card May Be Only Thing Preventing War China's Economic Card May Be Only Thing Preventing War We do not view Chinese economic sanctions on Taiwan as a tail risk but rather as our base case. Of course, we eschew conspiracy theories and usually seek to curb enthusiasm over war risks, as with Sino-Indian saber-rattling. But Taiwan is the epicenter of the political, military, and technological struggle between Washington and Beijing. War is a tail-risk, but even minor clashes would have a major impact on global financial markets. Other Risks Come To Forefront Amid Stimulus Hiccup Chart 10Trump’s Comeback Substantial If Stimulus Passes, Pandemic Subsides Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable The longer stimulus is delayed, the more likely that other risks will rise to the forefront and trouble the equity market. The US election does not offer much upside for markets at this point. Other risks stem from Iran and Russia. In the US election, President Trump is beginning to make a comeback in the opinion polling (Chart 10). Trump’s approval rating benefits from signing off on deals, so a final stimulus bill from Congress is essential. But a stimulus bill, a continued rollover in new cases of COVID-19, and a revival of support among his base would improve his odds of winning. Former Vice President Joe Biden is not polling much better against Trump than former Secretary of State Hillary Clinton did back in 2016 (Chart 11). Biden’s momentum in national opinion polling has been arrested, especially in battleground states, and the lower end of the “band of uncertainty” around the polling also suggests that Trump is within striking distance (Chart 12). Chart 11Biden Polling About Same As Hillary Versus Trump Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable   Chart 12Trump Still Within Striking Distance Of Biden Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable Our election model suggests that Trump has a 42% chance of winning, which is higher than our subjective 35% (Chart 13). We will upgrade if a stimulus bill is agreed. A Trump comeback may be received well by US equity markets – as it prevents tax hikes, re-regulation, higher minimum wages, and a federal push to revive labor unions, all promoted by Biden and the Democrats. But then again, Biden’s agenda is more reflationary, whereas Trump faces obstacles in a still-Democratic House, leaving global trade as the path of least resistance – which is market-negative. The dollar may bounce on the prospect of a Trump second term (Chart 14). Tech stocks, Chinese currency, and other cyclicals, such as the euro and European stocks, will suffer a setback if Trump is reelected. Chart 13We Give Trump 35% Odds, Quant Model Shows Upside At 42% Trade War Sans Stimulus Is Unsustainable Trade War Sans Stimulus Is Unsustainable Lesser risks, still notable, include Iran and Russia. Chart 14Trump Could Trigger Near-Term Dollar Bounce Trump Could Trigger Near-Term Dollar Bounce Trump Could Trigger Near-Term Dollar Bounce We have maintained that the US and Iran are in a bull market of geopolitical tensions and that this could result in crisis around the election. The US’s decision on August 20 unilaterally to maintain the expiring international conventional arms embargo on Iran is a clear trigger for a military incident. The macro and market implications are different and less dire than with a US-China crisis. But oil price volatility would rise due to regional instability, President Trump’s reelection bid could benefit, and that would carry the implication of expanding trade war with China. Meanwhile our expectation of sharply rising Russian geopolitical risk is materializing both within Russia and in relations with Europe, which is preparing sanctions over the suppression of dissent within both Russia and its satellite state Belarus. Russia is capable of interfering in the US election while a Democratic victory would likely lead to a US policy offensive against Russia. Investors must look beyond the short term. If stimulus is passed, the stock market will go up, but the US and China will be further enabled and ultimately their strategic showdown will cap the gains by harming the tech sector. Meanwhile, if the stimulus fails, then the market will plunge. Investment Takeaways At present the stock market seems prepared for Trump to remain in the White House – or for Republicans to retain the Senate. The market’s YTD profile matches that of past elections that result in gridlock, as opposed to the Democratic “clean sweep” scenario that we have flagged as the likeliest outcome (Chart 15). However, this profile will change, the market will correct, if Trump does not sign a new relief act. Assuming stimulus ultimately passes, markets will cheer and Trump’s comeback in the polls will get a boost. He could still lose the election, given fundamental political and economic weaknesses captured in our state-by-state quantitative model above. But the election itself would be more closely fought – with a contested outcome more likely to occur and roil markets. Finally a Trump victory would give a new mandate to the US-China breakdown and the revolution in the global trading system, which is ultimately negative for risk assets and the cyclical recovery. Hence our confidence that the next few months will be marked by volatility. Ultimately geopolitical and macro fundamentals are negative for the dollar even if Trump provides the occasion for a last gasp in the past decade’s dollar bull market. The US is monetizing its debt and flooding the world with dollar liquidity. Meanwhile China and other powers are diversifying away from the dollar and into gold, the euro, the yen, and other reserve currencies over the long run (Chart 16). Chart 15Dollar Outlook Bearish In Medium Term Dollar Outlook Bearish In Medium Term Dollar Outlook Bearish In Medium Term Chart 16Stock Market Preparing For Trump Win And More Gridlock? Stock Market Preparing For Trump Win And More Gridlock? Stock Market Preparing For Trump Win And More Gridlock? The great US fiscal debate is over, regardless of Trump or Biden, as populism has made austerity impracticable and massive twin deficits will ensue. Thus we remain long gold and the Japanese yen. We have refrained from re-initiating our long EUR-USD trade given our expectation of stimulus hiccups and US-China tensions, but will reconsider if and when these hurdles are cleared. Our strategic portfolio continues to expect a global recovery over the next twelve months and beyond but tactically we are positioned against downside risks.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com

Dear clients, The Foreign Exchange Strategy will take a summer break next week. We will resume our publication on September 4th. Best regards, Chester Ntonifor, Vice President Foreign Exchange Strategy Feature The economy of Hong Kong SAR1 has been held under siege by two tectonic forces. With the highest share of exports-to-GDP in the world, and at very close proximity to China, the epicenter of the pandemic shock, economic growth has been knocked down hard. The second shock to Hong Kong’s economy has been political instability. The extradition bill that was proposed in February 2019, followed by the enactment of the national security law this past June, has been accompanied by cascading street-wide protests and social unrest. The spirit of the bill is that crimes committed in Hong Kong can be trialed in China. The US has moved to impose sanctions on Hong Kong, as it no longer sees the city-state as autonomous, the latest of which is revoking its extradition treaty with the former colony. Some commentators have defined this as the end of the one country, two systems socio-economic model that has been in place since the handover from British rule in 1997. From a currency perspective, these shocks put in question the sustainability of the Hong Kong dollar (HKD) peg. Historically, currency pegs more often than not fail, especially in the midst of both geopolitical and economic turmoil. This was the story of the Asian Financial crisis in the late 1990s, and the Mexican peso crisis earlier that decade. Is the Hong Kong dollar destined for the same fate? If so, what are the potential adjustments in the exchange rate? Finally, what indicators can investors look to as a guide for any pending adjustment? A Historical Perspective Chart 137 Years Of Stability 37 Years Of Stability 37 Years Of Stability The HKD is no stranger to shifting exchange-rate regimes. Over the last 170 years, it has been linked to the Chinese yuan, backed by silver, pegged to the British pound, free-floating, and, since 1983, tied to the US dollar. Therefore, a bet on the unsustainability of the peg is historically justified. That said, the stability of the peg to the US dollar has survived 37 years of economic volatility, suggesting the Hong Kong Monetary Authority (HKMA) has been able to successfully navigate a post-Bretton Woods currency era (Chart 1).   Beginning as a bi-metallic monetary regime in the early 19th century, the HKD was initially linked to gold and silver prices, akin to the commodity–monetary standard that dominated that era. When Britain colonized Hong Kong in 1841, and as new trade alliances developed, the drawbacks of the bi-metallic monetary standard became apparent. As bilateral trade boomed, adjustments to imbalances (surpluses or deficits) could not occur through the exchange rate since it was fixed. Therefore, they had to occur through the real economy. This led to very volatile and destabilizing domestic prices. The stability of the peg to the US dollar has survived 37 years of economic volatility. Most Anglo-Saxon countries finally converted from bi-metallic exchange rates to the gold standard in the late 1800s, and strong ties to China dictated that Hong Kong naturally adopted the silver dollar in 1863. However, the silver system had the same drawbacks as the bi-metallic standard. Specifically, when your money supply is fixed, any increase in output leads to “few dollars chasing many goods.” This is synonymous with falling prices, just as “many dollars chasing few goods” is synonymous with rising inflation. The petri dish for this phenomenon was the post-World War I construction boom. A fixed money supply under the gold (and silver) standard meant rapidly falling prices globally. By the late 1920s, most countries had overvalued exchange rates relative to gold (and silver), that exerted powerful deflationary forces on their domestic economies. This forced most Western governments to debase fiat money vis-à-vis gold to stop price deflation. Correspondingly, China had to abandon the silver standard in November 1935, with Hong Kong shortly following suit. At the time of debasement, the United Kingdom was the leading economic power. As a colony, it made sense for the Hong Kong government to link the HKD to the British pound. The established rate was GBP/HKD 16, giving birth to the currency board system (Chart 2). Meanwhile, as a trading hub, a peg with an international currency made sense. The problems there were two-fold. First, the pound was still gold-linked. And second, Britain’s subsequent decline in economic power was accompanied by a series of sudden and dramatic devaluations in the pound, which was hugely disruptive to Hong Kong’s financial system. By 1972, the British government decided to float the pound, which effectively ended the GBP/HKD peg. Chart 2A History Of The HKD Peg A History Of The HKD Peg A History Of The HKD Peg In July 1972, the authorities made the decision to peg the Hong Kong dollar to the US dollar at USD/HKD 5.65, which was another policy mistake. The switch made sense given the rising economic power of the US, as well as rising trade links (Chart 3). However, the dollar was also under a crisis of confidence following the Nixon devaluation in 1971. In February 1973, the HKD was freely floated. Chart 3The Peg Is Usually Against The Dominant Economic Power The Peg Is Usually Against The Dominant Economic Power The Peg Is Usually Against The Dominant Economic Power Counter-intuitively, the free-floating era for HKD was arguably the most volatile for its domestic economy. For one, discipline in monetary policy was gone. Money and credit growth exploded, inflation hit double-digits, home prices soared and the trade balance massively deteriorated. Political instability was also rife, given the uncertainty surrounding the end of British claims on the island. As the dialogue included China’s reclaim of political control over Hong Kong, there was uncertainty over the rule of law. This cocktail of political and economic uncertainty led to a 33% depreciation in the HKD between mid-1980 and October 1983. Panicked policymakers returned to the US dollar peg. Paul Volcker, then Federal Reserve chairperson, was establishing himself as the world’s most credible central banker, having dropped US inflation from almost 15% in 1980 to below 3% by 1983. Economic and financial links with the US also justified a peg. In August of 1983, the authorities announced a USD/HKD fixed rate of 7.80, which has remained in place since. The Current Peg: Advantages And Disadvantages Chart 4Fiscal Prudence In Hong Kong Fiscal Prudence In Hong Kong Fiscal Prudence In Hong Kong The advantage of the HKD peg is that the choice of the nominal anchor, the US dollar, renders it credible. First, the US dollar is an international reserve currency dominating international trade, which helps to facilitate settlements while instilling confidence among transacting participants. As a financial hub, this is crucial for Hong Kong. Meanwhile, such an anchor imposes fiscal discipline, since government deficits cannot be monetized by money printing. In the case where the government tries to be profligate, the rise in inflation will lower real rates and lead to capital outflows. This will force the HKMA to sell US dollars and absorb local currency. In the extreme case, the central bank can run out of reserves, causing the peg to collapse. Indeed, over the past several years, government debt in Hong Kong has been close to nil (Chart 4). The drawback of a fixed exchange rate regime is that a country or a region relinquishes control over independent monetary policy. In the case of Hong Kong, this means that interest rates are determined by the actions of the US Fed. Such a marriage was justified when the business cycles between the two economies were in sync, but in times of economic divergences, the fixed exchange rate leads to economic volatility. Chart 5Currency Peg And Internal Devaluation Currency Peg And Internal Devaluation Currency Peg And Internal Devaluation Chart 6Hong Kong Interest Rates In The Late 90's Hong Kong Interest Rates In The Late 90's Hong Kong Interest Rates In The Late 90's This divergence was clearly evident in the 1990s, as falling interest rates in the US supercharged a housing and stock market bubble in Hong Kong. When the Asian crisis finally came around in 1997, the lack of exchange-rate flexibility led to a vicious internal devaluation (Chart 5). A prolonged period of high unemployment and stagnant wages was needed for Hong Kong to finally improve its competitiveness. Most importantly, in 1998, in the depths of the Asian financial crisis, the peg attracted a concerted attack from speculators who believed a devaluation of the Hong Kong dollar alongside other regional currencies was inevitable. Their assault inflicted considerable pain, driving short-term HKD interest rates (Chart 6) and wiping out over a quarter of the local stock market in a matter of weeks. At the time, the Hong Kong government was successful in fending off the speculative attacks by intervening massively in both the foreign exchange and equity markets. Is An Adjustment Pending? If So, When?      Chart 7USD/HKD And Interest Rate Spreads USD/HKD And Interest Rate Spreads USD/HKD And Interest Rate Spreads As the above narrative suggests, the HKD is no stranger to socio-economic shocks and speculative attacks, and it has, more recently, weathered them pretty well. The more immediate question is whether the shift in the political landscape could be potent enough to crack the peg this time around. While plausible, it is unlikely for a few reasons. First, the HKD continues to trade on the stronger side of the peg as US interest rates have collapsed, wiping off any positive carry that would have catalyzed outflows. Fluctuations in the USD/HKD within the 7.75-7.85-band track the Libor-Hibor spread pretty closely (Chart 7). A currency board has unlimited ability to defend the strong side of the peg, since it can print currency and absorb foreign reserves (print HKDs and use these to buy USDs in this case). On the weak side, these foreign exchange reserves are drawn down. Therefore, any threat to the peg should be preceded by consistent trading on the weaker side, questioning the HKMA’s ability to keep selling FX reserves to defend the peg. Fluctuations in the USD/HKD within the 7.75-7.85-band track the Libor-Hibor spread pretty closely. Second, the Hong Kong peg remains extremely credible, since the entire monetary base is backed over two times by FX reserves (Chart 8). Even as a percentage of broad money supply, Hong Kong reserves are ample and very high by historical standards (Chart 8, bottom panel). Meanwhile, since 1983, the currency board system has undergone a number of reforms and modifications, allowing it to adapt to the changing macro environment. This represents a powerful insurance policy for the HKMA’s ability to defend the currency peg, significantly enhancing the system’s credibility. Chart 8Ample Foreign Exchange Reserves Ample Foreign Exchange Reserves Ample Foreign Exchange Reserves Chart 9Hong Kong Runs Recurring Surpluses Hong Kong Runs Recurring Surpluses Hong Kong Runs Recurring Surpluses Third, ever since the peg was instituted, Hong Kong has mostly run budget surpluses. As a result, government debt in Hong Kong is almost non-existent, as we illustrate above. This has removed any incentive to monetize spending, which remains an open argument in the US, Japan or even the euro area. One of our favored metrics on the health of a currency is the basic balance, and on this basis, Hong Kong scores much more favorably than the US. While Hong Kong has transitioned from being a goods exporter to that of services, it remains extremely competitive, with a healthy current account surplus of 5% of GDP (Chart 9). These recurring surpluses have propelled Hong Kong to one of the biggest creditors in the world, with a net international investment position that is a whopping 430% of GDP and rising (Chart 10).   Chart 10Hong Kong Is A Net Creditor To The World The Hong Kong Dollar Peg And Socio-Economic Debate The Hong Kong Dollar Peg And Socio-Economic Debate Fourth, over the past few years, productivity in Hong Kong has outpaced that of the US and most of its trading partners (Chart 11). This has lifted the fair value of the currency tremendously. This means it is more like that when the peg adjusts, the outcome will be HKD appreciation. On a real effective exchange rate basis, the HKD is not that overvalued compared to the US dollar, after accounting for the massive increase in relative productivity (Chart 12). It is notable that during the Asian financial crisis, currencies like the Thai bhat were massively overvalued, which is why the adjustment was back down toward fair value. Chart 11Hong Kong Is Highly Productive Hong Kong Is Highly Productive Hong Kong Is Highly Productive Chart 12Trade-Weighted HKD Is Slightly Expensive Trade-Weighted HKD Is Slightly Expensive Trade-Weighted HKD Is Slightly Expensive Fifth, there is a strong incentive for both Beijing and Hong Kong to defend the peg, because the relevance of Hong Kong is no longer as a shipping port, but as a financial center. The peg reduces volatility, as transactions are essentially dollarized. The relevance of Hong Kong in Asia can be seen by looking at the market capitalization of the Hang Seng index compared to that of the Topix index in Tokyo or the Shanghai Composite index. Any escalation in the US-China trade war, especially in the technology sphere, will only lead to more listings on the Hong Kong stock exchange. Equity flows through the HK-Shanghai and HK-Shenzhen stock connect program are rising, suggesting the market still considers Hong Kong an important intermediary in doing business with China (Chart 13).  On the political front, the most potent risk is that the US Treasury moves to unilaterally limit access to US dollars by Hong Kong banks. While this was discussed by President Trump’s top advisers, it was also dismissed as unwise due to the potential shock to the global financial system. Meanwhile, with massive swap lines with the Fed, Hong Kong’s international banks can always draw on US liquidity. Tariffs on Hong Kong goods are another option, but this again will not really deal a severe blow to the peg, since Hong Kong mainly re-exports, with very little in the way of domestic goods exports (Chart 14). Chart 13Hong Kong Is An Important Financial Center Hong Kong Is An Important Financial Center Hong Kong Is An Important Financial Center Chart 14Hong Kong Is Partially Insulated From Tariffs Hong Kong Is Partially Insulated From Tariffs Hong Kong Is Partially Insulated From Tariffs   Property Market Blues The property market is the one area in Hong Kong where a sanguine view is difficult to paint. Hong Kong is one of the most unaffordable cities on the planet, and high income inequality has been a reason behind resident angst. The gini coefficient, a measure of inequality in a society, is more elevated in Hong Kong compared to Singapore, China or even South Africa. After years of loose monetary policy, property prices in Hong Kong have completely decoupled from fundamentals. Housing is even more unaffordable now than it was back in 1997, and domestic leverage is very high. With such a high debt stock, even a gradual uptick in interest rates will have a significant impact on the debt service burden (Chart 15). Stocks and real estate prices are positively correlated, suggesting deleveraging pressures will likely be quite high if both unravel (Chart 16). Chart 15High Debt Service Burden##br## In Hong Kong High Debt Service Burden In Hong Kong High Debt Service Burden In Hong Kong Chart 16Hong Kong Stocks Are Tied To The Property Market Hong Kong Stocks Are Tied To The Property Market Hong Kong Stocks Are Tied To The Property Market However, there are offsetting factors. First, it is unlikely that interest rates in Hong Kong (or anywhere in the developed world for that matter) will rise anytime soon. COVID-19 has provided “carte blanche” in terms of global stimulus. More importantly, the US is at the forefront of this campaign, meaning interest rates in Hong Kong will remain low for a while. Second, in recent history, Hong Kong has proven that it has the resilience to handle volatility in the property markets. During the Asian crisis, property prices fell by 60%, yet no bank went bust. Share prices also collapsed but are much higher today, suggesting the drop was a buying opportunity. And with such a low government debt burden, any systemic threat to banks will nudge the authorities to bail out important companies and sectors. In terms of asset markets, the performance of the Hang Seng index relative to the S&P 500 is purely a function of interest rates. The US stock market is dominated by technology and healthcare that do well when interest rates fall, while banks and real estate dominate the Hong Kong market. So rising rates hurt the US stock market much more than Hong Kong (Chart 17). Meanwhile, the recent turmoil has made Hong Kong assets very cheap relative to its sister-city, Singapore (Chart 18). This suggests that a lot of the potential equity outflows have already occurred, based on today’s situation. Chart 17Interest Rates And The Hong Kong Stock Market Interest Rates And The Hong Kong Stock Market Interest Rates And The Hong Kong Stock Market Chart 18Hong Kong Has Cheapened Relative To Singapore Hong Kong Has Cheapened Relative To Singapore Hong Kong Has Cheapened Relative To Singapore The Future Of The Peg A peg to the Chinese RMB makes sense. The Hong Kong economy is now heavily tied to the Chinese economy, with over 50% of exports going to China (previously mentioned Chart 3). However, that will sound the death knell for Hong Kong’s status as a financial center, since the US dollar remains very much a reserve currency. There is also a risk that if Beijing uses RMB depreciation as a weapon in a blown-out confrontation with the US in the coming years, it will threaten the sustainability of the HKD peg, since it could inflate asset bubbles. What is more likely is that the option of re-pegging to the RMB comes many years down the road, when the yuan has become a fully convertible currency. The recent turmoil has made Hong Kong assets very cheap relative to its sister-city, Singapore. There is the option to assume another currency board akin to Singapore. This option makes sense, since this would give the HKMA scope to link to cheaper currencies, such as the yen and euro. Such an overhaul will require significant technical expertise and political will from both Beijing and Hong Kong. It is not very clear what the cost/benefit outcome would be of this initiative, but it is worth considering since the RMB itself is managed against other currencies. Finally, there is always the option to fully float the peg, but this is likely to increase volatility. As well, for policymakers, it makes sense to continue pegging the exchange rate to the US dollar as it depreciates against major currencies, since it ends up easing financial conditions for Hong Kong concerns.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Special Administrative Region of the People's Republic of China  Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. While dedicated EM equity investors should for now maintain an underweight position in India within an EM equity portfolio, they should consider upgrading this bourse on potential near-term underperformance. Absolute-return investors should consider buying this bourse on a setback in the coming months. Fixed-income investors should continue receiving 10-year swap rates but use any rupee selloff to rotate into cash bonds. Feature Indian share prices have staged a remarkable comeback following the financial carnage in March. However, the outlook for the economy and for corporate profits does not justify the current level of share prices. While this thesis is applicable to most markets around the world, the gap between share prices and economic activity is even larger in India. Chart I-1Loans To Companies Are Muted In India Loans To Companies Are Muted In India Loans To Companies Are Muted In India In particular: The credit and liquidity crunch has been more acute in India than in many other EM and DM economies. Bank loan growth has surged in many countries as companies have borrowed to avoid a liquidity crunch due to a plunge in sales. However, in India bank loans to companies been shown little improvement (Chart I-1). This means that enterprises in India have not been able to draw on bank loans – to the same extent as they have done elsewhere – to attenuate a liquidity crunch stemming from revenue contraction. As a result, Indian enterprises have retrenched more in terms of both employment and capital spending, and their rebound has been more muted. As an example, the global manufacturing and non-manufacturing PMIs have risen above the 50 line but the same measures in India remain below the 50 line (Chart I-2). India’s employment index from the Manpower group has fallen to a record low as of early July (Chart I-3). As a result, household nominal income growth – which was slumping before the pandemic – has fallen much further. Chart I-2India Is Lagging In Global Recovery India Is Lagging In Global Recovery India Is Lagging In Global Recovery Chart I-3India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor   Passenger car and commercial vehicle sales have plummeted (Chart I-4). Corporate investment expenditure and production have crashed. Manufacturing output, capital goods production and imports all plummeted in March and April and rebounded only mildly in June (Chart I-5). Chart I-4India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... Chart I-5...As Are Production And Investment ...As Are Production And Investment ...As Are Production And Investment Table I-1India: Share Of Each Equity Sector In Profits & Market Cap Strategy For Indian Equities And Fixed-Income Strategy For Indian Equities And Fixed-Income Economic activity will improve gradually but the level of activity will remain below the pandemic level for some time. As a result, corporate profits will be slow to revive. Odds are that it will take more than one and half years before the EPS of listed companies reach their 2019 level. This is especially true for severely hit sectors – financials, industrials, materials, and consumer discretionary stocks – which together account for 44% of listed companies’ profits. The sectors less affected by the pandemic recession – namely, consumer staples, information technology and health care – together account for 30% of corporate profits (Table I-1). A Breakdown In The Monetary Transmission Mechanism Impediments to rapid economic recovery are the modest fiscal stimulus and a breakdown in the monetary transmission mechanism. While India announced a large fiscal stimulus, much of this is made up of loan guarantees. Some measures like central bank purchases of government bonds also do not represent actual fiscal spending. Chart I-6 illustrates that government spending has risen only moderately and it has been offset by the drop in the credit impulse. Provided that the credit impulse will remain weak due to reasons we discuss below, the aggregate stimulus will not be sufficient to produce a robust and rapid recovery. The outlook for the economy and for corporate profits does not justify the current level of share prices. Critically, the monetary policy transmission mechanism was impaired even before the pandemic broke out in India, and the situation has gotten worse since March. Even though the Reserve Bank of India (RBI) has been reducing its policy rate, the prime lending rate has dropped very modestly (Chart I-7). Indian commercial banks which are saddled with non-performing loans (NPLs) have been reluctant to reduce their lending rates. Chart I-6Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Chart I-7India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate   Even though AAA local currency corporate bond yields have dropped, BBB corporate bond yields remain above 10% (Chart I-8). This compares with 5-year government bond yields of 5%. Critically, in real (inflation-adjusted) terms, borrowing costs remain elevated (Chart I-9). Such elevated real borrowing costs will continue to hinder credit demand. Chart I-8Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Chart I-9Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive   Finally, banks might be reluctant to originate much credit because of the rise in NPLs and the uncertainty over the extension of government guarantees on pandemic-induced NPLs and their own recapitalization programs. Bottom Line: Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. Beyond Mega Caps The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. The MSCI equity index has rallied by 50% since its late March lows and stands only 7% below its pre-pandemic highs in local currency terms. Yet, the MSCI equal-weighted index and small caps are, in local currency terms, still 15% and 16% below their pre-pandemic highs, respectively (Chart I-10). The performance of the overall equity index has been exaggerated by the rally in Reliance Industries’ share price as well as information technology stocks, consumer staples and health care. The 150% surge in Reliance Industries stock price since late March lows is due to company-specific rather than macro factors. This company presently accounts for 15% of the MSCI India index. The monetary policy transmission mechanism was impaired even before the pandemic broke out in India. In addition, info technology, consumer staples and health care (including sales of personal care products and medicine) have benefited due to the pandemic. By contrast, equity sectors leveraged to the business cycle in general and discretionary spending in particular have all underperformed. Importantly, bank share prices have been devasted due to poor economic growth and rising NPLs. India’s mega-cap stocks that have led the rally since March lows are expensive, as anywhere else. Finally, India’s equal-weighted equity index has failed to meaningfully outperform the EM equal-weighted index after underperforming severely in late 2019 and Q1 2020 (Chart I-11). Chart I-10Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Chart I-11India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance   Bottom Line: The advance in Indian share prices has been amplified by the rally in large-cap stocks. Meanwhile, the equal-weighted and small-cap indexes have done considerably worse reflecting the downbeat economic conditions. Equity Valuations And Strategy Chart I-12Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... As discussed earlier, India’s equity market leaders like information technology, consumer staples and health care are already expensive, trading at a trailing P/E ratio of 23, 47 and 33, respectively. The rest of the equity market is not expensive, but its profit outlook is mediocre. As to other valuation metrices, the market seems to be moderately expensive both on an absolute basis and versus the EM equity benchmark: The 12-month forward P/E ratio is 22.5, the highest in the decade (Chart I-12, top panel). Relative to the EM benchmark, on the same measure is trading at 50% premium (Chart I-12, bottom panel). Based on the equal-weighted equity index – i.e. stripping out the effect of large-cap stocks on the index, Indian equities are overvalued in absolute terms (Chart I-13, top panel). On this equal-weighted measure, Indian stocks are currently trading at a 35% premium versus their EM peers (Chart I-13, bottom panel). The cyclically-adjusted P/E ratio is close to the historical mean (Chart I-14, top panel). Chart I-13...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis Chart I-14Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio   However, the CAPE ratio is agnostic to corporate earnings on a cyclical horizon. It assumes corporate profits will revert to their long-term rising trend (Chart I-14, bottom panel). This is not assured in the next six months in our opinion. Hence, a lackluster profits recovery – profits disappointments – is a risk to the performance of India’s bourse in the coming months. Equity Strategy: Weighing pros and cons, we recommend that dedicated EM equity investors maintain an underweight position in India within an EM equity portfolio. However, they should consider upgrading this bourse on potential near-term underperformance. The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Absolute-return investors should consider buying this bourse on a setback in the coming months. Odds are that the index could drop up to 15% in US dollar terms triggered by a potential global risk-off phase and domestic profit disappointments. Currency And Fixed-Income Chart I-15Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India We have been recommending receiving 10-year swap rates in India since April 23 and this recommendation remains intact. As argued above, the economic recovery will be gradual, and the output gap will remain negative for some time. Consequently, wages and inflation will likely surprise on the downside. Even though headline and core inflation rates have recently picked up, this has been due to a rise in food prices, transportation and personal care products (Chart I-15). Hence, there are not genuine inflationary pressures in India and the RBI will be making a mistake if it stops easing due to rises in headline or core CPI readings. Food prices have been rising for a while due to supply shocks. Importantly, the rise in food prices should not be interpreted as genuine inflation. Meanwhile, personal care products include gold jewelry and this CPI sub-component has therefore been rising due to the surge in gold prices (Chart I-15, bottom panel). Finally, transport costs have been on the rise due to supply chain bottlenecks in India as a result of COVID-19 and due to the rise in global oil prices. The broken monetary transmission mechanism means that the RBI will have to cut rates by much more. The fixed-income market is not discounting rate cuts.  There is value in long-term rates in India. The yield curve is very steep – the spread between 10-year and 1-year swap rates is 92 basis points. In addition, 10-year government bond yields are currently yielding 522 basis points above 10-year US Treasurys. We are not particularly concerned about public debt. Central government debt was at 52% of GDP before the recession and total public debt (including both central and state governments) was 80% of GDP. The same ratios are much higher in many other EM and DM economies. Chart I-16India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance Finally, the rupee could correct as the US dollar rebounds from oversold levels, but foreign investors should use that setback in India’s exchange rate to rotate from receiving rates to buying 10-year government bonds outright, i.e., taking on currency risk. The RBI has been accumulating foreign exchange reserves, meaning it has been preventing the currency from appreciating. The current account is balanced and the financial/capital account has passed its worse phase. India will continue to attract foreign capital due to its long-term appeal and higher-than-elsewhere interest rates.  Domestic investors should favor bonds over stocks in the near term (Chart I-16). Bottom Line: Continue betting on lower interest rates in India. Fixed income investors should switch from receiving rates to buying 10-year government bonds on a correction in the rupee in the coming months. Dedicated EM local currency bond portfolios should continue overweighting India.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The Beirut blast calls attention to instability in the Shia Crescent. A turbulent push for political change will now ensue in Lebanon. Hezbollah’s and Iran’s political capital in Lebanon will suffer significantly. Lebanon is a red herring, but Iraq is a Black Swan. It is at risk of social unrest contagion. Iran’s financial troubles are weighing on its ability to maintain its sphere of influence. It is adopting a strategy of measured sabotage and deterrence against US interests in Iraq. The double whammy of low oil prices and pandemic is weighing on Saudi Arabia’s finances. Nevertheless it is prioritizing a cooperative relationship with Iraq. Iran could stage a major attack or President Trump’s poor election prospects could force him to “wag the dog.” Massive excess oil capacity will mute the oil market impact of a supply shortfall in Iraq. However, the risk becomes more relevant as demand recovers and markets rebalance in the second half of the year. Stay long Brent crude oil and gold. Feature The August 4 explosion at the Port of Beirut was devastating. It killed more than 220, wounded over 6000, left 300,000 homeless, and damaged buildings as far away as 9km from the site of the explosion. The blast added insult to injury to the country’s already troubled finances. Estimates for the cost of repair range anywhere between $5 billion and $15 billion. Global investors can largely write off the incident as an idiosyncratic shock. Even though emigration is likely to pick up, Lebanon’s population is only a third of Syria’s prior to its civil war. Assuming that a third of Lebanese become displaced abroad – a generous assumption more suitable to Syrian-style civil war than Lebanon’s situation – about 2 million Lebanese will be displaced, half of which will make their way to Europe or elsewhere outside the Middle East. As long as an antagonistic Turkey upholds its agreement with the EU, a mass exodus from Lebanon does not risk an unmanageable migrant crisis for Europe (Chart 1). Political tensions will rise and potentially lead to a populist backlash, given Europe’s battered economy. But Lebanon alone is not enough. The risk is broader Middle Eastern instability, which is a credible risk. Chart 1Middle Eastern Instability Could Fuel European Populism Middle Eastern Instability Could Fuel European Populism Middle Eastern Instability Could Fuel European Populism Thus Lebanon in itself is a red herring, but it is a bellwether for further unrest in the Middle East in countries that are not red herrings (Map 1). Map 1Lebanon Is A Red Herring; Iraq And Saudi Arabia Are Relevant From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup A major conflict in Iraq is an underrated risk to global oil supply. The catastrophe calls attention to instability the Shia Crescent – a region in a tug of war between rival sectarian and geopolitical interests. Whereas the 2008 crisis led to the largely Sunni Arab states in the so-called Arab Spring, the 2020 crisis is piling pressure onto already unstable Shia states and regions: Iran, Iraq, Lebanon, Syria, and possibly eastern Saudi Arabia. Of particular significance is the fate of Iraq. Popular grievances are eerily similar to Lebanon’s. Baghdad is on shaky ground, yet the ramp up in US-Iran tensions going into the November US elections makes the threat of instability in Iraq more acute. As OPEC’s second ranked oil producer, a major conflict in Iraq poses an underrated risk to global oil supply. Supply losses are a tailwind to oil prices when market conditions are tight. However OPEC 2.0’s 8.3mm b/d of voluntary cuts means massive spare capacity is available globally to offset potential losses in Iraq, reducing the potential upside to oil prices. Nevertheless, this risk becomes more relevant as markets tighten on the back of a demand-side recovery, i.e. as balance is restored to the oil market and as excess spare capacity is eliminated. With oil markets likely rebalancing in 3Q20, unrest in Iraq poses an upside risk to our Commodity & Energy Strategy service’s expectation that 2H20 Brent prices will average $44/bbl and 2021 prices will average $65/bbl (Chart 2). Even though gold has already rallied 30% since mid-March, geopolitical risks including US-Iran tensions suggest any near-term selloff is a buying opportunity (Chart 3). The bullish gold narrative – geopolitical risks, falling dollar, and low real interest rates for the foreseeable future – remain intact even as the downturn gives way to a cyclical recovery. We continue to recommend gold on a strategic time horizon. Chart 2Oil Price Rally Remains Intact Oil Price Rally Remains Intact Oil Price Rally Remains Intact Chart 3Gold Is Due For A Breather Gold Is Due For A Breather Gold Is Due For A Breather Lebanon’s economic collapse highlights risks to other regional economies tied to the oil dependent Arab economies of the Persian Gulf. As the latter grapple with record low oil prices, production cuts, and the pandemic-induced recession, second-order effects will reverberate throughout the region, hitting economies such as Egypt and Jordan whose economic as well as political structures are intimately intertwined with Gulf Cooperation Council finances and policies. Lebanon’s Collapse Was Inevitable Lebanon was already going through an economic and financial meltdown before the explosion (Chart 4). Aside from the humanitarian loss, the economic impact is also profound. The country – highly dependent on imports of basic goods and suffering from food insecurity – must now contend with the loss of its main port and most of its grain reserves, destroyed in the explosion. As the dust settles, grief is morphing into anger on the streets. Regardless of whether the blast was due to happenstance or malice, the immediate cause was 2,750 tons of ammonium nitrate in storage for six years. The government was warned about the risks of the explosive chemicals at least four times this year – with the latest being on the day of the blast. Chart 4Beirut Port Explosion Accelerated Lebanon’s Collapse From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup Mass protests are already taking place, calling on the government to be held accountable for criminal negligence. A controversial petition to return Lebanon to French mandate has gained more than 60,000 signatures. Prime Minister Hassan Diab’s seven-month-old cabinet has resigned. (It was put in place last year amid an earlier bout of unrest.) Official incompetence and neglect are in fact the best-case explanations for the explosion. Many questions remain unanswered. For instance, what triggered the fire? Israel swiftly denied any connection and offered humanitarian aid, while Hezbollah’s leader Hassan Nasrallah claimed to know more about the Port of Haifa than about Beirut Port. Early parliamentary elections and the cabinet’s resignation will not appease the protesters. Photos of Nasrallah, President Aoun, Speaker of Parliament Nabih Berri, and former Prime Minister Saad Hariri were among those hung by protesters in gallows in Martyrs’ Square over the weekend. Berri and Gebran Bassil are known to be the source of the cabinet’s decision-making power.1 They have veto over all decisions, large and small. During the mass protests in October 2019, Nasrallah stated that Hezbollah has two red lines:     Aoun must finish his term, which expires in 2022;     No early elections will be held, i.e. the speaker of the house will not be changed. While early elections have now been promised, these red lines highlight that corruption runs deep in Lebanon and opposition groups face an uphill battle against the establishment. A turbulent push for political change will now ensue. Hezbollah’s and Iran’s political capital in Lebanon will suffer significantly. Another Israeli confrontation with Hezbollah is not the base case but it could occur. Bottom Line: Lebanon is a failed state. As with the Arab Spring, the question is whether popular anger will prove contagious and spread to more market-relevant neighboring countries. The rally in the Israeli shekel in trade weighted terms since mid-March has already started to fizzle and may be tested further as turmoil in Lebanon raises the risk of confrontation. Contagion? In order for a geopolitical event in the Middle East to warrant investors’ attention, it must affect at least two of the following factors : (1) global oil supply, (2) geography of existential significance to a regional power, or (3) sectarian conflict which could lead to contagion. In this context, Lebanon is a red herring, but Iraq is not – therefore investors should watch to see if anything causes destabilization in Iraq. A decline in Iranian funds will weaken Tehran’s sphere of influence. Like Lebanon, Iraq is dominated by a highly corrupt sectarian system that has been plundering the wealth; people are suffering from rising rates of unemployment; and the regime is in the crosshairs of competing foreign agendas (Chart 5). Chart 5Iraqis And Lebanese Suffer Similar Grievances From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup Iraq is in Iran’s sights because it aspires to establish a land bridge to the Mediterranean through a friendly “Shia Crescent” (Map 2). Iran’s modus operandi is to establish a presence in its neighbors’ domestic politics through Iran-backed factions. Map 2Iraq Essential To Iran’s Aspirational ‘Land Bridge’ To The Mediterranean From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup Given the current state of Iran’s economy, it is not far-fetched to envision a significant drop in the funding of its foreign proxies (Chart 6). Historically these funds have followed the ebbs and flows of oil prices. For instance, in 2009, when faced with declining oil prices and US sanctions Iran’s funds to Hezbollah were estimated to have fallen by 40%. This happened again in 2014-16 and is not too different from today. Thus Iraq is at risk of contagion. Iran’s financial troubles are weighing on its ability to maintain its sphere of influence. Syrian fighters have reported paychecks being slashed, Iranian projects in Syria have stalled, and Hezbollah employees report to have missed paychecks and lost other benefits. Tehran’s finances are essential for Hezbollah’s survival.2 Iran’s proxies in Iraq are facing a similar fate.3 Chart 6Iran Suffering Under "Maximum Pressure" Iran Suffering Under "Maximum Pressure" Iran Suffering Under "Maximum Pressure" Bottom Line: Iraq faces an uptick in social unrest due to the poor living conditions and possible contagion from Lebanon. Meanwhile, Iran-backed groups there face a decline in funds from Tehran, which will send them searching for replacement funds. If Lebanon falters the world can usually ignore it but if Iraq falters the world will have to take notice. Saudi Arabia Prioritizes Revenue Over Growth Beirut’s foreign policy stances in recent years have been seen as appeasing Iran at the expense of Gulf Arab states.4 This trend coincides with a decline in Gulf Cooperation Council financing to Lebanon. Now the collapse in oil prices and pandemic have weighed on Saudi Arabia’s budget, which still depends on the energy sector for most of its revenues despite efforts to diversify. State revenues were down 49% year-on-year in Q2 pulling the budget deficit down to $29 billion (Chart 7). Riyadh is reassessing its priorities. Opting for revenue at the expense of growth, Riyadh has tightened the screws on its citizens. The government has had to pare back some of the benefits Saudis have long been accustomed to. The value-added-tax rate tripled from 5% to 15%, and a bonus cost-of-living allowance of $266 for public sector employees ended. The kingdom also announced plans to reduce spending on major projects by $26 billion – including some of those associated with Crown Prince Mohammed bin Salman’s reform agenda, Vision 2030. Chart 7Saudi Arabia Under Pressure From Double Whammy Saudi Arabia Under Pressure From Double Whammy Saudi Arabia Under Pressure From Double Whammy Severe economic turmoil poses a risk to the Saudi social contract in which citizens pledge allegiance to the ruling class in exchange for financial and social guarantees. The risk now is that the fiscal challenges dent Saudi citizens’ pocketbooks and thus impact social and political stability. However, oil prices are recovering to levels consistent with the kingdom’s fiscal breakeven oil price next year. The global economic recovery will begin to support the kingdom’s economy in the second half of this year (Chart 8). This will ease pressure on the budget and hence households. Moreover the slowdown is likely to hit foreign workers hardest and thus hasten the Saudization process. Foreign workers are the lowest hanging fruit and will be the first to find themselves jobless. In that sense the crisis is expediting some of Riyadh’s long-term reform targets. That said, there is still some risk of internal instability or even a palace coup. Tehran could incite sectarian tensions in the kingdom’s Eastern Province where an estimated 30-50% of the population is believed to be Shia. This is relevant given that nearly all Saudi oil production is located there. Chart 8KSA Benefits From EM GDP Growth ... KSA Benefits From EM GDP Growth ... KSA Benefits From EM GDP Growth ... Regarding the possibility of a palace coup, Crown Prince Mohammed bin Salman has spent this year cracking down on potential dissidents. Former Crown Prince Mohammed bin Nayef and King Salman’s only surviving full-brother Prince Ahmed bin Abdulaziz – both influential and well-liked – were among those detained in March. The kingdom’s contradictory policies – reform through repression – may eventually culminate in an overt political crisis. Though such a crisis may not occur until the time of royal succession. These economic and political challenges may force Saudi Arabia to adopt an inward stance. Its foreign interventions to date have been costly and come with little benefit – judging by the war in Yemen. It is also possible that Saudi Arabia, which is already the third largest defense spender globally, will try to strengthen its position vis-à-vis Iran. Crown Prince Mohammed bin Salman has already stated that the kingdom will pursue a nuclear program if Iran develops a nuclear bomb. This is relevant in today’s context with Iran no longer complying with restrictions to its nuclear program (Table 1). Saudi Arabia, like Iran, claims its nuclear program is for peaceful purposes – in order to generate nuclear power as part of efforts to diversify its economy.5 Table 1Iran No Longer Complying With 2015 Nuclear Deal From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup Still, low oil prices tend to discourage petro states from engaging in conflict (Chart 9). Arab petro states may show restraint, at least until oil markets recover. Chart 9Low Oil Prices Discourage Petro States From Engaging In Conflict From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup Overall weakness in oil-producing economies will hurt various countries that rely on remittances (Chart 10). The downturn will also hurt countries dependent on remittances from petro states in the region such as Egypt and Jordan. Bottom Line: The collapse in oil prices is forcing Saudi Arabia to reconsider its priorities and is expediting some long-term reforms. For now, it is adopting a pro-revenue rather than a pro-growth stance. This is likely to result in a focus inward for the kingdom. The implication is that countries that are leveraged to the petro-economies of the Gulf for remittances, bilateral aid, and capital flows will take a hit. These include Lebanon, Egypt, and Jordan. Chart 10Egypt And Jordan Also Vulnerable To Petro State Weakness Egypt And Jordan Also Vulnerable To Petro State Weakness Egypt And Jordan Also Vulnerable To Petro State Weakness Iraq Is The Prize Not unlike Lebanon, Iraq’s political class has been suffering a legitimacy crisis since protests erupted there last October resulting in the resignation of then-Prime Minister Adel Abdul Mahdi. However unlike Lebanon, Iraq is a significant geography for global investors. It is a major OPEC producer – second only to Saudi Arabia – accounting for 16% of the cartel’s production last year. The Iraqi oil minister’s first foreign trip was to the Saudi capital. This is not surprising. Iraq not only seeks Saudi leniency in OPEC 2.0 cuts, but also needs financial assistance to develop a natural gas field that will allow it to reduce dependence on Iran. Saudi Arabia also hopes to reduce Iraq’s dependence on Iranian natural gas and coax it into its sphere of influence. When it comes to crude oil, the additional 1mm b/d of voluntary cuts in June announced unilaterally by Saudi Arabia beyond its agreed OPEC 2.0 commitments are also a sign of Saudi willingness to accommodate Iraq and its non-compliance  (Chart 11).6 Saudi Arabia does not want to see Iraq’s newly elected government failing on the back of budgetary strain. In fact, al-Kadhimi is an opportunity for the Saudis. Formerly the director the National Intelligence Service with warm ties to the US, he is a champion of Iraqi sovereignty. Even though Iraq is being forced to compensate for past overproduction of oil in August and September, it was cajoled by the promise of a $500 million “bridging” loan from Saudi Arabia, to be repaid when oil markets recover. While financial assistance shows the kingdom’s commitment to Iraq, more significantly it reflects Riyadh’s desperation to revive oil markets and bring prices closer to its fiscal breakeven oil price amid the still uncertain demand outlook. Chart 11Saudi Arabia Willing To Accommodate Iraq From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup Neither Saudi Arabia’s nor al-Kadhimi’s efforts are guaranteed to succeed in pulling Iraq out of Iran’s sphere. The prime minister received a rude awakening upon his arrest of 14 Kata’ib Hezbollah fighters in June on grounds of a plan to launch a rocket attack on US interest in Baghdad. They were swiftly released, and the case against them dropped. It is hard to curb Iranian influence. For its part, Iran stood behind al-Kadhimi’s nomination despite him being perceived as pro-Western. Tehran needed to avoid an anti-Iranian backlash on the streets of Baghdad if it had stood against him. Instead, Iran’s calculus was that it is in its best interest to swallow the pill and work with the new government at a time when Iraqi anger was targeted against US involvement rather than at Iranian interference. Prior to the US assassination of Qassem al-Suleimani and Abu Mahdi al-Muhandis on Iraqi soil, Iraqis were rebelling against Iran’s influence. That being said, Iran will maintain pressure on Iraq through continued attacks on US interests there (Table A1 in Appendix). This is also reflected in the July assassination of top Iraqi security expert Hisham al-Hashimi, who had previously advised the government on how to curb Iranian control. Iran was looking to make it to the US election in November without an escalation in tensions, hoping the US elections will result in a more dovish Democratic Party leadership averse to conflict with Iran. However, recent cyber-attacks on key Iranian infrastructure raise the likelihood that tensions will escalate ahead of the elections. The US is also threatening to maintain maximum sanctions even if the United Nations Security Council disagrees. As always, Iraq will find itself in the crossfire of any deterioration in relations. Bottom Line: Maintaining a cooperative relationship with Iraq aligns with both of Saudi Arabia’s interests there: limiting Iranian interference and supporting global oil markets through supply-side discipline. Iran will maintain pressure on Iraq’s new government through continued attacks on US interests. However, these attacks are supposed to fall short of killing US citizens and giving President Trump a reason to launch air strikes that could give him a patriotic boost in opinion polls. Nevertheless, tensions in the Gulf could escalate if Iran stages a major attack or if President Trump’s poor election prospects force him to “wag the dog.” In that case Iraqi oil supply would be disrupted. Investment Implications The Shia Crescent remains at heightened risk of instability on the back of Iran’s economic deterioration. Massive excess oil capacity will mute the oil market impact of a supply shortfall in Iraq. However, the risk becomes more relevant as demand recovers and markets rebalance in the second half of the year. Given that the Saudi loan will ensure Iraq’s commitment to compensatory production cuts in August and September, supply-side risks are a tailwind to oil prices in H2. The elevated risk of an escalation in US-Iran tensions also favors holding gold. President Trump’s polling has bottomed, yet he remains the underdog in the election – we maintain his odds of winning reelection are 35%. This raises the risk that he adopts a “war president” posture. Iran could become a target as the financial price of confronting Iran is negligible for Trump, whereas a major China confrontation could sink the stock market. The collapse in oil prices and pandemic have weighed on Saudi Arabia’s budget. It has adopted a revenue over growth posture. While this could be a risk to domestic stability, our base case is that it accelerates the kingdom’s long-term reforms. The oil market rout and economic downturn will hurt other countries in the region that are leveraged to Arab petro states – chiefly Egypt and Jordan. Investors should monitor risks to state stability in the coming years. Lebanon’s crisis will incentivize emigration, but given the relatively small size of its population, the major risk to Europe comes from any broader state failures and Middle Eastern instability rather than from Lebanon’s failure alone. If the Democratic Party wins the US election, as expected, then the US-Iran strategic détente will resume and Iran will get a lifeline. But the immediate transition will still be rocky given the Israeli and Saudi desire to exploit Iran’s extreme vulnerability and build leverage with Washington. The COVID-19 crisis heralds another round of Middle Eastern crisis, much as the 2008 crisis led to the Arab Spring. Stay strategically long Brent crude oil and gold. Also, in the wake of yesterday’s 15% pullback in silver, go strategically long silver (XAGUSD), which will continue benefiting from the same structural trends favoring gold but also outperform gold as the global economy recovers, given its greater industrial utility.     Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com       Appendix Table A1Iran Adopting Deterrence Strategy In Iraq From The Arab Spring To The Shia Crackup From The Arab Spring To The Shia Crackup   Footnotes 1     Berri is of the Hezbollah-allied Amal Movement and has been parliamentary speaker since 1992, while Bassil is President Aoun’s son-in-law and president of the Free Patriotic Movement, which has the most seats in parliament. 2     Hezbollah gains legitimacy at home through its charity work that plugs the gap in services normally provided for by the government. 3    According to a commander of an Iran-backed paramilitary group in Iraq, Iran slashed its monthly funding to the top four militias by nearly half this year. Please see “Coronavirus and sanctions hit Iran’s support of proxies in Iraq,” Reuters, July 2, 2020. 4    Hezbollah has gained control over the foreign policy and Lebanon has recently taken stances that are seen as bowing to Iranian pressure. Lebanon did not attend a March 22, 2018 extraordinary Arab League meeting discussing violations committed by Iran. Prior to that, Beirut did not condemn Iranian attacks on a Saudi diplomatic mission in Tehran. 5    However an undisclosed facility for processing uranium ore in the northeast of the kingdom has recently appeared. 6    This is not unlike the US’s decision to extend sanction waivers by four months, allowing Baghdad to import Iranian energy in order to ensure that the new government of Prime Minister Mustafa al-Kadhimi can stand on its own and is not overly dependent on Iran.