Geopolitics
for three reasons. First, while he will not be removed from office by a Republican Senate, his impeachment trial threatens to mar his re-election chances. This is a prime motivation to pursue foreign policy objectives to distract the public and seek policy…
BCA’s positive outlook depends on both China and the US respecting their trade truce. However, the two countries are long-term rivals and the rising geopolitical power of China relative to the US will cause tensions to escalate in the coming decades. This…
With the killing of General Soleimani, Middle Eastern tensions are once again surging. In the US, the House of Representatives may try to wrestle the power to wage war away from President Trump, but the Senate will not ratify such a move. As a result, the…
Feature One of BCA Research’s key geopolitical views since May 2019, outlined recently in our 2020 Outlook, is rapidly materializing: a dramatic escalation in the US-Iran conflict. On January 3 the United States successfully conducted a drone strike against a convoy carrying two high-level targets near the Baghdad International Airport. These were Iranian General Qassim Soleimani and his key Iraqi associate, Abu Mahdi al-Muhandes. The former, Soleimani, was Iran’s most influential military and intelligence leader, and one of its most powerful leaders overall. He was the head of the formidable Quds Force, the overseas arm of the Iranian Revolutionary Guard Corps (IRGC), the staunchest military wing of the regime at home and abroad. The latter target, al-Muhandes, was the head of Iraq’s Kataib Hezbollah militia and the broader coalition of pro-Iran Shiite militias in Iraq known as the Popular Mobilization Forces (PMF). This coalition was partly responsible for defeating the Islamic State in Iraq and Syria. Since then it has sought to consolidate Iranian influence in Iraq, pushing back against Iraqi Sunnis and Shia nationalists, and their allies in the US and Persian Gulf. Chart 1Bull Market In US-Iran Tensions The US assassinations follow a significant increase in Iranian and Iran-backed militant attacks against US allies in the Middle East this year. These stem from a breakdown in the US-Iran diplomatic detente that was enshrined in the 2015 nuclear agreement. President Donald Trump revoked this agreement in 2018 and in May 2019 imposed crippling sanctions on Iran’s oil exports and economy — initiating a “bull market” in US-Iran strategic tensions (Chart 1). Recent events show a clear path of strategic escalation — even in the wake of a summer of “fire and fury” and the extraordinary Iran-backed attack on Saudi Arabia’s Abqaiq oil refinery in September. Widespread popular unrest has dissolved the Iraqi government, creating intense competition between Iraqi nationalists, led by Moqtada al-Sadr, and Iran’s proxies, led by al-Muhandes and the PMF. This unrest marked a significant challenge to Iran’s sphere of influence and necessitated an Iranian backlash. For instance, al-Sadr’s enemies attacked his headquarters with a drone in early December. Meanwhile Kataib Hezbollah launched a spate of rocket strikes against US and Iraqi bases that culminated in the death of an American contractor near Kirkuk on December 28 — crossing an American red line. The US retaliated with damaging air strikes against Kataib Hezbollah in Iraq and Syria on December 29, prompting a PMF blockade of the US Embassy in Baghdad on December 31. While this was a limited blockade, the US has now retaliated by assassinating Soleimani and al-Muhandes, taking the conflict to a new level. There is every reason to expect tensions to escalate further in the new year. First, the Iranian regime is under severe economic stress due to the US sanctions and broader global slowdown (Charts 2A&B). Domestic protests have erupted in recent years, while the regime struggles with economic isolation, a restless youth population, and a looming succession when Supreme Leader Ali Khamenei eventually steps down. This is an existential struggle for the regime, while President Trump may only be in office for 12 months. Public opinion polls show that the Iranian populace blames the government for economic mismanagement, and yet that the renewed conflict with the US under the Trump administration is shifting the blame to US sanctions (Chart 3). Hence the regime will continue to distract the populace by resisting Trump’s pressure tactics. Chart 2ARegime Survival ... Chart 2B... An Existential Challenge Chart 3US Conflict Distracts From Domestic Woes This tendency will be reinforced by the death of Soleimani, which heightens the regime’s vulnerability while rallying domestic support due to Soleimani’s popularity as a leader (Chart 4). The regime is looking to its survival over the long run. It would be a remarkable shift in policy for Tehran to enter negotiations with Trump, since it would then risk vindicating his “maximum pressure” doctrine, possibly helping him secure a second term in office. Chart 4Hard-Line Soleimani Was Popular (Reformist President Rouhani Is Not) Meanwhile President Trump’s circumstances are apparently urging him to double down on his aggressive foreign policy against Iran. First, while he will not be removed from office by a Republican Senate, his impeachment trial threatens to mar his re-election chances. This is a prime motivation to pursue foreign policy objectives to distract the public and seek policy wins. Chart 5Falling Oil Import Dependency Emboldens US Second, the Trump administration may feel emboldened by the rise of US shale oil production and decline in US oil import dependency (Chart 5). Simulations we published in our December 6 Strategic Outlook show that Iran would have to sustain an oil supply cutoff as large as the Abqaiq attack for four months in order to drive gasoline prices high enough to harm the US economy as a whole. This buffer may have convinced Trump he has plenty of room for maneuver in confronting Iran. Third, Trump undoubtedly feels the need to maintain the credibility of his threats against Iran, North Korea, and other nations given his impeachment, widely known electoral and economic vulnerability, and his recent capitulation to China in the trade war. The clear threat by Iran to create a humiliating US embassy crisis in Baghdad likely struck a nerve in the White House, reviving memories of Saigon under Gerald Ford, Tehran under Jimmy Carter, and Benghazi under Barack Obama. By taking the offensive, President Trump has reinforced the red line against the death of American citizens or attacks on US assets. Nevertheless he now runs the risk of driving Iran into further escalation rather than negotiation. Iran is not yet likely to court a full-scale American attack by shutting down the Strait of Hormuz. It is more likely to retaliate via regional proxy attacks, including cutting off oil production, pipelines, and shipping — at a time of its choosing. If Trump’s pressure tactics succeed, it will advance its nuclear program rather than staging large-scale attacks. Investment Conclusions Iraqi instability will worsen as a result of the past month’s events, bringing 3.5 million barrels of daily oil production under a higher probability of disruption than when we first flagged this risk. Supply disruptions there or elsewhere in the region would hasten the drawdown in global inventories and backwardation of prices occurring due to the revival in global demand on China stimulus and OPEC 2.0 production cuts. Continued oil volatility, as in 2018-19, should be expected, but the risk for now lies to the upside as Middle East tensions could cause an overshoot. We remain long Brent crude and overweight energy sector equities. Second, the US election — and hence US domestic and foreign policy over the next five years — could hang in the balance if the Iran conflict escalates to broader and more open hostilities as we expect. President Trump is favored for re-election. Yet we have contended since 2018 that the revocation of the Iran nuclear deal was a grave geopolitical decision that could jeopardize Trump’s economy and hence re-election — and that remains the case. Chart 6Trump 'Maximum Pressure' A Gamble In 2020 Trump was elected in part because he is viewed as strong on terrorism, and the confrontation with Iran and its proxies will reinforce that reputation in the short run. Iranian attacks will also boost Trump’s approval rating, other things being equal. However, much can change by November. Jimmy Carter’s election troubles with Iran point to a serious risk to Trump, as the initial surge in patriotic support could turn sour over time if unemployment rises as a result of any oil shocks (Chart 6). Even George Bush Jr saw a dramatic fall in approval, from a much higher base than Trump, despite foreign policy conditions that were more transparently favorable to him in 2004 than any conflict with Iran will be to Trump in 2020. Trump has campaigned against Middle Eastern wars to a war-weary public, so the rally around the flag effect will not necessarily play to his favor in the final count. It is too soon to speculate about these matters — our view remains unchanged — but the Iran conflict is now much more likely to be a major factor in the US election and Iran is certainly capable of frustrating US presidents. This reinforces our base case that Trump is only slightly favored to win. Moreover his foreign policy conflicts — in Asia as well as the Middle East — ensure that global policy uncertainty and geopolitical risk will remain elevated despite dropping off from the highs reached last year amid the trade war. We remain long pure play global defense stocks on a cyclical and secular basis. We see gold as the appropriate hedge given our expectation that the trade ceasefire and China stimulus will reinforce a global growth recovery despite Middle Eastern turmoil. Higher oil prices push up inflation expectations and limit any benefit to government bonds. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com
Conservatives won 364 seats last night. This comfortable majority for the Conservatives is a medium-term positive for UK exposed investments, as Prime Minister Boris Johnson is not dependent on the 20 or so hard Brexit extremists to pass any free trade deal…
Highlights 2019 was a good year for our constraint-based method of political analysis. Trump was impeached, the trade war escalated, and China (modestly) stimulated – all as predicted. Nevertheless Trump caught us by surprise in Q2, with sanctions on Iran and tariffs on China. Our best trades were long defense stocks, gold, and Swiss bonds. Our worst trade was long rare earth miners. Feature Jean Buridan’s donkey starved to death because, faced with equal bundles of grain on both sides, it could not decide which to eat. So the legend goes. Investors face indecision all the time. This is especially the case when a geopolitical sea change is disrupting the global economy. Two or more political outcomes may seem equally plausible, heightening uncertainty. What is needed is a method for eliminating the options that require the farthest stretch. That’s what we offer in these pages, but we obviously make mistakes. The purpose of our annual report card is to identify our biggest hits and misses so we can hone our ability to combine fundamental macro and market analysis with the “art of the possible,” delivering better research and greater returns for clients. This is our last report for 2019. Next week we will publish a joint report with Anastasios Avgeriou of BCA Research’s US Equity Strategy. We will resume publication in early January. We wish all our clients a merry Christmas, happy holidays, and a happy new year! American Politics: Unsurprising Surprises Chart 1Our 2019 Forecast Held Up On the whole our 2019 forecast held up very well. We argued that the global growth divergence that began in 2018 would extend into 2019 with the Fed hiking rates, a lack of massive stimulus from China, and an escalation in the US-China trade war. The biggest miss was that the Fed actually cut rates three times – addressed at length in our BCA Research annual outlook. But the bulk of the geopolitical story panned out: the US dollar, US equities, and developed market equities all outperformed as we expected (Chart 1). Geopolitical risk in the Trump era is centered on Trump himself. Beginning in 2017, we argued that the Democrats would take the House of Representatives in the midterm elections and impeach the president. Congress would not be totally gridlocked: while we argued for a government shutdown in late 2018, we expected a large bipartisan budget agreement in late 2019 and always favored the passage of the USMCA trade deal. Still, Congress would encourage Trump to go abroad in pursuit of policy victories, increasing geopolitical risks. We also argued that, barring “smoking gun” evidence of high crimes, the Republican-held Senate would acquit Trump – assuming his popularity held up among Republican voters themselves (Chart 2). These views either transpired or remain on track. The implication is that Trump-related risk continues and yet that Trump’s policies are ultimately constrained by the guardrails of the election. The latter factor helped propel the equity rally in the second half of the year. We largely sat out that rally, however. We overestimated the chances that Senator Bernie Sanders would falter and Senator Elizabeth Warren would swallow his votes, challenging former Vice President Joe Biden for the leading position in the early Democratic Party primary. We expected a significant bout of equity volatility via fears of a sharp progressive-populist turn in US policy (Chart 3). Instead, Sanders staged a recovery, Warren fell back, Biden maintained his lead, and markets rallied on other news. Chart 2Trump Will Be Acquitted Chart 3Fears Of A Progressive Turn Did Not Derail The H2 Rally Warren could still recover and win the nomination next year. But the Democratic Primary was not a reason to remain neutral toward equities, as we did in September and October. China’s Tepid Stimulus In recent years China first over-tightened and then under-stimulated the economy – as we predicted. But we misread the credit surge in the first quarter as a sign that policymakers had given up on containing leverage. In total this year’s credit surge amounts to 3.4% of GDP, about 1.2% short of what we expected (based on half of the 9.2% surge in 2015-16) (Chart 4). China’s credit surge was about 1.2% short of what we expected, but the direction was correct. While the government maintained easy monetary policy as expected, its actions combined with negative sentiment to snuff out the resurgence in shadow banking by mid-year (Chart 5). Chart 4China's Credit Surge Was Underwhelming Still, China’s policy direction is clear – and fiscal policy is indeed carrying a greater load. The authorities are extremely unlikely to reverse course next year, so global activity should turn upward (Chart 6). Our “China Play Index” – iron ore prices, Swedish industrials, Brazilian stocks, and EM junk bonds, all in USD terms – has appreciated steadily (Chart 7). Chart 5China's Shadow Banking Remained Under Pressure Chart 6Global Activity Should Turn Upward In 2020 Chart 7Our 'China Play Index' Performed Well US-China: Underestimating Trump’s Risk Appetite We have held a pessimistic assessment of US-China relations since 2012. We rejected the trade truces agreed at the G20 summits in December 2018 and June 2019 as unsustainable. Our subjective probabilities of Trump achieving a bilateral trade agreement with China have never risen above 50%. Since September we have expected a ceasefire but not a full-fledged deal. Nevertheless we struggled with the timing of the trade war ups and downs (Chart 8). In particular we accepted China's new investment law as a sufficient concession and were surprised on May 5 when talks collapsed and Trump increased the tariffs. The lack of constraints on tariffs prevailed in 2019 but in 2020 the electoral constraint will prevail as long as Trump still has a chance of winning. Our worst trade recommendation of the year emerged from our correct view that the June G20 summit would lead to trade war escalation. We went long rare earth miners based outside of China. We expected China to follow through on threats to impose a rare earth embargo on the US in retaliation for sanctions against Chinese telecom giant Huawei. Not only did the US grant Huawei a reprieve, but China’s rare earth companies outperformed their overseas rivals. The trade went deeply into the red as global sentiment and growth fell (Chart 9). Only with global growth turning a corner have these high-beta stocks begun to turn around. Chart 8Expect A Ceasefire, Not A Full-Fledged Trade Agreement Chart 9Our Worst Call: Long Rare Earth Miners Chart 10North Korean Diplomacy Has Not Collapsed (Yet) Our sanguine view on North Korea was largely offside this year. Setbacks in US negotiations with North Korea have often preceded setbacks in US-China talks. This was the case with the failed Hanoi summit in February and the inconsequential summit at the demilitarized zone in June. This could also be the case in 2020, as Washington and Pyongyang are now on the verge of breaking off talks with the latter threatening a “Christmas surprise” such as a nuclear or missile test. It is not too late to return to talks. Beijing is the critical player and is still enforcing crippling sanctions on North Korea (Chart 10). Beijing would benefit if North Korea submitted to nuclear and missile controls while the US reduced its military presence on the peninsula. We view this year as a hiccup in North Korean diplomacy but if talks utterly collapse and military tensions break out then it would undermine our view on US-China talks, Trump’s reelection odds, and US Treasuries in 2020. Hong Kong, rather than Taiwan, became the site of the geopolitical “Black Swan” that we expected surrounding Xi Jinping’s aggressive approach to domestic dissent. We have never downplayed Hong Kong. The loss of faith in the governing arrangement with the mainland began with the Great Recession and shows no sign of abating (Chart 11). We shorted the Hang Seng after the protests began, but closed at the appropriate time (Chart 12). The problem is not resolved. Also, Taiwan can test its autonomy much farther than Hong Kong and we still expect Taiwan to become ground zero of Greater China political risk and the US-China conflict. Chart 11Hong Kong Discontent Is Structural Chart 12Our Hang Seng Short Is Done Chart 13Trump Needs A Trade Ceasefire Trump is unlikely to seek another trade war escalation given the negative impact it would have on sentiment and the economy (Chart 13). He could engage in another round of “fire and fury” saber-rattling against North Korea, as the economic impact is small, but he will prefer a diplomatic track. Taiwan, however, cannot be contained so easily if tempers flare. As we go to press it is not clear if Trump will hike the tariff on China on December 15. Some investors would point to his tendency to take aggressive action when the market gives him ammunition (Chart 14). We doubt he will, as this would be a policy mistake – possibly quickly reversed or possibly fatal for Trump. Trump’s electoral constraint is more powerful in 2020 than it was in 2019. Chart 14Trump Ceasefire Will Last As Long As Economy Is At Risk Chart 15Our 'Doomsday Basket' Captured Trump's First Three Years Our best tactical trade of the year stemmed from the geopolitical risk in Asia (and the Fed’s pause): we recommended a long gold position this summer that gained 16%. We also closed out our “Doomsday Basket” of gold and Swiss bonds, initiated in Trump’s first year, for a gain of 14% (Chart 15). Now that the market has digested Trump’s tactical retreat, we have reinitiated the gold trade as a long-term strategic hedge against both short-term geopolitical crises and the long-term theme of populism. Iran: Fool Me Once, Shame On You … This is the second year in a row that we are forced to explain our analysis of Iran – we were only half-right. Our long-held view is that grand strategy will push the US to pivot to Asia to counter China while scaling back its military activity in the Middle East. Two American administrations have confirmed this trend. That said, there is still a risk that President Trump will get entangled in Iran and that risk is growing. Global oil volatility – which spiked during the market share wars of 2014 – declined through the beginning of 2018, until the Trump administration took clearer steps toward a policy of “maximum pressure” on Iran. The constraints on Trump are obvious: the US economy is still affected by oil prices, which are set globally, and Iran can damage supply and push up prices. Therefore Trump should back down prior to the 2020 election. Yet Trump imposed sanctions, waivered on them, and then re-imposed them in May 2019 – catching us by surprise each time (Chart 16). Chart 16Trump Flip-Flopped On Iran Policy Chart 17Iran Tensions Backwardated Oil Markets This saga is not resolved – we are witnessing what could become a secular bull market in Iran tensions. True, a Democratic victory in 2020 could lead to an eventual restoration of the 2015 nuclear deal. True, the Trump administration could strike a deal with the Iranians (especially after reelection). But no, it cannot be assumed that the US will restore the historic 2015 détente with Iran. Within Iran the regime hardliners are likely to regain control in advance of the extremely uncertain succession from Supreme Leader Ali Khamenei and this will militate against reform and opening up. We went long Brent crude Q1 2020 futures relative to Q1 2021 to show that tensions were not resolved (Chart 17) – the attack on Saudi Arabia in September confirmed this view. And yet the oil price shock was fleeting as global supply was adequate and demand was weak. Our current long Brent spot trade is not only about Iran. Global growth is holding up and likely to rebound thanks to monetary stimulus and trade ceasefire, OPEC 2.0 has strong incentives to maintain production discipline (driven by both Saudi Arabian and Russian interests), and the Iranian conflict has led to instability in Iraq, as we expected. The UK: Not Dead In A Ditch British Prime Minister Boris Johnson proclaimed this year that he would "rather be dead in a ditch” than extend the deadline for the UK to leave the EU. The relevant constraint was that a disorderly “no deal” exit would have meant a recession, which we used as our visual illustration of why Johnson would not actually die in a ditch (Chart 18). The test was whether parliament could overcome its coordination problems when it reconvened in September, which it immediately did, prompting us to go long GBP-USD on September 6 (Chart 19). This trade was successful and we remain long GBP-JPY. Chart 18The Reason We Rejected Chart 19UK Parliament Voted Down No-Deal Brexit Populism faltered in Europe, as expected. As we go to press, the UK Christmas election is reported to have produced a whopping Conservative majority. This year Johnson mounted the most credible threat of a no-deal Brexit that we are ever likely to see and yet ultimately delayed Brexit. The Conservative victory will produce an orderly Brexit. The trade deal that needs to be negotiated next year will bring volatility but it does not have a firm deadline and is not harder to negotiate than Brexit itself. The UK has passed through the murkiest parts of Brexit uncertainty. Moreover, our high-conviction view that more dovish fiscal policy would be the end-result of the Brexit saga is now becoming consensus. Europe: Not The Crisis You Were Looking For The European Union was a geopolitical “red herring” in 2019 as we expected. Anti-establishment feeling remained contained. Italy remains the weakest link in the Euro Area, but the political “turmoil” of 2018-19 is the populist exception that mostly proves the rule: Europeans are not as a whole rebelling against the EU or the euro. On France, Italy, and Spain our views were fundamentally correct. Even in the European parliament, where anti-establishment players have a better chance of taking seats than in their home governments, the true Euroskeptics who want to exit the union only make up about 16% of the seats (Chart 20). This is up from 11% prior to the elections in May this year. Chart 20Euroskepticism Was Overstated Yet the European political establishment is losing precious time to prepare for the next wave of serious agitation, likely when a full-fledged recession comes. Chart 21Trump Did Not Pile Tariffs Onto Auto Sector Germany is experiencing a slow transition from the long reign of Angela Merkel, whose successor has plummeted in opinion polls. The shock of the global slowdown – particularly heavy in the auto sector (Chart 21) – hastened Germany’s succession crisis. Chart 22Overstated EU Political Risk, Understated Chinese Risk There is a silver lining: this shock is forcing the Germans to reckon with de-globalization. Attitudes across the country are shifting on the critical question of fiscal policy. Even the conservative Christian Democrats are loosening their belts in the face of the success of the Green Party and a simultaneous change in leadership among the Social Democrats to embrace bigger spending. The Trump administration refrained from piling car tariffs onto Europe amidst this slowdown in the automobile sector and overall economy. We expected this delay, as there is little support in the US for a trade war with Europe, contra China, and it is bad strategy to fight a two-front war. But if the US economy recovers robustly and Trump is emboldened by a China deal then this risk could reignite in future. With European political risk overstated, and Chinese mainland risk understated, we initiated a long European equities relative to Chinese equities trade (Chart 22), as recommended by our colleagues at BCA Research European Investment Strategy. And now we are initiating the strategic long EUR/USD recommendation that we flagged in September with a stop at 1.18. Japan: Shinzo Abe Has Peaked Japanese Prime Minister Shinzo Abe is still in power and still very popular, whether judged by the average prime minister in modern memory or his popular predecessor Junichiro Koizumi. But he is at his peak and 2019 did indeed mark the turning point – it is all downhill from here. First, he lost his historic double super-majority in the Diet by falling to a mere majority in the upper house (Chart 23). He is still capable of revising the constitution, but now it is now harder – and the high water mark of his legislative power has been registered. Chart 23Abe Lost His Double Super Majority Chart 24Consumption Tax Hike Shows Limits Of Abenomics Second, he proceeded with a consumption tax from 8% to 10% that predictably sent the economy into a tailspin given the global slowdown (Chart 24). We thought the tax hike would be delayed, but Abe opted to hike the tax and then pass a stimulus package to compensate. This decision further supports the view that Abe’s power will decline going forward. It is now incontrovertible that the Liberal Democrats are eschewing a radical plan of debt monetization in which they coordinate ultra-dovish fiscal policy with ultra-dovish monetary policy. “Abenomics” has not necessarily failed but it is a fully known quantity. Abe will next preside over the 2020 summer Olympics and prepare to step down as Liberal Democratic party leader in September 2021. It is conceivable he will stay longer, but the likeliest successors have been put into cabinet positions, including Shinjiro Koizumi, son of the aforementioned, whom we would not rule out as a future prime minister. Constitutional revision or a Russian peace deal could mark the high point of his premiership, but the peak macro consequences have been felt. Japan suffered a literal and figurative earthquake in 2011. Over the long run Tokyo will resort to more unorthodox economic policies and redouble its efforts at reflation. But not until the external environment demands it. This suggests that the JPY-USD is a good hedge against risks to the cyclically bullish House View in 2020 and supports an overweight stance on Japanese government bonds. Emerging Markets: Notable Mentions India: We were correct that Narendra Modi would be reelected as prime minister, but we did not expect that he would win a single-party majority for a second time (Chart 25). The risk is that this result leads to hubris – particularly in foreign policy and domestic social policy – rather than accelerating structural reform. But for now we remain optimistic about reform. Chart 25 East Asia: We are optimistic on Southeast Asia in the context of US-China competition. But we proved overly optimistic on Malaysia and Indonesia this year, while we missed a chance to close our long Thai equity trade when it would have been very profitable to do so. Turkey: Domestic political challenges to President Recep Tayyip Erdoğan have led to a doubling down on unorthodox monetary policy and profligate fiscal policy, as expected. Early in the year we advised clients that Erdoğan would delay deployment of the Russian S-400 air defense system in deference to the US but it quickly became clear that this was not the case. Thus we correctly anticipated the sharp drop in the lira over the autumn (Chart 26). The US-Turkey relationship continues to fray and additional American sanctions are likely. Russia: President Vladimir Putin focused on maintaining domestic stability amid tight fiscal and monetary policy in 2019. This solidified our positive relative view of Russian currency and equities (Chart 27). But it also highlighted longer-term political risks. We expect this trend to continue, but by the same token Russia is a potential “Black Swan” risk in 2020. Chart 26The Lira's Autumn Relapse Chart 27Russia's Eerie Quiet In 2019 Venezuela: Venezuela’s President Nicolas Maduro eked out another year of regime survival in 2019 despite our high-conviction view since 2017 that he would be finished. However, the economy is still collapsing and Russian and Chinese assistance is still limited (Chart 28). Before long the military will need to renovate the regime, even if our global growth and oil outlook for next year is positive for the regime on the margin. Chart 28Maduro Clung To Power Chart 29Our 2019 Winner: Global Defense Stocks Brazil: We were late to the Brazilian equity rally. While we have given the Jair Bolsonaro administration the benefit of the doubt, a halt to structural reforms in 2020 would prove us wrong. Our worst trade of the year was long rare earth miners, mentioned above. Our best trade was long global defense stocks (Chart 29), a structural theme stemming from the struggle of multiple powerful nations in the twenty-first century. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky Research Analyst ekaterinas@bcaresearch.com Jingnan Liu Research Associate jingnan@bcaresearch.com Marko Papic Consulting Editor marko@bcaresearch.com
Highlights OPEC 2.0 agreed to cut output by another 500k b/d at its Vienna meeting last week, bringing the total official cuts by the producer coalition to 1.7mm b/d. Saudi Arabia added 400k b/d of additional voluntary cuts, bringing its total cuts to almost 900k b/d vs. its October 2018 production level. We think the market will tighten, as a result, and are getting long 2H20 Brent vs. short 2H21 Brent; this is the backwardation trade that worked well this year, producing an average return of 180%. There was no extension of OPEC 2.0 output cuts beyond end-March, although an extraordinary meeting of the coalition was scheduled for March 5, 2020. Anti-government civil unrest in Iraq and Iran has resulted in the killing of hundreds of protesters in both countries by state security forces. The unrest raises the threat of disruptions to oil supplies from Iraq and to ships transiting the Strait of Hormuz. Clashes between pro-Iranian protesters and Iraqi nationalists in Baghdad prompted a visit to the city by Iran’s top military commander, Qassem Soleimani, over the weekend. Soleimani reportedly is participating in talks to find a new prime minister for Iraq. Soleimani’s visit drew criticism from Grand Ayatollah Ali al-Sistani, the most prominent Shia religious leader in Iraq. Feature OPEC 2.0’s deepening of production cuts to 1.7mm b/d will be largely ceremonial, unless free riders in the producer coalition – led by the Kingdom of Saudi Arabia (KSA) and Russia – fully comply with the new levels agreed last week in Vienna (Chart of the Week).1 Contrary to our expectation, the production cuts were not extended beyond end-March, although an extraordinary meeting of the coalition was scheduled for March 5, 2020, in Vienna to review market conditions prior to the deal’s expiry.2 The market was not expecting anything other than symbolism in the just-concluded discussions among OPEC 2.0 members regarding production cuts. The bulk of the cuts in the coalition’s production are the result of US sanctions against Venezuela and Iran, which have removed ~ 1.8mm b/d from the market and KSA's cuts, which will total ~ 900k b/d following OPEC 2.0's Vienna meeting. We believe this will lead to a tighter market, and will steepen the backwardation in the Brent forward curve. We are, therefore, recommending a longer 2H20 Brent position vs. a short 2H21 Brent position. The sanctions-induced cuts are squeezing the economies of both Venezuela and Iran, which, in the case of the latter, is producing a blowback on Iraq. Chart of the WeekOPEC 2.0 Raises Output Cuts To 1.7mm b/d In Vienna Iran Fights To Maintain Influence In Iraq Following an unexpected increase in gasoline prices last month, violent anti-government protests erupted around Iran, which provoked a deadly crackdown by the state. The ongoing unrest has resulted in the death of hundreds of protesters, which, by the US’s estimate, stand at more than 1,000. This claim was refuted by Iranian officials.3 It is impossible to overstate the importance of maintaining freedom of navigation through the Strait of Hormuz. The unrest that followed the gasoline price hike was the deadliest since that country’s Islamic Revolution in 1979, according to the New York Times. The Times reported that the Islamic Revolutionary Guards Corps opened fire on protestors calling for the removal of leadership, killing scores.4 Protests also erupted in states closely aligned with Iran in the past couple of months – i.e., Lebanon, Iraq.5 For the oil market, Iraq matters most: It is difficult to overstate the importance of keeping Iraq’s 4.7mm b/d of crude oil production flowing to global markets. Likewise, it is impossible to overstate the importance of maintaining freedom of navigation through the Strait of Hormuz, which connects the Persian Gulf with the Arabian Sea and the rest of the world’s oil-consuming markets (Map 1). Map 1The Persian Gulf And Strait of Hormuz More than 20% of the world’s crude oil and condensates supplies transit the Strait on any given day (Chart 2). The anti-government protests in Iraq and Iran raise the threat level to production in Iraq, and attacks on shipping transiting the Strait of Hormuz by the latter, or a direct confrontation with the US and its Gulf allies. Our colleagues in BCA Research’s Geopolitical Strategy (GPS) are following the evolution of events in Iran and Iraq closely. Following is their assessment of what led to the most recent unrest in Iraq.6 Chart 2Violence Again Threatens Gulf Oil Supply Chart 3AFertile Ground For Unrest In Iraq Deadlock In Iraq While both the grievances and demands of the protesters in Lebanon and Iraq are similar, the unrest in Iraq is of much greater consequence from a global investor’s perspective. The trigger was the removal of the highly revered Lieutenant General Abdul-Wahab al-Saadi from his position in the Iraqi army by Prime Minister Adel Abdul-Mahdi.7 The popular general was unceremoniously transferred to an administrative role in the Ministry of Defense. Iraqi protesters are united in their economic grievances, frustrated at a political and economic system that is unwilling to translate economic gains to improved livelihoods for its people. The sacking of al-Saadi – considered a neutral figure – was interpreted as evidence of Iranian influence and the greater sway of the Iran-backed Popular Mobilization Forces (PMF), an umbrella organization of various paramilitary groups. Iraqis all over the country responded by attacking the Iranian consulate in Karbala and offices linked to Iranian-backed militias. Iraqi protesters are united in their economic grievances, frustrated at a political and economic system that is unwilling to translate economic gains to improved livelihoods for its people. The May 2018 parliamentary elections, which ushered in Prime Minster Abdul-Mahdi, failed to generate much improvement. The country continues to be plagued by high unemployment, corruption, and an utter lack of basic services (Charts 3A & 3B). This has ultimately resulted in a lack of confidence in Iraqi leadership who are being increasingly perceived as benefiting from the status quo at the expense of the populace. Chart 3BFertile Ground For Unrest In Iraq Most importantly, the ruling elite has failed to respond to key trends that emerged in last year’s parliamentary elections. The extremely low voter turnout reveals that Iraqis are disenchanted with the government's ability to meet their needs. Meanwhile the success of Shia cleric Moqtada al-Sadr’s Sairoon coalition – running on a platform stressing non-sectarianism and national unity – in securing the largest number of seats highlights the desire for a reduction of foreign interference (both Iranian as well as US/Saudi) in domestic politics. Neither the US nor Saudi Arabia have an appetite to step in and provide the support necessary to counteract Iran. Moreover, Iran and its proxies in Iraq will not back down easily. Thus, the ongoing protests are to a great extent the result of the new government’s failure to heed the warnings brought about by the 2018 election and protests. They have served to deepen the rift between the rival Shia blocs, particularly those Iraqi nationalists who deeply resent the intrusion of Iran into its political structures. Iraq is in a state of deadlock. That said, Iran is unlikely to stand by idly as its influence wanes. As a result, we are likely to witness greater unrest as the rift between the two Shia blocs intensifies. Neither the US nor Saudi Arabia have an appetite to step in and provide the support necessary to counteract Iran. Moreover, Iran and its proxies in Iraq will not back down easily. At the same time, the geographical spread of the protest movement demonstrates that Iraqis are fed up with the current system.8 This points to greater instability in Iraq as no side is backing down and the only foreign power willing and able to interfere is Iran. US Sanctions Continue To Pressure Iran The Trump administration’s crippling “maximum pressure” sanctions have sent Iran’s Economy reeling. The Trump administration continues to enforce its “maximum pressure” sanctions, which have reduced Iranian oil exports from 1.8 million barrels per day at their recent peak to 100,000 barrels per day in November (Chart 4). These are crippling sanctions that have sent Iran’s economy reeling. Chart 4Iran Remains Under “Maximum Pressure” Iran’s Supreme Leader Ayatollah Ali Khamenei has ruled out negotiations with Trump. They would be unpopular at home without a major reversal on sanctions from Trump (Chart 5). Chart 5 Major US Reversal Prerequisite For Iran Talks Trump presumably aims to avoid an oil shock ahead of the election. The US and its allies have visibly shied away from conflict in the wake of Iran’s provocations, including the spectacular attack on eastern Saudi Arabia's oil infrastructure that knocked 5.7 million barrels of oil per day offline in September. However, this does not mean the odds of war are zero. Opinion polls show that the Iranian public primarily blames the government for the collapsing economy. The Americans or the Iranians could miscalculate. Both sides might think they can improve their standing at home by flexing military muscle abroad. Iran is a rational actor and would not normally court American airstrikes or antagonize a potentially lame duck president. Yet it is under extreme pressure due to the sanctions, as the riots and protests following the gasoline price hikes indicate. Iran also faces significant unrest in its sphere of influence, as discussed above. Opinion polls show that the Iranian public primarily blames the government for the collapsing economy, and yet that American sanctions are siphoning off some of this anger (Chart 6). This could tempt Iran’s leaders to continue staging provocations in the Strait of Hormuz or elsewhere in the region, perhaps with attacks on US assets or those of its GCC allies. Chart 6Iranians Blame Tehran, Tehran Blames America Hardline Iranian military leaders and politicians currently receive the most favor in polling, while the reformist President Rouhani – undercut by the American withdrawal from the 2015 deal – is among the least popular. Elections for the Majlis, or Parliament, in February will likely reverse the reformist turn in Iranian politics that began in 2012. The regime stalwarts are gearing up for the supreme leader’s succession in the coming years. While a Democratic White House could restore the 2015 deal Trump unilaterally abrogated, that ship may have sailed. Trump, under impeachment, could seek to distract the public. This was Bill Clinton’s tactic with Operations Infinite Reach, Desert Fox, and Allied Force in 1998-99. These operations were minor and not comparable to a conflict with Iran. However, Trump may be emboldened. On paper the US Strategic Petroleum Reserve – along with OPEC and other petroleum reserves and spare capacity – could cover most major oil-shock scenarios. A supply outage the size of the Abqaiq attack in September would have to persist for four months to cause enough price pressure to harm the US economy and decrease Trump’s chances of winning re-election. The simulations in Chart 7 overstate the gasoline price impact by assuming that global strategic oil reserves remain untapped, along with spare capacity. Chart 7Desperation Could Force Iran To Take Excessive Risks Thus while the Iranians may take excessive risks, the Trump administration may not refrain this time from airstrikes. Bottom Line: While the Middle East is always full of risks to oil supply, Iran’s vulnerability and Trump’s status at home make the situation unusually precarious. We continue to believe an historic oil-supply disruption is a fatter tail risk than investors realize, or are pricing in currently. Market Round-Up Energy: Overweight Following the long-awaited OPEC 2.0 meeting held last week, the group “surprised” the market by announcing it will deepen its production cut by ~ 500k b/d, pushing the total cut to 1.7mm b/d. The bulk of the additional adjustments comes from Saudi Arabia (Chart of the Week). Importantly, the group emphasizes the importance of full compliance by every member – this would imply a ~225k b/d reduction from Iraq alone. We remain overweight oil in 2020. Base Metals: Neutral Copper prices rose sharply over the past week, reaching $2.71/lb at Tuesday's close, a level last seen in July 2019. US-China trade optimism last Friday sparked the rally. Copper’s physical market remains tight, inventories are low globally, and demand is set to rebound on the back of major central banks’ accommodative monetary policy. Even so, sentiment and positioning remain weak (Chart 8). We expect this to reverse, further supporting prices over the short term. Precious Metals: Neutral Risk-on sentiment following President Trump’s upbeat comments on US-China trade negotiations pushed gold prices down by $18/oz last Friday – one of the largest single-day declines YTD. Precious metals markets continue to follow the ups and downs of trade-war headlines and global growth-related news. Nonetheless, our fair-value model suggests gold is fairly priced at ~ $1,465/oz (Chart 9). Any significant drop below that level would provide an entry opportunity for investors to add gold as a portfolio hedge in 2020. Ags/Softs: Underweight The USDA released its final crop progress update on Monday. Corn was 8% behind full harvest, with North Dakota remaining the laggard with only 43% of the corn picked. Markets ignored this as March Corn futures slid close to 1.5% on a weekly basis. Chinese purchases of at least five bulk cargo shipments of U.S. soybeans lifted prices above $9/bu on Tuesday in anticipation of the USDA monthly crop production report. Wheat prices were flat on a weekly basis, as traders awaited results of an Egyptian purchase tender on Tuesday. Chart 8Copper Sentiment And Positioning Remain Weak Chart 9Gold Fair Value Is ~ 5/oz Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1 Please see On OPEC 2.0’s Agenda In Vienna: More Production Cuts, Longer Deal, published December 5, 2019. We noted most of the production cuts that matter to the market already are in place – i.e., Saudi Arabia’s over-compliance of ~ 400k b/d, along with Venezuela’s and Iran’s involuntary production cuts of ~ 1.8mm b/d resulting from US sanctions, as of October 2019. Under the amended production cuts, KSA agreed to remove close to 170k b/d more, lifting its total official voluntary quota and over-compliance, which brings its total cuts to close to 900k b/d. The total OPEC 2.0 additional cuts come to just over 500k b/d. Based on media reports going into the Vienna meeting last week, it would appear Russia prevailed on the producer coalition in its effort to keep the expiry of the production deal at end-March. However, the March 5 extraordinary meeting of the coalition states indicates KSA was successful in keeping the discussion re extending the deal alive. 2 In our current modeling, we assume the original 1.2mm b/d of cuts will remain in place to year-end 2020. We will be updating our balances and price forecasts in next week’s Commodity & Energy Strategy. 3 Please see U.S. says Iran may have killed more than 1,000 in recent protests, published by uk.reuters.com December 5, 2019. Iranian leaders blamed “thugs” aligned with the US and rebels for the violence, and, in a separate report citing an Amnesty International claim that 143 protesters were killed, said “several people, including members of the security forces, were killed and more than 1,000 people arrested.” Please see Iran says hundreds of banks were torched in 'vast' unrest plot published November 27, 2019, by uk.reuters.com. The size of the price increase is difficult to ascertain: The government says gasoline costs were increased by 50% with a goal of raising $2.55 billion/year, while other reports claim the hike amounted to as much as 300% in different parts of the country last month. 4 Please see With Brutal Crackdown, Iran Is Convulsed by Worst Unrest in 40 Years, published by the New York Times December 1, 2019. 5 The extent to which these states are entwined with Iran recently came to light via a cache of leaked Iranian diplomatic cables obtained by The Intercept, a not-for-profit news organization established by Pierre Omidyar, a founder of eBay. The cables were published jointly by The Intercept and the New York Times November 19, 2019. Please see The Iran Cables: Secret Documents Show How Tehran Wields Power in Iraq, published by the Times. The article claims “The unprecedented leak exposes Tehran’s vast influence in Iraq, detailing years of painstaking work by Iranian spies to co-opt the country’s leaders, pay Iraqi agents working for the Americans to switch sides and infiltrate every aspect of Iraq’s political, economic and religious life.” 6 This analysis in the remainder of this report is an abridged version of original work published by BCA Research’s GPS service in reports entitled Iraq's Challenge To Iran Is Underrated and 2020 Key Views: The Anarchic Society published November 8 and December 6, 2019. We believe events over the past week and weekend warrant this in-depth examination of the ongoing unrest and instability in Iraq and Iran. Both reports are available at gps.bcaresearch.com. 7 Lt. Gen. Abdul-Wahab al-Saadi was recognized and respected among Iraqis for fighting terrorism and his role in ridding the country of the Islamic State. The Iran-backed Popular Mobilization Forces were uneasy with Saadi’s close relationship with the US military. His abrupt removal was likely a result of the Iraqi government’s growing concern over al-Saadi’s popularity and rumors of a potential military coup. 8 Protests are occurring in all regions in Iraq. They are supported by Grand Ayatollah Ali al-Sistani. This is a significant development from the 2018 protests which were mainly concentrated in Iraq’s southern region. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades