Geopolitics

Highlights Ronald Reagan cast a long shadow over the elected officials who followed him … : The influence of the economic policies associated with Ronald Reagan held such persistent sway that even the Clinton and Obama administrations had to follow their broad outlines.  … just as Paul Volcker did over central bankers at home and abroad … : The Volcker Fed’s uncompromising resistance to the 1970s’ runaway inflation established the Fed’s credibility and enshrined a new global central banking orthodoxy.  … but it appears their enduring influence may have finally run its course … : The pandemic overrode everything else in real time, but investors may ultimately view 2020 as the year in which Democrats broke away from post-Reagan orthodoxy and the Fed decided Volcker’s vigilance was no longer relevant.  … to investors’ potential chagrin: If inflation, big government and organized labor come back from the dead, globalization loses ground, regulation expands, anti-trust enforcement regains some bite and tax rates rise and become more progressive, then the four-decade investment golden age that Reagan and Volcker helped launch may be on its last legs. Feature The pandemic dominated everything in real time in 2020, as investors scrambled to keep up with its disruptions and the countermeasures policymakers deployed to shelter the economy from them. With some distance, however, investors may come to view it as a year of two critical policy inflection points: the end of the Reagan fiscal era and the end of the Volcker monetary era. The shifts could mark a watershed because Reagan’s and Volcker’s enduring influence helped power an investment golden age that has lasted for nearly 40 years. What comes next may not be so supportive for financial markets. Political history often unfolds in cycles even if their starting and ending dates are never as clear cut in real life as they are in dissertations. Broadly, the FDR administration kicked off the New Deal era, a 48-year period of increased government involvement in daily life via the introduction and steady expansion of the social safety net, broadened regulatory powers and sweeping worker protections. It was followed by the 40-year Reagan era, with a continuous soundtrack of limited government rhetoric made manifest in policies that sought to curtail the spread of social welfare programs, deregulate commercial activity, devolve power to state and local government units and the private sector and push back against unions. The Obama and Trump administrations challenged different aspects of Reaganism, but the 2020 election cycle finally toppled it. Ordinarily, that might only matter to historians and political scientists, but the Reagan era coincided with a fantastic run in financial markets. So, too, did the inflation vigilance that lasted long after Paul Volcker’s 1979-1987 tenure at the helm of the Federal Reserve, which drove an extended period of disinflation, falling interest rates and rising central bank credibility. Our focus here is on fiscal policy, and we touch on monetary policy only to note that last summer’s revision of the Fed’s statement of long-run monetary policy goals shut the door on the Volcker era. The end of both eras could mark an inflection point in the trajectory of asset returns. The Happy Warrior The nine most terrifying words in the English language are, “I’m from the government, and I’m here to help.”1 Ronald Reagan held his conservative views with the zeal of the convert that he was.2 Those views were probably to the right of much of the electorate, but his personal appeal was strong enough to make them palatable to a sizable majority (Chart 1). Substitute “left” for “right” and the sentiment just as easily sums up FDR’s ability to get the New Deal off the ground. Personal magnetism played a big role in each era’s rise, with both men radiating relatability and optimism that imbued their sagging fellow citizens with a sense of comfort and security that made them willing to try something very different. Chart 1After The Recession, Reagan Was A Hit After The Recession, Reagan Was A Hit After The Recession, Reagan Was A Hit 1980 was hardly 1932 on the distress scale, but America was in a funk after the upheaval of the sixties, the humiliating end to Vietnam, Watergate, stagflation and a term and a half of uninspiring and ineffectual presidential leadership. Enter the Great Communicator, whose initial weekly radio address evoked the FDR of the Fireside Chats – jovial, resolute and confident, with palpable can-do energy – buffed to a shine by a professional actor and broadcaster whose vocal inflections hit every mark.3 The Gipper,4 with his avuncular bearing, physical robustness and ever-present twinkle in his eye, was just what the country needed to feel better about itself. Reaganomics 101 Government does not tax to get the money it needs; government always finds a need for the money it gets.5 President Reagan’s economic plan had three simple goals: cut taxes, tame government spending and reduce regulation. From the start of his entry into politics in the mid-sixties, Reagan cast himself as a defender of hard-working Americans’ right to keep more of the fruits of their labor from a grasping federal government seeking funding for wasteful, poorly designed programs. He harbored an intense animus for LBJ’s Great Society, which extended the reach of the federal government in ways that he characterized as a drag on initiative, accomplishment and freedom, no matter how well intentioned it may have been. That message hung a historic loss on Barry Goldwater in 1964 when inflation was somnolent but it proved to be far more persuasive after the runaway inflation of the seventies exposed the perils of excessive government (Chart 2). Chart 2Inflation Rises When The Labor Market Heats Up Inflation Rises When The Labor Market Heats Up Inflation Rises When The Labor Market Heats Up As the Reagan Foundation website describes the impact of his presidency’s economic policies, “Millions … were able to keep more of the money for which they worked so hard. Families could reliably plan a budget and pay their bills. The seemingly insatiable Federal government was on a much-needed diet. And businesses and individual entrepreneurs were no longer hassled by their government, or paralyzed by burdensome and unnecessary regulations every time they wanted to expand.” “In a phrase, the American dream had been restored.” The Enduring Reach Of Reaganomics I’m not in favor of abolishing the government. I just want to shrink it down to the size where we can drown it in the bathtub. – Grover Norquist Though President-Elect Clinton bridled at limited government’s inherent restrictions, bursting out during a transition briefing, “You mean to tell me that the success of the economic program and my re-election hinges on the Federal Reserve and a bunch of f***ing bond traders?” his administration largely observed them. This was especially true after the drubbing Democrats endured in the 1994 midterms, when the Republicans captured their first House majority in four decades behind the Contract with America, a skillfully packaged legislative agenda explicitly founded on Reagan principles. Humbled in the face of Republican majorities in both houses of Congress, and hemmed in by roving bands of bond vigilantes, Clinton was forced to tack to the center. James Carville, a leading architect of Clinton’s 1992 victory, captured the moment, saying, “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or … a .400 … hitter. But now I would like to come back as the bond market. You can intimidate everybody.” Reagan’s legacy informed the Bush administration’s sweeping tax cuts (and its push to privatize social security), and forced the Obama administration to tread carefully with the stimulus package it devised to combat the Great Recession. Although the administration’s economic advisors considered the $787 billion (5%-of-peak-GDP) bill insufficient, political staffers carried the day and the price tag was kept below $800 billion to appease the three Republican senators whose votes were required to pass it. Even with the economy in its worst state since the Depression, the Obama administration had to acquiesce to Reaganite budget pieties if it wanted any stimulus bill at all. Its leash got shorter after it agreed with House Republicans to “sequester” excess spending under the Budget Control Act of 2011. On the Republican side of the aisle, Grover Norquist, who claims to have founded Americans for Tax Reform (ATR) at Reagan’s request, enforced legislative fealty to the no-new-tax mantra. ATR, which opposes all tax increases as a matter of principle, corrals legislators with the Taxpayer Protection Pledge, “commit[ting] them to oppose any effort to increase income taxes on individuals and businesses.” ATR’s influence has waned since its 2012 peak, when 95% of Republicans in Congress had signed the pledge, and Norquist no longer strikes fear in the hearts of Republicans inclined to waver on taxes. His declining influence is testament to Reaganism’s success on the one hand (the tax burden has already been reduced) and the fading appeal of its signature fiscal restraint on the other. Did Government Really Shrink? When the legend becomes fact, print the legend. – The Man Who Shot Liberty Valance For all of its denunciations of government spending, the Reagan administration ran up the largest expansionary budget deficits (as a share of GDP) of any postwar administration until the global financial crisis (Chart 3). Although it aggressively slashed non-defense discretionary spending, it couldn’t cut enough to offset the Pentagon’s voracious appetite. The Reagan deficits were not all bad: increased defense spending hastened the end of the Cold War, so they were in a sense an investment that paid off in the form of the ‘90s peace dividend and the budget surpluses it engendered. Chart 3Cutting The Federal Deficit Is Harder Than It Seems Cutting The Federal Deficit Is Harder Than It Seems Cutting The Federal Deficit Is Harder Than It Seems Nonetheless, the Reagan experience reveals the uncomfortable truth that there is little scope for any administration or Congressional session to cut federal spending. Mandatory entitlement spending on social security, Medicare and Medicaid constitutes the bulk of federal expenditures (Chart 4) and they are very popular with the electorate, as the Trump campaign shrewdly recognized in the 2016 Republican primaries (Table 1). Discretionary spending, especially ex-defense, is a drop in the bucket, thanks largely to a Reagan administration that already cut it to the bone (Chart 5). Chart 4The Relentless Rise In Mandatory Spending ... The Relentless Rise In Mandatory Spending ... The Relentless Rise In Mandatory Spending ... Chart 5Overwhlems Any Plausible Discretionary Cuts Overwhlems Any Plausible Discretionary Cuts Overwhlems Any Plausible Discretionary Cuts Table 1How Trump Broke Republican Orthodoxy On Entitlement Spending Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper The Reagan tax cuts therefore accomplished the easy part of the “starve the beast” strategy but his administration failed to make commensurate cuts in outlays (Chart 6). If overall spending wasn’t cut amidst oppressive inflation, while the Great Communicator was in the Oval Office to make the case for it to a considerably more fiscally conservative electorate, there is no chance that it will be cut this decade. As our Geopolitical Strategy service has flagged for several years, the median US voter has moved to the left on economic policy. Reagan-era fiscal conservatism has gone the way of iconic eighties features like synthesizers, leg warmers and big hair, even if it had one last gasp in the form of the post-crisis “Tea Party” and Obama’s compromise on budget controls. Chart 6Grover Norquist Is Going To Need A Bigger Bathtub Grover Norquist Is Going To Need A Bigger Bathtub Grover Norquist Is Going To Need A Bigger Bathtub Do Republicans Still Want The Reagan Mantle? Reaganism is dead, killed by a decided shift in broad American public opinion, and within the Republican and Democratic parties themselves. Americans are just as divided today as they were in Reagan’s era about the size of the government but the trend since the late 1990s is plainly in favor of bigger government (Chart 7). Recent developments, including the 2020 election, reinforce our conviction that that trend will not reverse any time soon. The Republicans are the natural heirs of Reagan’s legacy. Much of President Trump’s appeal to conservatives lay in his successful self-branding as the new Reagan. Though he lacked the Gipper’s charisma and affability, his unapologetic assertion of American exceptionalism rekindled some of the glow of Morning-in-America confidence. Following the outsider trail blazed by Reagan, he lambasted the Washington establishment and promised to slash bureaucracy, deregulate the economy and shake things up. Chart 7"Limited Government" Falling Out Of Fashion Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Trump’s signature legislative accomplishment was the largest tax reform since Reagan’s in 1986. He oversaw defense spending increases to take on China, which he all but named the new “evil empire.”6  Like Reagan, he was willing to weather criticism for face-to-face meetings with rival nations’ dictators. Even his trade protectionism had more in common with the Reagan administration than is widely recognized.7 But major differences in the two presidents’ policy portfolios underline the erosion of the Reagan legacy’s hold. President Trump outflanked his Republican competitors for the 2016 nomination by running against cutting government spending – he was the only candidate who opposed entitlement reform. His signature proposal was to stem immigration by means of a Mexican border wall. While Reagan had sought to crack down on illegal immigration, he pursued a compromise approach and granted amnesty to 2.9 million illegal immigrants living in America to pass the Immigration Reform and Control Act of 1986, sparing businesses from having to scramble to replace them (Chart 8). While Reagan curtailed non-defense spending, Trump signed budget-busting bills with relish, even before the COVID pandemic necessitated emergency deficit spending. Trump tried to use the power of government to intervene in the economy and alienated the business community, which revered Reagan, with his scattershot trade war. Trump’s greater hawkishness on immigration and trade and his permissiveness on fiscal spending differentiated him from Reagan orthodoxy and signaled a more populist Republican Party. More fundamentally, Trump represents a new strain of Republican that is at odds with the party’s traditional support for big business and disdain for big government. If he leads that strain to take on the party establishment by challenging moderate Republicans in primary elections and insisting on running as the party’s next presidential candidate, the GOP will be swimming upstream in the 2022 and 2024 elections. It is too soon to make predictions about either of these elections other than to say that Trump is capable of splitting the party in a way not seen since Ross Perot in the 1990s or Theodore Roosevelt in the early 1900s (Chart 9).8 If he does so, the Democrats will remain firmly in charge and lingering Reaganist policies will be actively dismantled. Chart 8Reagan’s Amnesty On Immigration Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Chart 9Trump Could Start Third Party, Give Democrats A Decade-Plus Ascendancy Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Even if the party manages to preserve its fragile Trumpist/traditionalist coalition, it is hard to imagine it will recover its appetite for shrinking entitlements, siding against labor or following a laissez-faire approach to corporate conduct and combinations. Republicans will pay lip service to fiscal restraint but Trump’s demonstration that austerity does not win votes will lead them to downplay spending cuts and entitlement reform as policy priorities – at least until inflation again becomes a popular grievance (Chart 10). Republicans will also fail to gain traction with voters if they campaign merely on restoring the Trump tax cuts after Biden’s likely partial repeal of them. Support for the Tax Cut and Jobs Act hardly reached 40% for the general public and 30% for independents and it is well known that the tax reform did little to help Republicans in the 2018 midterm elections, when Democrats took the House (Chart 11). Chart 10Republicans Have Many Priorities Above Budget Deficits Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper On immigration the Republican Party will follow Trump and refuse amnesty. Immigration levels are elevated and Biden’s lax approach to the border, combined with a looming growth disparity with Latin America, will generate new waves of incomers and provoke a Republican backlash. Chart 11Trump Tax Cuts Were Never Very Popular Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper On trade and foreign policy, Republicans will follow a synthesis of Reagan and Trump in pursuing a cold war with China. The Chinese economy is set to surpass the American economy by the year 2028 and is already bigger in purchasing power parity terms (Chart 12). The Chinese administration is becoming more oppressive at home, more closed to liberal and western ideas, more focused on import substitution, and more technologically ambitious. The Chinese threat will escalate in the coming decade and the Republican Party will present itself as the anti-communist party by proposing a major military-industrial build-up. Yet it is far from assured that the Democrats will be soft on China, which is to say that they will not be able to cut defense spending substantially. Chart 12China Is the New "Evil Empire" For GOP China Is the New "Evil Empire" For GOP China Is the New "Evil Empire" For GOP Will Biden Take Up The Cause? One might ask if the Biden administration might seek to adopt some elements of the Reagan program. President Biden is among the last of the pro-market Democrats who emerged in the wake of the Reagan revolution. Those “third-way” Democrats thrived in the 1990s by accommodating themselves to Reagan’s free-market message while maintaining there was a place for a larger federal role in certain aspects of the economy and society. The 2020 election demonstrated that the Democrats’ political base is larger than the Republicans’ and third-way policies could be a way to make further inroads with affluent suburbanites who helped deliver Georgia and Virginia. Alas, the answer appears to be no. The Democrats’ base increasingly abhors Reagan-era economic and social policies, and the country’s future demographic changes reinforce the party’s current, progressive trajectory. That means fiery younger Democrats don’t have to compromise their principles with third-way policies when they can just wait for Texas to turn blue. Biden has only been in office for one month but a rule of thumb is that his party will pull him further to the left the longer Republicans remain divided and ineffective. His cabinet appointments have been center-left, not far-left, though his executive orders have catered to the far-left, particularly on immigration. In order to pass his two major legislative proposals through an evenly split Senate he must appeal to Democratic moderates, as every vote in the party will be needed to get the FY2021 and FY2022 budget reconciliation bills across the line, with Vice President Kamala Harris acting as the Senate tie breaker. Nevertheless his agenda still highlights that the twenty-first century Democrats are taking a page out of the FDR playbook and unabashedly promoting big government solutions (Chart 13). Chart 13Democrats Look To New Deal, Eschew 'Third Way' Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Biden’s $1.9 trillion American Rescue Plan is not only directed at emergency pandemic relief but also aims to shore up state and local finances, education, subsidized housing, and child care. His health care proposals include a government-provided insurance option (originally struck from the Affordable Care Act to secure its passage in 2010) and a role for Medicare in negotiating drug prices. And his infrastructure plan is likely to provide cover for a more ambitious set of green energy projects that will initiate the Democratic Party’s next big policy pursuit after health care: environmentalism. The takeaway is not that Biden’s administration is necessarily radical – he eschews government-administered health care and is only proposing a partial reversal of Trump’s tax cuts – but rather that his party has taken a decisive turn away from the “third-way” pragmatism that defined his generation of Democrats in favor of a return to the “Old-Left” and pro-labor policies of the New Deal era (Chart 14). The party has veered to the left in reaction to the Iraq War, the financial crisis, and Trumpism. Vice President Harris, Biden’s presumptive heir, had the second-most progressive voting record during her time in the Senate and would undoubtedly install a more progressive cabinet. Table 2 shows her voting record alongside other senators who ran against Biden in the Democratic primary election. All of them except perhaps Senator Amy Klobuchar stood to his left on the policy spectrum. Chart 14Democrats Eschew Budget Constraints Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Fundamentally the American electorate is becoming more open to a larger role for the government in the economy and society. While voters almost always prioritize the economy and jobs, policy preferences have changed. The morass of excessive inflation, deficits, taxation, regulation, strikes and business inefficiencies that gave rise to the Reagan movement is not remembered as ancient history – it is not even remembered. The problems of slow growth, inadequate health and education, racial injustice, creaky public services, and stagnant wages are by far the more prevalent concerns – and they require more, not less, spending and government involvement (Chart 15). Insofar as voters worry about foreign threats they focus on the China challenge, where Biden will be forced to adopt some of Trump’s approach. Table 2Harris Stood To The Left Of Democratic Senators Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Chart 15Public Concern For Economy Means Greater Government Help Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper When inflation picks up in the coming years, voters will not reflexively ask for government to be pared back so that the economy becomes more efficient, as they did once they had a taste of Reagan’s medicine in the early 1980s. Rather, they will ask the government to step in to provide higher wages, indexation schemes, price caps, and assistance for labor, as is increasingly the case. The ruling party will be offering these options and the opposition Republicans will render themselves obsolete if they focus single-mindedly on austerity measures. Americans will have to experience a recession caused by inflation – i.e. stagflation – before they call for anything resembling Reagan again. The Post-Reagan Market Landscape Many investors and conservative economists were shocked9 that the Bernanke Fed’s mix of zero interest rates and massive securities purchases did not foster runaway inflation and destroy the dollar. They failed to anticipate that widespread private-sector deleveraging would put a lid on money creation (and that other major central banks would follow in the Fed’s ZIRP and QE footsteps). But a longer view of four decades of disinflation suggests another conclusion: Taking away the monetary punch bowl when the labor party gets going and pursuing limited-government fiscal policy can keep inflation pressures from gaining traction. Globalization, technology-enabled elimination of many lower-skilled white-collar functions and the hollowing out of the organized labor movement all helped as well, though they helped foment a revolt among a meaningful segment of the Republican rank-and-file against Reagan-style policies. The Volcker Fed set the tone for pre-emptive monetary tightening and subsequent FOMCs have reliably intervened to cool off the economy when the labor market begins heating up. The Phillips Curve may be out of favor with investors, but wage inflation only gathers steam when the unemployment rate falls below its natural level (Chart 16), and the Fed did not allow negative unemployment gaps to persist for very long in the Volcker era. Without wage inflation putting more money in the hands of a broad cross-section of households with a fairly high marginal propensity to consume, it’s hard to get inflation in consumer prices. Chart 16Taking The Punch Bowl Away From The Union Hall Taking The Punch Bowl Away From The Union Hall Taking The Punch Bowl Away From The Union Hall The Fed took the cyclical wind from the labor market’s sails but the Reagan administration introduced a stiff secular headwind when it crushed PATCO, the air traffic controllers’ union, in 1981, marking an inflection point in the relationship between management and labor. That watershed event opened the door for employers to deploy much rougher tactics against unions than they had since before the New Deal.10 Reagan’s championing of free markets helped establish globalization as an economic policy that the third-way Clinton administration eagerly embraced with NAFTA and a campaign to admit China to the WTO. The latter coincided with a sharp decline in labor’s share of income (Chart 17). Chart 17Outsourcing Has Not Been Good For US Labor Outsourcing Has Not Been Good For US Labor Outsourcing Has Not Been Good For US Labor The core Reagan tenets – limited government, favoring management over labor, globalization, sleepy anti-trust enforcement, reduced regulation and less progressive tax systems with lower rates – are all at risk of Biden administration rollbacks. While the easy monetary/tight fiscal combination promoted a rise in asset prices rather than consumer prices ever since the end of the global financial crisis, today’s easy monetary/easy fiscal could promote consumer price inflation and asset price deflation. We do not think inflation will be an issue in 2021 but we expect it will in the later years of Biden’s term. Ultimately, we expect massive fiscal accommodation will stoke inflation pressures and those pressures, abetted by a Fed which has pledged not to pre-emptively remove accommodation when the labor market tightens, will eventually bring about the end of the bull market in risk assets and the expansion. Investment Implications Business revered the Reagan administration and investors rightfully associate it with the four-decade bull market that began early in its first term. Biden is no wild-eyed liberal, but rolling back core Reagan-era tenets has the potential to roll back juicy Reagan-era returns. Only equities have the lengthy data series to allow a full comparison of Reagan-era returns with postwar New Deal-era returns (Table 3), but the path of Treasury bond yields in the three-decade bear market that preceded the current four-decade bull market suggests that bonds generated little, if any, real returns in the pre-Reagan postwar period (Chart 18). Stagnant precious metal returns point to tame Reagan-era inflation and downward pressure on input costs. Chart 18Bond Investors Loved Volcker And The Gipper Bond Investors Loved Volcker And The Gipper Bond Investors Loved Volcker And The Gipper Table 3Annualized Real Market Returns Before And After Reagan Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Owning the market is not likely to be as rewarding going forward as it was in the Reagan era. Active management may again have its day in the sun as the end of the Reagan tailwinds open up disparities between sectors, sub-industries and individual companies. Even short-sellers may experience a renaissance. We recommend that multi-asset investors underweight bonds, especially Treasuries. We expect the clamor for bigger government will contribute to a secular bear market that could rival the one that persisted from the fifties to the eighties. Within Treasury portfolios, we would maintain below-benchmark duration and favor TIPS over nominal bonds at least until the Fed signals that its campaign to re-anchor inflation expectations higher has achieved its goal. Gold and/or other precious metals merit a place in portfolios as a hedge against rising inflation and other real assets, from land to buildings to other resources, are worthy of consideration as well. BCA has been cautioning of a downward inflection in long-run financial asset returns for a few years, based on demanding valuations and a steadily shrinking scope for ongoing declines in inflation and interest rates. Mean reversion has been part of the thesis as well; trees simply don’t grow to the sky. Now that the curtain has fallen on the Volcker and Reagan eras, the inevitable downward inflection has received a catalyst. We remain constructive on risk assets over the next twelve months, but we expect that intermediate- and long-term returns will fall well short of their post-1982 pace going forward.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Table A1BPolitical Capital: Household And Business Sentiment Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Table A1CPolitical Capital: The Economy And Markets Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Table A2Political Risk Matrix Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Table A3Political Capital Index Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper Table A4Biden’s Cabinet Position Appointments Requiem For Volcker And The Gipper Requiem For Volcker And The Gipper       Footnotes 1     August 12, 1986 Press Conference News Conference | The Ronald Reagan Presidential Foundation & Institute (reaganfoundation.org), accessed February 4, 2021. Reagan makes the quip in his prepared opening remarks. 2     Reagan was a Democrat until he entered politics in his fifties. He claimed to have voted for FDR four times. 3    April 3, 1982 Radio Address President Reagan's Radio Address to the Nation on the Program for Economic Recovery - 4/3/82 - YouTube, accessed February 4, 2021. 4    As an actor, Reagan was perhaps best known for his portrayal of Notre Dame football legend George Gipp, who is immortalized in popular culture as the subject of the “win one for the Gipper” halftime speech. 5    July 22, 1981 White House Remarks to Visiting Editors and Broadcasters reaganfoundation.org, accessed February 8, 2021. 6    Reagan famously urged his followers, in reference to the USSR, “I urge you to beware the temptation of pride—the temptation of blithely declaring yourselves above it all and label both sides equally at fault, to ignore the facts of history and the aggressive impulses of an evil empire.” See his “Address to the National Association of Evangelicals,” March 8, 1983, voicesofdemocracy.umd.edu.   7     Robert Lighthizer, the Trump administration trade representative who directed its tariff battles, was a veteran of Reagan’s trade wars against Japan in the 1980s. 8    “Exclusive: The Trump Party? He still holds the loyalty of GOP voters,” USA Today, February 21, 2021, usatoday.com. 9    Open Letter to Ben Bernanke,” November 15, 2010. Open Letter to Ben Bernanke | Hoover Institution Accessed February 23, 2021. 10   Please see the following US Investment Strategy Special Reports, “Labor Strikes Back, Parts 1, 2 and 3,” dated January 13, January 20 and February 3, 2020, available at usis.bcaresearch.com.

Highlights Both the US and Iran have the intention and capability of restoring the 2015 nuclear deal so investors should presume that an escalation in tensions will conclude with a new arrangement by August this year. However, the deal that the Iranians will offer, and that Biden can accept, may be unacceptable to the Israeli government, depending on Israel’s March 23 election. Moreover if a deal is not clinched by August, the timeframe will stretch out for most of Biden’s term and strategic tensions will escalate. Major Middle Eastern conflicts and crises tend to occur at the top of the business cycle when commodity prices are soaring rather than in the early stages where we stand today. But regional instability is possible regardless, especially if the US-Iran talks fall apart. Maintain gold and safe-haven assets as the Iranian question can lead to near-term escalation even if a deal is the end-game. Feature Geopolitics is far from investors’ concerns today, so it could create some nasty surprises. Two urgent tests await the Biden administration – China/Taiwan and Iran – and provide a basis for investors to add some safe-haven assets and hedges amidst an exuberant stock rally in which complacency is very high. The past week’s developments underscore these two tests. First, Chinese officials flagged that they would cut off rare earth elements to the US, implying that they would retaliate if Biden refuses to issue waivers for US export controls on semiconductors to China.1 Second, Biden spoke on the phone with Benjamin Netanyahu for the first time. The delay signaled Biden’s distance from Netanyahu and intention to normalize ties with Israel’s arch-enemy Iran. In both the Taiwan Strait and the Persian Gulf, the base case is not a full-fledged military conflict in the short run. This is positive for the bull market. But major incidents short of war are likely in the near term and major wars cannot be ruled out. In this report we update our view of the Iran risk. A long-term solution to the nuclear threat is not at hand, which means that Israel could in the worst-case take military action on its own. Meanwhile tensions and attacks will escalate until a deal is agreed. Iranian-backed forces in Iraq have already attacked a US base near Erbil, killing an American military contractor.2 In the event of an Iranian diplomatic crisis, the stock market selloff will be short. The macro backdrop is highly reflationary and investors will buy on the dips. In the event of full-scale war, the US dollar will suffer for a longer period. Oil Price A Boon But Middle East Regimes Still Vulnerable Chart 1Oil Recovery A Boon For Middle East Markets Oil Recovery A Boon For Middle East Markets Oil Recovery A Boon For Middle East Markets Brent crude oil prices have rebounded to $65 per barrel on the global economic recovery. Middle Eastern equities are rallying in absolute terms, though not relative to other emerging markets (Chart 1). This underperformance is fitting given that the region suffers from poor governance, obstacles to doing business, resource dependency, insufficient technology and capital, and high levels of political and geopolitical risk. Non-oil producers and non-oil sectors in the Middle East have generally lagged the global economic recovery (Chart 2). The continuation of the recovery is essential to these regimes because most of them lack the fiscal room to provide large fiscal relief packages. The global average in fiscal support over the past year has been 7.4% but most Middle Eastern governments have provided 2% or less (Chart 3). Current account deficits have plagued oil producers since the commodity bust of 2014 and twin deficits have become a feature of the region, limiting the fiscal response to the global pandemic. Chart 2Middle East Economy Starts To Recover Middle East Economy Starts To Recover Middle East Economy Starts To Recover Chart 3Middle Eastern Regimes Fiscally Constrained Biden, Iran, Markets Biden, Iran, Markets The good news is that the recovery is likely to continue on the back of vaccines and fiscal pump-priming in all of the major economies. The bad news is that a black cloud hangs over the Middle East in the form of geopolitics. Given the underperformance of regional equities, global investors are not ignoring these risks – but they are a persistent factor until the Biden administration survives its initial tests in the region to create a new equilibrium. The unfinished geopolitical business in the region centers on the role of the US and the question of Iran. It is widely understood that the US has less and less interest in the region due to its newfound energy independence on the back of the shale revolution (Chart 4). This is why the US can afford to sign and break deals as it pleases under different administrations, namely the 2015 Iranian nuclear deal, otherwise known as the Joint Comprehensive Plan of Action (JCPA). The Obama administration spent two terms concluding the deal while the Trump administration spent one term nullifying it, leaving the central geopolitical question of the region in limbo. Israel and Arab governments feel increasingly insecure in light of the US’s apparent lack of foreign policy coherence and declining interest in the region. The US has not truly abandoned the region – if anything the Biden administration is looking to maintain or increase US international involvement.3 Washington still sees the need to preserve a strategic balance between Iran and the Arab states, prevent Iran from gaining nuclear weapons, and maintain security in the critical oil chokepoint of the Persian Gulf and Strait of Hormuz (Chart 5). But Washington’s appetite for commitment and sacrifice is obviously waning. The American public is openly hostile to the idea of Middle Eastern entanglements, and three presidents in a row have been elected on the assurance that they would scale down America’s “forever wars.” A decisive majority of Americans, including military veterans and Republicans, believe the wars in Afghanistan and Iraq were not worth fighting.4 And only 6% of Americans view Iran as the top threat to their country. Chart 4Waning US Interest In Middle East Waning US Interest In Middle East Waning US Interest In Middle East Chart 5Strait Of Hormuz Critical To Global Stability Biden, Iran, Markets Biden, Iran, Markets America’s lack of concern about the Iranian threat marks a difference from the early 2000s and especially from its critical Middle Eastern ally Israel. Naturally Israelis have a much greater fear of Iran, and 58% see it as the nation’s top threat (Chart 6). Israel and the Gulf Arab states are drawing together, under the framework of the Trump administration’s Abraham Accords, in case the US abandons the region. A deal normalizing relations with Iran would enable Iran to expand its power and influence and, if unchecked by the US, would pose a long-lasting threat to US allies. Chart 6No US Appetite For War With Iran – Israel A Different Story Biden, Iran, Markets Biden, Iran, Markets Chart 7China/Asia, Not Iran, The Strategic Priority For The US China/Asia, Not Iran, The Strategic Priority For The US China/Asia, Not Iran, The Strategic Priority For The US The US’s reason for dealing with Iran is that it needs to devote more attention to its strategy in the western Pacific in countering China (Chart 7). But China is also a reason for the US to stay involved in the Middle East. China’s role is expanding because of resource dependency and the desire to expand economic integration. Beijing wants to deepen its global investments, open up new markets, and create closer links with Europe (Chart 8). Chart 8AChina's Expanding Role In Middle East China's Expanding Role In Middle East China's Expanding Role In Middle East Chart 8BChina's Expanding Role In Middle East China's Expanding Role In Middle East China's Expanding Role In Middle East Chart 9Unresolved US-Iran Deal A Geopolitical Risk Unresolved US-Iran Deal A Geopolitical Risk Unresolved US-Iran Deal A Geopolitical Risk The opening of the Iranian economy would give the US (and EU) a greater role in Iran’s development, where China has a special advantage as long as Iran is a pariah. The US would add economic leverage to its military leverage in a region that provides China with its energy. The Chinese are not yet as capable of projecting power into the region but that is changing rapidly. There is a possible strategic balance to be established between these simultaneous foreign policy revolutions: the US-Iran détente, the Israeli-Arab détente, and the rise of Mideast-China ties. But balance is an ideal and not yet a reality. In the meantime these foreign policy revolutions must actually take place – and revolutions are rarely bloodless. It is possible for a meltdown to occur in light of the region’s profound changes. In particular, the US-Iran détente is incomplete and faces Israeli/Arab opposition, Iranian paranoia, and US foreign policy incoherence. At the moment it is premature to declare an end to the bull market in US-Iran tensions. That will come when a deal is actually sealed, and then tested and enforced. In the meantime Iranian incidents will occur (Chart 9). Geopolitical risks threaten to reduce global oil supply. Different regimes and their militant proxies will strike out against each other to establish red lines. But a US-Iran deal is highly likely – and once that occurs, the risk to oil supply shifts to the upside, as Iran’s economy will open up. Not only will Iran start exporting again but Gulf Arab producers will want to preserve their market share, which means they will pump more oil. Iran’s Regime Hardens Its Shell Ahead Of Leadership Succession The COVID-19 crisis has weakened regimes in the Middle East, much like the Great Recession sowed the seeds for the Arab Spring and many other sweeping changes in the region. But unlike the Arab Spring, the regimes most at risk today are majority Shia Muslim – with Lebanon, Iran, and Iraq all teetering on the verge of chaos (Chart 10). Chart 10Iranian Sphere De-Stabilized Amid COVID Biden, Iran, Markets Biden, Iran, Markets Chart 11Iranian Economy Weak (Despite Green Shoots) Iranian Economy Weak (Despite Green Shoots) Iranian Economy Weak (Despite Green Shoots) Chart 12Jobless Iranian Youth Jobless Iranian Youth Jobless Iranian Youth The Iranian economy is starting to show the faintest green shoots but it is far too soon to give the all-clear signal. US sanctions have shut off access to oil export revenues. Domestic demand is weak and imports are still contracting, albeit much less rapidly. The country has seen a double dip recession over the past ten years (Chart 11). Unemployment is rife, especially among the youth. The working-age population makes up 60% of total and periodically rises up in protest (Chart 12). Inflation is soaring and the currency is still wallowing in deep depreciation (Chart 13). All of these points suggest Iran is weaker than it looks and will seek to negotiate a deal with the Biden administration. But Iran cannot trust the US so it will simultaneously prepare for the worst outcome – no deal, sanctions, and eventually war. Chart 13Iran Still Ripe For Social Unrest Iran Still Ripe For Social Unrest Iran Still Ripe For Social Unrest Chart 14Iranian Regime Turning Hawkish Biden, Iran, Markets Biden, Iran, Markets Iran’s response to the US’s withdrawal from the 2015 nuclear deal and imposition of maximum pressure sanctions has been to adopt a siege mentality and fortify the regime for a potential military confrontation. The country is preparing for a highly uncertain and vulnerable transition from Supreme Leader Ali Khamenei to a future leader or group of leaders. The government fixed the 2020 parliamentary elections so that hardliners or “principlists” rose to prominence at the expense of independents and especially the so-called reformists. The reformists have been humiliated by the US betrayal of the deal and re-imposition of sanctions, which exploded the economic reforms of President Hassan Rouhani, who will step down in August (Chart 14). The Timeline Of Biden’s Iran Deal Still, it is likely that the US and Iran will return to some form of the 2015 nuclear deal. Lame duck Rouhani is politically capable of returning to the deal: President Rouhani is a lame duck president whose popularity has cratered. If he can restore the deal before August then he can salvage his legacy and provide a pathway for Iran out of economic ruin by removing sanctions. It is manifestly in Iran’s interests to restore the deal – one reason why it has never left the deal and has only made incremental and reversible infractions against it. If Rouhani falls on his sword he provides the Supreme Leader and the next administration with a convenient scapegoat to enable the deal to be restored. Freshman President Biden has enough political capital to return to the deal: Biden is capable of restoring the deal, as he clearly intends to do judging by his statements, cabinet appointments, and diplomatic actions thus far. He has demanded that Iran enter back into full compliance with the deal before he eases sanctions but even this demand can be fudged. After all, it was the US that exited the deal in the first place, and Iran remains in partial compliance, so it stands to reason that the US should make the first concession to bring Iran back into compliance. None of the signatories have nullified the deal other than the US, and it was an executive (not legislative) deal, so President Biden can ultimately rejoin it by fiat. This would not be a popular move at home but the US public is preoccupied. Biden would achieve a foreign policy objective early in his term. The timeline is critical – an early deal is our base case. But if it falls through, then it could take the rest of Biden’s term in office, or longer, to forge a deal. Tensions would skyrocket over that period. The timeline is shown in Table 1. The US has identified April or May as the time when Iran will reach “breakout” capability, i.e. produce enough highly enriched uranium to make a nuclear bomb. The Israelis, for their part, estimate that breakout phase will be reached in August – the same month Rouhani is set to step down. Both the US and Israel view breakout as a red line, though there is some room for interpretation. Table 1Can Lame Duck Rouhani Salvage US Deal For Legacy By August? Biden, Iran, Markets Biden, Iran, Markets The option of rejoining the old deal with Rouhani as a scapegoat will end when Rouhani exits in August. The next Iranian president is unlikely to repeat Rouhani’s mistake of pinning his administration on a promise from the Americans that could be revoked as early as January 20, 2025. The next Iranian president will be a nationalist or hardliner. Opinion shows that the public looks most favorably upon the firebrand ex-President Mahmoud Ahmadinejad or the hardline candidate from 2017 Ebrahim Raisi. Another possible candidate is Hossein Dehghan, a brigadier general. The least favorable political figures are the reformists like Rouhani (Chart 15). Chart 15Iran’s Next President Will Be Hawkish Biden, Iran, Markets Biden, Iran, Markets We cannot vouch for the quality of these opinion polls but they are corroborated by other polls we have seen and they make sense with what we know and have observed in recent years. Apparently the public has turned its back on the dream of greater economic opening, with self-sufficiency making a comeback in the face of US sanctions (Chart 16). The regime will promote this attitude in advance of the leadership transition as it must be prepared to conduct a smooth succession even under the worst-case scenario of sanctions or war. Chart 16Iran Preparing For Supreme Leader’s Succession Biden, Iran, Markets Biden, Iran, Markets Chart 17Nuclear Bomb Key To Regime Survival Biden, Iran, Markets Biden, Iran, Markets The hitch is that Iran is interested in rejoining the deal it signed in 2015, not a grander deal. It will not sign an expanded deal that covers its regional militant proxies and ballistic missile program or requires irreversible denuclearization. The Supreme Leader has witnessed that an active nuclear weapon program and ballistic missile program provide the surest guarantees of regime survival over the long haul. The contrasting cases of Libya and North Korea illustrate the point (Chart 17). Libya gave up its nuclear program and weapons of mass destruction in the wake of the US invasion of Iraq in 2003 only to see the regime collapse in 2011 and leader Muammar Gaddafi die under NATO military pressure. By contrast, North Korea refused to give up its nuclear and missile programs and repeatedly cut deals with the US that served only to buy time and ease sanctions, and today North Korea possesses an estimated 30-45 nuclear weapons deliverable through multiple platforms. Leader Kim Jong Un has used this leverage to bargain with the great powers. The lesson for Iran could not be clearer: a short-term deal with the Americans may buy time and a reprieve from sanctions. But total, verifiable, and irreversible denuclearization means regime suicide. The Biden administration would prefer to create a much more robust deal rather than suffer the criticism of rejoining the 2015 deal, given its flaws and that the first set of deadlines in 2025 is only four years away. But Biden cannot possibly reconstruct the P5+1 coalition of countries to force Iran into a grander bargain in the context of US-Russia and US-China tensions. The sacrifices that would be necessary to bring Russia and China on board would not be worth it. Therefore Biden’s solution will be to rejoin the existing deal plus an Iranian promise to enter negotiations on a more comprehensive deal in future. The Iranians can accept this option since it serves their purpose of buying time without making irreversible concessions on their nuclear and missile programs. Israel then becomes the sticking point, as Iranian officials have said that the US rejoining the original 2015 deal would be a “calamity” and unacceptable. The Israeli government is studying options for military action in the event that Iran reaches nuclear breakout. However, the Israeli election on March 23 will determine the fate of Benjamin Netanyahu and his government’s hawkish approach to Iran. A change of government in Israel would likely bring the US and Israel into line on concluding a deal with Iran so as to avoid military conflict for the time being. If Netanyahu wins, yet the US and Iran fall back into compliance with the 2015 deal (Table 2), then Iran is still limiting its nuclear capabilities through 2025, obviating the need for a unilateral Israeli strike in the near term. Israel will not launch a unilateral strike except as a last resort, as it fears permanent alienation from its greatest security guarantor, the United States. Table 2Iran’s Compliance (And Non-Compliance) With The Joint Comprehensive Plan Of Action Biden, Iran, Markets Biden, Iran, Markets If a deal cannot be put together by the time Rouhani steps down then the risk of conflict will increase as there will not be a prospect of a short-term fix. A much longer diplomatic arc will be required as Iran would draw out negotiations and the US would have to court allies to pressure Iran. The US and/or Israel could conduct sabotage or air strikes to set back the Iranian nuclear program. It is possible that the Iranian leadership or the increasingly powerful Iranian Revolutionary Guard Corps could overplay their hand in the belief that the US has no stomach for waging war. While it is true that the US public is war-weary, it is also true that that attitude would change overnight in the event of a national humiliation or attack. Investment Takeaways The Trump administration drew a hard line on nuclear proliferation. Trump’s defeat marks a softening in the US line regarding proliferation. This does not mean that the Biden administration will be ineffective – it could be even more effective with a more flexible approach – but it does mean that nuclear aspirants currently feel less pressure to make major concessions. This will hold at least until Biden demonstrates that he too can impose maximum pressure. Hence nuclear and missile tests will go up in the near term – as will various countries’ demonstrations of credible threats and red lines. The global economic recovery will strengthen oil producers by giving them greater government revenues with which to stabilize their domestic politics and restart foreign policy initiatives. The global oil price is reasonably correlated with international conflicts involving oil producers (Chart 18). With rising oil revenues, Russia, Saudi Arabia, Iran, Iraq, and others will be emboldened to pursue their national interests. Chart 18Oil Price And Global Conflict Go Hand In Hand Biden, Iran, Markets Biden, Iran, Markets While the Biden administration’s end-game is a nuclear deal with Iran, the period between now and the conclusion of a deal will see an increase rather than a decrease in tensions and tit-for-tat military strikes across the region. Unexpected cutoffs of oil supplies and a risk premium in the oil price will be injected first, as we have argued. When a deal is visible on the horizon then oil prices face a downside risk, due to the resumption of Iranian oil exports and any loss of OPEC 2.0 discipline. It is possible that this moment is already upon us. This report shows a clear path to a US-Iran deal by August. US Secretary of State Anthony Blinken is reaching out to the Iranians. Saudi Arabia has recently announced that it will not continue with large production cuts. Russian oil officials have argued that the global market is balanced and production cuts are no longer necessary.5 But given that the Russians and Saudis fought an oil market share war as recently as last year, it is not clear that a collapse in OPEC 2.0 discipline is imminent. What will be the market impact if hostilities revive in anticipation of a deal? Or worse, if a deal cannot be achieved and a much longer period of US-Iran conflict opens up for Biden’s term in office? Table 3 provides a list of major geopolitical incidents and crises in the Middle East since the Yom Kippur war. We look at the S&P500’s peak and trough within the three months before and after each crisis. The median drawdown is 8% and the market has usually recovered within one month. Twelve months later the S&P is up by 12%. Table 3Stock Market Reaction To Middle East Geopolitical Crises Biden, Iran, Markets Biden, Iran, Markets Table 4 shows a shortened list of the same incidents with the impact on the trade-weighted dollar, which is notable in the short run but is only persistent in the long run in the case of full-fledged wars like the first and second Persian Gulf wars. Table 4US Dollar Falls On Middle East Geopolitical Crises Biden, Iran, Markets Biden, Iran, Markets The stock market impact can last for a year if the crisis coincides with a bear market and recession. Middle Eastern crises tend to occur at the height of business cycles when economic activity is running hot, inflationary pressures are high, and governments feel confident enough in their economic foundation to take foreign policy risks. The Yom Kippur war and first oil shock initiated a recession in 1973. The first Iraq war also coincided with the onset of a recession. The terrorist attack on the USS Cole occurred near the height of the Dotcom bubble and was followed by the 2001 recession. The 2019 Iranian attack on Saudi Arabia’s Abqaiq refinery also occurred at the peak of the cycle. More analogous to the situation today are crises that occurred in the early stages of the global cycle. The Arab Spring and related events in 2011 coincided with a period of market weakness that lasted for most of the year as the aftershocks of the Great Recession rippled across the emerging world. This scenario is relevant in 2021 and especially 2022, as global stimulus wears off and governments strive to navigate the deceleration in growth. Middle Eastern instability could compound that problem. The chief risk in the coming years would be a failure to resolve the Iranian question followed by a US-Iran or Israel-Iran conflict that generates instability across the Middle East. Such a catastrophe could cause major energy supply shock that would short-circuit the global economy. History shows this risk is more likely to come late in the cycle rather than early but the above analysis indicates that a failure of the Biden administration to conclude a deal this year could lead to a multi-year escalation in strategic tensions with a new hawkish Iranian president. That path, in turn, could bring forward the time frame of a major war and supply shock. The Iranians have taken a hawkish turn, are fortifying their regime for the future, and will reject total denuclearization. The US is fundamentally less interested in the region and thus susceptible to continued foreign policy incoherence. The Israelis are just capable of taking military action on their own in the event of impending Iranian nuclear weaponization. These points suggest that the risk of war with Iran is non-trivial, even though a US-Iran deal is the base case.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 See Sun Yu and Demetri Sevastopulo, "China targets rare earth export curbs to hobble US defence industry," Financial Times, February 15, 2021, ft.com. 2 For the US response to the Erbil attack see Jim Garamone, "Austin Pleased With Discussions With NATO Leaders," Department of Defense News, February 17, 2021, defense.gov. 3 For example, Biden is unlikely to withdraw precipitously from the region, including Afghanistan, as Trump intended, especially as long as he is in a high-stakes negotiation with Iran. 4 Ruth Igielnik and Kim Parker, "Majorities of U.S. veterans, public say the wars in Iraq and Afghanistan were not worth fighting," Pew Research, July 10, 2019, pewresearch.org. 5 See Benoit Faucon and Summer Said, "Saudi Arabia Set to Raise Oil Output Amid Recovery in Prices," Wall Street Journal, February 17, 2021, wsj.com; Yuliya Fedorinova and Olga Tanas, "Global Oil Markets Are Now Balanced, Russia’s Novak Says," Bloomberg, February 14, 2021, Bloomberg.com.

Highlights Health care remains a top priority of the Democratic Party even though it is flying under the radar at the moment. Health care embodies the shift from small government to big government. While the 2021 budget reconciliation will hit Big Pharma and expand Medicaid, the 2022 reconciliation will seek a public health insurance option and Medicare role in price negotiations. If forced to choose between health care and climate change priorities, Democrats will choose health care. It is a bigger vote-winner. Stay short managed health care relative to the S&P 500. Go long health care facilities and equipment relative to the rest of the health sector. Feature The US Senate acquitted former President Donald Trump on a vote of 57-43 on February 13. No one was hanged.1 The trial was not economically or financially significant except insofar as it underscored peak US political polarization, US distraction from the global stage, and the extent of divisions within the Republican Party. Equity market volatility melted away as stocks surged higher on the generally positive backdrop of COVID vaccines and stimulus.   Seven Republicans joined Democrats in voting to convict the former president of “incitement to insurrection.” Trump’s performance was worse than Bill Clinton’s but better than Andrew Johnson’s, though neither Clinton nor Johnson saw defections from their own party (Chart 1). The Republicans’ internal differences are serious enough to hobble them in the 2022 or 2024 elections but it is too soon to draw any hard conclusions. The Democratic agenda is also capable of bringing Republicans back together. Meanwhile the maximum of seven Republican defectors shows that it will be extremely difficult for Democrats to get 10 Republicans to join them in passing any controversial legislation in the Senate (Table 1). Hence the filibuster will remain in jeopardy over the long run if not in the short run. Also, in 2022, the Democrats have a chance to pick up seats in Pennsylvania and North Carolina. Chart 1Trump’s Acquittal And Historic Impeachment Results Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table 1The Seven Senate Republicans Who Defected From Trump Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Biden’s Agenda After The American Rescue Plan Democrats are plowing forward with the first of two budget reconciliation bills, which enables them to pass legislation with a simple majority in the Senate. They hope to pass President Biden’s $1.9 trillion American Rescue Plan by mid-March, when unemployment benefits expire under the Consolidated Appropriations Act of 2020. The final sum might be a bit less than this headline number. The second budget reconciliation bill, for fiscal year 2022, will be passed in the autumn or next spring and will contain anywhere from $4 trillion to $8 trillion worth of additional spending on health care, child care, infrastructure, and green projects over a ten-year period (Chart 2). This number will be watered down in negotiation as the pandemic subsides and the aura of crisis dies down, reducing the willingness of moderate Democrats to vote for anything controversial. But investors should not doubt Biden’s agenda at this stage. If there is anything we know about the reconciliation process it is that the ruling party will get what it wants. Investors should plan accordingly: the output gap will be closed sooner than expected and inflationary pressures will build faster than expected, even though it will take a while for the labor market to heal. Chart 2Biden’s Agenda AFTER The American Rescue Plan Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy This policy combination of “loose fiscal, loose monetary” policy continues to drive stocks higher (and the dollar lower) despite the misgivings we noted about underrated geopolitical risks (Chart 3). A critical question is when the Fed will normalize monetary policy. This is not an apolitical question. Fed chair Jerome Powell’s term ends in February of 2022. He may contemplate tapering asset purchases prior to that date, causing troubles in the equity market, but actual tapering is more likely to occur in 2022, in the view of our US Bond Strategist Ryan Swift. Powell would only taper in 2022 if he is forced to do so by an ironclad policy consensus precipitated by robust inflation and possibly financial instability concerns. This timing gives President Biden an opportunity to nominate an ultra-dovish Fed chair. Rate hikes are entirely possible in 2022 but our political bias implies they are unlikely before 2023 (unless an ironclad consensus develops that they are necessary). Even in 2023, an ultra-dove will be reluctant to hike, depending on the context. And rate hikes are virtually off limits in 2024, at least until after the November election. This political timeline reinforces the view that the Fed will not be hiking anytime soon and investors should prepare for inflation risks to surprise to the upside over the coming years. Chart 3"Easy Fiscal, Easy Monetary" Policy Combination "Easy Fiscal, Easy Monetary" Policy Combination "Easy Fiscal, Easy Monetary" Policy Combination The Senate parliamentarian has not yet ruled whether a federal minimum wage hike to $15 per hour can be included in the bill. Biden has accepted it may be cut but his party will push it through if possible. Last week we found that a higher minimum wage would not have a dramatic macroeconomic impact. Still, wages will rise in the coming years due to the cumulative effect of the Democratic Party’s policies. Higher wages, taxes, and regulatory hurdles will cut into corporate profits. But the passage of a higher minimum wage today would not in itself be a negative catalyst for equities. Rather, we would expect the rally to take a breather once the first reconciliation bill is finished (next week or in the coming weeks), since it will bring wage hikes, rate hikes, and tax hikes more clearly into view on the investment horizon.  Unlike minimum wages, there is little controversy over whether budget reconciliation can be used to change the health care system. This was done in 2010 as the second critical part to President Barack Obama’s Affordable Care Act (Obamacare). Hence Biden is highly likely to get his health agenda passed, which is largely an agenda of entrenching and expanding Obamacare. That is, as long as he prioritizes health care above other structural reforms like climate change. We think he will. In the rest of this report we look at Biden’s health care policy and the implications for US financial markets. Biden’s Health Care Policy Health care has been a top priority of the Democrats since 1992 yet they have repeatedly lost control of the agenda due to surprise Republican victories in 2000 and 2016. Republicans expanded Medicare under Bush but then failed to repeal and replace Obamacare under Trump. Now Democrats have only the narrowest of majorities in the House and Senate and will push hard to solidify and build on Obamacare. There is a low chance that they will leave this issue unsettled under the Biden administration. If new obstacles arise, more political capital will be spent to secure health care reform at the expense of other policies on the agenda. COVID-19 reinforces the Democrats’ focus on health care. The US has seen around 1,500 deaths per million people, making it one of the worst performers amid the crisis, comparable to the UK and Italy (Chart 4). Yet COVID is only the latest in a line of US public health failings and it is important to put COVID into perspective. For example, among US adults aged 25-44 years old, all-cause excess mortality from March to July last year was about 11,899 more than expected. By contrast, during the same period in 2018, there were 10,347 unintentional deaths due to opioids (Chart 5).2 In other words, the COVID crisis last year was comparable to the opioid crisis in magnitude, at least for middle-aged people. Obviously COVID has taken a terrible toll and is a more deadly disease for the old and the sick. The point is that the public’s wrath over poor public health and the US government’s ineffectiveness is well established. A pandemic was foreseeable, and foreseen, yet not prepared for, and it came on top of the opioid crisis and the debate about 30 million Americans who lack health insurance. The Biden administration has the intention and the capability to address these issues. Chart 4US Handling Of COVID-19 Left Much To Be Desired Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy   Chart 5Opioid Crisis Versus COVID Crisis Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy  The structural problem is well-known: The US spends more than other countries on health care but achieves worse results (Charts 6A & 6B). When workers get fired they lose health care, as insurance is tied to employment. Those whose employers do not provide health care or who are unemployed count among the ranks of the roughly 30 million uninsured. This number has fallen from its peak at 47 million in 2010 when Obamacare was enacted but has crept upward again since Trump’s attempt to dismantle that law and the lockdowns of 2020 (Chart 7). This is a driver of popular discontent that has proven again and again to generate votes, including in key swing states. Chart 6AThe US Spends More On Health Care … Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Chart 6B… But Sees Worse Avoidable Mortality Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Chart 7Rising Number Of Uninsured Even Pre-COVID Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy A range of public opinion polling over many years shows that health care is a close second or third to the economy and jobs in voter priorities. Voters care more about COVID and health care than they do about climate change and the environment (Chart 8, first panel). Chart 8Public Opinion On Biden’s Priorities: Jobs, Health, Then Climate Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Another important takeaway from this opinion polling is that voters could not care less about budget deficits. Big spending solutions are all the rage (Chart 8, second panel). The Biden administration is prioritizing economic recovery and the pandemic response but will also pursue its health care reforms. If this policy requires a tradeoff with infrastructure and renewables, we would expect health care to get the greater attention.  Over the long run Obamacare can be replaced but not repealed. The law is getting more popular over time and entitlements get harder to repeal over time. Slightly more than half of voters have a favorable view of the law and only 34% have an unfavorable view. Only 29%of voters want to repeal or scale back the law while about 62% want to build on it or keep it as it is (Chart 9). Underscoring this polling is the fact that the law was modeled on a Republican plan and even Trump adopted several of the most popular provisions: requiring insurance coverage for patients with preexisting conditions and slapping caps on pharmaceutical prices through import and pricing schemes. The Supreme Court has ruled Obamacare constitutional and is not expected to change that ruling this spring. It could object to the individual mandate – the most controversial part of Obamacare that required each person to pay a tax penalty if they did not purchase health insurance. But if parts of the law are stricken, Democrats have the votes to patch it up or provide an alternative.  Chart 9Obamacare Has Grown On American Public Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Biden simultaneously shows that Democrats rejected the most popular alternative to Obamacare – “Medicare for All,” or single-payer government-provided health care – at least for the current presidential cycle. Medicare for All was co-sponsored by Vice President Kamala Harris and is still a long-term goal of the progressive wing of the Democratic Party. However, voters do not like the proposal when asked about its practical consequences (Chart 10). In the Democratic primary, only Senators Bernie Sanders and Elizabeth Warren argued for wholesale revolution in US health care that would see private insurance cease to exist and 176 million voters moved onto a public health system. Sanders’s plan would have cost an estimated $31 trillion, increasing the budget deficit by $13 trillion over 10 years, and would have encouraged the overuse of medical services due to the absence of a co-pay or fixed cost. This idea will not vanish but the Biden administration’s likely success in expanding Obamacare will lead the party to focus on other things (e.g. climate change). Chart 10Insufficient Public Demand For Government-Provided Health Care (For Now) Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Biden’s big proposal is to add a public insurance option that would exist alongside current private insurance options. This idea was originally part of Obamacare but was removed during negotiations – precisely because the Democrats eschewed the use of budget reconciliation (again, not a constraint this time).3 The Biden plan is estimated to cost $2.25 trillion over 10 years and includes larger subsidies, the ability of workers to choose whether they want their employer-provided plan or the public option, automatic enrollment, a lower age of eligibility for Medicare (from 65 to 60), drug price caps, and various other provisions (Table 2). Table 2Biden’s Health Care Plan Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Medicare, a giant consumer, would be able to negotiate drug prices directly with companies to drive down the price. Tax hikes on high-income earners and capital gains would pay for Biden’s policy.  With public backing and full Democratic control of Congress, there is little that can stop Biden from achieving this health care policy, other than a change in direction from his party, which we do not expect. The first budget reconciliation only contains small parts of the Biden agenda, such as incentives for states to expand Medicaid under Obamacare and a reduction in Medicaid rebates for drug manufacturers.4 The second budget reconciliation process will have to cover health care and tax hikes. But the consensus view is that the second reconciliation will focus on infrastructure and green energy. This is a conflict of priorities that will have to be resolved. The research above suggests it will be resolved in favor of health care. This would leave the regular budget process as the means to advance infrastructure and green projects. Macro Impact Of Biden’s Health Care Policy The great health care debate over the past decade reflected the broad post-Cold War debate in the US over the role of government in the economy. It centered on whether government involvement should increase to expand health insurance coverage. Although private US health care spending accounts for 31% of total health care spending, and is thus larger than either Medicare (21%) or Medicaid (16%), the government has control of 44% of spending when all of its functions are added together. This share is set to increase now that the debate has been decided in favor of Big Government (at least for now). Future administrations might carve out more space for private choice and competition in health care but a permanent step-up in government involvement and regulation has occurred given the above points about Obamacare’s irrevocability. What are the macro consequences of such a change?   The imposition of Obamacare may have contributed to the sluggish economic recovery in the wake of the Great Recession but the case is hard to examine objectively because the tax penalties only took effect in 2015-16 and then a new administration ceased implementation in 2017. In 2015 the Congressional Budget Office estimated that repealing Obamacare would increase the budget deficit by $353 billion over a ten year period but that it would also increase GDP by an average of 0.7% per year during the latter end of full implementation, thus boosting revenues and producing a net $137 billion increase in the budget deficit over ten years.5 In other words, Obamacare marginally tightened fiscal policy and encouraged some workers to cut their hours or stop working due to expanded subsidies, tax credits, and Medicaid eligibility.6 Repealing it would have reduced the tax burden on corporations and reduced the subsidy benefits to households but possibly with a slight boost to growth (Chart 11). Going forward, Biden’s policies are adjustments rather than a total overhaul but they would ostensibly add $2.25 trillion in spending and $1.4 trillion in revenue, resulting in a negative impact on the budget deficit (fiscal loosening) of $850 billion. The implication is that Biden’s plan would increase rather than decrease aggregate demand, albeit marginally in an era of already gigantic deficits. It would also remove some labor supply and eventually drag on GDP growth. Yet the impact of these effects is still uncertain given the general context of loose fiscal and loose monetary policy, the reduction in the number of uninsured people, and the potentially positive second-order effects of this increase in the social safety net for low-income families with high marginal propensities to consume. The bottom line is that the macro effects of Biden’s health plan will not be known for many years but the headline effect in the short run is an incremental addition to an already extremely loose fiscal policy setting.  Chart 11Macro Effects Of Obamacare Repeal Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy The negative effects will largely fall on high-income earners, capital gains earners, and corporations who will provide the revenue to pay for the plan. The private health insurance industry faced an existential threat from the Sanders plan but it still faces a loss of customers and earnings from the Biden plan. The major difference between Obamacare and Bidencare is that Obamacare forced insurance companies to provide a basic insurance option to the public but did not offer a public option to compete with them. Therefore their customer base increased albeit at a lower profit. Whereas Biden’s plan will create a public competitor that will siphon off customers from private insurance. Biden proposed giving workers this choice anytime but in the presidential debates suggested there would be limits. Either way private insurers stand to lose customers over time. This is not a major political constraint given that Big Insurance gets little sympathy from the public but it will have a negative impact on innovation and productivity in the health sector. Meanwhile Medicare would reimburse hospitals, clinics, and drug providers less for their services and goods. This would weigh on the profitability of small and private medical outfits and favor large and public providers that receive government subsidies and can stomach higher costs. It would also take a toll on Big Pharma and biotech sectors which have operated in a lucrative environment of low taxes, low regulation, and sizable pricing power. The US government has enormous negotiating power in the market, especially over home care, hospitals, nursing homes, and prescription drugs. Private and public investment are roughly evenly split, with public money dominating health care research and private money dominating structures and equipment. The government accounts for about 40% of total drug spending and both political parties believe this influence should be used to keep costs down, as public opinion is increasingly dissatisfied with high drug costs.7 There is a lot more to be said about the US health care system. A risk of Biden’s health reform is that it will increase the demand for health services without arranging for consummate increases in supply. In this sense it is inflationary. Investment Takeaways Health care stocks and each of the health care sub-sectors – pharmaceuticals, biotech, managed health care, facilities, and equipment – underperformed the S&P500 index amid the passage of Obamacare from March 23 to November 20, 2010. Within the sector, managed health care (health insurance) and biotech suffered most when the legislation first hit while facilities and equipment suffered most over the whole legislative episode. Once the law took full effect in 2014-15, equipment and managed health care outperformed, facilities were flat, and pharma and biotech underperformed. A look at the performance of the health care sector relative to the S&P 500 over the past 13 years shows that the sector rallied on President Obama’s victories in 2008, fell during the passage of Obamacare, staged a recovery that continued through the Supreme Court’s decision to uphold the new law in June of 2012, and then dropped off (Chart 12 A). Health stocks benefited from the global macro backdrop from 2011-15. After 2015, when Obamacare took full effect, the business cycle entered its later stage, and populism emerged (with Sanders threatening a government takeover and Trump firing up the cyclical economy), health care stocks underperformed the market. Chart 12AHealth Sector's Response To Obamacare Saga Health Sector's Response To Obamacare Saga Health Sector's Response To Obamacare Saga Subsequent rallies have occurred, notably on the outbreak of COVID-19, but have not been sustainable. When Republicans failed to repeal Obamacare, when various crises gave defensive plays a tailwind, when Biden won the Democratic nomination over Sanders or Warren, and when the pandemic arose, the sector surged, often due to risk aversion in financial markets. In the end the negative trend reasserted itself as the combination of rising risk sentiment and policy headwinds outweighed the underlying demographic tailwind for earnings as society aged. Since the Democratic sweep of government in the 2020 elections the sector is testing new lows in relative performance. Pharmaceuticals charted a similar course to the overall health sector but never regained their pre-Obamacare peak in relative performance. They have underperformed again and again since the rise of Bernie Sanders and are today touching new lows (Chart 12B). Chart 12BBig Pharma's Response To Obamacare Saga Big Pharma's Response To Obamacare Saga Big Pharma's Response To Obamacare Saga A closer look at the sector since the 2020 election and especially the Democratic victory in the Senate shows that it continues to underperform the broad market. Facilities are the most resilient, pharma and biotech are trying to find a bottom, and equipment and managed health care have sold off. Relative to the health care sector, equipment and facilities are the outperformers but, again, pharma and biotech are trying to bottom (Chart 13). These results make sense as Biden’s biggest policy impact will be to stimulate demand for health care facilities and equipment while constraining profits for Big Insurance and Big Pharma via the public insurance option and allowing Medicare to negotiate drug prices. Thus equipment and facilities benefit from the political environment, pharma and biotech should be monitored to see if they break down to new lows on the passage of legislation, and managed health care gets the short end of the stick. Our US Equity Strategy service is neutral on the sector as a whole, overweight equipment, and underweight pharma. Chart 13Health Care Sector Response To Biden's Democratic Sweep Health Care Sector Response To Biden's Democratic Sweep Health Care Sector Response To Biden's Democratic Sweep Putting it all together, health care stocks are good candidates for a short-term, tactical bounce when the exuberant stock rally suffers a correction but they are not yet candidates for strategic investments. They are not likely to find a bottom until Biden’s policies are passed, or the pro-cyclical macro backdrop has changed. Biden’s policies are high priority for his party and face low legislative and political hurdles to passage, yet will have a huge impact on the relevant industries – undercutting the private health insurance customer base and capping the profits of America’s drug makers. These changes will have long-term ramifications so they are not likely to be fully discounted yet. Previously health care firms had huge pricing power – they could charge whatever they wanted while they did not face the full might of the government in setting prices – but going forward that will change. Biotech and pharma have large profit margins that are exposed to this policy shift so they are exposed to further downside – we would not be bottom-feeders. Moreover pharmaceuticals make up 28% of the health sector while biotech makes up 13%, so that these sectors will weigh down the whole sector. One would think that health care would outperform during a global pandemic – and most sectors did see a big bounce during the height of the COVID-19 outbreak. But the pandemic has created the impetus for a stimulus splurge that has fired up the cyclical parts of the economy. It has also underscored the industry’s public role and undercut its profit-making capabilities, not least by producing a Democratic sweep bent on improving US health outcomes – at the expense of US health industry profits. In sum, from a tactical point of view, health care stocks are well-positioned for a near-term rally in relative performance but from a strategic point of view they continue to face policy headwinds and should be underweighted relative to the broad S&P 500. Tactically, stay short the managed health care sub-sector relative to the S&P 500 (Chart 14). Strategically, go long health care facilities and equipment relative to the health care sector. Chart 14Health Stocks Outlook Under Biden Administration Health Stocks Outlook Under Biden Administration Health Stocks Outlook Under Biden Administration     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.Kuri@bcaresearch.com   Appendix Table A1APolitical Capital: White House And Congress Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A1BPolitical Capital: Household And Business Sentiment Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A1CPolitical Capital: The Economy And Markets Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A2Political Risk Matrix Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy Table A3Biden’s Cabinet Position Appointments Don't Forget Biden's Health Care Policy Don't Forget Biden's Health Care Policy           Footnotes 1     During the election crisis [of 1876], Kentucky Democrat Henry Watterson urged that “a hundred thousand petitioners” and “ten thousand unarmed Kentuckians” go to Washington to see that justice was done. Years later, when he was sitting next to [Ulysses S.] Grant at a dinner party, Watterson told him, “I have a bone to pick with you.” “Well, what is it?” asked Grant. “You remember in 1876,” said Watterson, “when it was said I was coming to Washington at the head of a regiment, and you said you would hang me if I came.” “Oh, no,” cried Grant, “I never said that.” “I am glad to hear it,” smiled Watterson. “I like you better than ever.” “But,” added Grant drily, “I would, if you had come.” See Paul F. Boller, Jr, Presidential Campaigns: From George Washington To George W. Bush (Oxford: Oxford University Press, 2004 [1984]), p. 141. 2     See Jeremy Samuel Faust, Harlan M. Krumholz, and Chengan Du, “All-Cause Excess Mortality and COVID-19-Related Mortality Among US Adults Aged 25-44 Years, March-July 2020,” Journal of the American Medical Association, December 16, 2020, jamanetwork.com. 3    The death of Senator Edward Kennedy forced the Democrats to use reconciliation for the second part of President Obama’s health care reform, the Healthcare and Education Reconciliation Act of 2010.  4    Currently the Medicaid rebate cap is set at 100% of the cost of making a drug. Other provisions would include a boost for rural health care services (a partial reallocation of headline COVID relief funds) and an expansion of Obamacare tax credits and subsidies for unemployed workers to keep their former employer-provided insurance. These are mainly COVID relief measures rather than aspects of Biden’s long-term health agenda. See Julie Rovner, “KHN’s ‘What the Health?’: All About Budget Reconciliation,” Kaiser Family Foundation, February 11, 2021, khn.org; see also Nick Hut, “A look at some of the healthcare-specific provisions in the pending COVID-19 relief legislation,” Healthcare Financial Management Association, February 10, 2021, hfma.org. 5    For the CBO’s original report on repeal, see “Budgetary and Economic Effects of Repealing the Affordable Care Act,” Congressional Budget Office, June 19, 2015, cbo.gov. More recently see Paul N. Van de Water, “Affordable Care Act Still Reduces Deficits, Despite Tax Repeals,” Center for Budget and Policy Priorities, January 9, 2020, cbpp.org. 6    See BCA Global Investment Strategy, “The Fed’s Dilemma,” May 12, 2017 and “Four Key Questions On The 2018 Global Growth Outlook,” January 5, 2018, bcaresearch.com. Regarding the debate around Obamacare, promoters highlight the recovery in US growth and jobs – including full-time jobs and small-business jobs – by 2015. Critics say the recovery would have been stronger if not for the law. See e.g. Casey B. Mulligan, “Has Obamacare Been Good for the Economy?” Manhattan Institute, Issues Brief, June 27, 2016, manhattan-institute.org; Cathy Schoen, “The Affordable Care Act and the U.S. Economy: A Five-Year Perspective,” Commonwealth Fund, February 2016, commonwealthfund.org. 7     Republican Senator Chuck Grassley co-sponsored a bill with his Democratic counterpart Ron Wyden of Oregon that would penalize drug companies that raised drug prices faster than inflation. In a separate bill with Senator Amy Klobuchar of Minnesota, he also proposed to prevent big name drug companies from paying generic drug-makers to delay the introduction of generics to the market. These bills were not debated on the main floor because then-Senate Majority Leader Mitch McConnell was unenthused about them but they exemplify the bipartisan consensus on government intervention to push down drug prices.

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

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

Highlights Italy looks like it will form a national unity coalition under Super Mario Draghi – though it is not yet a done deal. A snap election is still our base case, whether in 2021 or 2022, but the ECB will do “whatever it takes,” as will Draghi if he becomes Italy’s prime minister. Even if the right-wing populist parties win power in a snap election, their goal is to expand fiscal spending, not exit the Euro Area. And they would rule in a world where even Germany and Brussels concede the need for soft budgets. Go long BTPs versus German bunds, and Italian stocks versus Spanish stocks, on a tactical 3-6 month horizon. The structural outlook for Italy is still bearish until Italy can secure its recovery and launch structural reforms. Feature In 2016-17 we wrote two special reports on Italy under the heading of “Europe’s Divine Comedy.” In “Inferno” we focused on Italy’s structural flaws and in “Purgatorio” we explained why Italy would stay in the European Union. We have long awaited the chance to write the third installment, which must be called “Paradiso” in honor of Dante Alighieri. But the tragedy of the pandemic makes this title sadly inappropriate. The new government that is tentatively taking shape is not the solution to the country’s long-term problems either. Former European Central Bank President Mario Draghi is an excellent policymaker and would ensure that Italy does not add political chaos to its pandemic woes this year. A unity government under Draghi – which is not yet a done deal as we go to press – would be a tactical and even cyclical positive for Italian equity and bond prices but not a structural positive. The paradise of national revival will have to wait for a later date. In the meantime Italy’s performance will be dictated by its surroundings. The Black Death Italy suffered worse than the rest of Europe from COVID-19, judging both by deaths and the economic slump (Chart 1). It was the first western country to suffer a major outbreak. Outgoing Prime Minister Giuseppe Conte was the first western leader to impose a Chinese-style lockdown – which came as a shock for democratic populations unfamiliar with such draconian measures. Few will forget the terrifying moment in March when the military was deployed in Bergamo to help dispose of the bodies.1 Chart 1Italy's National Crisis Italy's National Crisis Italy's National Crisis Chart 2Italy’s Unemployment Problem – Especially In The South Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? The crisis struck at an awkward time in Italian politics as well. Like the US and UK, Italy saw a surge of populism in the 2010s. Hostility toward the political elite arose largely in reaction to hyper-globalization, the adoption of the euro, and deep structural flaws that have engendered a sluggish and unequal economy: Poor demographics: Italy’s population peaked in 2017 and is expected to fall from 61 million to 31 million by the year 2100. Its fertility rate is 1.3, the lowest in the OECD except South Korea. It has the third smallest youth share of population (13%) and stands second only to Japan in elderly share of population (23%).2 North-South division: Southern Italy, the Mezzogiorno, is poorer, less educated, less efficient, and less well governed than northern Italy. Unemployment is 7 percentage points higher in the south than in Italy on average (Chart 2). In our “Inferno” report we concluded that regional divisions discourage exiting the Eurozone and EU, since southern Italy benefits from EU transfers and northern Italy would refuse to subsidize southern Italy without EU support (Chart 3).   Chart 3EU Budget Allocations Favor Italy Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Low productivity: Italy’s real output per hour has lagged that of its European peers as the country has struggled to adjust to globalization, digitization, aging, and emerging technologies (Chart 4). Chart 4Italy's Lagging Productivity Italy's Lagging Productivity Italy's Lagging Productivity High debt: Italy’s debt-to-GDP ratio is expected to rise from to 134.8% to 152.6% by the year 2025, putting it on a higher-debt trajectory than even the worst case projections prior to the pandemic (Chart 5). Normally Italy runs a current account surplus and primary budget surplus, although the pandemic has pushed the country down the road of budget deficits (Chart 6). The debt problem is manageable as long as inflation is low and the ECB purchases Italian government bonds – which it will do in the interest of financial stability. But it sucks away growth and investment over time, a problem that will revive whenever the EU Commission tries to return to semi-normal fiscal policy restraints. Chart 5Italy’s Debt Pile Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Chart 6Italy’s Budget Surplus Destroyed By COVID-19 Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Italy’s predicament can be illustrated simply by comparing the growth of GDP per capita over the past decade to that of Spain, which is a structurally comparable Mediterranean European economy and yet has generated a lot more wealth for its people after having slashed government spending and reformed the labor market and pension system in the wake of the debt crisis (Chart 7). Chart 7Spain Reformed, Italy Didn't Spain Reformed, Italy Didn't Spain Reformed, Italy Didn't Structural reforms undertaken by the technocratic Mario Monti government in the wake of the sovereign debt crisis proved insufficient. Subsequent reform efforts went up in a puff of smoke when Matteo Renzi’s pro-reform constitutional referendum failed in 2016. Italy’s government is congenitally gridlocked because the lower and upper houses of the legislature have equal powers, like in the US, but its parliamentary governments can be easily toppled by either house. The 2016 constitutional reforms would have given the central government historic new powers to force through painful yet necessary structural changes – but centrist voters of different stripes hesitated to grant these new powers since they looked likely to go to populist parties on the brink of victory in the looming 2017 elections. The populists – the right-wing League in the north and the left-wing Five Star Movement in the south – did indeed come to power in 2017 but Italian’s political establishment subsequently restrained them from pursuing either serious euroskepticism or massive fiscal spending. Pro-establishment President Sergio Mattarella rejected any cabinet members who would attack the monetary union. Subsequent battles with Brussels and Germany prevented Italy from passing a blowout stimulus that challenged EU fiscal orthodoxy and threatened to precipitate a solvency crisis in the banking system. In 2019 the ambitious League broke with the Five Star Movement, which collaborated with the center-left Democratic Party to form a new coalition. But the resulting compromise government, its populism diluted, only managed one structural reform – to reduce the size of parliament – plus a moderate increase in government spending. The populist parties ended up being right about the need for more proactive fiscal policy, as Germany conceded in late 2019 and as COVID-19 lockdowns made absolutely necessary in early 2020. French President Emmanuel Macron and German Chancellor Angela Merkel agreed to launch a €750 billion EU Recovery Fund that enabled jointly issued debt for EU members, solidifying a proactive fiscal turn in the bloc. Italy now has €209 billion coming its way. This is a boon for the recovery, though it is also the origin of the politicking that brought down the ruling coalition last month. With central banks monumentally dovish, European and American fiscal engines firing on all cylinders, and China’s 2020 stimulus still coursing through the world’s veins, the macro backdrop is positive for Italy. But with Italy’s economy still shackled by fundamental flaws, it will not be a lead actor or an endogenous growth story. Bottom Line: Italy missed the chance in the 2010s to undertake structural reforms that could lift productivity and potential growth. Now it is struggling to maintain political order in the wake of a devastating pandemic and recession. The vaccine and global recovery will lift Italian assets but the future remains extremely uncertain, given the eventual need to climb down from extreme stimulus and impose painful structural reforms. Paradiso? Or Paradiso Perduto? The latest political turmoil arose over the EU Recovery Fund and how Italy will spend the €209 billion allotted to it, as well as the €38.6 billion allotted to the country under the EU’s structural budget for 2021-28. Ostensibly Matteo Renzi pulled his Italia Viva party out of the ruling coalition because he feared that former Prime Minister Conte, together with his economy and industry ministers, would spend the funds on short-term vote-winning handouts rather than long-term structural fixes in health, education, and culture. But Renzi was not appeased when Conte offered to spend more on health and education as requested. Renzi’s party fares poorly in opinion polls and the recent electoral reforms were not favorable to it, so he can hardly have wanted a new election. He wanted Italy to tap €36 billion from the European Stability Mechanism in addition to taking EU recovery funds, since this would come with strings attached in the form of structural reform. He apparently wanted to precipitate a new pro-establishment coalition. President Mattarella’s appointment of Mario Draghi to lead a national unity coalition is the solution. But as we go to press it is not certain that Draghi will be able to command a majority in parliament. Chart 8Salvini's League Lost Steam But Populist Right Still Powerful Salvini's League Lost Steam But Populist Right Still Powerful Salvini's League Lost Steam But Populist Right Still Powerful Matteo Salvini and the League are the pivotal players now. Salvini and his party suffered loss of popular support in 2019 as a result of his ambitious attempt to break from the government, force new elections, and rule on its own. The party especially suffered from the pandemic, which hit its base of voters in Lombardy hard and sent voters in support of the central government as well as the political establishment (Chart 8). Salvini must now decide whether to try to rebuild his status by joining Draghi in the national interest, to show he can be a team player, albeit at risk of being seen as an institutional politician. If so, he would cede the right-wing anti-establishment space to his partner Giorgia Meloni, who leads the Brothers of Italy, which has eaten up all the support Salvini has lost since the European parliament election of 2019. What is clear is that his current strategy is not working, and he played ball with the big boys during the 2017-19 period, so we would not rule him out of a Draghi government. If Draghi does not win over Salvini and the League, he would need to win the support of the Five Star Movement to form a coalition. The party’s leaders initially said they would not join Draghi, who epitomizes the establishment of which they are sworn enemies. Yet Five Star has not lost any popular support for working with the conventional Democratic Party, in stark contrast with the League, which stayed ideologically pure but lost supporters. Some Five Star members, including Foreign Minister Luigi Di Maio, former leader of the party, want to work with Draghi and stay in government. Hence the party could still join Draghi, or it could break apart with some members defecting. It would require 33% of Five Star members in the Chamber of Deputies and 28% of Five Star members in the Senate to join Draghi to give him a majority, assuming the League and Brothers of Italy refuse to cooperate (Table 1). Interestingly, if the League is absent from the vote, and all parties other than the Brothers and Five Star join Draghi, then he could also form a government. This would give cover to the League under the pretense of COVID vigilance, without being seen as actively preventing a government formation. Table 1'Whatever It Takes' To Build A National Unity Coalition Under Super Mario Draghi Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? We have favored an early election and this could still occur. If there is an election it will happen before June because an election cannot happen within the last six months of the current president’s term, as per Article 88 of the Constitution. If Italy avoids a snap election till June, political stability is ensured at least till January. The pandemic was the justification for avoiding a snap election but the pandemic did not prevent the regional elections or constitutional referendum in September. The referendum was a hurdle that needed to be cleared before the next election, so now the way is open. All of the parties are greedily eying the presidency, with President Mattarella’s seven-year term set to expire next January. Mattarella has emerged as a staunch defender of the establishment and a check on anti-establishment parties. If the populists gain a plurality prior to January, then they can try to get a more sympathetic or neutral policymaker in that position. By contrast, the pro-establishment parties are hoping that a Draghi coalition can last long enough to ensure that one of their own holds that post. Since the latter need either the League or Five Star to govern, they would have to compromise on the next president – which is a very big concession. In distributing EU recovery funds, there is little doubt that a unity government under Draghi would be a credible way of proceeding. Draghi has joined other central bankers, like the Fed’s Janet Yellen, in voicing strong support for fiscal policy to get the developed democracies out of their current low-growth morass. He would have the authority and expertise to direct spending to productivity-enhancing projects at home while working with Brussels to allow Italy the greatest possible flexibility. Italy’s portion of EU recovery funds is shown in Chart 9, with the black bar indicating the part consisting of loans. The sector breakdown of total EU recovery fund is shown in Table 2. Chart 9Italy’s Fiscal Stimulus To Receive EU Top-Up Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Table 2Composition Of EU Recovery Fund By Economic Sector Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Yet a Draghi government is not a permanent solution to Italy’s political crisis or its economic malaise. Currently the political parties are squabbling over how to distribute a windfall of special funds – Italy is benefiting from a more pragmatic EU policy as it emerges from a crisis. But in future the parties will be fighting over what to do when the funds are spent. Even if the EU continues to be generous the stimulus will decelerate, while structural reforms will have to be attempted yet again. A technocratic Draghi government would be well positioned to institute the reforms that Italy needs but the economic medicine could sow the seeds for another voter backlash – in which case the anti-establishment right would be in prime position. This would set up a giant clash with Germany and Brussels. Italy, The EU, And Global Power Politics Geopolitically, Italy matters because it is a test of whether the European Union will continue consolidating power within its sphere of influence. If Draghi can form a unity government, oversee economic recovery and long-delayed structural reforms, and survive to reap the benefits at the voting booth, it would mark a historic victory for the EU as it lurches from crisis to crisis in pursuit of deeper integration and ever closer union. The Italian question would effectively be resolved and the EU would have the capacity to handle other challenges elsewhere. Europe’s geopolitical coherence is critical for global geopolitics as well. Europe is the prime beneficiary of US-China competition – at least until such time as it is forced to choose sides. Since Europe is a great power, it can remain neutral for a long time, using America as a stick against Chinese technology theft while expanding market share in China as it diversifies away from the United States (Chart 10). Chancellor Merkel has already signaled to Biden that she is not eager to join any “bloc” against China. Biden will have to devote a massive diplomatic effort to convince the Europeans, who are not as concerned about China’s military and strategic threat, that it is necessary to form a grand alliance toward containing China’s rise. Chart 10EU Balances Between US And China Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? The EU’s efforts to carve out a sphere of influence have momentum. The German and EU approach to fiscal policy has become more dovish and proactive, a concession to the southern European economies that will improve their support for the European project. Across the Atlantic the EU states see President Trump’s rise and fall as a story of America’s declining influence, which improves the EU’s authority over its own populace, and yet has not resulted in an American-imposed trade war that would undermine the recovery. To the east, EU states see Russian authoritarianism and its discontents, which reinforce the public’s commitment to democratic values and the single market. To the north, they see the negative example of Brexit, which continues to plague the UK, with Scotland pushing for independence again. To the south, Europeans have become less concerned about illegal immigration, having watched the inflow of migrants from Turkey, the Middle East, and North Africa fall sharply – at least until the next major regime failure in these regions causes a new wave of refugees (Chart 11). These events have encouraged various countries to fall in line behind the consensus of European solidarity and geopolitical independence. A technocratic government in Italy would reinforce these trends but a populist government would not be able to avoid or override them. Chart 11Europe Less Concerned About Refugees (For Now) Europe Less Concerned About Refugees (For Now) Europe Less Concerned About Refugees (For Now) Chart 12Italian Euroskeptics Constrained By Public Opinion Europe's Divine Comedy III: Paradiso? Or Paradise Lost? Europe's Divine Comedy III: Paradiso? Or Paradise Lost? The Italian populist parties are still in the ascent but they do not seek to exit the EU or monetary union (Chart 12). We fully expect Italy to see snap elections in 2022 if not 2023, given the fragility of any new coalition to emerge today. If the right-wing League and Brothers should win control of government, and clash with Germany and Brussels, they would still operate within an environment circumscribed by these geopolitical limitations. Otherwise greater solidarity gives the EU greater room for maneuver among the US, China, and Russia. Investment Takeaways In the short run, the Draghi government is bullish for Italian assets. If Draghi fails and snap elections are called, the downside to European equities and the euro is limited, since any risk of an Italian exit from the EU dissipated back in 2016-18. Past turmoil resulted in higher Italian bond yields and wider spreads between BTPs and German bunds because markets had to price in the risk that the Euro Area would break up. We have long highlighted that this risk was overstated and markets are well aware of that by now. The market’s muted reaction to this latest kerfuffle proves the point (Chart 13). Chart 13Markets Unimpressed By Italian Political Turmoil Markets Unimpressed By Italian Political Turmoil Markets Unimpressed By Italian Political Turmoil On overweight stance toward Italian government bonds has been one of the highest conviction calls of our fixed income strategist, Rob Robis, over the past year. He expects that Italian bond yields (and spreads over German debt) will converge to Spanish levels, thus restoring a relationship last seen sustainably in 2016. He also notes that the ECB is willing to use quantitative easing to support Italy when its politics inject a risk premium into government bonds and spreads widen. The central bank is also providing additional support to Italy via cheap bank funding (TLTROs) that helps limit Italian risk premia at a time when underlying credit growth is exceedingly weak. During the height of the COVID lockdowns last year, the ECB increased its buying of Italian bonds higher than levels implied by its Capital Key weighting scheme, which officially governs bond purchases. Once Italian yields fell back to pre-pandemic levels, the ECB slowed the pace of purchases to levels at or below the Capital Key weights. As long as the pandemic lingers, the ECB will have the ability and pretext to ensure that Italian spreads do not rise too high (Chart 14). Chart 14Overweight Italian Government Bonds Overweight Italian Government Bonds Overweight Italian Government Bonds True, investors may be more reluctant to drive Italian yields and spreads to new lows as long as there is a risk of elections this year or next that could bring anti-establishment leaders to power and trigger an increase in Italian political risk premia. But this trap between politics and QE still justifies an overweight stance within global bond portfolios, as Italian yields will remain too attractive for investors to ignore given the puny levels of alternative sovereign bond yields available elsewhere in the Euro Area. Go tactically long Italian BTPs relative to German bunds. Italian stocks have seen a long and dreary downtrend versus global stocks, whether relative to developed or emerging markets, including or excluding the US and China. However, they are trading at a heavy discount in terms of price-to-book and price-to-sales metrics and a Draghi government to direct stimulus funding is doubly good news. Italian stocks have rebounded against Spanish equities since 2017 – as have Italian banks versus Spanish banks. Italian non-performing loans declined from a peak of €178 billion in 2015 to €63 billion in 2020. The banks raised enough equity capital to cover these NPLs. Since banks form a significant part of the Italian bourse, an improvement in bank balance sheets would be positive for the overall market. A Draghi government would reinvigorate this tendency, especially if it credibly commits to structural reforms that elevate potential growth. Spain’s structural reforms are priced in and it is next in line for a post-COVID political shakeup (Chart 15). Go tactically long Italian stocks relative to Spanish. While a Draghi coalition is marginally positive for the euro there are several factors motivating the dollar’s counter-trend bounce in the near term (Chart 16). US and Eurozone growth are diverging, with the EU struggling to roll out its COVID vaccine while the US prepares to pile a new $1.5-$1.9 trillion fiscal stimulus on top of the unspent $900 billion stimulus passed at the end of last year. Chart 15Italian Stocks Have Upside Versus Spanish Italian Stocks Have Upside Versus Spanish Italian Stocks Have Upside Versus Spanish Chart 16Wait For Geopolitical Risk To Clear Before Shorting USD-EUR Wait For Geopolitical Risk To Clear Before Shorting USD-EUR Wait For Geopolitical Risk To Clear Before Shorting USD-EUR Over the long run, a Draghi government provides limited upside with regard to Italian assets. The new coalition serves to avoid an election, not enable structural reform. An unstable ruling coalition will lose support over time in what will be a difficult post-pandemic environment. An early election and anti-establishment victory are not unlikely, if not in 2021 then in 2022 when Italy faces a falling stimulus impulse and the need for painful reforms. For now the truly bullish development is Germany’s dovish shift on fiscal policy rather than any temporary sign of Italian political functionality. Dysfunction can return to Italy fairly quickly but an accommodative Germany is hard to be gotten. Hence Italy’s biggest political risks will come if populist parties win full control of government in the next election while Germany and Brussels seek to normalize fiscal policy and impose some semblance of restraint in the wake of the crisis. It is also possible that a new economic shock or wave of immigration could bring Italy’s populists not only to take power but to rediscover their original euroskepticism. Thus any preference for Italian assets should be seen as a cyclical play on global growth and European solidarity and reflation – not a structural play on Italy’s endogenous strengths. Last week we shifted to the sidelines of the stock rally due to our concern that political and geopolitical risks have fallen too much off the radar. The Biden administration faces tests over China/Taiwan and Iran/Israel. Biden’s tax hikes will come into view soon. Chinese policy tightening is also a concern, even for those of us who do not expect overtightening. These factors pose downside risk to bubbly global stock markets in the near term.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 Angela Giuffrida and Lorenzo Tondo, "‘A generation has died’: Italian province struggles to bury its coronavirus dead," The Guardian, March 19, 2020, theguardian.com. 2 See Stein Emil Vollset et al, "Fertility, mortality, migration, and population scenarios for 195 countries and territories from 2017 to 2100: a forecasting analysis for the Global Burden of Disease Study," The Lancet, July 14, 2020, thelancet.com.