Geopolitics

Highlights So What? Maintain a cautious stance on Turkish currency and risk assets. Why? Following the AKP’s defeat in Istanbul, Erdogan has doubled down on unorthodox economic policies. Improvements in the current account balance are temporary. Unless investor sentiment is meaningfully repaired, the lira will resume its decline in 2020. In the meantime, tensions with the West – especially the U.S. – will remain elevated. The imposition of secondary sanctions from the U.S. is likely. Feature U.S. President Donald Trump is wavering in the trade war, which is ostensibly positive news for global risk assets that are selling off dramatically amid very gloomy expectations about the near future. The question is whether the delay is too little, too late to halt the slide in financial markets in the near term. The reason to be optimistic is that interest rates have fallen and the global monetary policy “put” is fully in effect. Moreover, it is irrefutable now that President Trump is sensitive to the negative financial effects of the trade war. He is delaying new tariffs on some of the remaining $300 billion worth of imports from China not simply because consumer price inflation has ticked up but more fundamentally because the tightening of financial conditions increases the risk of a recession. A president can survive a small increase in inflation but not a big increase in unemployment. The reason to be pessimistic is that global economic expectations are threatening the crisis levels of 2008 (Chart 1) and Trump’s tariff delay offers cold comfort. His administration has not delayed all the tariffs, and the delay lasts only three months. Rather than renew the license for U.S. companies to do business with Chinese telecom giant Huawei, his Commerce Department has deferred any decision – leaving uncertainty to fester in the all-important tech sector. Chart 1Global Economic Expectations Near Crisis Levels Global Economic Expectations Near Crisis Levels Global Economic Expectations Near Crisis Levels Chart 2More China Stimulus Needed To Prevent EM Breakdown More China Stimulus Needed To Prevent EM Breakdown More China Stimulus Needed To Prevent EM Breakdown Beneath the surface is the fact that China’s money-and-credit growth faltered in July, suggesting that negative sentiment is still suppressing credit demand and preventing policy stimulus from having as big of a bang as in 2015-16. The late-July Politburo meeting signaled a more accommodative turn in policy, as we have expected, and BCA’s China strategist Jing Sima expects more fiscal stimulus to be announced after the October 1 National Day celebration. But high-beta economies and assets will suffer in the meantime – especially emerging market assets (Chart 2). Emerging markets are also seeing geopolitical risks rise across the board – and with the exception of China and Brazil, these risks are underrated by markets: Greater China: Beijing is getting closer to intervening in Hong Kong with police or military force. Such a crackdown will increase the odds of a confrontation with Taiwan and a backlash across the region and world, meaning that East Asian currencies in particular have more room to break down. India: The escalation in Kashmir is not a “red herring.” A single terrorist attack in India blamed on Pakistan could trigger a dangerous military standoff that hurts rather than helps Indian equities, unlike the heavily dramatized standoff ahead of the election earlier this year. Russia: Large-scale protests, overshadowed by Hong Kong, highlight domestic instability amid falling oil prices. These developments bode ill for Russian currency and equities. We will return to these risks in the coming weeks. This week we offer a special report on Turkey, where political risk is becoming extremely underrated as the lira rallies despite a further deterioration in governance (Chart 3). Chart 3Political Risks Are Underrated In Turkey Political Risks Are Underrated In Turkey Political Risks Are Underrated In Turkey Too Early To Write Off Erdogan “Whoever wins Istanbul, wins Turkey … Whoever loses Istanbul, loses Turkey.” President Recep Tayyip Erdogan Turkey’s ruling Justice and Development Party (AKP) has had a tough year. The March 31 local elections – especially the rerun election for mayor of Istanbul – dealt the party its biggest electoral losses since it emerged as the country’s dominant political force in 2002 (Chart 4). The elections came to be seen as a referendum on President Recep Tayyip Erdogan and thus raise the question of whether the party’s strongman leader is in decline – and what that might mean for emerging market investors. Erdogan’s grip on power has long been overrated – it is his vulnerability that has driven him to such extremes of policy over the past decade. The Gezi Park protests of 2013 and the attempted military coup of 2016 revealed significant strains of internal opposition in the aftermath of the Great Recession. Chart 4 With each case of dissent, the AKP responded by stimulating the economy and tightening state control over society (Chart 5). But this strategy faltered last year when monetary policy finally became overextended, the currency collapsed, and the country slid into recession. The opposition finally had its moment. Chart 5 The AKP is less a source of unity. Chart 6 As a consequence, the AKP is less a source of unity among Turkish voters. Both its share of seats in parliament and the overall level of party concentration in the Turkish parliament have declined since 2002 (Chart 6). Were it not for its coalition partner, the Nationalist Movement Party (MHP), the AKP would not have gained a majority in the 2018 parliamentary election. The AKP’s popular base consists of conservative, rural, and religious voters. This bloc is losing influence in parliament relative to centrist and left-wing parties (Chart 7). Moreover, the share of Turks identifying with political Islam, while still the largest grouping, is declining. Those who identify with more secular Turkish nationalism are on the rise (Chart 8). Chart 7 Does this shift entail a major turn in national policy? Will a new party emerge to challenge the AKP at last? Chart 8Secular Nationalism Is On The Rise Secular Nationalism Is On The Rise Secular Nationalism Is On The Rise There has long been speculation that former AKP leaders such as former Turkish president Abdullah Gul, former prime minister Ahmet Davutoglu, and former deputy prime minister Ali Babacan might form a political alternative. The latter resigned from the AKP on July 8, reviving speculation that a rival party could emerge that is capable of combining disillusioned AKP voters with the broader opposition movement at a time when Erdogan’s vulnerability has been made plain. However, the opposition is likely getting ahead of itself. The ruling party still has many tools at its disposal. Its share of seats in parliament is more than double that of the main opposition party, the Republican People’s Party (CHP). It is also viewed favorably in rural areas, and support for Erdogan there will not shift easily. Moreover, despite the negative electoral trend, the AKP has a lot of enthusiasm among its supporters – it is the party with the highest favorability among its own voters (Chart 9). The March election served as a wakeup call for the AKP – a warning not to take its power for granted. Erdogan can still salvage his position. The next election is not due until June 2023, leaving the party with four years to recuperate. While polls for the 2023 parliamentary election paint an ominous sign (Chart 10), they are very early, and the key will be whether Erdogan can divide the opposition and reconnect with his voter base. Above all, this will depend on what changes he makes to economic policy. Chart 9 Chart 10Erdogan Needs To Reconnect With Voter Base Erdogan Needs To Reconnect With Voter Base Erdogan Needs To Reconnect With Voter Base Bottom Line: Erdogan’s and the AKP’s popularity is waning, but it is too soon to write them off. The key question is how Erdogan will handle economic policy now that there are chinks in his armor. Doubling Down On Erdoganomics The fluctuation in the lira “is a U.S.-led operation by the West to corner Turkey … The inflation rate will drop as we lower interest rates.” President Recep Tayyip Erdogan Chart 11 Erdogan needs to see the economy back to recovery in order to secure his success in the next election. A survey conducted early this year reveals that Turks view unemployment, the high cost of living, and the depreciation of the lira as the most significant problems facing Turkey, with 27% of respondents indicating that unemployment is the most important problem facing the country (Chart 11). More importantly, Turks do not have much confidence in the government’s ability to manage this pain – only one-third of respondents viewed economic policies as successful, a 14pp decline from the previous year. This highlights the need for Erdogan to revive confidence in Turkey’s policymaking institutions and to deliver on the economic front.     The key is how Erdogan will handle economic policy. However, it is still too early to call for a sustainable improvement in the Turkish economy as many of the same fundamental imbalances continue to pose risks. While the current account has improved significantly – even registering a surplus in May – the improvement will not endure (Chart 12). On the one hand, the weaker lira has made exports more attractive relative to global competition. However, the improvement in the external balance is in large part due to weaker imports which are now more expensive for Turkey’s residents and have fallen by 19% y/y in 1H2019. Shrinking imports also reflect weak domestic demand which has been weighed down by tight monetary conditions (Chart 13). Chart 12Current Account Improvement Will Not Endure Current Account Improvement Will Not Endure Current Account Improvement Will Not Endure Chart 13Tight Monetary Conditions Weighed On Domestic Demand Tight Monetary Conditions Weighed On Domestic Demand Tight Monetary Conditions Weighed On Domestic Demand What is more, portfolio inflows which in the past were necessary to offset the large current account deficit, have collapsed (Chart 14). Were it not for the improvement in the trade balance, the central bank of the Republic of Turkey (CBRT) would have experienced a pronounced decline in its foreign reserves, and currency pressures would have been significant. A meaningful improvement in investor sentiment – which will remain cautious on the back of economic and geopolitical risks – is a necessary precondition for the return of these inflows. Nevertheless, the current account deficit will likely remain narrow in the second half of the year as the trade balance improves on the back of a weak lira and imports remain depressed due to soft domestic demand. This will keep the lira supported over this period. Although risks from a wide current account deficit have been temporarily put off, years of foreign debt accumulation are a hazard to a sustainable improvement in the lira. Foreign debt obligations (FDO) due over the coming 12 months are extremely elevated at $167 billion (Chart 15). It is not clear that they can be paid off. While the FDO figure is overly pessimistic as some of these debts will be rolled over, net central bank foreign exchange reserves can cover only 2.7% of these obligations. This poses downside risks on the lira at a time when inflows have not yet recovered.1 Moreover, unorthodox economic policies will eventually reverse any improvement in the currency. Chart 14Financial Account Does Not Lend Support Financial Account Does Not Lend Support Financial Account Does Not Lend Support Chart 15FDO Pose A Risk To The Currency FDO Pose A Risk To The Currency FDO Pose A Risk To The Currency While the 4 years between now and the next election could be an opportunity to embark on unpopular structural reforms that will improve the outlook by the time voting season rolls in, Erdogan has instead doubled down on his current strategy. Less than two weeks after the results of the Istanbul election rerun, CBRT governor Murat Cetinkaya was removed by presidential decree. A month later, key CBRT staff were dismissed.2 Chart 16 At his first monetary policy committee meeting as governor on July 25, Murat Uysal slashed the one-week repo rate by 425bps. Given Erdogan’s outspoken distaste for high interest rates, the president’s consolidation of power over economic decision making implies that the outlook for easier monetary policy is now guaranteed. However, the ramifications of this dovish shift will be concerning for voters. The depreciating lira was singled out as the most important economic problem facing Turkey by the largest number of survey respondents (Chart 16). Erdogan’s pursuit of dovish policies despite popular opinion shows that he is doubling down on unorthodox policy despite popular opinion. Monetary easing threatens to unwind the current account improvement and ultimately de-stabilize the lira. Assuming that the banking sector does not hold back the supply of credit to the private sector, lower rates will generate a pickup in demand which will raise imports and widen the current account deficit. Unless there is a marked improvement in investor sentiment – which will remain tainted by the erosion of central bank independence and increased tensions with the West – a return in portfolio inflows to pre-2018 levels is unlikely. As a consequence the lira will begin to soften anew in 2020. The lira will soften anew in 2020. While inflation will subside as the lira stabilizes this year, it will likely remain elevated relative to pre-2018 levels – in the 10% to 15% range. Contrary to Erdoganomics, traditional economic theory postulates that interest rate cuts pose upside pressure on prices. The resurgence in domestic demand will occur against a backdrop of rising wages (Chart 17). Chart 17Price Pressures Will Persist Price Pressures Will Persist Price Pressures Will Persist With foreign currency reserves running low, the CBRT recently adopted several measures to discourage locals from exchanging their liras for foreign currency. These efforts reflect attempts to mitigate the negative impact of monetary easing on the lira, and to ensure FX reserves are supported: A 1-percentage point increase in the reserve requirement ratio for foreign currency deposits and participation funds. A 1-percentage point reduction in the interest rate on dollar-denominated required reserves, reserve options and free reserves held at the bank. An increase in the tax on some foreign exchange sales to 0.1% from zero. These measures make it more expensive for banks to hold foreign currency, incentivizing lira holdings instead. They also raise the CBRT’s foreign reserves highlighting the downside risks on these holdings and the lira. However, given that these measures boost CBRT reserves only superficially – rather than mirroring an improvement in the underlying economic conditions – they highlight that need for policy tightening to defend the lira, even as the CBRT officially pursues an accommodative path. Bottom Line: The Turkish economy will be extremely relevant to Erdogan’s fate in 2023. However with large foreign debt obligations, a rate cutting cycle underway, and foreign investors who remain uneasy, the case for Turkey’s economic recovery – especially amid turbulent global conditions – is weak. In the meantime, Erdogan will continue to blame external factors for the nation’s malaise. Don’t Bet On Trump-Erdogan Friendship “Being Asian and in Asia is as important as being European and in Europe for us.” Turkish Foreign Minister Melvut Cavusoglu For several years Erdogan has attempted to distract the populace from the country’s economic slide by adopting an aggressive foreign policy, particularly toward the West. The immediate cause is Syria, where Turkey has fundamental security interests that clash with those of the U.S. and Europe. But tensions also stem from Erdogan’s economic and political instability. This aggressive foreign policy has not changed in the wake of the AKP’s electoral loss. Erdogan is continuing to test the U.S.’s and EU’s limits and the result is likely to be surprise events, such as U.S.-imposed sanctions, that hurt Turkey’s economy and financial assets. Erdogan clashes with the West both because of substantive regional disagreements and because it plays well domestically. Turks increasingly see the U.S. and other formal NATO allies as a threat, while looking more favorably upon American rivals like Russia, China, Iran, and Venezuela (Chart 18). The U.S., meanwhile, is expanding the use of “secondary sanctions” to impose costs on states that make undesirable deals with its rivals, and Turkey is now in its sights. The reason is Erdogan’s decision to purchase the S400 missile defense system from Russia. This decision exemplifies the breakdown in the U.S.-Turkish alliance and Turkey’s search for alternative partners and allies. The arms sale is likely – eventually – to trigger secondary sanctions under the U.S. International Emergency Economic Powers Act and especially the Countering America’s Adversaries Through Sanctions Act (CAATSA). Washington has already imposed sanctions on China for buying the same weapons from Russia. Erdogan recently accepted the first delivery of components for the S400s, which are supposed to go live by April 2020. He stuck with this decision in disregard of Washington’s warnings. He has a solid base of popular support across political parties for this act of foreign policy and military independence from the U.S. (Chart 19). But the full consequences have not yet been felt. Chart 18 Chart 19 President Trump’s response is muted thus far. He banned Turkish pilots from the U.S. F-35 program and training but has not yet imposed sanctions due to his special relationship with Erdogan and ongoing negotiations over Syria. Syria is the root of the breakdown in Turkish-American relations since 2014. Washington and Ankara have clashed repeatedly over their preferred means of intervening into the Syrian civil war and fighting the Islamic State. The U.S. relies on the Syrian Democratic Forces, led by the Kurdish People’s Protection Units (YPG), which are affiliated with the Kurdistan Workers’ Party (PKK). The PKK is based in Turkey and both the U.S. and Turkey designate it as a “terrorist organization” due to its militant activities in its long-running struggle for autonomy from Turkey. Chart 20 Turkey has intervened in Syria west of the Euphrates River and has repeatedly threatened to conduct deeper strikes against the Kurds. The latter would put U.S. troops in harm’s way and could result in lost leverage for Western forces seeking to maintain their YPG allies and force an acceptable settlement to the Syrian conflict. There is a basis for a deal between Presidents Trump and Erdogan that could keep sanctions from happening. Trump is attempting to wash its hands of Syria to fulfill a promise of limiting U.S. costs in wars abroad. Meanwhile an aggressive intervention in Syria is not a popular option in Turkey, which is why Erdogan has not acted on threats to seize a larger swath of territory (Chart 20). As a result, the U.S. and Turkey recently formed a joint operation center to coordinate and manage “safe zones” for Syrian refugees. If they can manage the gray area on the Turkish-Syrian border, the Trump administration can continue to prepare for withdrawal while preventing Erdogan from taking too much Kurdish territory. The tradeoff is clear, but similar agreements have fallen apart. First, the U.S. Congress is ready to impose sanctions over the S400s and Trump is under pressure to punish Turkey for undermining NATO and dealing with the Russians. Second, the Trump administration has not found an acceptable solution to the Syrian imbroglio that makes full withdrawal possible. If Trump becomes convinced that the risks of a total and rapid withdrawal from Syria are greater than the rewards (as many of his GOP allies staunchly believe), then he has less incentive to protect Erdogan. Meanwhile Erdogan could still decide he needs to plunge deeper into Syria to counteract the YPG. Or he could retaliate against any sanctions over the S400s and provoke a broader tit-for-tat exchange. He has threatened to cancel orders for Boeing aircraft worth $10 billion. Clearly U.S. sanctions will cause the lira to fall and send Turkey into another bout of financial turmoil. In the meantime Turkey’s relations with Europe also pose risks. While the refugee crisis has abated, in great part due to Turkish cooperation, other disagreements are still problematic: The EU is not upgrading Turkey’s customs union and both sides know that Turkey is not eligible for EU membership anytime soon. In response to what the EU has deemed as illegal drilling for oil and gas off the coast of Cyprus, the EU called off high-level political meetings with Turkey and suspended EUR 145.8 million in pre-accession aid. EU foreign ministers have also put off talks on the Comprehensive Air Transport Agreement between the two parties which would have led to an increase in passengers using Turkish airports as a transit hub. In addition, EU ministers asked the European Investment Bank to review its lending activities in Turkey, which amounted to EUR 358.8 million last year. Erdogan is taking a bolder approach to Cyprus. He has decided to send a fourth ship to drill for natural gas in Cyprus’s Exclusive Economic Zone in the Eastern Mediterranean. The purpose is to rally support for his government by calling on the public’s strong allegiance to Turkish Cypriots (Chart 21). The problem is that a confrontation sought as a domestic distraction could provoke negative policy reactions from the EU (or the U.S., which is reconsidering its arms embargo on the Greek Cypriot side). Relations with the West would get worse. Chart 21 Chart 22... But Turkey Cannot Afford To Flout The EU ... But Turkey Cannot Afford To Flout The EU ... But Turkey Cannot Afford To Flout The EU Turkey cannot afford to flout the U.S. and EU. Its economy is dependent on Europe (Chart 22). And the U.S. still underwrites Turkey’s NATO membership and access to the global financial system. The problem is that Erdogan is an ambitious and unorthodox leader and he has clearly wagered that he can rally domestic support through various confrontations with Western policies. This means that for the immediate future the country is more likely to clash with Western nations than it is to recognize its own limits. Political risks are frontloaded and investors should be cautious before trying to snap up the depressed lira or Turkish government bonds. Bottom Line: Tensions with the West – especially the U.S. – will likely lead to economic sanctions. While there is a basis for Presidents Trump and Erdogan to avoid a falling out, it is not reliable enough to underpin a constructive investment position – especially given Erdogan has not changed course in the wake of this year’s significant electoral loss. Investment Conclusions Chart 23Optimism On Lira Amid Unresolved Risks Optimism On Lira Amid Unresolved Risks Optimism On Lira Amid Unresolved Risks The lira has rallied by 3.6% since the Istanbul election. It has risen 0.3% since the replacement of CBRT Governor Murat Cetinkaya and rallied further despite the sacking of the central bank’s chief economist and other high-level staff (Chart 23). Given that the market knows that the central bank reshuffle entails interest rate cuts, is this a clear signal that the lira has hit a firm bottom and cannot fall further? Turkey is more likely to clash with Western nations.  We doubt it. First, Erdogan’s doubling down on unorthodox policy threatens the recovery in the currency and risk assets and his aggressive foreign policy raises the risk of sanctions and further economic pain. Second, although Turkey is not overly exposed to China, it is heavily exposed to Europe, which is on the brink of a full-fledged recession and depends heavily on the Chinese credit cycle – which had another disappointment in July. German manufacturing PMI has been sinking further below the 50 boom-bust mark since the beginning of the year, and the economy contracted in 2Q2019 (Chart 24). Chart 24Global Backdrop Not Yet Supportive Global Backdrop Not Yet Supportive Global Backdrop Not Yet Supportive Chart 25Improvement In Spread Will Be Fleeting Improvement In Spread Will Be Fleeting Improvement In Spread Will Be Fleeting Given these domestic and global economic risks and geopolitical tensions, we expect any improvement in the sovereign spread to be fleeting (Chart 25). While the lira may experience temporary improvement, pressures will re-emerge in 2020 as the lagged impact of Erdogan’s pursuit of growth at all costs re-emerge. Stay on the sidelines as any improvement in the near term is fraught with risk.     Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy roukayai@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Emerging Markets Strategy Weekly Report, “Country Insights: Indonesia, Turkey, And The UAE” May 2, 2019, ems.bcaresearch.com. 2 Among those removed are the central bank’s chief economist Hakan Kara as well as the research and monetary policy general manager, markets general manager, and banking and financial institutions general manager.

Highlights Economic data suggest the current business cycle in China has not yet reached a bottom. Stimulus measures have not been forceful enough to fully offset a slowing domestic economy and weakening global demand. With possibly more U.S. tariffs to come, intensifying political unrest in Hong Kong and a currency set to depreciate further, the potential downside risks outweigh any potential upside over the near term. Investors who are already positioned in favor of Chinese equities should stay long. We are still early in a credit expansionary cycle, and we expect further economic weakness to pave the way for more policy support in China. However, we recommend investors who are not yet invested in Chinese assets to remain on the sidelines until clearer signs of materially stronger stimulus emerge. Feature Chart 1A Breakdown In Chinese Stocks A Breakdown In Chinese Stocks A Breakdown In Chinese Stocks Financial market volatility surged in the first half of the month following U.S. President Donald Trump’s recent tweet, vowing to impose a 10% tariff on the remaining $300 billion of U.S. imports of Chinese goods by September 1st. By the end of last week, prices of China investable stocks relative to global equities had nearly wiped out all their 2019 year-to-date gains. (Chart 1) The extent of the decline has left some investors wondering whether the time has come to bottom-fish Chinese assets. In our view, the answer is no. In this week’s report we detail five reasons why the near-term outlook for China-related assets remains negative. We remain bullish on Chinese stocks over the cyclical (i.e. 6-12 month) horizon and recommend investors who are already positioned in favor of China-related assets stay long. However, we also recommend investors who are not yet invested to remain on the sidelines until surer signs of materially stronger stimulus emerge. As we go to press, the U.S. Trade Representative Office announced that the Trump administration would delay imposing the 10% tariff on a series of consumer goods imported from China — including laptops and cell phones — until December.1 Stocks in the U.S. surged on the news. Today’s rally in the equity market highlights our view, that short-term market performance can be dominated and distorted by news on the trade front. However, market rallies based on headline news will not sustain without the support of economic fundamentals. Reason #1: Chinese Economic Growth Has Not Yet Bottomed In a previous China Investment Strategy report,2  we presented some simple arithmetic to help investors formulate their outlook on the Chinese economy. We argued that in a full-tariff scenario, investors should focus on the likely outcome of one of the two following possibilities: Scenario 1 (Bullish): Effects of Stimulus – Impact of Tariff Shock > 0 Scenario 2 (Bearish): Effects of Stimulus – Impact of Tariff Shock ≤ 0 In scenario 1, the impact of China’s reflationary efforts more than offsets the negative shock to aggregate demand from the sharp decline in exports to the U.S. Scenario 2 denotes an outcome where China’s reflationary response is not larger than the magnitude of the shock. For now, we remain in scenario 2 due to Chinese policymakers’ continual reluctance to allow the economy to re-leverage. The magnitude of the credit impulse so far has been “half measured” relative to previous cycles.3  More than seven months into the current credit expansionary cycle, Chinese economic data have not yet exhibited a clear bottom. As a result, more than seven months into the current credit expansionary cycle, Chinese economic data have not yet exhibited a clear bottom, with the main pillars supporting China’s “old economy” still in the doldrums (Chart 2 and Chart 3). Chart 2No Clear Bottom, Yet No Clear Bottom, Yet No Clear Bottom, Yet Chart 3Key Economic Drivers Struggling To Trend Higher Key Economic Drivers Struggling To Trend Higher Key Economic Drivers Struggling To Trend Higher   In addition to a weakening domestic economy, China’s external sector has been weighed down by U.S. import tariffs as well as slowing global demand. (Chart 4).  The possibility of adding a 10% tariff by year end on the remaining $300 billion of Chinese goods exports to the U.S. may trigger another tariff “front-running” episode in the 3rd quarter. However, Chart 5 and Chart 6 highlight that any front-running would be against the backdrop of sluggish global demand. Therefore, not only the upside in Chinese export growth will be very limited in the subsequent months following the front-running, but export growth is also likely to fall deeper into contraction. Chart 4Domestic Demand More Concerning Than Exports Domestic Demand More Concerning Than Exports Domestic Demand More Concerning Than Exports Chart 5Pickup In Global Demand Not Yet Visible Pickup In Global Demand Not Yet Visible Pickup In Global Demand Not Yet Visible Chart 6Bottoming In Global Manufacturing Also Delayed Bottoming In Global Manufacturing Also Delayed Bottoming In Global Manufacturing Also Delayed Reason # 2: A-Shares Are Not Yet Signaling A Sizeable Policy Response Chart 7 In previous China Investment Strategy reports, we have written at length about how Chinese policymakers are reluctant to undo their financial deleveraging efforts and push for more stimulus. After incorporating July credit data, our credit impulse, at a very subdued 26% of nominal GDP, was in fact a pullback from June’s credit growth number (Chart 7). This confirms our view that the current stimulus is clearly falling short compared to the 2015-2016 credit expansionary cycle. It underscores Chinese policymakers’ commitment to keep their foot off the stimulus pedal. What’s more, the recent performance of China’s domestic financial markets has been consistent with a half-measured credit response, and is not yet signaling a meaningful change in China’s policy stance. The A-share market since last summer has been trading off of the likely policy response to the trade war. Chart 8Market Not Signaling Significant Policy Shift Market Not Signaling Significant Policy Shift Market Not Signaling Significant Policy Shift Chart 8 (top panel) shows that the A-share market has closely tracked China’s domestic credit growth over the past year. Given this, we believe that the A-share market is reacting more to the likely policy response to the trade war, in contrast to the investable market which rises and falls in near-lockstep with trade-related news (middle panel). The fact that A-share stocks have been trending sideways underscores that China’s domestic equity market continues to expect “half measured” stimulus. This week’s sharp decline in China’s 10-year government bond yield is in part related to escalating political unrest in Hong Kong (bottom panel), and in our view does not yet signal any major change in the PBOC’s stance. Finally, our corporate earnings recession probability model provides another perspective on the equity market implications of the current path of stimulus. If the current size of stimulus holds through the end of 2019, our model suggests that the probability of an outright contraction in corporate earnings lasting through year end remains quite elevated, at close to 50% (first X in Chart 9). The July Politburo statement signaled a greater willingness to stimulate the economy; as a result, we are penciling in a slightly more optimistic scenario on forthcoming credit growth through the remainder of the year, by adding 300 billion yuan of debt-to-bond swaps4 and 800 billion yuan of extra infrastructure spending5 to our baseline estimate for the rest of 2019. However, this would only add a credit impulse equivalent of 1 percentage point of nominal GDP and would only marginally reduce the probability of an earnings recession to 40% (second X in Chart 9). A 40% chance of an earnings recession is well above “normal” levels that would be consistent with a durable uptrend in stock prices, and in previous cycles, Chinese stock prices picked up only after business cycles and corporate earnings had bottomed (Chart 10). In sum, the current pace of credit growth, signals from the domestic equity market, and our earnings recession model all suggest that it is too early to bottom fish Chinese stocks. Chart 9A "Measured" Pickup in Stimulus Will Not Be A Game Changer A "Measured" Pickup in Stimulus Will Not Be A Game Changer A "Measured" Pickup in Stimulus Will Not Be A Game Changer Chart 10Too Early To Bottom Fish Too Early To Bottom Fish Too Early To Bottom Fish Reason #3: The Trade War Is Far From Over Our Geopolitical Strategy team maintains that the U.S. and China have only a 40% chance of concluding a trade agreement by November 2020, and that any trade truce is likely to be shallow.6 We agree with this assessment, which has clear negative near-term implications for Chinese investable stocks, even if temporary rallies such as what took place yesterday periodically occur. Since the onset of the trade war, Chinese investable stocks appear to have traded nearly entirely in reaction to trade-related events. Hence, until global investors are given proof that much stronger stimulus can and will offset the impact of the trade war on corporate earnings, Chinese stocks are likely to continue to underperform their global peers. Reason #4: The Hong Kong Crisis Is A Near-Term Risk Another near-term catalyst for financial market turbulence in China is the worsening situation in Hong Kong. For now, we hold the view that a full-blown crisis (i.e. China intervening with military force) can be avoided, but we are not ruling out the possibility of a severe escalation or its potential impact on market sentiment towards Chinese assets.  On the surface, China investable stocks (the MSCI China Index, the predominantly investable index that now includes some mainland A-shares) are not directly linked to businesses in Hong Kong: Out of the top 10 constituents of the MSCI China Index, which account for roughly 50% of the index’s market capitalization, seven are headquartered in mainland China and do not appear to have significant revenue exposure to Hong Kong. By contrast, at least 30% of Hang Seng Index-listed companies have business operations in Hong Kong. The remaining three companies in the top 10 MSCI China Index are Tencent (the largest component of the index, with a weight of approximately 15%), Ping An Insurance (4% weight), and China Mobile (3% weight) – all of which registered large losses in the past week. Both Tencent and Ping An Insurance are headquartered in Shenzhen, a southeastern China metropolis that links Hong Kong to mainland China. China Mobile appears to have the most revenue exposure to Hong Kong of any top constituent through its CMHK subsidiary, which is the largest telecommunications provider in Hong Kong. It is true that there has been little evidence so far that Chinese investable stocks have been more impacted by the escalation in political unrest in Hong Kong than by the escalation in the trade war. Indeed, the fact that the two escalations were overlapping this past week makes it difficult to isolate their effects. But if unrest in Hong Kong spirals out of control, it could result in mainland China intervening. According to an analysis done by BCA’s Geopolitical Strategy team,6 the deployment of mainland troops would likely lead to casualties and could trigger sanctions from western countries. The 1989 Tiananmen Square incident shows that such an event could lead to a non-negligible hit to domestic demand and foreign exports under sanctions. Should this to occur, the near-term idiosyncratic risk to Chinese stocks in both onshore and offshore markets will be significant. Reason #5: Further RMB Depreciation May Weigh On Stock Prices Whether due to manipulation or market forces, last week’s depreciation in the Chinese currency (RMB) was economically justified and long overdue. Chart 11RMB Depreciation Long Overdue RMB Depreciation Long Overdue RMB Depreciation Long Overdue Chart 11 shows the close relationship between the U.S.-China one-year swap rate differential and the USD/CNY exchange rate. The true source of the correlation shown in the chart remains somewhat of a mystery, given that Chinese capital controls, particularly following the 2015 devaluation episode, prevent the arbitrage activities that link rate differentials and exchange rates in economies with fully open capital accounts. However, Chart 11 clearly shows that China’s currency would have already weakened by now if it was fully market-driven, and we do not believe that the People’s Bank of China will be inclined to tighten monetary policy in order to reverse the recent devaluation. Hence, the path of least resistance for the CNY is further depreciation.  If the threatened 10% tariff on all remaining U.S. imports from China is imposed this year, our back-of-the-envelope calculation based on Chart 12 suggests that a market-driven “equilibrium” USD/CNY exchange rate should be at around 7.6. We have high conviction, based on previous RMB devaluation episodes, that China’s central bank will not allow its currency to depreciate in a manner that invites speculation of meaningful further weakness – meaning we are not likely to see a straight-lined or rapid depreciation down to the 7.6 mark. Chart 12Market Driven 'Equilibrium' Provides Some Guidance On The Exchange Rate Market Driven 'Equilibrium' Provides Some Guidance On The Exchange Rate Market Driven 'Equilibrium' Provides Some Guidance On The Exchange Rate A “managed” currency depreciation is in and of itself stimulative for the Chinese economy. At the same time, aggressive market intervention via the PBoC burning through its foreign exchange reserves is also unlikely: A “managed” currency depreciation is in and of itself stimulative for the economy. It improves Chinese export goods’ price competitiveness and helps mitigate some of the pain caused by increased tariffs. Therefore it is in the PBoC’s every interest to allow such depreciation. However, no matter how “orderly” RMB depreciation may be, the fact that the PBoC has signaled it is no longer defending a “line in the sand” exchange-rate mark is likely to trigger another round of “race to the bottom” currency devaluation from other regional, export-dependent economies.7 A weaker RMB and emerging market currencies will also contribute to USD strength. A strong dollar has been negatively correlated with global risky assets, implying that for a time, a weaker RMB will be a risk-off event for risky assets and thus presumably for Chinese and EM equity relative performance. Investment Implications Our analysis above highlights that the near-term outlook for Chinese stocks is fraught with risk, and it is for this reason that we recommended an underweight tactical position in Chinese stocks for the remainder of the year in our July 24 Weekly Report.8 However, by next summer (the tail-end of our cyclical investment horizon), it is our judgement that one of two things will have likely occurred: The trade war with the U.S. will have abated or been called off, and investors will have determined that a “half-strength” credit cycle is likely enough to stabilize Chinese domestic demand and the earnings outlook. In this scenario, Chinese stocks are likely to rise US$ terms over the coming year, relative to global stocks. The trade war with the U.S. will have continued, and Chinese policymakers will have acted on the need to stimulate aggressively further in order to stabilize domestic demand. In combination with an ultimately stimulative (although near-term negative) decline in the RMB, the relative performance of Chinese stocks versus the global benchmark will likely be higher in hedged currency terms. Because of the near-term risks to the outlook, we agree that investors who are not yet invested should remain on the sidelines until surer signs of materially stronger stimulus emerge. But investors who are already positioned in favor of Chinese equities should stay long, and should bet on the latter scenario: rising relative Chinese equity performance in local currency terms, alongside a falling CNY-USD / appreciating USD-CNY exchange rate.   Jing Sima  China Strategist JingS@bcaresearch.com   Footnotes 1      “US to delay some tariffs on Chinese goods”, Financial Times, August 13, 2019. 2      Please see China Investment Strategy Weekly Report, “Simple Arithmetic”, dated May 15, 2019, available at cis.bcaresearch.com. 3      Please see China Investment Strategy Weekly Reports, “Threading A Stimulus Needle (Part 1): A Reluctant PBoC”, dated July 10, 2019, and “Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?”, dated July 24, 2019, available at cis.bcaresearch.com. 4      The remaining of 14 trillion debt-to-bond swap program rounds up to 315 billion yuan. 5      The relaxed financing requirement for infrastructure projects can add 800 billion yuan. 6      Please see Geopolitical Strategy Weekly Report, “The Rattling Of Sabers”, dated August 9, 2019, available at gps.bcaresearch. 7      Please see Emerging Markets Strategy Weekly Report, “The RMB: Depreciation Time?”, dated May 23, 2019, available at ems.bcaresearch.com. 8      Please see China Investment Strategy Weekly Report, Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?”, dated July 24, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: Hawkish trade policy will continue to weigh on bond yields for at least the next few months, but a rebound in global economic growth should take hold before the end of the year. Ultimately, a growth rebound will lead to higher bond yields on a 12-month horizon, but the timing is difficult and investors should keep portfolio duration close to benchmark for the time being. High-Yield: The Fed’s accommodative policy stance and the likelihood of a global growth recovery argue for maintaining an overweight allocation to corporate credit. Within that allocation, junk bonds should outperform investment grade due to much more attractive valuations. 10-Year Treasury Yield: The current shock to global economic growth is of a similar magnitude to the one that occurred in 2015/16. However, wage and inflationary pressures are higher now than they were back then. This means that the 10-year Treasury yield will not re-visit the 2016 trough of 1.37%, and is probably already close to its floor. Feature Regular readers will be aware of our Fed Policy Loop framework for analyzing the wiggles in financial markets. The Loop works as follows: Step 1: A dovish shift in Fed policy leads to a favorable market reaction, easing financial conditions. Step 2: Easier financial conditions suggest to the Fed that economic growth will strengthen in the future. The Fed can therefore respond by adopting a more hawkish policy stance. Step 3: The Fed’s hawkish policy shift leads to a negative market reaction, tightening financial conditions. Step 4: Tighter financial conditions suggest to the Fed that economic growth will weaken in the future. The Fed is forced to ease monetary policy at the margin. Return to Step 1 But it appears that BCA readers aren’t the only ones aware of the Fed Policy Loop. President Trump has also been exploiting the two-way relationship between Fed policy and financial conditions as he escalates his trade war with China. Chart 1 illustrates how this has been working. Step 1 of the Fed policy loop continues to function exactly as described above. However, the last few times that financial conditions have eased, the President has seized the opportunity to ratchet up trade tensions. Much like the Fed, the President reasons that periods of easier financial conditions are when the economy and financial markets can best handle a negative shock. The fall-out is that financial conditions tighten in response to the hawkish trade announcement, and the Fed is forced to respond to tighter financial conditions by turning even more dovish. Chart 1 The end result is that the part of the Fed Policy Loop labeled “Hawkish Fed” is by-passed. Without that step it is impossible for bond yields to rise (Chart 2). Chart 2The Back-Drop Of The Interrupted Fed Policy Loop The Back-Drop Of The Interrupted Fed Policy Loop The Back-Drop Of The Interrupted Fed Policy Loop Our Geopolitical Strategy service provided a comprehensive breakdown of U.S./China trade negotiations in last week’s report.1 The overall message is that the 2020 election is the President’s main constraint. He views hawkish trade policy as a winning issue, but only insofar as it can be accomplished without a significant decline in the stock market or economic activity. Faced with that constraint, the President will continue to interrupt the Fed Policy Loop, and the Fed will continue to do its job by adopting a more dovish monetary policy to offset possible trade shocks. At present, this means that another rate cut is likely in September. Against the back-drop of the “interrupted” Fed Policy Loop, Treasury yields can only move higher if global economic growth strengthens. In that case, the policy loop will remain operative, but at an overall higher level of yields. With that in mind, while hawkish trade policy will continue to weigh on bond yields for at least the next few months, a rebound in global economic growth should take hold before the end of the year. This will lead to higher bond yields on a 12-month horizon. Still Tracking The 2015/16 Roadmap In our research, we have repeatedly pointed out the similarities between the 2015/16 episode of flagging global growth and the current period. Specifically, we continue to witness weak manufacturing data – both in the U.S. and abroad – but a resilient service sector and strong labor market. Much like in 2015/16, we expect that the shifts toward easier monetary policy in the U.S. and more accommodative credit conditions in China will eventually put a floor under the global manufacturing cycle. The Fed will continue to do its job by adopting a more dovish monetary policy to offset possible trade shocks. At present, this means that another rate cut is likely in September. Case in point, even as President Trump has tightened global financial conditions at the margin through his hawkish trade policy, overall global financial conditions have eased since the beginning of the year (Chart 3). In 2016, easier financial conditions eventually led to upturns in crucial measures of global growth such as the Goldman Sachs Current Activity Indicator (Chart 3, top panel), the Global Manufacturing PMI (Chart 3, panel 2), and the CRB Raw Industrials index (Chart 3, bottom panel). The same dynamic should play out this time around. It’s likely that the main reason why global growth has not responded as quickly as it did in 2016 is that Chinese policy easing has not been as rapid (Chart 4). Our China Investment Strategy service’s Li Keqiang Leading Indicator – a composite measure of money and credit indicators designed to lead Chinese economic activity – has clearly bottomed, but has not yet surged as it did in 2015/16. However, Chinese policy easing continues to ramp up, a process that will continue in the months ahead. The most recent indication of this trend was China’s decision to de-value its currency versus the U.S. dollar, causing the exchange rate to jump above the important psychological threshold of 7 yuan per dollar (Chart 4, bottom panel). China took similar measures to de-value its currency in August 2015, a move that initially roiled markets but eventually helped usher in a rebound in global growth. Chart 3The 2015/2016 Scenario Has Yet To Play Out... The 2015/2016 Scenario Has Yet To Play Out... The 2015/2016 Scenario Has Yet To Play Out... Chart 4...As Long As China Does Not Stimulate More ...As Long As China Does Not Stimulate More ...As Long As China Does Not Stimulate More When it comes to strategy, we remain confident that global growth is close to a trough, but admit that timing the rebound is difficult. One indicator that should help with timing is the ratio between the CRB Raw Industrials index and Gold (Chart 5). This ratio is tightly correlated with the 10-year Treasury yield, and will only rise when the perceived improvement in global growth – proxied by the CRB index – starts to outpace the perceived dovish tilt to Fed policy – proxied by the rising gold price. Chart 5Keep Tracking The CRB / Gold Ratio Keep Tracking The CRB / Gold Ratio Keep Tracking The CRB / Gold Ratio In light of these difficulties with timing, we recommend that investors keep portfolio duration close to benchmark, but position for a rebound in global growth by maintaining an overweight allocation to credit risk and by running a heavily barbelled Treasury portfolio, overweighting the long and short ends of the curve while avoiding the 5-year and 7-year maturities. The barbell strategy increases average portfolio yield, and also avoids the part of the yield curve that will suffer the most when yields rise. Take Credit Risk In Junk As mentioned above, we recommend that investors maintain an overweight allocation to corporate credit versus Treasuries, despite our recent shift to benchmark duration.2 This is particularly true for high-yield bonds, where spreads are very attractive. Charts 6A and 6B show one of our favorite ways of looking at corporate bond spreads. The charts show the 12-month breakeven spread for each credit tier as a percentile rank relative to history.3 We show each credit tier individually to control for the time-varying average credit rating of the overall indexes. Similarly, we show breakeven spreads instead of the average option-adjusted spreads to control for the time-varying average duration of the bond indexes. Chart 6A shows the following valuation for investment grade credit tiers: Throughout history, Aaa credits have been more expensive than they are today only 13% of the time. Aa credits have been more expensive than they are today 19% of the time. A-rated credits have been more expensive 20% of the time. Baa credits have been more expensive 33% of the time. Chart 6B shows that the corresponding valuation for high-yield is much more compelling: Ba credits have been more expensive than today 55% of the time. B credits have been more expensive 81% of the time. Caa credits have been more expensive 84% of the time. Chart 6AInvestment Grade Breakeven Spreads Investment Grade Breakeven Spreads Investment Grade Breakeven Spreads Chart 6BHigh-Yield Breakeven Spreads High-Yield Breakeven Spreads High-Yield Breakeven Spreads In general, this way of looking at spreads shows that investment grade credits are quite expensive, while high-yield credits are either fairly valued or cheap. However, there is one more adjustment we can make to get an even better picture of corporate bond value. Adjusting For The Phase Of The Cycle A useful tool for cyclical portfolio allocation is to split the cycle into three phases based on the slope of the yield curve (Chart 7). We define the three phases as: Chart 7The Three Phases Of The Cycle The Three Phases Of The Cycle The Three Phases Of The Cycle Phase 1: From the end of the last recession until the 3/10 Treasury slope flattens to below 50 bps. Phase 2: When the 3/10 slope is between 0 bps and +50 bps. Phase 3: From when the 3/10 slope inverts until the start of the next recession. We have previously discussed the implications of the different phases for bond portfolio allocation in more depth.4 This week, we simply want to point out that credit spreads tend to be tighter during Phase 2 of the cycle, when monetary policy has tightened, but not by enough to cause a surge in corporate defaults. The recent surge in investment grade net debt-to-EBITDA likely reflects the shift toward a greater concentration of Baa-rated issuers. With this cyclical decomposition in mind, we can calculate the median breakeven spread for each credit tier in past Phase 2 periods and use that as a spread target for this cycle. We then convert our breakeven spread targets into average option-adjusted spread targets using current index duration. Charts 8A and 8B show how far each credit tier’s spreads are from target. The message is quite clear. Outside of Aaa, investment grade credits are more or less fairly valued, while high-yield credits appear very cheap. Chart 8AInvestment Grade Spread Targets Investment Grade Spread Targets Investment Grade Spread Targets Chart 8BHigh-Yield Spread Targets High-Yield Spread Targets High-Yield Spread Targets One might reasonably challenge this approach to corporate bond valuation by noting that, outside of looking at credit tiers individually, we have not taken fundamental credit quality trends into account. That is, we have made no adjustment for the fact that the credit quality of a Ba-rated issuer might be worse today than in prior cycles. We are skeptical that fundamental credit metrics matter more than the phase of the monetary policy cycle when it comes to corporate bond spread forecasting.5 However, this point of view is still worth exploring, especially considering that net debt-to-EBITDA for the median corporate bond issuer is quite elevated compared to history (Chart 9). Note that we have not attempted to maintain consistent weightings between the different credit tiers in the bottom-up samples shown in Chart 9. This means that the recent surge in investment grade net debt-to-EBITDA likely reflects the shift toward a greater concentration of Baa-rated issuers. Nonetheless, the net debt-to-EBITDA ratio of the median junk issuer is clearly worse than during the past two recoveries. But even if we take this into account by looking at the ratio between the junk index 12-month breakeven spread and the median net debt-to-EBITDA, we see that the ratio is still close to its historical median (Chart 10). In other words, at current spread levels junk investors appear reasonably compensated for the elevated median net debt-to-EBITDA ratio Chart 9Elevated Corporate Leverage Elevated Corporate Leverage Elevated Corporate Leverage Chart 10Favor Junk Bonds Favor Junk Bonds Favor Junk Bonds Bottom Line: The Fed’s accommodative policy stance and the likelihood of a global growth recovery argue for maintaining an overweight allocation to corporate credit. Within that allocation, junk bonds should outperform investment grade due to much more attractive valuations. Close To The Floor Chart 11Now Vs. Mid-2016 Now Vs. Mid-2016 Now Vs. Mid-2016 In a prior report we walked through the process of creating a macroeconomic fair value model for the 10-year Treasury yield, with a focus on describing the different independent variables that might be included in such a model, and the rationale for each one.6 This week, we focus on two vital macroeconomic variables and use them to demonstrate why the 10-year Treasury yield is unlikely to re-visit its mid-2016 trough of 1.37%. The two main variables we focus on are (i) the pace of economic growth, and (ii) the size of the output gap. All else equal, a stronger pace of economic growth leads to expectations for a higher policy rate in the future and a higher 10-year Treasury yield today. However, it is not just the pace of growth that matters. The same rate of economic growth generates more inflationary pressure when the output gap is small than when it is large. This means that bond yields should be higher when the output gap is smaller (or more specifically, less negative). We have found that the Global Manufacturing PMI is probably the indicator of economic growth that correlates best with the 10-year Treasury yield. Similarly, measures of wage growth – and to a lesser extent core inflation – tend to give the best read on the output gap. With that in mind, we can see how these factors look today relative to when the 10-year yield troughed at 1.37% in mid-2016 (Chart 11). Global economic growth looks slightly worse, but not dramatically so. The Global Manufacturing PMI is at 49.3 today. It troughed at 49.9 in 2016. If this were the only variable that mattered, we might reason that the 10-year yield should be below 1.37% already. But we also need to consider that wage growth and inflation are both much higher than in 2016. Average hourly earnings are growing at a year-over-year rate of 3.2%, compared to a rate of 2.8% when the 10-year troughed in 2016. Similarly, the Atlanta Fed’s measure of median wage growth is up to 3.7% for the un-weighted sample and 3.9% for the sample that is weighted to more closely match the demographic characteristics of the overall population (Chart 11, panel 3). It’s true that core PCE inflation is running below where it was in mid-2016, but the trimmed mean measure is much higher (Chart 11, bottom panel). The core PCE inflation measure also has a strong track record of converging toward the trimmed mean, a process we expect is playing out again. The core PCE inflation measure also has a strong track record of converging toward the trimmed mean, a process we expect is playing out again. Bottom Line: The current shock to global economic growth is of a similar magnitude to the one that occurred in 2015/16. However, wage and inflationary pressures are higher now than they were back then. This means that the 10-year Treasury yield will not re-visit the 2016 trough of 1.37%, and is probably already close to its floor.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Weekly Report, “The Rattling Of Sabers”, dated August 9, 2019, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy Portfolio Allocation Summary, “Underinsured”, dated August 6, 2019, available at usbs.bcaresearch.com 3 The 12-month breakeven spread is the basis point widening required on a 12-month horizon for each credit tier to break even with a duration-matched position in Treasuries. 4 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, “The Risk From U.S. Corporate Debt: Theory And Evidence”, dated April 23, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

This Monday we published a Special Report by Matt Gertken, Chief Geopolitical Strategist where Matt takes a dive into implications of the U.S.-Iran hot and U.S.-China cold wars.  What follows is a snipped of the investment conclusions and a road map for what to expect in the future: If the U.S. continues the pivot to Asia, and the U.S. and China proceed with tariffs, tech sanctions, saber-rattling, diplomatic crises, and possibly even military skirmishes, China will be forced into an abrupt and destabilizing economic transition. The U.S. dollar will strengthen as global growth decelerates. Developed market equities will outperform emerging market equities, but equities as a whole will underperform sovereign bonds and other safe-haven assets. Our highest conviction call on this matter is that any trade deal before the U.S. 2020 election will be limited in scope (see Diagram). It will fall far short of a “Grand Compromise” that ushers in a new era of U.S.-China engagement – and hence it will be a disappointment to global equities. Please refer to our most recent Special Report for a full discussion of the U.S.-China and U.S.-Iran tensions. Chart 1

Dear Client, Instead of our regular report, this week we are sending you a Special Report penned by Matt Gertken, Chief Geopolitical Strategist of our sister Geopolitical Strategy service, titled “The Polybius Solution.” In this report Matt argues that a full-fledged cold war with China would put a cap on American political polarization, putting China at a disadvantage. By contrast, a U.S. war with Iran would exacerbate polarization, giving China a huge strategic opportunity. We trust that you will find this Special Report useful and insightful. Best regards, Anastasios Avgeriou, U.S. Equity Strategist Highlights So What? U.S.-Iran risk is front-loaded, but U.S.-China is the greater risk overall. A full-fledged cold war with China will put a cap on American political polarization, putting China at a disadvantage. By contrast, a U.S. war with Iran would exacerbate polarization, giving China a huge strategic opportunity. War with Iran or trade war escalation with China are both ultimately dollar bullish – even though tactically the dollar may fall.  Feature The idea of the “Thucydides Trap” has gone viral in recent years – for good reason. The term, coined by Harvard political scientist Graham Allison, refers to the ancient Greek historian Thucydides (460-400 BC), author of the seminal History of the Peloponnesian War. The “trap” is the armed conflict that most often develops when a dominant nation that presides over a particular world order (e.g. Sparta, the U.S.) faces a young and ambitious rival that seeks fundamental change to that order (e.g. Athens, China).1 This conflict between an “established” and “revisionist” power was highlighted by the political philosopher Thomas Hobbes in his translation of Thucydides in the seventeenth century; every student of international relations knows it. Allison’s contribution is the comparative analysis of various Thucydides-esque episodes in the modern era to show how today’s U.S.-China rivalry fits the pattern. The implication is that war (not merely trade war) is a major risk. We have long held a similar assessment of the U.S.-China conflict. It is substantiated by hard data showing that China is gaining on America in various dimensions of power (Chart 1). Assuming that the U.S. does not want to be replaced, the current trade conflict will metastasize to other areas. If the U.S. and China really engage in an epic conflict, American political polarization should fall. There is an important but overlooked corollary to the Thucydides Trap: if the U.S. and China really engage in an epic conflict, American political polarization should fall. Polarization fell dramatically during the Great Depression and World War II and remained subdued throughout the Cold War. It only began to rise again when the Soviet threat faded and income inequality spiked circa 1980. Americans were less divided when they shared a common enemy that posed an existential threat; they grew more divided when their triumph proved to benefit some disproportionately to others (Chart 2). Chart 1China Is Gaining On The U.S. China Is Gaining On The U.S. China Is Gaining On The U.S. Chart 2U.S. Polarization Falls During Crisis U.S. Polarization Falls During Crisis U.S. Polarization Falls During Crisis   If the U.S. and China continue down the path of confrontation, a similar pattern is likely to emerge in the coming years – polarization is likely to decline. China possesses the raw ability to rival or even supplant the United States as the premier superpower over the very long run. Its mixed economy is more sustainable than the Soviet command economy was, and it is highly integrated into the global system, unlike the isolated Soviet bloc. As long as China’s domestic demand holds up and Beijing does not suppress its own country’s technological and military ambitions, Trump and the next president will face a persistent need to respond with measures to limit or restrict China’s capabilities. Eventually this will involve mobilizing public opinion more actively. Further, if the U.S.-China conflict escalates, it will clarify U.S. relations with the rest of the world. For instance, Trump’s handling of trade suggests that he could refrain from trade wars with American allies to concentrate attention on China, particularly sanctions on its technology companies. Meanwhile a future Democratic president would preserve some of these technological tactics while reinstituting the multilateral approach of the Barack Obama administration, which launched the “Pivot to Asia,” the Trans-Pacific Partnership, and intensive freedom of navigation operations in the South China Sea. These are all aspects of a containment strategy that would reinforce China’s rejection of the western order. Bottom Line: If the White House, any White House, were to pursue a consistent strategy to contain China, the result would be a major escalation of the trade conflict that would bring Americans together in the face of a common enemy. It would also encourage the U.S. to form alliances in pursuit of this objective. So far these things have not occurred, but they are logical corollaries of the Thucydides Trap and they will occur if the Thucydides thesis is validated. How Would China Fare In The Thucydides Trap? China would be in trouble in this scenario. The United States, if the public unifies, would have a greater geopolitical impact than it currently does in its divided state. And a western alliance would command still greater coercive power than the United States acting alone (Chart 3). External pressure would also exacerbate China’s internal imbalances – excessive leverage, pollution, inefficient state involvement in the economy, poor quality of life, and poor governance (Chart 4). China has managed to stave off these problems so far because it has operated under relative American and western toleration of its violations of global norms (e.g. a closed financial system, state backing of national champions, arbitrary law, censorship). This would change under concerted American, European, and Japanese efforts. Chart 3China Fears A Western 'Grand Alliance' China Fears A Western 'Grand Alliance' China Fears A Western 'Grand Alliance' Chart 4China's Domestic Risks Underrated China's Domestic Risks Underrated China's Domestic Risks Underrated Concerted external pressure would make it harder for China to manage its internal imbalances. How would the Communist Party respond? First, it could launch long-delayed and badly needed structural reforms and parlay these as concessions to the West. The ramifications would be negative for Chinese growth on a cyclical basis but positive on a structural basis since the reforms would lift productivity over the long run – a dynamic that our Emerging Markets Strategy has illustrated, in a macroeconomic context, in Diagram 1. This is already an option in the current trade war, but China has not yet clearly chosen it – likely because of the danger that the U.S. would exploit the slowdown. Diagram 1Foreign Pressure And Structural Reform = Short-Term Pain For Long-Term Gain The Polybius Solution The Polybius Solution Alternatively the Communist Party could double down on confrontation with the West, as Russia has done. This would strengthen the party’s grip but would be negative for growth on both a cyclical and structural basis. The effectiveness of China’s fiscal-and-credit stimulus would likely decline because of a drop in private sector activity and sentiment – already a nascent tendency – while the lack of “reform and opening up” would reduce long-term growth potential. This option makes structural reforms look more palatable – but again, China has not yet been forced to make this choice. None of the above is to say that the West is destined to win a cold war with China, but rather that the burden of revolutionizing the global order necessarily falls on the country attempting to revolutionize it. Bottom Line: If the Thucydides Trap fully takes effect, western pressure on China’s economy will force China into a destabilizing economic transition. China could lie low and avoid conflict in order to undertake reforms, or it could amplify its aggressive foreign policy. This is where the risk of armed conflict rises. Introducing … The Polybius Solution The problem with the above is that there is no sign of polarization abating anytime soon in the United States. Extreme partisanship makes this plain (Chart 5). Rising polarization could prevent the U.S. from responding coherently to China. The Thucydides Trap could be avoided, or delayed, simply because the U.S. is distracted elsewhere. The most likely candidate is Iran. Chart 5 A lesser known Greek historian – who was arguably more influential than Thucydides – helps to illustrate this alternative vision for the future. This is Polybius (208-125 BC), a Greek who wrote under Roman rule. He described the rise of the Roman Empire as a result of Rome’s superior constitutional system. Polybius explains domestic polarization whereas Thucydides explains international conflict. Polybius took the traditional view that there were three primary virtues or powers governing human society: the One (the king), the Few (the nobles), and the Many (the commons). These powers normally ran the country one at a time: a dictator would die; a group of elites would take over; this oligarchy would devolve into democracy or mob-rule; and from the chaos would spring a new dictator. His singular insight – his “solution” to political decay – was that if a mixture or balance of the three powers could be maintained, as in the Roman republic, then the natural cycle of growth and decay could be short-circuited, enabling a regime to live much longer than its peers (Diagram 2). Diagram 2Polybius: A Balanced Political System Breaks The Natural Cycle Of Tyranny And Chaos The Polybius Solution The Polybius Solution In short, just as post-WWII economic institutions have enabled countries to reduce the frequency and intensity of recessions (Chart 6), so Polybius believed that political institutions could reduce the frequency and intensity of revolutions. Eventually all governments would decay and collapse, but a domestic system of checks and balances could delay the inevitable. Needless to say, Polybius was hugely influential on English and French constitutional thinkers and the founders of the American republic. Chart 6Orthodox Economic Policy Has Made Recessions Less Frequent And Less Acute Orthodox Economic Policy Has Made Recessions Less Frequent And Less Acute Orthodox Economic Policy Has Made Recessions Less Frequent And Less Acute What is the cause of constitutional decay, according to Polybius? Wealth, inequality, and corruption, which always follow from stable and prosperous times. “Avarice and unscrupulous money-making” drive the masses to encroach upon the elite and demand a greater share of the wealth. The result is a vicious cycle of conflict between the commons and the nobles until either the constitutional system is restored or a democratic revolution occurs. Compared to Thucydides, Polybius had less to say about the international balance of power. Domestic balance was his “solution” to unpredictable outside events. However, states with decaying political systems were off-balance and more likely to be conquered, or to overreach in trying to conquer others. Bottom Line: The “Polybius solution” equates with domestic political balance. Balanced states do not allow the nation’s leader, the elite, or the general population to become excessively powerful. But even the most balanced states will eventually decline. As they accumulate wealth, inequality and corruption emerge and cause conflict among the three powers. Why Polybius Matters Today It does not take a stretch of the imagination to apply the Polybius model to the United States today. Just as Rome grew fat with its winnings from the Punic Wars and decayed from a virtuous republic into a luxurious empire, as Polybius foresaw, so the United States lurched from victory over the Soviet Union to internal division and unforced errors. For instance, the budget surplus of 2% of GDP in the year 2000 became a budget deficit of 9% of GDP after a decade of gratuitous wars, profligate social spending and tax cuts, and financial excesses. It is on track to balloon again when the next recession hits – and this is true even without any historic crisis event to justify it. U.S. polarization is contaminating foreign policy. The rise in polarization has coincided with a rise in wealth inequality, much as Polybius would expect (Chart 7). In all likelihood the Trump tax cuts will exacerbate both of these trends (Chart 8). Even worse, any attempts by “the people” to take more wealth from the “nobles” will worsen polarization first, long before any improvements in equality translate to a drop in polarization. Chart 7Polarization Unlikely To Drop While Inequality Rises Polarization Unlikely To Drop While Inequality Rises Polarization Unlikely To Drop While Inequality Rises Chart 8Trump Tax Cuts Fuel Inequality Trump Tax Cuts Fuel Inequality Trump Tax Cuts Fuel Inequality Most importantly, from a global point of view, U.S. polarization is contaminating foreign policy. Just as the George W. Bush administration launched a preemptive war in Iraq, destabilizing the region, so the Obama administration precipitously withdrew from Iraq, destabilizing the region. And just as the Obama administration initiated a hurried détente with Iran in order to leave Iraq, the Trump administration precipitously withdrew from this détente, provoking a new conflict with Iran and potentially destabilizing Iraq. Major foreign policy initiatives have been conducted, and revoked, on a partisan basis under three administrations. And a Democratic victory in 2020 would result in a reversal of Trump’s initiatives. In the meantime Trump’s policy could easily entangle him in armed conflict with Iran – as nearly occurred on June 21. Iranian domestic politics make it very difficult, if not impossible, to go back to the 2015 setting. Despite Trump’s recent backpedaling, his administration runs a high risk of getting sucked into another Middle Eastern quagmire as long as it enforces the sanctions on Iranian oil stringently. China would be the big winner if such a war occurred, just as it was one of the greatest beneficiaries of the long American distraction in Afghanistan and Iraq. It would benefit from another 5-10 years of American losses of blood and treasure. It would be able to pursue regional interests with less Interference and could trade limited cooperation with the U.S. on Iran for larger concessions elsewhere. And a nuclear-armed Iran – which is a long-term concern for the U.S. – is not in China’s national interest anyway. Bottom Line: The U.S. is missing the “Polybius solution” of balanced government; polarization is on the rise. As a result, the grand strategy of “pivoting to Asia” could go into reverse (Chart 9). If that occurs, the conflict with China will be postponed or ineffective. Chart 9Will The Pivot To Asia Reverse? Will The Pivot To Asia Reverse? Will The Pivot To Asia Reverse? Iran Is The Wild Card If the U.S. gets bogged down in the Middle East yet again, the “Pivot To Asia” will go into reverse and the “Thucydides Trap” with China will be delayed. A war with Iran manifestly runs afoul of the Trump administration’s and America’s national interests, whereas a trade war with China does not. First, although an Iranian or Iranian-backed attack on American troops would give Trump initial support in conducting air strikes, the consequences of war would likely be an oil price shock that would sink his approval rating over time and reduce his chances of reelection (Chart 10). We have shown that such a shock could come from sabotage in Iraq as well as from attacks on shipping in the Strait of Hormuz. Iran could be driven to attack if it believes the U.S. is about to attack. Second, not only would Democrats oppose a war with Iran, but Americans in general are war-weary, especially with regard to the Middle East (Chart 11). President Trump capitalized on this sentiment during his election campaign, especially in relation to Secretary Hillary Clinton who supported the war in Iraq. Over the past two weeks, he has downplayed the Iranian-backed tanker attacks, emphasized that he does not want war, and has ruled out “boots on the ground.” Chart 10Carter Gained Then Lost From Iran Oil Shock Carter Gained Then Lost From Iran Oil Shock Carter Gained Then Lost From Iran Oil Shock Chart 11 Third, it follows from the above that, in the event of war, the United States would lack the political will necessary to achieve its core strategic objectives, such as eliminating Iran’s nuclear program or its power projection capabilities. And these are nearly impossible to accomplish from the air alone. And U.S. strategic planners are well aware that conflict with Iran will exact an opportunity cost by helping Russia and China consolidate spheres of influence. The wild card is Iran. President Hassan Rouhani has an incentive to look tough and push the limits, given that he was betrayed on the 2015 deal. And the regime itself is probably confident that it can survive American air strikes. American military strikes are still a serious constraint, but until the U.S. demonstrates that it is willing to go that far, Iran can test the boundaries. In doing so it also sends a message to its regional rivals – Saudi Arabia, the Gulf Arab monarchies, and Israel – that the U.S. is all bark, no bite, and thus unable to protect them from Iran. This may lead to a miscalculation that forces Trump to respond despite his inclinations. The China trade war, by contrast, is less difficult for the Trump administration to pursue. There is not a clear path from tariffs to economic recession, as with an oil shock: the U.S. economy has repeatedly shrugged off counter-tariffs and the Fed has been cowed. While Americans generally oppose the trade war, Trump’s base does not, and the health of the overall economy is far more important for most voters. And a majority of voters do believe that China’s trade practices are unfair. Strategic planners also favor confronting China – unlike Trump they are not concerned with reelection, but they recognize that China’s advantages grow over time, including in critical technologies. Bottom Line: While the media and market focus on China and Iran risks can alternate in the short run, the Trump administration is likely to continue downgrading the conflict with Iran and upgrading the conflict with China over the next six-to-18 months. Neither politics nor grand strategy support a war with Iran, whereas politics might support a trade war with China and grand strategy almost certainly does. China Could Learn From Polybius Too China also lacks the Polybius solution. It suffers from severe inequality and social immobility, just like the Latin American states and the U.S., U.K., and Italy (Chart 12). But unlike the developed markets, it lacks a robust constitutional system. Political risks are understated given the emergence of the middle class, systemic economic weaknesses, and poor governance. Over the long run, Xi Jinping will need to step down, but having removed the formal system for power transition, a succession crisis is likely. Chart 12 China’s imbalances could cause domestic instability even if the U.S. becomes distracted by conflict in the Middle East. But China has unique tools for alleviating crises and smoothing out its economic slowdown, so the absence of outside pressure will probably determine its ability to avoid a painful economic slump. China also lacks the “Polybius solution” of balanced government – and it even lacks a robust constitutional system. This helps to explain China’s interest in dealing with the U.S. on North Korea. President Xi Jinping’s first trip to Pyongyang late last month helped pave the way for President Trump to resume negotiations with the North’s leader Kim Jong Un at the first-ever visit of an American president north of the demilitarized zone (DMZ). China does not want an unbridled nuclear North Korea or an American preventative war on the peninsula. If Beijing could do a short-term deal with the U.S. on the basis of assistance in reining in North Korea’s nuclear and missile programs, it could divert U.S. animus away from itself and encourage the U.S. to turn its attention toward the next rogue nuclear aspirant, Iran. It would also avoid structural economic concessions. Of course, a smooth transition today means short-term gain but long-term pain for Chinese and global growth. Productivity and potential GDP will decline if China does not reform (Diagram 3). But this kind of transition is the regime’s preferred option since Beijing seeks to minimize immediate threats and maintain overall stability. Diagram 3Stimulus And Delayed Reforms = Socialist Put = Stagflation The Polybius Solution The Polybius Solution If Chinese internal divisions do flare up, China’s leaders will take a more aggressive posture toward its neighbors and the United States in order to divert public attention and stir up patriotic support. Bottom Line: China suffers from understated internal political risk. While U.S. political divisions could lead to a lack of coherent strategy toward China, a rift in China could lead to Chinese aggression in its neighborhood, accelerating the Thucydides Trap. Investment Conclusions If the U.S. reverses the pivot to Asia, attacks Iran, antagonizes European allies, and exhausts its resources in policy vacillation, its budget deficit will balloon (Chart 13), oil prices will rise, and China will be left to manage its economic transition without a western coalition against it. The implication is a weakening dollar, at least initially. But the U.S. is nearing the end of its longest-ever business expansion and an oil price spike would bring forward the next recession, both of which will push up the greenback. Much will depend on the extent of any oil shock – whether and how long the Strait of Hormuz is blocked. Beyond the next recession, the dollar could suffer severe consequences for the U.S.’s wild policies. Chart 13An Iran War Will Bust The Budget An Iran War Will Bust The Budget An Iran War Will Bust The Budget Persian Gulf risks are coming to the fore. But over the next six-to-18 months, U.S.-China conflict will be the dominant marketmover. If the U.S. continues the pivot to Asia, and the U.S. and China proceed with tariffs, tech sanctions, saber-rattling, diplomatic crises, and possibly even military skirmishes, China will be forced into an abrupt and destabilizing economic transition. The U.S. dollar will strengthen as global growth decelerates. Developed market equities will outperform emerging market equities, but equities as a whole will underperform sovereign bonds and other safe-haven assets. Our highest conviction call on this matter is that any trade deal before the U.S. 2020 election will be limited in scope. It will fall far short of a “Grand Compromise” that ushers in a new era of U.S.-China engagement – and hence it will be a disappointment to global equities. Our trade war probabilities, updated on July 26, can be found in Diagram 4. The combined risk of further escalation is 60% -- meaning that the U.S. will either implement the final batch of tariffs or refuse to renew Huawei’s trade license, or both. We are maintaining our risk-off trades: long JPY/USD, long gold, long Swiss bonds, and long USD/CNY. Diagram 4U.S.-China Trade War Decision Tree (Updated July 26, 2019) The Polybius Solution The Polybius Solution   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Graham Allison, “The Thucydides Trap: Are The U.S. And China Headed For War?” The Atlantic, September 24, 2015, and Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Mifflin Harcourt, 2017).