Equities

Chinese data is waving a red flag as we highlighted in this Monday’s Strategy Report where we also instituted a 2.5% rolling stop to the cyclicals vs. defensives ratio. Not only are the Chinese authorities trying to engineer a slowdown with the recent reverse repo operations, but also BCA’s China Monetary Indicator and the selloff in the Chinese sovereign bond market are all corroborating the economic deceleration signal (top & middle panels). Railway freight (and infrastructure spending) data also highlight that not everything is as rosy as it appears to the naked eye in the Middle Kingdom, giving us even more reasons to worry about the longevity of the US cyclical/defensive bull market run (bottom panel). Finally, the cyclical/defensive ratio is sitting 14% above its 200-day moving average confirming the dual stretched message that our valuation and technical indicators are emitting (not shown). Bottom Line: We put a 2.5% rolling stop on the cyclicals vs. defensives ratio in order to protect gains north of 17% since inception. Should it get triggered, we will downgrade the ratio from overweight to neutral via trimming the niche materials sector to a benchmark allocation. Stay tuned. ​​​​​​​

Special Report

Highlights Volatility subsided but we still think geopolitical risk is underrated in the near term. The new Biden administration faces critical tests on China/Taiwan and Iran. The Biden-Xi phone call did not resolve anything. We recommend investors hedge geopolitical risk by adding a tactical long CHF-USD. The medium-to-long-term macro backdrop is shifting in favor of frontier markets – but it is too soon to dive in. African frontier markets have not yet benefited from the global economic recovery – and may face more pain in the near term. The Ethiopian crisis will further destabilize the Horn of Africa region. Kenya is the relative beneficiary in geopolitical terms, though Kenyan stocks are expensive relative to other frontier markets. Feature Volatility subsided over the past two weeks, global stocks rallied, and bond yields rose. The US dollar bounce lost some of its steam. From a macro point of view, we understand investor exuberance. But from a geopolitical point of view, risks are now understated. President Joe Biden faces imminent tests from China, Iran, and Russia. Table 1 provides a checklist of what we need to see to conclude that a new US-China modus vivendi has been established. The phone conversation between Presidents Biden and Xi Jinping on February 10 is marginally positive but, judging by history, the call shows that tensions remain high.1 Until these conditions are met the two sides are hurtling toward a diplomatic crisis over the Taiwan Strait sometime after China emerges from its annual National People’s Congress. Incidentally, China’s ongoing policy shift toward slower and more disciplined growth will be the takeaway from this year’s legislative session, which is not positive for global cyclicals or China plays beyond the near term. China’s credit impulse has decisively rolled over and the combined fiscal-and-credit impulse is peaking now (Chart 1). Table 1First Biden-Xi Call Did Not Resolve US-China Tensions Chart 1China's Fiscal-And-Credit Stimulus Peaking Now A crisis is also brewing in the Middle East. Iran is not going to abandon its quest for nuclear weapons over the long run but it is willing to negotiate a deal in the short run that reduces US sanctions. Especially if lame duck President Hassan Rouhani gets it done before he steps down in August. The next Iranian president will not want to make the same mistake Rouhani made and bet his future on the unreliable United States. This requires Biden to rejoin the existing 2015 nuclear deal with a vague commitment to negotiate a better deal later. However, this outcome is precisely what Israeli officials have called a “calamity.” 2 The Biden team gives Iran three-to-four months before it has enough highly enriched uranium to make a bomb – it wants to move quickly on negotiations. Israel gives it a year – it wants to convince the Democrats to stick with Trump’s maximum pressure. Either way the first half of this year is crunch time. Otherwise Iran’s new administration will require a much longer negotiation. Negotiations will be checkered with attacks to demonstrate credible threats and red lines. Ultimately, since we expect Biden to forge a US-Iran détente, and since the China/Taiwan risk is negative for energy prices, we no longer express our Iran view in the form of a long oil position. Brent crude is close to our Commodity & Energy Strategy’s $63 per barrel target for this year’s average. The Saudis could abandon their production discipline when Iranian oil gets closer to coming online. Investors should distinguish these immediate geopolitical risks from the general, long-running US-China and US-Iran conflicts. These will wax and wane while global risk assets grind upward over the long haul. If China avoids over-tightening policy and the Biden administration passes early hurdles we will be more bullish. For now we recommend investors hedge their bets by increasing exposure to safe-haven assets. We remain long gold and Japanese yen. Tactically we recommend going long the Swiss franc versus the dollar as well. Finally, in what follows, we take a sojourn from these headline geopolitical risks to offer a special report on the Ethiopian crisis and implications for Africa, Europe, and frontier markets. Now is not the right time to dive headlong into African frontier markets given the risks outlined above but we do see an opportunity on the horizon. Is The Ethiopian Crisis Investment Relevant? Ethiopia is now in its fourth month of crisis. The country is grappling with internal conflict brought upon by political and ethnic differences among the former and current ruling elite. Over the past week, Ethiopian Prime Minister Abiy Ahmed spoke with US Secretary of State Antony Blinken, French President Emmanuel Macron, and German Chancellor Angela Merkel about reports that Eritrean soldiers have entered the fray. East Africa will become increasingly unstable as conflict persists, threatening security, migration, and investment into the region. Investors looking to frontier markets in light of the global liquidity explosion should exercise caution. Peacemaking Abiy Goes On The Offensive Ethiopian government forces continue to battle a minority group, the Tigray People Liberation Front (TPLF), in the north of the country. Large-scale attacks, like those seen at the start of the conflict, have mostly diminished. However, both sides continue to maintain their offensive positions. With the recent entry of Eritrean forces into Ethiopia to support the government’s battle against the TPLF, conflict between government forces and the TPLF will continue at the very least. Tensions between the government of Prime Minister Abiy and the Tigray people have been in play for years. The Tigray largely dominated Ethiopia’s ruling coalition and security forces until the past decade. Public protests in 2015 were driven by frustration over laws that denied Ethiopians basic civil and political rights. In 2018, a popular uprising brought Abiy to power and he ushered in democratic reforms and an end to conflict with neighboring Eritrea. Abiy’s “reforms” are so far of limited relevance to investors. He released several high-profile political prisoners, lifted a draconian state of emergency, and planned to amend the constitution to institute term limits for prime ministers. Some civil liberties were restored. The investment-relevant aspect of the reforms were proposals to end government monopolies in key economic sectors, including telecommunications, energy, and air transport – but these have yet to happen. Abiy was most eager to dismantle Ethiopia's previous ruling party, the Ethiopian People's Revolutionary Democratic Front (EPRDF), which was dominated by the Tigray and had run the country for 28 years. Abiy supplanted the EPRDF with a single national Prosperity Party, which was not organized on ethnic lines. Having controlled all facets of state power prior to its ouster in 2018, the TPLF views Abiy’s democratic reforms and proposals for economic liberalization with anxiety. Abiy’s interest in reforming the federalist structure of the Ethiopian state - which divides Ethiopia into nine self-governing ethnic territories - threatens to undermine the order that has historically permitted the small Tigrayan ethnic group to wield a power disproportionate to its population (Chart 2). Chart 2Major Ethnic Groups In Ethiopia Abiy is an Oromo by origin and thus a member of Ethiopia’s largest ethnic group. His espousal of a broader nationalist agenda over narrow ethnic priorities is viewed by many of the smaller ethnic groups as eroding the right to self-rule. This includes secession, which is granted by the Ethiopian Constitution to ethnically organized regions. The TPLF has also expressed unease with Abiy over his intentions to amend the Constitution, which provides the basis of the current ethnic federalism. In defiance, the TPLF broke away from the Prosperity Party and attempted to unite opposition forces under a new federalist coalition. Failing to do so led the TPLF to isolate itself from the country’s political process. Bottom Line: As is often the case in geopolitics, the media hype about the election of a young peacemaker and would-be reformer masked the reality that Ethiopia’s old regime was coming apart at the seams. Abiy And The TPLF Faceoff Since 2019, Abiy has accused the TPLF of trying to destabilize the country and suggested that the TPLF were responsible for several mass ethnic killings across Ethiopia. Matters worsened in March 2020, during the collapse of the global economy amid the COVID-19 pandemic, when Abiy postponed national and regional elections scheduled for August, causing mass discontent among the TPLF. Abiy claimed he postponed the election because of the pandemic, citing the risks involved in mass in-person voting. But Tigray leaders feared a power grab. This is because the 2020 election was to serve as a litmus test on Abiy. Furthermore, opposition parties believe the Prosperity Party has achieved little economic policy cooperation and support among other parties, which would weaken the prospect of Abiy forming a coalition government if need be. In essence they hoped to claw back some power during the election and its deferral sent them into revolt. Relations soured further in September 2020 when the TPLF went forward with elections in Tigray, despite the rest of the country holding out for the delayed 2021 elections. The TPLF reported an overwhelming victory in the popular vote. The newly installed regional legislators in Tigray immediately declared that Abiy’s government lacked legitimacy to govern the country and refused to recognize it. The national assembly countered by annulling Tigray’s election results and refusing to acknowledge the newly elected leadership. Federal funding to the region was slashed significantly, limiting the flow of resources only to local governments to keep basic services running. The leadership in Mekele, the capital of Tigray, called the cessation of funding a declaration of war. Tensions boiled over into physical violence between government troops and the TPLF in November 2020. Widespread military attacks had been reported almost weekly between November and December often with many casualties of military personnel, TPLF members, and civilians. In 2021, attacks have significantly decreased, but TPLF resistance remains strong and intact in the North of the country. While the local economy was hard-hit by the fighting, it is not clear how long the local economy can sustain the state of resistance by both government forces and the TPLF. Bottom Line: Violence and war will continue between Abiy and the TPLF for the foreseeable future. Peace is hard to see happening at the current juncture, as Abiy looks to increase the power of his government and the TPLF fights to retain vestiges of its former power. Conflict Derails Economic Progress Ethiopia has averaged double-digit growth over the past decade, driven by large-scale fiscal spending and foreign direct investment. The country’s consumer base is also rising – 110 million people make the country the second most populous in Africa, with 50% of working age. But COVID-19 has put the brakes on future growth expectations, now penned at levels last seen in the early 2000s (Chart 3). Post 2021, growth is expected to rise significantly, but protracted mass social unrest brought about by internal conflict will see the economy grow at much lower levels. Offering a reprieve to the country’s economic woes is coffee bean production, Ethiopia’s chief export, which is mostly to the east of the country. Futures markets have priced in rising risk since the onset of the conflict. Transporting coffee beans would have to move through the north east of the country to the nearest port for export, in Djibouti. Moving through this part of the country raises the risk of encountering sporadic conflict. Chart 3Ethiopia Economic Growth Chart 4Horn Of Africa Output Per Head In 2000, Ethiopia was the third-poorest country in the world. More than 50% of the population lived below the global poverty line—the highest poverty rate in the world. Just two decades later, Ethiopia almost doubled GDP per capita wealth – a noteworthy achievement. But the country is still only comparable to Uganda, a much smaller, less developed economy to the southwest (Chart 4). Whilst income shared across the country has been rising, Abiy’s government runs the risk of eroding several years of economic gains that have been felt throughout the population by maintaining its battle against the TPLF. An economic crisis now would exacerbate the conflict and pull Ethiopia’s economy further into recession and poverty. Bottom Line: The Ethiopian conflict will persist in the coming years, resulting in the deterioration of many years of hard-earned economic development. The TPLF’s military and economic resources may be fast declining, but the conflict is domiciled on home ground – the Tigray region – and is widely backed by the Tigray people. International criticism is unlikely to deter Abiy from trying to minimize the TPLF’s political prowess. His popularity will allow him to keep his hard line. Yet Abiy will have to deal with an economy that will further decline as fighting continues. Regional Stability At Risk? The Horn of Africa is a gateway to the Suez Canal and as such a strategically important region. Its coastal opening on the Red Sea positions it along the critical maritime trade artery linking Europe and Asia. The Horn of Africa is also a fragile region that has seen severe conflict over the past decades: a civil war in Somalia and continued attacks by Al-Shabaab; piracy off the coast of Somalia; civil war in Darfur and South Sudan; proximity to the civil war in Yemen; ethnic unrest in Ethiopia; and the securitization of the Red Sea, as exemplified by Djibouti, which now hosts more foreign military bases than any other country in the world. Ethiopia is the African linchpin of the region’s long-term stability. The country runs a successful peacekeeping mission in neighboring Somalia. This will end if conflict with the TPLF continues to escalate. The country contributes around 4,000 of the 17,000 troops under the African Union’s mission and has around 15,000 additional soldiers in Somalia on its own — more than any other nation. If need be, troops will be pulled from Somalia to fight the TPLF, creating a security vacuum in Somalia where Al-Shabaab would revive. To make matters worse, US troops began withdrawing from two bases in Somalia in October. Though former President Trump failed to pull all US troops from the country, and President Biden is ostensibly in favor of maintaining US global engagement, it remains to be seen whether the US will put real pressure on Ethiopia to halt the conflict, such as threatening to cut its roughly $1 billion in annual aid. Many of the 700-odd US forces in Somalia train and support Somali special forces (Danab), who seek to contain the Al-Shabaab insurgency. Considering that Al-Shabaab has carried out deadly attacks on civilians throughout the East African region, such as the Westgate shopping mall attack in Kenya eight years ago and an attack on a US military base in Kenya that killed 3 Americans in January 2020, terrorism will pick up if regional security efforts are reduced. Bottom Line: Neither Ethiopia nor international terrorism are high on the Biden administration’s list of things to do. At home Biden is focused on domestic legislation to handle the pandemic and economic recovery. Abroad he is focused on restoring the 2015 Iranian nuclear deal and countering China’s and Russia’s regional ambitions. The Europeans, for their part, will react with lukewarm punitive economic measures toward Ethiopia, as they are not wishing to destabilize the region any further. Migration Will Follow After Conflict For global investors a more pertinent concern may be the rise in displaced persons, asylum seekers, and refugee populations in the region. At the end of 2019, Sub-Saharan Africa had 16.5 million internally displaced persons and 6.5 million refugees. Of this, the Horn of Africa hosts 8.1 million internally displaced persons and 4.5 million refugees and Ethiopia hosts 1.7 million displaced persons and 700,000 refugees. Note that these numbers come from the year before Ethiopia’s tensions boiled over – Ethiopian refugees will surge in 2020-21. In terms of migrants outside of Africa and originating from Ethiopia, there were 170 000 refugees and asylum seekers at the end of 2019 (Chart 5). Refugees, asylum seekers, and displaced persons will multiply as conflict rages. Neighboring countries like South Sudan, Sudan, Eritrea, and Somalia, which are already stretched in their capacity to hold such persons, will be overwhelmed. Already, these four countries alone account for approximately 4.4 million refugees, making up more than half of Africa’s total number of refugees (Chart 6). While Ethiopia’s contribution to the continent’s migrant base (both refugees and asylum seekers) is small (2.2%) in comparison to its neighbors, it is this very reason that suggests destabilization will add significant numbers to the growing crisis on the continent. Chart 5Ethiopian Refugees And Asylum Seekers Chart 6African Refugees And Asylum Seekers Europe and the Middle East are the two preferred regions for Ethiopian migrants. Europe received approximately 22% of Ethiopian-born refugees and asylum seekers in 2019, again, prior to the outbreak of civil war (Chart 7).   Chart 7Ethiopian And African Refugees In The EU With reports suggesting that an additional 600,000 displaced persons have emerged due to this year’s conflict, and another 40,000 refugees, the EU could see an additional 10,000 migrants from Ethiopia alone over the next year. On top of that would be counted any increase in refugees and asylum seekers resulting from increasing instability in the Horn of Africa. A more intense conflict will drive the numbers up dramatically. Bottom Line: The effects resulting from conflict in the region’s most populous and stable economy will carry over into neighboring countries, such as Somalia, exacerbating the refugee and economic crises in the Horn of Africa and ultimately increasing the risk of greater immigration into Europe. In comparison to the Syrian refugee crisis, Ethiopia is not in a state of utter collapse like Syria but if it did collapse it would pose a larger risk to Europe. Ethiopia’s population is four times larger than that of Syria’s in 2011. Syria counted 6 million internally displaced persons and almost 5 million refugees (approximately 25% of the population) at the start of the civil war. From the 5 million refugees, 2% made their way into Europe. A civil war of a similar magnitude in Ethiopia would result in almost 28 million refugees (25% of 110 million population), and 600 000 refugees heading toward Europe, by the same metrics. Surrounding Markets Will Benefit From Re-Directed Investment Direct investment flows from the country’s primary benefactor, China, have helped to spur Ethiopia’s growth and development. The country has received approximately 67% of all Chinese direct investment funds into the Horn of Africa since 2005 and 8% of the total in Sub-Saharan Africa (Chart 8). Chart 8China Slows Investment In Africa The trend has turned down over the past couple of years, with Chinese officials citing over-exposure to Ethiopia as a reason for lower outward investment into the country. In this sense China appears to have recognized a growing problem in Ethiopia in recent years. Infrastructure projects such as the Addis Ababa-Djibouti railway have resulted in large losses for Chinese firms due to insecurity and liability risks. For example, parts of railway have at times been rendered inoperable due to infrastructure theft or sabotage, or by intentional accidents by civilians to claim liability against the railway line’s constructor and operators. Rising conflict in Ethiopia will squeeze Chinese interests out of the country and redirect them to more stable markets, such as Kenya, to expand its Belt and Road Initiative along the East African coast (Chart 9). Kenya has at times received more direct investment from China than Ethiopia. China’s various problems with investment projects in Kenya pale in comparison to Ethiopia’s general instability. A nudge toward a more sustained flow of funds to Kenyan projects is now on the horizon. China could build further economic interest in neighboring Uganda but political risk continues to rise in the country after a contested election saw the country’s ruler for the past 35 years, Museveni, win his sixth term in office. The same holds for other foreign investment flows into Ethiopia. On a net basis, foreign direct investment into Ethiopia has been declining since 2016, while neighboring Uganda and Kenya have recorded upticks over the same period (Chart 10). Chart 9China’s Investment In East Africa Chart 10Kenya And Uganda Will Get More Investment Bottom Line: Foreign direct investment into Ethiopia and the region has been declining, even from China and even prior to the 2020 crisis. Investors and foreign flows will look to relatively more stable markets, such as Uganda and Kenya, to take on longer-term risk. Where To From Here? The longer Abiy drags out military operations, the likelier the Tigray conflict could metastasize into an humanitarian crisis and ultimately civil war. While political survival is at the forefront of Abiy’s considerations, he has broadly staked his international reputation on being a reform-minded innovator who will usher in needed change to Ethiopia. A key question is whether Abiy will now move to de-escalate the conflict – to bring military operations to a close and turn his attention to reconciliation. The Ethiopian army’s convincing victory in Mekelle provides Abiy with a valuable off-ramp to enter negotiations and pivot back to his reform agenda. If Abiy does not take advantage of this moment, he risks undermining Ethiopia’s fledgling economy, fostering a prolonged humanitarian crisis, getting stuck in a protracted armed conflict, and destroying his international reputation. The EU has already delayed payment of 90 million euros in aid in the wake of the conflict, and is threatening to withhold more from the 2 billion euro aid package that the EU agreed to disperse to Ethiopia over several years. However, at present, Abiy remains defiant, stating that the offensive toward the TPLF is warranted and arguing that Ethiopia’s sovereignty is not “for sale” to international donors. Abiy will continue to put pressure on the TPLF unless they concede to federal supremacy. As the larger force in this battle, Abiy’s government will not back down. He has the backing of the military and neighboring forces such as the Eritrean military. His popularity has remained intact through the course of this latest conflict. With an upcoming national election, he is looking at the conflict as a way to consolidate control. Bottom Line: Abiy has the political capital to wait out the TPLF’s surrender, while the economy takes a knock from ongoing conflict. Investment Takeaways A major wave of immigration from the Horn of Africa into Europe would not have predictable financial consequences. The Syrian refugee crisis, which peaked in 2015, did not have a discernible impact on the Turkish lira, or Greek, Italian, or Turkish relative equity performance. It might have contributed to investor preference for the dollar over the euro but the real driver of euro weakness at that time stemmed from the European Central Bank’s quantitative easing and US relative growth and interest rates. A bounce in USD-EUR during the spike in refugees in mid-2016 cannot be attributed to interest rate differentials but it is brief (Chart 11). Thus the significance of any major wave of immigration in the post-COVID era will be found elsewhere – in politics and geopolitics. Chart 11Syrian Refugee Crisis A Political, Not Financial Event The geopolitical consequence of the Syrian refugee crisis was ultimately a rise in European populism or anti-establishment politics. The political establishment mostly blunted this trend by cracking down on migrant inflows. That could change in future if border controls are relaxed or the magnitude of migration increases. Falling GDP per capita in Africa over the past decade alongside superior quality of life in Europe will continue to motivate immigration, especially if Africa’s growth disappoints expectations in the aftermath of the crisis (Chart 12). Conflicts such as in Ethiopia will generate more emigration. What about African frontier markets? Ostensibly the global backdrop is as bullish for frontier markets and specifically African frontier markets. Valuations are deeply depressed after a decade of strong dollar and weak commodity prices. Now global central banks are flooding the world with liquidity, the dollar is falling, and commodity prices are rising. China, Europe, and the US have stabilized their economies. However, it should be noted that Sub-Saharan Africa’s exports have lagged and therefore the economic pain is not yet over for this region even though improvement is on the horizon (Chart 13). If growth returns to trend then Sub-Saharan Africa’s real GDP should grow in line with emerging markets at a little less than 5% per year. This is better than Latin America, which also has a slightly smaller stock of gross domestic savings, though both regions are savings-poor and struggling to form fixed capital. Chart 12Disparity Between Europe And Africa Chart 13Global Commodity Prices And African Exports Soaring Chart 14Sovereign Credit Spreads Emerging and frontier markets stand to benefit from low global interest rates and rising commodity prices but they need to see global economic stabilization first. Sovereign credit spreads have come down across the frontier markets, with African markets leading the way (Chart 14). However, debt levels are high in a number of these markets. Credit default swap rates are rising after their steep fall over the second half of last year (Chart 15). Emerging market equities have rallied sharply relative to developed markets and this trend should continue as the pandemic subsides and the global recovery gains steam. But frontier markets have underperformed emerging markets since mid-2019 and South Africa specifically since COVID-19, with no sign yet of reversing. Within frontier markets, African equities have outperformed since the first vaccines heralded a recovery in the global economy (Chart 16). Chart 15Credit Default Swaps The COVID-19 crisis has affected emerging and frontier markets differently than developed markets given that youthful populations are least susceptible to dying from the disease. However, the economic impact has required monetary easing and currency depreciation. EM and FM central banks have undertaken unprecedented and unorthodox easing actions – similar to what is seen in the developed world – to cushion the blow. Chart 16Emerging Markets Vs Frontier Markets Vs African Markets Not only have EM and FM central banks cut rates but they have also cut reserve requirements for banks, intervened in foreign exchange markets, and launched government bond purchases. South Africa has begun quantitative easing while Ghana has monetized debt. Table 2 provides a glimpse at equity performance, volatility, and relative valuations and momentum in frontier markets, including African frontier markets. Returns are paltry over the course of the COVID-19 crisis. African markets have generated a negative return during this period. The table shows valuations and momentum on a relative basis – that is, relative to other markets in the table. We include South Africa, a major emerging market, by comparison to indicate that frontier markets are not necessarily more volatile even though they are far cheaper. All of these stocks other than South Africa are cheap on a price-to-earnings basis and African markets look even better on a cyclically adjusted P/E basis. Table 2African Frontier Markets: Valuations, Momentum, Volatility Chart 17Hold Off From Frontier Markets Nigerian stocks are extremely cheap, they have benefited from the recovery in global oil prices, and they offer half as much volatility as South African stocks. They are even cheap relative to other African frontier markets like Kenya. However, the geopolitical situation is not stable. An incident of brutality from security forces last year did not lead to wider spread social unrest but the rapid growth of the population combined with the resource curse is not favorable for socio-political stability over the long term. Even in the short term Nigeria’s rally could be upset by a reversal in oil prices, which is possible if OPEC 2.0 fails to coordinate in the face of the eventual US-Iran deal. Moreover capital controls make risks excessive for most investors, as our Emerging Markets Strategy observes. Kenya is a geopolitical beneficiary of the Ethiopian crisis. It should receive greater foreign direct investment as a result of Ethiopia’s destabilization. However, this crisis is not a driver for Kenya’s equity markets. Rather, Kenya trades in line with the trade-weighted dollar. It is not a commodity play but a telecoms play. This has been a huge benefit over the past decade. Kenya is diversified and has a large manufacturing sector. It will eventually benefit from a revival of tourism. Kenyan stocks are cheap from a global point of view but not relative to frontier markets. The long-term trend of Kenyan stocks is flat whereas most African equities are falling (Chart 17). Our Emerging Markets Strategy team has highlighted that conditions will improve in the wake of material currency depreciation. From a tactical standpoint now is not the best time to dive into frontier markets or African frontier markets but an opportunity is around the corner. African exports have not recovered, several countries are pursuing monetary easing (thus weakening currencies), the US dollar is bouncing, and China’s credit impulse is rolling over. But the long-term global trends are supportive as long as China avoids over-tightening, interest rates stay low, and the dollar resumes its weakening path as we expect. Therefore we will devote more attention to frontier opportunities going forward as they offer the attraction of large capital gains and diversification.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Guy Russell Research Analyst GuyR@bcaresearch.com Footnotes 1 The absence of a Biden-Xi call would have been market-negative but the call itself does not suggest that tensions have declined yet. The American account shows Biden lecturing Xi Jinping. He kept the Trump administration’s language regarding a "free and open Indo-Pacific," chastised Xi for "coercive and unfair economic practices, crackdown in Hong Kong, human rights abuses in Xinjiang, and increasingly assertive actions in the region, including toward Taiwan." Cooperation will be "results-oriented" and based on the "interests" of the US. All of this, in diplomatic language, is fairly tough. The Chinese account consisted of Xi giving Biden an even longer lecture about the importance of cooperation over confrontation, equality of nations, and non-interference in domestic affairs, including core interests like Hong Kong, Xinjiang, and Taiwan. See "Readout of President Joseph R. Biden, Jr. Call with President Xi Jinping of China," the White House, February 10, 2021, whitehouse.gov; and "Xi speaks with Biden on phone," Xinhua, February 11, 2021, Xinhuanet.com. 2 See Yoav Limor, "IDF Crafting New Options To Counter Iranian Threat," Israel Hayom, January 14, 2021, israelhayom.com.

On the January 12 Insight we recommended investors put on a synthetic long SPY position using March 19th, 2021 long SPY $390/$410 call spread financed by a $340 put for a total debit of $0.8/contract, with a max payout of $20/contract. This options structure enabled us to participate on the melt up and concurrently not deploy a significant amount of capital. Today, this 3-legged option strategy has run a long way to the $6.21/contract mark for a 676% return since inception. Given that these gains accrued in just under a month, we are compelled to monetize them and roll the position over to the June expiry. This time, we are buying June 18th, 2021 long SPY $400/$420 call spread and financing it with a $340 put for a total debit of $0.3/contract. Once again this is a covered position recommendation, meaning that we postpone deploying capital today at $390 on the SPY and would rather go long by June at $340. Were the SPY to continue galloping higher in the next few months we would also participate in the mania via the long call spread segment of this option strategy. Bottom Line: Book healthy gains of $5.41/contract or 676% since inception in our synthetic SPY long position and roll it to June via a $400/$420 call spread financed by a short $340 put for an outflow of $0.3/contract and max payout $20/contract.

Highlights The Biden administration’s budget reconciliation bill will close the output gap, so markets will have to start thinking about upcoming tax hikes, rising wages, and eventual Fed interest rate hikes. Biden’s lax immigration policies will not have a major negative impact on wage growth. A doubling of the minimum wage, which could still make it into one of two budget reconciliation bills, would include a measure to index the post-2026 minimum wage to the average rate of wage rises. Biden’s industrial policy and support of labor unions would also increase wages. Stay long Treasury inflation-protected securities versus duration-matched Treasuries and long value stocks over growth stocks.  Feature The Senate and House of Representatives passed a concurrent resolution on the budget for FY2021, the first step in the budget reconciliation process that will enable Democratic leadership to pass President Joe Biden’s $1.9 trillion American Rescue Plan with only a simple majority in the Senate. The budget resolution is a fantasy that the ruling party uses to bypass the Senate filibuster, as was the case under George W. Bush, Barack Obama, and Donald Trump. The latest such resolution claims that the budget deficit will be smaller, not larger, after the Biden rescue plan than what is currently projected by the Congressional Budget Office (Chart 1). It envisions the entire $1.9 trillion being spent in 2021 and then a huge drop in expenditures in 2022. A fiscal cliff ahead of the 2022 midterm election will not occur. Instead the second budget reconciliation maneuver, for FY2022, will increase spending levels once again with infrastructure and green projects, as per Biden’s campaign platform. Chart 1Democrats Pass Budget Resolution The FY2021 budget resolution does not contain any tax increases, “revenue offsets,” to keep the budget in line because the COVID relief is emergency spending that is one-off, not recurring. The FY2022, however, will aim partially to repeal President Trump’s tax cuts. As such financial markets will continue to “buy the rumor” of additional fiscal spending for now but they will also sell the news given that the next reconciliation bill will push up inflation expectations even further, hasten the Federal Reserve’s policy normalization, and include tax hikes. And the current buy-the-rumor phase could be interrupted anyway by Biden’s immediate foreign policy challenges. Larry Summers And The Output Gap Democrats will err on the larger side of the $1.9 trillion stimulus because they regret erring on the smaller side back in 2009. But it is still possible for the price tag to be knocked down to around $1.5 trillion given that the economy is recovering and several moderate Democrats will balk at the enormous size. After all, $900 billion passed at the end of the year is not yet spent. Biden has already compromised by raising the eligibility requirements for households to receive $1,400 stimulus checks. Larry Summers, a frequent guest at the annual BCA conference and a veteran of the Clinton and Obama White Houses, has stirred up a firestorm over the past month by warning that too much federal money spent on short-term cash handouts today would crowd out the administration’s political capital and the amount of deficit spending that is available for long-term, productivity-enhancing investments. Summers warned that the current proposed stimulus is three times larger than required to fill the output gap. Chart 2 shows the output gap from 2009-12 and projected from 2021-24 alongside the size of the relevant stimulus packages to illustrate his point. Treasury Secretary Janet Yellen defended the $1.9 trillion price tag – like Summers, she is not normally one to worry about overheating the economy, but unlike Summers, she is now an administration official. She predicted that this size of package would bring the economy back to full employment by next year. The Congressional Budget Office, based on earlier congressional actions, had predicted employment would not return to its pre-COVID level until around 2024. The administration will look to Yellen now and in future to make the call on when enough stimulus is enough. With inflation expectations recovering rapidly, the Fed could be forced to hike rates as early as late 2022, though we think 2023 is more likely given our methodological bias as political analysts. This means the scope for overheating is quite large – a point reinforced by the comparison with the economic recovery back in 2009 (Chart 3). Summers’s criticism is not remiss and could come back to haunt the administration.1 When inflation picks up, the Fed will have to allow an overshoot according to its new policy of targeting average inflation. But once it is assured, it will have to start hiking rates. And once it starts hiking rates it could trigger a recession. Plus, even if we set recession risks aside, Summers’s critical point is that too much stimulus today will reduce the political and budgetary scope for Biden’s long-term agenda, which includes what will likely be his second major bill focused on infrastructure and renewables. The reconciliation process makes it highly likely that Democrats will drive through this initiative through the Senate but not if moderate Senate Democrats balk in the face of rising budget deficits and inflation. Chart 2How Much Is Too Much Stimulus? Our base case still holds that Democrats will pass both reconciliation bills over the next roughly 12 months but investors should keep Summers’s warning in mind. Chart 3Recovery Is Ahead Of The Previous Cycle There are tailwinds for Biden’s agenda. First, his political capital is moderate-to-strong and likely to strengthen over the coming year. It will get bumped up by improving economic conditions, including most recently a marked decline in bankruptcy filings from Q3 to Q4. Our updated Political Capital Index is shown in the  Appendix. Second, concern about budget deficits has eroded, as Republican fiscal largesse showed under Trump – the pandemic and atmosphere of crisis greatly reinforce this point. Third, divisions in the Republican Party have produced as many as five moderates who could assist Biden in winning close legislative votes – even beyond the relatively easy passage of the American Rescue Plan in his honeymoon period. This Republican Party split is the only significance of President Trump’s second impeachment. Trump’s legal woes will continue after he is acquitted in the Senate. The deeper Republicans are divided over Trump’s legacy the harder time they will have recovering in the 2022 midterms, where opposition parties are normally favored. But the Biden administration’s leftward agenda will bring Republicans together, especially once the country moves out of the crisis. One of the biggest battles looms over the southern border. Bottom Line: The $1.9 trillion American Rescue Plan will more than close the output gap and yet it is only one of two budget reconciliation bills that the Biden administration will seek to pass over the next 12 months. There are still domestic and international factors that could impede the recovery, not least China’s policy tightening, but the risk of excessively short-term stimulus at the expense of long-term public investment is clear. Republicans Will Regroup Over Immigration To Summers’s warning about Biden’s legislative window of opportunity, recall that President Trump never achieved his signature 2016 policy promise – to build a wall on the border with Mexico – because congressional Republicans led him to prioritize repealing and replacing the Affordable Care Act (which failed) and passing the Tax Cut and Jobs Act (which succeeded). There was no political capital left for a major legislative push on the border and immigration. Immigration is one of the areas where Biden has a major incentive to push his policies aggressively. Immigrants tend to skew Democratic in their party affiliations. Americans increasingly believe immigration should be increased, a trend that accelerated after Trump’s election on an avowedly anti-immigration platform (Chart 4, top panel). Today 34% believe it should be increased in addition to 36% who are comfortable with the current level. Meanwhile the number who believe it should be decreased has fallen to 28%, down from 34%-38% around the time of Trump’s election. An anti-immigration candidate may be able to win within the Republican Party (especially under the specific circumstances of 2015-16) but he or she will have trouble winning general elections. Trump himself discarded the topic in the 2020 race. For Democrats, immigration is also probably the single most effective way to drive a wedge between the populist and establishment factions of the Republican Party. For example, establishment Republican presidents oversaw huge infusions of foreigners into US society, the 1986 Immigration and Reform Control Act, which granted amnesty to three million illegal immigrants, and the 1990 Immigration Act, which increased the quota of legal immigrants. By contrast Trump rose to power by attacking the bipartisan consensus on “open borders.” As long as a substantial cohort of Republicans defends immigration on free market principles, and upholds the corporate interest in having plentiful availability of lower wage seasonal and specialized workers, the party will be divided. The above points explain why the Biden administration will pursue immigration reform more intently than public opinion would leave one to believe. Polls show that voters want to focus on the economic recovery, the pandemic response, and social and civil rights policies more than immigration. There is no question that Biden is prioritizing the pandemic, the economy, and health care (Chart 4, bottom panel). But the Democratic Party has a strategic interest in expanding immigration so Biden will continue to plow forward with executive orders and comprehensive immigration reform in Congress. The US does need immigration reform – to ensure the flow is orderly. President Trump’s “wall” proposal did not come out of nowhere. Like the “Know Nothing Party” that emerged in the 1840s and rose to prominence in the 1850s, the Trump movement arose amid a historic increase in the foreign-born share of the population (Chart 5). But Trump’s policies hardly made a dent in the flow of legal immigrants into the US. Now Biden will reverse them and encourage more incomers. Therefore immigration will persist as a bone of contention in the 2020s. Granted, immigration has amply attested positive effects on the economy – including most clearly by lifting the US’s fertility rate so that it does not suffer from as rapid of an aging process as other developed countries. Indeed, voters are primarily concerned about illegal, not legal, immigration. Still, Republicans will struggle to walk the line between tighter immigration policies and appealing to an audience beyond “old white folks.” This suggests the Biden administration has room to run. Chart 4Public Not Too Concerned About Immigration Chart 5Historically Large Foreign-Born Population It helps Biden that the post-World War II and post-Cold War booms in legal immigration are relatively measured when compared to the overall population. The inflow of migrants was around 0.3% in 2019, very far from its post-war peak of 0.7% per year (Chart 6). Thus the Biden administration will not be overly concerned about being too progressive on this issue. Chart 6Boom In Legal Immigration Less Impressive Relative To Population Chart 7Detainees On The Mexican Border Illegal immigration is the biggest factor motivating periodic public backlashes such as in 2016. Southwestern border apprehensions – the only credible way to measure the unauthorized flow of people over the Mexican border – spiked under President Obama as well as President Trump, though US agents detained nowhere near the numbers witnessed in the 1980s and 1990s (Chart 7). The stock of illegal immigrants in the US ranges from 10-11 million and has remained flat, or fallen slightly, since the financial crisis of 2008. The weakening of the US economy, in the context of tighter border security, reduced incentives to make the difficult journey (Chart 8). The fact that President Obama and Trump increased detentions suggests that the demand to get into the country recovered over the course of the last business cycle. Based on President Biden’s voting record in the Senate and statements during the 2020 campaign, he is not an ultra-dove on the border – but his party has moved to the left on the issue. This is clear from his rivals’ positions in the Democratic primary election. Even his Vice President Kamala Harris, who was not the most radical on stage, supported decriminalizing illegal border crossings and downgrading Immigration and Customs Enforcement. Still, until Democrats repeal the filibuster in the Senate, they will not have a chance of passing comprehensive immigration reform with Republicans unless they accept stronger enforcement provisions. Biden voted for the 2006 Secure Fence Act but more recently has emphasized high-tech upgrades to better monitor crossovers. Harris also accepted high-tech security funding that did not involve building a wall. Even with these compromises, it will still be a stretch to find 10 Republicans willing to cross the aisle on this issue while Trump and his faction remain active to punish them in primary elections. Chart 8Estimate Of Total Illegal Immigrants The demand to enter the US will revive once the pandemic is over. The big surge in illegal border crossings in the 1980s-90s coincided with a period in which US economic growth and wellbeing far outpaced that of Mexico and Central America (Chart 9). The gap in GDP per capita is the crudest possible measure and does not reflect the dramatic differences in quality of life that drive people to relocate. Nevertheless, the gap remains drastic, especially with Mexico. Chart 9The Grass Is Greener On The Other Side The gap in current economic activity, such as manufacturing PMIs, between the US and Mexico is as wide as ever. Even as manufacturing contracts in Mexico, the demand for workers in US service industries is soaring (Chart 10). Moreover the US economic revival will be super-charged by the gargantuan fiscal stimulus of 2020-21 whereas Mexican government support for the economy is comparatively austere (Chart 11) Chart 10Super-Charged US Recovery Opens Big Gap With Mexico Chart 11Less Government Support In Mexico Than US Bottom Line: Biden is opening up the borders at a time of economic disparity between the US and Latin America that will lead to an influx of immigration. This is positive for US labor force growth and productivity but it will be hard to pass a long-term solution through Congress. The Republican Party is deeply divided on the issue today but it is likely to become a rallying cry as numbers of newcomers increase and as Trump-style populism remains an active force within the party. Immigration, Wages, And The Minimum Wage   The macroeconomic and market impact of easier border and immigration controls boils down to the impact on wages. There is a vast literature on this subject and we will not pretend to be comprehensive. We will merely make a few observations. The foreign-to-native-born wage differential has narrowed substantially over the past twenty years. The discount to hire immigrants has shrunk from 24% to 15% (Chart 12). This is a reflection of the high demand for immigrant labor and especially the increase in high-skilled workers alongside the booming tech, legal, financial, personal care, and health care industries in the United States – the fastest growing sectors for foreign-born workers since 2003. Earnings growth for foreign workers is more cyclical than for native workers and has been rising faster in recent decades (Chart 13). Chart 12Immigrants Command A Higher Price Than They Used To Chart 13Immigrant Wages Grow In Boom Times Immigrants work the lowest-wage jobs and hence there is some correlation between the share of foreign-born workers in any given industry and the hourly wage, just as there was at the turn of the century (Chart 14). But it does not follow that an increase in immigration suppresses wages as a whole. Chart 15 shows that, over the last business cycle at least, a change in the foreign worker share of a given industry does not correlate with a change in wage growth. Of course, it stands to reason that increasing the supply of labor decreases the price. But not if demand is growing sufficiently to raise the price for all workers. As we have seen, since migrants are willing to undertake long and dangerous journeys for work, they are likely to go where the demand is strong and the price is right – and the flow drops when the jobs dry up. Chart 14Immigrants Work The Lowest Wage Jobs Chart 15More Immigration Not Necessarily A Pay Cut Academics debate the impact on wages. There could be a negative impact, especially for low-skilled native workers, but the aggregate effect is small. One study showed that wages for native workers fell by three percent cumulatively over the 20-year period from 1980-2000 due to immigration.2  This is not dramatic. We can test the connection between immigration and wage growth informally by plotting the growth of southwest border detentions and legal permanent residence admissions alongside that of real wages. There is no clear relationship either way (Chart 16). The same is true if we test it with real median wages – the surge in border apprehensions under President Trump coincided with a boom in wages across the spectrum.  Chart 16Border Influx Does Not Suppress Wages Thus we cannot rule out the possibility that the Biden administration’s relaxation of border controls will have a dampening effect on wages over the long run but we cannot endorse it either. Chances are that the rollout of COVID-19 vaccines and government spending will continue to power a recovery that tightens the labor market and lifts wages for most workers.   What about the administration’s simultaneous policy of doubling the federal minimum wage to $15 per hour by the year 2026 – and indexing wage growth after that date to the median hourly wage? The minimum wage hike might yet make it into the budget reconciliation bill under negotiation – but Biden has already signaled it can be delayed. There is a growing fear about the negative impact on small businesses struggling during the pandemic. The Congressional Budget Office estimates that anywhere from 1 million to 2.7 million jobs could be lost in 2025 if the wage hike were implemented now and businesses would pay $333 billion.3 But the proposal will return when the second budget reconciliation bill is up for consideration unless the Senate parliamentarian rules it out, in which case its passage becomes much less likely. Only about 2% of workers are paid at or below the current minimum wage of $7.25 per hour so a minimum wage hike but the CBO estimates that 10 percent of workers would be below the proposed wage level by 2025 (Chart 17). The states with higher proportions of minimum wage workers will be the ones most affected and are mostly in the south, including South Carolina, Mississippi, Kentucky, and Texas, though there are a few in the north such as New Hampshire and Pennsylvania (Chart 18). Chart 17Most Workers Earn More Than Minimum Wage Chart 18Minimum Wage Workers By State Previous minimum wage hikes did not prevent the economy from reaching full employment – nor did they lead to a lasting pickup in overall wage growth. But indexation to overall wage growth would mark a big change in favor of an eventual wage-price spiral. It cannot be ruled out given that the reconciliation option might be available to Democrats, though it would not take effect till 2026. Bottom Line: There is no firm link between immigration growth and wage growth. Increased immigration flows often coincide with higher incomes and wages as growth and productivity improve. Meanwhile a change in the minimum wage will have a limited impact from a macro point of view alone but a bigger impact if it is indexed to wage growth after 2026, which is possible. In the coming years the much greater impact of Biden’s policies will stem from the massive infusion of fiscal spending he is likely to pass through Congress, which will close the output gap quickly and put upward pressure on wages.    Investment Takeaways Easier immigration and a higher minimum wage are not the only Biden policies that will affect wages. One of the biggest developments since Biden took office is his confirmation that he will maintain a tougher trade policy than his predecessors, excluding Trump. Biden won the election among Midwestern blue collar voters at least partly by stealing Trump’s thunder on trade and globalization. Since taking office he has issued a “Buy American” executive order and declared that he will maintain “extreme” competition with China. His cabinet appointees – notably Antony Blinken at the State Department and Janet Yellen at the Treasury – have given words of warning to China over trade as well. Geopolitical risk is one reason we are cutting back on our participation in the market’s exuberance at the moment, given that critical foreign policy stances are likely to be tested early in Biden’s term. But there is also a long-term implication of the Democrats’ marginal increase in protectionism.   It was the overall policy context of hyper-globalization that led to sluggish wage growth in the United States over the previous forty years. A major factor was the decline of manufacturing and unionization as a result of a lack of competitiveness in the US as global production came online. The erosion in manufacturing jobs only stopped in recent years (Chart 19). Popular support for unions has risen to levels last seen in the late 1970s and 1990s since the Great Recession – under Trump even Republicans talked up unions. Chart 19Blame Fall In Manufacturing, Not Foreign Workers, For Flat Wages Biden’s policies outlined above are reminiscent of the “third way” Democrats in the 1990s – particularly Bill Clinton, who oversaw an increase in the minimum wage and a surge in both legal and illegal immigration. But on trade Biden is shaping up to be more like Trump than Clinton, albeit directing his protectionism more at China than other trade partners. His spending bills will also use fiscal spending to promote industrial policy. Meanwhile labor protections will go up and unionization will at least stem its multi-decade decline.    For the stock market the risk of higher wages looms mostly due to the super-charging of the economy with stimulus. But shoring up domestic manufacturing, unions, labor perks and protections, and possibly indexing the minimum wage will contribute to faster wage growth and – to corporations – higher employment costs (Chart 20). This is a headwind to the corporate earnings outlook. But like the Biden administration’s tax hikes it is not yet affecting the market’s overall bullishness – and may not until the first reconciliation bill passes and the narrative shifts from stimulus to structural reform. Investors may soon find out that they will be dealing with higher wages, higher taxes, higher inflation, and a higher cost of capital. Chart 20Higher Wages, Lower Corporate Profits Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Table A1BPolitical Capital: Household And Business Sentiment Table A1CPolitical Capital: The Economy And Markets Table A2Political Risk Matrix Table A3Biden’s Cabinet Position Appointments     Footnotes 1     See BCA Global Investment Strategy, “Fiscal Stimulus: How Much Is Too Much?” January 8, 2021, bcaresearch.com. 2     George J. Borjas and Stephen J. Trejo, “The Evolution of the Mexican-Born Workforce in the United States,” in Borjas, ed, Mexican Immigration to the United States (Chicago: Chicago University Press, 2005), pp.13-55.     3    See “The Budgetary Effects of the Raise the Wage Act of 2021,” Congressional Budget Office, February 2021, cbo.gov.