Geopolitics

Dear Client, With this weekly update on the Chinese economy, we are sending you a Special Report published by BCA Geopolitical Strategy team and authored by my colleague Matt Gertken. Lately we have been getting numerous questions from our clients, on the risk of a significant re-escalation in the US-China conflict. Matt’s report provides timely insights on the topic, and we trust you will find the report very helpful. Best regards, Jing Sima, China Strategist Feature An Update On The Chinese Economy Since mid-April, the speed of resumption in China’s domestic business activity has accelerated. Industrial enterprises appear to be operating at 87% of normal activity levels as of May 11, up from 81.8% one month ago. Small to medium-sized enterprise (SMEs) are estimated to now operate at 87.3% of their normal activity, a vast improvement from 82.3% just two weeks ago. Chart 1Pickup In M1 Still Modest Pickup In M1 Still Modest Pickup In M1 Still Modest The material easing in monetary conditions and strong flows of local government special-purpose bond issuance in the past two months helped jump start a recovery in the construction sector. But at this early stage of a domestic economic rebound and in the middle of a deep global economy recession, China’s corporate marginal propensity to invest remains muted (Chart 1). Household consumption showed some resilience during last week’s “Golden Week” holiday. The strength in big-ticket item purchases, however, was highly concentrated among consumers in China’s wealthiest urban areas (Chart 2). The COVID-19 pandemic has created a situation resembling a combination of SARS and the global financial crisis. Now the physical constraints on consumption have largely been lifted, consumers’ willingness to spend, after a brief period of compensatory spending, will be suppressed if their expectations of the medium-term job and income security remain pessimistic (Chart 3). Chart 2A Compensatory Rebound In Big-Ticket Item Sales A Compensatory Rebound In Big-Ticket Item Sales A Compensatory Rebound In Big-Ticket Item Sales Chart 3The Average Chinese Consumer Remains Cautious The Average Chinese Consumer Remains Cautious The Average Chinese Consumer Remains Cautious Next week we will publish a report, focusing on China’s consumption in a post-pandemic environment. Looking forward, we maintain the view that China’s business activity will pick up momentum in H2, when the massive monetary and fiscal stimuli continue working its way into the economy.  Downside risks to employment and income loom large, which makes it highly unlikely that the authorities will tighten their policy stance any time soon. As such, while we maintain our defensive tactical positioning due to near-term economic and geopolitical uncertainties, our view remains constructive on both the economy and Chinese financial asset prices in the next 6 to 12 months.  (Chart 4). Chart 4Recovery To Gain Traction In H2 Recovery To Gain Traction In H2 Recovery To Gain Traction In H2   Jing Sima China Strategist jings@bcaresearch.com     #WWIII The phrase “World War III” or #WWIII went viral earlier this year in response to a skirmish between the US and Iran (Chart 1). Only four months later, the US and China are escalating a strategic rivalry that makes the Iran conflict look paltry by comparison (Chart 2). Chart 1US-Iran Tensions Were Just A Warm-Up #WWIII #WWIII Chart 2The Thucydides Trap The Thucydides Trap The Thucydides Trap Fortunately, the two great powers are constrained by the same mutually assured destruction that constrained the US and the Soviet Union during the Cold War. They are also constrained by the desire to prevent their economies from collapsing further. Unfortunately, the intensity of their rivalry can escalate dramatically before reaching anything truly analogous to the Berlin Airlift or Cuban Missile Crisis – and these kinds of scenarios are not out of the question. Safe haven assets will catch a bid and the recovery in US and global risk assets since the COVID selloff will be halted. We maintain our defensive tactical positioning and will close two strategic trades to book profits and manage risk. In the wake of the pandemic and recession, geopolitics is the next shoe to drop. The War President Over the past 24 hours the White House has taken several steps indicating that President Trump is adopting the “war president” posture in the run-up to the US election: Export controls: Trump has gone forward with new export controls on “dual-purpose” technologies – those that have military as well as civilian applications, in a delayed reaction to China’s policy of civil-military technological fusion. The Commerce Department has wide leeway in whether to grant export licenses under the rule – but it is a consequential rule and would be disruptive if enforced strictly. Supply chain de-risking: Trump is also going forward with new restrictions on the import of foreign parts for US power plants and electricity grid. The purpose is to remove risks from critical US infrastructure. COVID investigation: Trump has hinted that the novel coronavirus that causes the COVID-19 disease may have originated in the Wuhan Institute of Virology. The Director of National Intelligence issued a statement indicating that the Intelligence Community does not view the virus as man-made (not a bio-weapon), but is investigating the potential that the virus transferred to humans at the institute. The State Department had flagged the institute for risky practices long before COVID. Trump avoided the bio-weapon conspiracy theory and is focused on the hypothesis that the laboratory’s investigations into rare coronaviruses led to the outbreak. New tariffs instead of reparations: Director of the National Economic Council Larry Kudlow denied that the US would stop making interest and principal payments on some Chinese holdings of US treasuries. He said that the “full faith and credit of the United States’ debt obligation is sacrosanct. Absolutely sacrosanct.” Trump denied that this form of reparations, first floated by Republican Senator Marsha Blackburn of Tennessee, was under consideration. Instead he suggested that new tariffs would be much more effective, raising the threat for the first time since the Phase One trade deal was agreed in principle in December. Strategic disputes: Tensions have flared up in specific, concrete ways across the range of US-Chinese relations – in the cyber-realm, psychological warfare, Korean peninsula, Taiwan Strait, and South China Sea. These could lead to sanctions. The war president posture is one in which President Trump recognizes that reelection is extremely unlikely in an environment of worse than -4.8% economic growth and likely 16% unemployment. Therefore he shifts the basis of his reelection to an ongoing crisis and appeals to Americans’ patriotism and desire for continuity amid crisis. Bottom Line: Protectionism is not guaranteed to work, and therefore it was not ultimately the path Trump took last year when he still believed a short-term trade deal could boost the economy. Now the bar to protectionism has been lowered. The Decline Of US-China Relations President Trump may still be bluffing, China may take a conciliatory posture, and a massive cold war-style escalation may be avoided. However, it is imprudent to buy risk assets on these reasons today, when the S&P 500’s forward price-to-earnings ratio stands at 20.15. It is more prudent to prepare for a historic escalation of tensions first, buy insurance, then reassess. Why? Because the trajectory of US-China relations is empirically worsening over time. US household deleveraging and the Chinese shift away from export-manufacturing (Chart 3) broke the basis of strong relations during the US’s distractions in Iraq and Afghanistan and China’s “peaceful rise” in the early 2000s. US consumers grew thriftier while Chinese wages rose. Not only has China sought economic self-sufficiency as a strategic objective since General Secretary Xi Jinping took power in 2012, but the Great Recession, Trump trade war, and global pandemic have accelerated the process of decoupling between the two economies. Decoupling is an empirical phenomenon, and it has momentum, however debatable its ultimate destination (Chart 4). Obviously policy at the moment is accelerating decoupling. Chart 3The Great Economic Divorce The Great Economic Divorce The Great Economic Divorce Chart 4Decoupling Is Empirical Decoupling Is Empirical Decoupling Is Empirical The US threat to cease payments on some of China’s Treasury holdings is an inversion of the fear that prevailed in the wake of 2008, that China would sell its treasuries to diversify away from dependence on the US and the greenback. China did end up selling its treasuries, but the US was not punished with higher interest rates because other buyers appeared. The US remains the world’s preponderant power and ultimate safe haven (Chart 5). By the same token, Trump and Kudlow naturally poured water on the threat of arbitrarily stopping payments because that would jeopardize America’s position. Instead Trump is threatening a new round of trade tariffs. Since the US runs a large trade deficit with China, and China is more exposed to trade generally, the US has the upper hand on this front. But it is important to notice that US tariff collections as a share of imports bottomed under President Obama (Chart 6). Chart 5Treasuries Can't Be Weaponized By Either Side... Treasuries Can't Be Weaponized By Either Side... Treasuries Can't Be Weaponized By Either Side... Chart 6... But Tariffs Can And Will Be ... But Tariffs Can And Will Be ... But Tariffs Can And Will Be   The US shift away from free trade toward protectionism occurred in the wake of the 2008 financial crisis. President Trump then popularized and accelerated this policy option in an aggressive and unorthodox way. Trade tariffs are a tool of American statecraft, not the whim of a single person, who may exit the White House in January 2021 anyway. The retreat from globalization is not a passing fancy. Today’s recession also marks the official conclusion of China’s historic 44 year economic boom – and hence a concrete blow to the legitimacy of the ruling Communist Party (Chart 7). The more insular, autarkic shift in the Communist Party’s thinking is not irreversible, but there are no clear signs that Xi Jinping is pivoting toward liberalism after eight years in power. Chart 7Recession Destabilizes The 'G2' Powers Recession Destabilizes The 'G2' Powers Recession Destabilizes The 'G2' Powers China’s unemployment rate has been estimated as high as 20.5% by Zhongtai Securities, which then retracted the estimate (!). It is at least at 10%. Moreover 51 million migrant workers vanished from the job rolls in the first quarter of the year. Maximum employment is the imperative of East Asian governments, especially the Communist Party, which has not dealt with joblessness since the late 1990s. The threat to social and political stability is obvious. The party will take extraordinary measures to maintain stability – not only massive stimulus but also social repression and foreign policy distraction to ensure that people rally around the flag. Xi Jinping has tried to shift the legitimacy of the party from economic growth to nationalism and consumerism, the “China Dream.” But the transition to consumer growth was supposed to be smooth. Financial turmoil, the trade war, and now pandemic and recession have forced the Communist Party off the training wheels well before it intended. Xi’s communist ideology, economic mercantilism, and assertive foreign policy have created an international backlash. The US is obviously indulging in nationalism as well. A stark increase in inequality and political polarization exploded in President Trump’s surprise election on a nationalist and protectionist platform in 2016 (Chart 8). All candidates bashed China on the campaign trail, but Trump was an anti-establishment leader who disrupted corporate interests and followed through with his tariff threats. The result is that the share of Americans who see China’s power and influence as a “major threat” to the United States has grown from around 50% during the halcyon days of cooperation to over 60% today. Those who see it as a minor threat have shrunk to about a quarter of the population (Chart 9). Chart 8A Measure Of Inequality In The US A Measure Of Inequality In The US A Measure Of Inequality In The US Chart 9US Nationalism On The Rise #WWIII #WWIII Chart 10Broad-Based Anti-China Sentiment In US #WWIII #WWIII As with US tariff policy, the bipartisan nature of US anger toward China is significant. More than 60% of Democrats and more than 50% of young people have an unfavorable view of China. College graduates have a more negative opinion than the much-discussed non-college-educated populace (Chart 10). Already it is clear, in Joe Biden’s attack ads against Trump, that this election is about who can sound tougher on China. The debate is over who has the better policy to put “America first,” not whether to put America first. Biden will try to steal back the protectionist thunder that enabled Trump to break the blue wall in the electorally pivotal Rust Belt in 2016 (Map 1). Biden will have to win over these voters by convincing them that he understands and empathizes with their Trumpian outlook on jobs, outsourcing, and China’s threats to national security. He will emphasize other crimes – carbon emissions, cyber attacks, human rights violations – but they will still be China’s crimes. He will return to the “Pivot to Asia” foreign policy of his most popular supporter, former President Barack Obama. Map 1US Election: Civil War Lite #WWIII #WWIII Bottom Line: Economic slowdown and autocracy in China, unprecedented since the Cultural Revolution, is clashing with the United States. Broad social restlessness in the US that is resolving into bipartisan nationalism against a peer competitor, unprecedented since the struggle with the Soviets in the 1960s, is clashing with China. Now is not the time to assume global stability. Constraints Still Operate, But Buy Insurance The story outlined above is by this time pretty well known. But the “Phase One” trade deal allowed global investors to set aside this secular story at the beginning of the year. Now, as Trump threatens tariffs again, the question is whether he will resort to sweeping, concrete, punitive measures against China that will take on global significance – i.e. that will drive the financial markets this year. Trump is still attempting to restore his bull market and magnificent economy. As long as this is the case, a constraint on conflict operates this year. It is just not as firm or predictable. Therefore we are looking for three things. First, will President Trump’s approval rating benefit so much from his pressure tactics on China that he finds himself driven into greater pressure tactics? This raises the risk of policy mistakes. Second, will Trump’s approval rating fall into the doldrums, stuck beneath 43%, as the toll of the recession wears on him and popular support during the health crisis fades? “Lame duck” status would essentially condemn him to electoral loss and incentivize him to turn the tables by escalating the conflict with China. Chart 11Trump May Seek A Crisis ‘Bounce’ To Popularity #WWIII #WWIII Presidents are not very popular these days, but a comparison with Trump’s two predecessors shows that while he can hardly obtain the popularity boost that Obama received just before the 2012 election, he could hope for something at least comparable to what George W. Bush received amid the invasion of Iraq (Chart 11). (Trump has generally been capped at 46% approval, the same as his share of the popular vote in 2016.) The reason this is a real risk, not a Shakespearean play, is outlined above: however cynical Trump’s political calculus, he would be reasserting US grand strategy in the face of a great power that is attempting to set up a regional empire from which, eventually, to mount a global challenge. Thus if he is convinced he cannot win the election anyway, this risk becomes material. Investors should take seriously any credible reports suggesting that Trump is growing increasingly frustrated with his trailing Biden in head-to-head polls in the swing states. Third, will China, under historic internal stress, react in a hostile way that drives Trump down the path of confrontation? China has so far resorted to propaganda, aircraft carrier drills around the island of Taiwan, and maritime encroachments in the South China Sea – none of which is intolerably provocative to Trump. A depreciation of the renminbi, a substantial change to the status quo in the East or South China Seas, or an attempt to vitiate US security guarantees regarding US allies in the region, could trigger a major geopolitical incident. A fourth Taiwan Strait crisis is fully within the realm of possibility, especially given that Taiwan’s “Silicon Shield” is fundamentally at stake. While we dismissed rumors of Kim Jong Un’s death in North Korea, any power vacuum or struggle for influence there is of great consequence in today’s geopolitical context. Aggressive use of tariffs always threatened to disrupt global trade and financial markets, but tariffs function differently in the context of a global economic expansion and bull market, as in 2018-19, than they do in the context of a deep and possibly protracted recession. Trump has a clear political incentive to be tough on China, but an equally clear financial and economic incentive to limit sweeping punitive measures and avoid devastating the stock market and economy. If events lower the economic hurdle, then the political incentive will prevail and financial markets will sell. Bottom Line: However small the risk of Trump enacting sweeping tariffs, the downside is larger than in the 2018-19 period. The stock market might fall by 40%-50% rather than 20% in an all-out trade war this year. Investment Takeaways Go tactically long US 10-year treasuries. Book a 9.7% profit on our long 30-year US TIPS trade. Close long global equities (relative to US) for a loss of 3.8%.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes Cyclical Investment Stance Equity Sector Recommendations

Highlights Global stimulus efforts are sufficient thus far, but more will need to be done, especially by Europe and emerging markets. Hiccups will not be well-received by financial markets. The net public wealth of countries helps put debt constraints into perspective in a world of zero and negative interest rates. Insufficient fiscal policy is a bigger risk for Europe in the near term than any Germany-mandated withdrawal of ECB quantitative easing. European states remain locked in a geopolitical predicament that prevents them from abandoning each other despite serious differences over fiscal policy, which will persist. We are tactically long defensive plays and safe havens. Stay long JPY-EUR. Feature This week we focus on two questions: Will global stimulus be enough to fill the gap in demand? And will Germany impose a hard limit on European stimulus efforts? Our answers are yes to the first and no to the second. It is impossible for governments to replace private activity indefinitely, but the resumption of private activity is inevitable one way or another. Governments are continuing to provide massive fiscal and monetary support. The near term is cloudy, however, due to the mismatch between uncertain economic reopening and increasing impediments to new stimulus. Weak spots in the global fiscal stimulus efforts arise in Europe and emerging markets excluding China. Europe, at least, is a temporary catch – as Germany has no choice but to help the rest of the EU prop up aggregate demand. But fiscal policy is a greater near-term risk to peripheral European assets than any cessation of monetary support from the ECB. Will Global Stimulus Be Enough? Yes, Eventually Chart 1 shows the latest update of our global fiscal stimulus chart comparing the size of today’s stimulus to the 2008-10 period. Countries that make up 92% of global GDP are providing about 8% of global GDP in fiscal stimulus. Full calculations can be found in the Appendix. Chart 1US Still Leads In Fiscal Stimulus Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? The chief difference between our calculation and that of others is that we include government loans while excluding government loan guarantees. If a government gives a loan to a business or household, funds are transferred to the receiver’s deposits and can be spent to make necessary purchases or pay fixed costs. A loan guarantee, by contrast, is helpful but does not involve a transfer of funds. Our colleague Jonathan LaBerge, has recently written a Special Report analyzing the size of global fiscal stimulus. He provides an alternative calculation in Chart 2, which focuses on “above the line” measures, i.e. only measures affecting government revenues and expenditures. Government loans, guarantees, and other “below the line” measures are left aside in this conservative definition of stimulus. Chart 2Japan Leads In IMF “Above The Line” Account Of Stimulus Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Chart 3 shows the discrepancies between Jonathan’s version and our own – they are not very large. The major differences are Japan, China, Germany, Italy, and South Africa. Of these only Germany, Japan, and China are significant.1 Chart 3Geopolitical Strategy Estimates Accord Less Stimulus To Japan, More To Germany And China, Than IMF Does Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? In Japan’s case, we include the stimulus measures that Japan passed at the end of 2019 because even though they were not passed in response to the pandemic, they will take affect at the same time as those that were. We do not include private sector complements to government action, which Japan includes in its account, since private responses are hard to predict and we do not include them for other countries. In China’s case, official estimates underrate the easing of credit policy. Credit is a quasi-fiscal function in China since the Communist Party controls the banks. With a large credit expansion the overall stimulus impact will be larger than expected, as long as borrowers still want to borrow. Data thus far this year suggests that they do, if only to cover expenses and debt payments. Our assessment that China’s stimulus will reach about 10% of GDP follows BCA Research’s China Investment Strategy. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts … Is global stimulus “enough” to plug the gap in demand? Chart 4 shows our colleague Jonathan’s narrower definition of stimulus compared with estimates of the drop in demand from social lockdowns and spillover effects. It assumes a fiscal multiplier of 1.1. The result suggests that the US, China, and Australia are clearly doing enough; Germany, Japan, and Canada are arguably doing enough; other countries including Italy, France, and Spain will likely have to do more. Chart 4Which Countries Have Plugged The Gap In Demand So Far? Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? The latest news confirms this assessment. The US Congress is negotiating another phase of stimulus that will provide a second round of direct payments to households, a third infusion of small business loans, and a large bailout of state and local governments. The current total is $2 trillion, and so far this year these totals are only revised upward. This tendency stems from the political setup: Trump needs to stimulate for the election, GOP senators’ fates ultimately hinge on Trump, while the House Democrats cannot withhold stimulus merely to undermine the Republicans. Similarly, there can be little doubt that China and Japan will provide more stimulus to maintain full employment – their different political systems have always demanded it. We are more concerned about Europe. The UK and especially Italy, Spain, and France are falling short in their stimulus efforts, with the last three ranging from 2%-4% of GDP, according to Chart 4 above. They will add more stimulus, but might they still fall short of what is needed? Assuming that the ECB will provide adequate liquidity, and that low bond yields for a long time will enable debts to be serviced, these countries can service their debts for some time. But what then is the constraint? From a long-term point of view, the UK and peripheral European nations have relatively fewer national assets to weigh against their well-known liabilities. They are closer to their constraints in issuing debt, even if those constraints are nearly impossible to establish and years away from being hit. This is apparent from the IMF’s data series on net public wealth, i.e. total public sector assets and liabilities (Chart 5A). These data, from 2016, are a bit stale, but they are still useful because they take account of assets like natural resources, real estate, state-owned companies, and pension plans that retain value over the long run. It does no good to refer to the large debt loads of countries without considering the vast holdings that they command. By the same token, at some point the debt loads look formidable even relative to these huge realms. Chart 5ANet Public Wealth: A Fuller Picture Of The Debt Story Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? These data tend to underrate the sustainability of developed markets, which are highly indebted but have reserve currencies, safe haven status, and large, liquid credit markets. They overrate the sustainability of emerging markets, with large resource wealth and low-debt, but vulnerable currencies and credit markets. This is not only true for emerging markets with the most negative net worth, like Brazil, or with unsustainable fiscal policies, like Turkey and South Africa. China would look a lot worse in net public wealth, if this could be calculated, than it does on the general government ledger (Chart 5B), due to the liabilities of its state-owned enterprises and local governments. It would look more like the US or Japan in net public wealth – yet without a reserve currency. Chart 5BNet Government Debt: Flatters EM, Not DM Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Nevertheless the European states have a problem that the other developed markets do not have: the Euro Area’s “constitutional” order is still unsettled. Questions are continually arising about whether countries’ liabilities are backstopped by a single currency authority and the entire assets of the Euro Area. These questions will tend to be settled in favor of European integration. But treaty battles in the context of upcoming elections – in the Netherlands, Germany, France, and likely Italy and Spain – will provide persistent volatility. Bottom Line: Fiscal stimulus passed thus far is only “sufficient” in a few economies; it is insufficient in southern Europe and emerging markets. Uncertainty about the pandemic, and the pace of economic reopening and normalization, combined with any hiccups in providing adequate stimulus will create near-term volatility. Will Germany Halt Quantitative Easing? No, Not Ultimately The questions about Europe highlighted above have come to the fore with the reemergence of the “German question,” which in today’s context means Germany’s and northern Europe’s willingness to conduct fiscal policy to help rebalance the Euro Area and monetary policy to ease conditions for heavily indebted, low productivity southern Europe. We have little doubt that Germany will provide more than its current 10.3% of GDP fiscal stimulus given that it has explicitly stated that state lender KfW has no limit on the amount of loans it can provide to small businesses. This accounts for the difference between our fiscal stimulus estimate and the IMF’s, but the fullest count, including “below the line” measures, would amount to nearly 35% of GDP. A sea change in the German attitude toward fiscal policy has occurred, which we have tracked in reports over the years. This shift gives permission for other European states to loosen their belts as well. We also have little doubt that German leaders will ultimately accept the ECB’s need to take desperate measures to backstop the European financial system: The “dirty little secret” of the Euro Area is that debt is already mutualized through the Target 2 banking imbalance, worth 1.5 trillion euros (Chart 6). As our Chief European Investment Strategist Dhaval Joshi has argued, Germany, as the largest shareholder in the ECB, holds a large quantity of Italian bonds, and Italians have deposited the proceeds of these bond purchases in German banks. All of this is denominated in euros. If Italy redenominates into lira, it can make bond payments in lira and the ECB and Germany will suffer capital losses. Germany would then face Italians withdrawing their deposits from German banks that would still be denominated in euros (or the deutschmark). The cause of this predicament is the ECB’s quantitative easing program (Chart 7). Chart 6Europe’s Gordian Knot Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Thus Chancellor Angela Merkel’s shift in tone to become more supportive of joint debt issuance belies the fact that European debt is already mutualized through the Gordian knot of Target2 imbalances. This is a politically unpalatable reality for Germans, but they generally accept it because it is in Germany’s national interest to maintain the monetary union and broader European integration. Chart 7Quantitative Easing Puts Germans On Hook For Italy Quantitative Easing Puts Germans On Hook For Italy Quantitative Easing Puts Germans On Hook For Italy However, the market may need reassurances about “the German question” from time to time, as EU institutional evolution is ongoing. Financial markets did not sell off on the German court’s ruling on May 5, which ostensibly gave the Bundesbank three months before withdrawing from the ECB’s quantitative easing program. Since the sovereign debt crisis, investors have come to recognize that there is more undergirding European integration than mere German preference. Namely, geopolitics – which we have outlined many times, originally in a 2011 Special Report. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. Still, there will be more consequences from this week’s ruling. At issue is the budgetary sovereignty of the European member states as well as Article 123 of the Treaty of Europe, which holds that neither the ECB nor the national central banks of member states can directly purchase public debts. The latter is a prohibition on the monetary financing of deficits. It became controversial in the wake of Mario Draghi’s 2012 declaration that the ECB would do “whatever it takes” to preserve the euro and the ECB’s 2015 Public Sector Purchase Program (PSPP) quantitative easing program, which the European Court of Justice deemed legal on December 11, 2018. The controversy is now implicitly shifting to the new Pandemic Emergency Purchase Program. The other principle concerned is that of “proportionality,” which requires that EU entities not take actions beyond what is necessary to achieve treaty objectives. If the ECB acted without regard to the limits of its mandate, the fiscal supremacy of the states, and the broader economic and fiscal consequences of QE, then its actions would violate the principle of proportionality and would require adjustment by EU authorities or non-participation from member state authorities. The German court did not attempt to overrule or invalidate the European court’s decision in favor of QE, or QE as a whole. Rather, it held that this ruling was not “comprehensible,” hence requiring an independent German ruling, and that the larger question of whether QE violates the prohibition against debt monetization is “not ascertainable.” The reason is that the ECB did not explain its actions adequately and the European Court of Justice did not demand an explanation. Presumably once this is done more decisive determinations can be made. Essentially the German court is demanding “documentation” by the ECB Governing Council that it weighed its monetary decisions against larger economic and fiscal consequences. So will the Bundesbank withdraw from the ECB’s QE operations in three months? Highly unlikely! The ECB, whether directly or indirectly, will provide an assessment of the proportionality of its actions to the Bundesbank and the German court will probably conclude, with limitations, that the ECB’s actions were largely within its mandate. If not, however, markets will plunge. Then the Bundestag or the Bundesbank will have to intervene to ensure that Germany does not in fact withdraw support from the ECB. European nations cannot compete globally without banding together, and Germany is not powerful enough to go it alone. How can we be sure? German opinion. Chancellor Merkel and her ruling Christian Democrats have not suffered this year so far from launching a wartime fiscal expansion and backing the ECB and EU institutions in their emergency actions. On the contrary, they have received one of the biggest bounces in popular opinion polls of any western leaders over the course of the global pandemic. While the bounce will deflate once the acute crisis subsides, this polling signals more than the average rally around the flag (Chart 8). Merkel’s approval rating started to rise when her party embraced more expansive fiscal policy in late 2019 in reaction to malaise revealed in the 2017 election. Germany’s handling of today’s crisis, both the pandemic and the expansive fiscal policy, has put the ruling party in the lead for the 2021 elections (Chart 9). Chart 8Germans See Popular Opinion ‘Bounce’ Amid COVID Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Chart 9Merkel's CDU Revives Amid Global Crisis Merkel's CDU Revives Amid Global Crisis Merkel's CDU Revives Amid Global Crisis Chart 10Germans Support Euro, But Lean On ECB Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Moreover Germans are enthusiastically in support of the euro and the EU relative to their peers – which makes sense because Germany has been the greatest beneficiary of European integration (Chart 10). The ECB, by contrast, does not have strong support – and is losing altitude. But a crisis provoked by the court and centered on the ECB would quickly become a crisis about the euro and European project as a whole. Opinion has broken in this direction despite Merkel’s and Germany’s many compromises over the years. Remember that Merkel’s capitulation to the Mediterranean states on the European Council in June 2011, which paved the way for Draghi’s famous dictum, was initially seen as a failure by her to defend German interests. Merkel and her party have also recovered from the hit they took when she insisted that Germany take in a huge influx of Syrian refugees in 2015. German popular opinion is relevant when discussing the judicial system and rule of law. No court can ignore popular opinion entirely, no matter how independent and austere, because every court ultimately needs public opinion to maintain its credibility. The European Court’s decision is final, as long as Germany remains committed to the EU. Yet German sovereignty still gives German institutions a say. If the German court persists in attempting to block Bundesbank participation in QE, the result will be a bond market riot that pushes up peripheral debt funding costs. This would eventually risk forcing peripheral states out of the Euro Area, which is against German interests. It is very unlikely things will go so far. Rather, the court will back down after receiving due attention and having its legitimate concerns addressed. The imperatives of European integration are as powerful today as they were in 2011. True, other court challenges will open up against the ECB, particularly the PEPP. But bear in mind that it will be even easier to show that ECB actions are proportional – that broader economic consequences have been weighed – in the case of the pandemic relief emergency than with respect to PSPP prior to COVID. Today it is households and small businesses that need protection from an act of God, not banks and bureaucracies that need protection from the consequences of their excesses. As for the size and duration of QE, the court will try to force some limitations to be acknowledged given the risk to fiscal sovereignty. In this sense, the ECB faces a new constraint, albeit one that we doubt will prove relevant in the near term. Ultimately, the consequence of imposing some limits on central bank policy is to restore authority to member state budgets and European fiscal coordination. In the short term, emergency provision can be provided via the European Stability Mechanism (ESM), whose lending conditions can be relaxed, and by the ECB’s Outright Monetary Transactions (OMT), which can buy bonds amid a market riot. But beyond the immediate crisis the clash over fiscal policy will persist because at some point countries will have to climb down from their extraordinary stimulus and the attempt to restore limits will be contentious. Germany has already made a huge shift in a more fiscally accommodative direction. Italy, Spain, and France are currently not providing enough, but they will add more. Future governments might demand more than even today’s more dovish Germany is willing to accept. Down the road, if these states do not provide more stimulus, then their recoveries will be weaker and political malaise will get worse. An anti-establishment outcome is already likely in Italy in the coming year or two, due to the ability of the League to capitalize on post-COVID voter anger. The big question after that is France in 2022. Macron’s approval rating is holding up, we expect him to win, but his bounce amid the pandemic is not remarkable. From our point of view the peripheral states have a license to spend, so spend they will. But then fiscal conflicts will revive later. Bottom Line: The German constitutional court is not going to try to force the Bundesbank to withdraw from QE, but it is attempting to lay a foundation for the imposition of at least some limits on this policy. The risk to European assets in the short run is not on the monetary side but the fiscal side. Over the long run, the “German question” will never be settled. But the imperatives of European integration are as powerful today as they were in 2011. Each new crisis exposes the weakness of the peripheral states, their need for European institutions. It also exposes Germany’s need to accommodate them when they form a united front. Investment Takeaways Financial markets have no clarity on economic reopening in the face of the virus or how governments will respond to resurgent outbreaks or a second wave in the fall. Taking into consideration the initial shock of the lockdowns plus spillover effects, the cumulative impact to annual GDP rises to 6%-8% by the end of this year for major economies. If another lockdown occurs, the level of GDP would be 10-12% lower at the end of the year depending on the region. This bare risk suggests that global equities face a relapse in the near term. Eventually economic reopening will proceed, as the working age population will demand it. But the path between here and there is rocky and any hiccups in providing stimulus will create even more volatility. Globally, we continue to argue that political and geopolitical risks are rising across the board as the pandemic and recession evolve into a struggle among nations to maintain security amid vulnerabilities and distract from their problems at home. Rumors that China is about to declare an air defense identification zone (ADIZ) in the South China Sea are unverified but we have long expected this to occur and tensions and at least some saber-rattling would ensue. We also expect the US to surprise the market with punitive tech and trade measures against China in the near term and to upgrade relations with Taiwan. We remain long JPY-EUR on a tactical 0-3 month horizon. We are converting our tactical long S&P consumer staples, which is up 6%, to a relative trade against the broad market. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Appendix Table 1The Global Fiscal Stimulus Response To COVID-19 Will Europe Halt The Global Gravy Train? Will Europe Halt The Global Gravy Train? Footnotes 1 In the case of Italy, we assume that parliament will pass the latest proposed increase in stimulus from 1.4% to 3.1% of GDP. In the case of South Africa, we expect the IMF to include these measures soon. Germany is discussed below.

Highlights Our baseline view foresees a U-shaped recovery, as economies slowly relax lockdown measures. There are significant risks to this forecast, however. On the upside, a vaccine or effective treatment could hasten the reopening of economies and recovery in spending. On the downside, containment measures could end up being eased too quickly, leading to a surge in new cases. A persistent spell of high unemployment could also permanently damage economies, especially if fiscal and monetary stimulus is withdrawn too quickly. In addition, geopolitical risks loom large, with the US election likely to be fought on who sounds tougher on China. Earnings estimates have yet to fall as much as we think they will, making global equities vulnerable to a near-term correction. Nevertheless, the spread between earnings yields and bond yields is wide enough to justify a modest overweight to stocks on a 12-month horizon. Is It Safe To Come Down? We published a report two weeks ago entitled Still Stuck In The Tree where we likened the current situation to one where an angry bear has chased a hiker up a tree.1 Having reached a high enough branch to escape immediate danger, the hiker breathes a sigh of relief. As time goes by, however, the hiker starts to get nervous. Rather than disappearing back into the forest, the bear remains at the base of the tree licking its chops. Meanwhile, the hiker is cold, hungry, and late for work. Like the hiker, the investment community breathed a collective sigh of relief when the number of cases in Italy and Spain, the first two major European economies to be hit by the coronavirus, began to trend lower. In New York City, which quickly emerged as the epicentre of the crisis in the United States, more COVID patients have been discharged from hospitals than admitted for the past three weeks (Chart 1). Chart 1Discharges From New York Hospitals Have Exceeded Admissions For The Past Three Weeks Risks To The U Risks To The U Deepest Recession Since The 1930s Yet, this progress has come at a very heavy economic cost. The IMF expects the global economy to shrink by 3% this year (Chart 2). In 2009, global GDP barely contracted. Chart 2Severe Damage To The Global Economy This Year Risks To The U Risks To The U The sudden stop in economic activity has led to a surge in unemployment. According to the Bloomberg consensus estimate, the US unemployment rate rose to 16% in April. The true unemployment rate is probably higher since to be considered unemployed one has to be looking for work, which is difficult if not impossible in the presence of widespread lockdowns. Regardless, even the official unemployment rate is the worst since the Great Depression (Chart 3). Chart 3Unemployment Rate Seen Jumping To Levels Not Reached Since The Great Depression Unemployment Rate Seen Jumping To Levels Not Reached Since The Great Depression Unemployment Rate Seen Jumping To Levels Not Reached Since The Great Depression   Unshackling The Economy A key difference from the 1930s is that today’s recession has been self-induced. Policymakers want workers to stay home as much as possible. The hope is that once businesses reopen, most of these workers will return to their jobs. How long will that take? Our baseline scenario envisions a slow but steady reopening of the global economy starting later this month, which should engender a U-shaped economic recovery. Since mid-March, much of the world has been trying to compensate for lost time by taking measures that would not have been necessary if policymakers had acted sooner. As Box 1 explains, some loosening of lockdown measures could be achieved without triggering a second wave of cases once the infection rate has been brought down to a sufficiently low level. To the extent that economic activity tends to move in tandem with the number of interactions that people have, a relaxation of social distancing measures should produce a modest rebound in growth. New technologies and a better understanding of how the virus is transmitted should also allow some of the more economically burdensome measures to be lifted. As we have discussed before, mass testing can go a long way towards reducing the spread of the disease (Chart 4).2 Right now, high-quality tests are in short supply, but that should change over the coming months.  Chart 4Mass Testing Will Help Risks To The U Risks To The U Increased mask production should also help. Early in the pandemic, officials in western nations promulgated the view that masks do not work. At best, this was a noble lie designed to ensure that anxious consumers did not deprive frontline workers of necessary safety equipment. At worst, it needlessly led many people astray. As East Asia’s experience shows, mask wearing saves lives. A recent paper estimated that the virus could be vanquished if 80% of people wore masks that were at least 60% effective, a very low bar that even cloth masks would pass (Chart 5).3  Chart 5Masks On! Risks To The U Risks To The U Recent research has also cast doubt on the merits of closing schools. The China/WHO joint commission could not find a single instance during contact tracing where a child transmitted the virus to an adult. A study by the UK Royal College of Paediatrics provides further support to the claim that children are unlikely to be important vectors of transmission. The evidence includes a case study of a nine year-old boy who contracted the virus in the French Alps but fortunately failed to transmit it to any of the more than 170 people he had contact with in three separate schools.4  Along the same lines, there is evidence that the odds of adults catching the virus indoors is at least one order of magnitude higher than outdoors.5 This calls into question the strategy of states such as California of clearing out prisons of dangerous felons in order to make room for beachgoers.6 Upside Risks To The U: Medical Breakthroughs While a U-shaped economic recovery remains our base case, we see both significant upside and downside risks to this outcome. The best hope for an upside surprise is that a vaccine or effective treatment becomes available soon. There are already eight human vaccine trials underway, with another 100 in the planning stages. In the race to develop a vaccine, Oxford is arguably in the lead. Scientists at the university’s Jenner Institute have developed a genetically modified virus that is harmless to people, but which still prompts the immune system to produce antibodies that may be able to fight off COVID. The vaccine has already worked well on rhesus monkeys. If it proves effective on humans, researchers hope to have several million doses available by September. On the treatment side, Gilead’s remdesivir gained FDA approval for emergency use after early results showed that it helps hasten the recovery of coronavirus patients. Hydroxychloroquine, which President Trump has touted on numerous occasions, is the subject of dozens of clinical trials internationally. While evidence that hydroxychloroquine can treat the virus post-infection is thin, there is some data to suggest that it can work well as a prophylactic.7 Research is also being conducted on nearly 200 other treatments, including an improbable contender: famotidine, the compound found in the heartburn remedy Pepcid.8  Downside Risk: Too Open, Too Soon Chart 6The Lesson From The Spanish Flu: The Second Wave Could Be Worse Than The First Risks To The U Risks To The U As noted above, once the number of new cases drops to sufficiently low levels, some relaxation of containment measures can be achieved without reigniting the pandemic. That said, there is a clear danger that measures will end up being relaxed too aggressively and too soon. This is precisely what happened during the Spanish Flu (Chart 6). It has become customary to talk about the risk of a second wave of infections; however, the reality is that we have not even concluded the first wave. While the number of cases in New York has been falling, it has been rising in many other US states. As a result, the total number of new coronavirus cases nationwide has remained steady for the past five weeks (Chart 7). It is the same story globally: Falling caseloads in western Europe and East Asia have been offset by rising cases in countries such as Russia, India, and Brazil (Chart 8). Chart 7The Spread Of COVID-19 Has Not Been Contained Everywhere (I) Risks To The U Risks To The U Chart 8The Spread Of Covid-19 Has Not Been Contained Everywhere (II) Risks To The U Risks To The U   Chart 9Widespread Social Distancing Has Dampened The Spread Of All Flus And Colds Risks To The U Risks To The U At the heart of the problem is that COVID-19 remains a highly contagious disease. Most studies assign a Reproduction Number, R, of 3-to-4 to the virus. As a point of comparison, the Spanish flu is estimated to have had an R of 1.8. An R of 3.5 would require about 70% of the population to acquire herd immunity to keep the virus at bay.9 As discussed in Box 2, the “true” level of herd immunity may be substantially greater than that. At this point, if you come down with a cough and fever, you should assume you have COVID. As Chart 9 shows, social distancing measures have brought the number of viral respiratory illnesses down to almost zero in the United States. Up to 30% of common cold cases stem from the coronavirus family. Just like it would be foolhardy to assume that the common cold has been banished from the face of the earth, it would be unwise to assume that COVID will not return if containment measures are quickly lifted.   Downside Risk: Permanent Economic Damage Chart 10No Spike In Bankruptcies For Now Risks To The U Risks To The U There are a lot of asymmetries in economics: It is easier to lose a job than to find one; starting a new business is also more difficult than going bankrupt.  The good news so far is that bankruptcies have been limited and most unemployed workers have not been permanently laid off (Chart 10 and Chart 11). Thus, for the most part, the links that bind firms to workers have not been severed.   Chart 11Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Temporary Layoffs Account For Most Of The Recent Increase In Unemployment Temporary Layoffs Account For Most Of The Recent Increase In Unemployment   Unfortunately, there is a risk that the economy will suffer permanent damage if unemployment remains high and economic activity stays depressed. For some sectors, such as airlines, long-term damage is nearly assured. It took a decade for real household spending on airlines to return to pre 9/11 levels (Chart 12). It could take even longer for the physiological scars of the pandemic to fade. While businesses outside the travel and hospitality sectors will see a quicker rebound, they could still experience subdued demand for as long as social distancing measures persist. Chart 129/11 Was A Big Shock For US Air Travel 9/11 Was A Big Shock For US Air Travel 9/11 Was A Big Shock For US Air Travel There is not much that fiscal policy can do to reverse the immediate hit to GDP from the pandemic. If people cannot work, they cannot produce. What fiscal stimulus can do is push enough money into the hands of households and firms to enable them to meet their financial obligations, while hopefully creating some pent-up demand that can be unleashed when businesses reopen. For now and for the foreseeable future, there is no need to tighten fiscal policy. The private sector in the major economies is generating plenty of savings with which governments can finance budget deficits. Indeed, standard economic theory suggests that if governments tried to “save more” by reducing budget deficits, total national savings would actually decline.10   Nevertheless, just as fiscal policy was prematurely tightened in many countries following the Great Recession, there is a risk that austerity measures will be reintroduced too quickly again. Likewise, calls to tighten monetary policy could grow louder. Just this week, Germany’s constitutional court ruled that the EU Court of Justice had overstepped its powers by failing to require the ECB to conduct an assessment of the “proportionality” of its controversial asset purchase policy. The German high court ordered the Bundesbank to suspend QE in three months unless the ECB Governing Council provides “documentation” showing it meets the criteria of proportionality. Among other things, the ruling could undermine the ECB’s newly launched €750 billion Pandemic Emergency Purchase Programme (PEPP). Downside Risk: Geopolitical Tensions Had the virus originated anywhere else but China, President Trump could have made a political case for further deescalating the Sino-US trade war in an effort to shore up the US economy and stock market. Not only did that not happen, but the likelihood of a new clash between China and the US has gone up dramatically. Antipathy towards China is rising (Chart 13). As our geopolitical team has stressed, the US election is likely to be fought on who can sound tougher on China. With the economy on the ropes, Trump will try to paint Joe Biden as too passive and conflicted to stand up to China. Indeed, running as a “war president” may be Trump’s only chance of getting re-elected. Chart 13US Nationalism Is On The Rise Amid Broad-Based Anti-China Sentiment Risks To The U Risks To The U At the domestic political level, the pandemic has exacerbated already glaringly wide inequalities. While well-paid white-collar workers have been able to work from the comfort of their own homes, poorer blue-collar workers have either been furloughed or asked to continue working in a dangerous environment (in nursing homes or meat-packing plants, for example). It is not clear what the blowback from all this will be, but it is unlikely to be benign. Investment Implications Global equities and credit spreads have tracked the frequency of Google search queries for “coronavirus” remarkably well (Chart 14). As coronavirus queries rose, stocks plunged; as the number of queries subsided, stocks rallied. If there is a second wave of infections, anxiety about the virus is likely to grow again, leading to another sell-off in risk assets. Chart 14Joined At The Hip 9/11 Was A Big Shock For US Air Travel Joined At The Hip 9/11 Was A Big Shock For US Air Travel Joined At The Hip Chart 15Negative Earnings Revisions Will Weigh On Stocks In The Near Term Risks To The U Risks To The U   Earnings estimates have come down, but are still above where we think they ought to be. This makes global equities vulnerable to a correction (Chart 15). Meanwhile, retail investors have been active buyers, eagerly gobblingup stocks such as American Airlines and Norwegian Cruise Lines that have fallen on hard times recently (Chart 16). They have also been active buyers of the USO oil ETF, which is down 80% year-to-date. When retail investors are trying to catch a falling knife, that is usually an indication that stocks have yet to reach a bottom. As such, we recommend that investors maintain a somewhat cautious stance on the near-term direction of stocks. Chart 16Retail Investors Keen To Buy The Dip Risks To The U Risks To The U   Chart 17Favor Equities Over Bonds Over A 12-Month Horizon Favor Equities Over Bonds Over A 12-Month Horizon Favor Equities Over Bonds Over A 12-Month Horizon   Chart 18USD Is A Countercyclical Currency USD Is A Countercyclical Currency USD Is A Countercyclical Currency Looking further out, the spread between earnings yields and bond yields is wide enough to justify a modest overweight to stocks on a 12-month horizon (Chart 17). If global growth does end up rebounding, cyclicals should outperform defensives. As a countercyclical currency, the dollar will probably weaken (Chart 18). A weaker greenback, in turn, will boost commodity prices (Chart 19). Historically, stronger global growth and a softer dollar have translated into outperformance of non-US stocks relative to their US peers (Chart 20). Thus, investors should prepare to add international equity exposure to their portfolios later this year.   Chart 19Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Commodity Prices Usually Rise When The Dollar Weakens Chart 20Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening Non-US Equities Tend To Outperform Their US Peers When Global Growth Is Improving And The Dollar Is Weakening   Box 1The Dynamics Of R Risks To The U Risks To The U Box 2Why Herd Immunity Is Not Enough Risks To The U Risks To The U Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  Please see Global Investment Strategy Weekly Report, “Still Stuck In The Tree,” dated April 16, 2020. 2 Please see Global Investment Strategy Weekly Report, “Testing Times,” dated April 9, 2020. 3 Philip Anfinrud, Valentyn Stadnytskyi, et al., “Visualizing Speech-Generated Oral Fluid Droplets with Laser Light Scattering,” nejm.org (April 15, 2020); Jeremy Howard, Austin Huang, Li Zhiyuan, Zeynep Tufekci, Vladmir Zdimal, Helene-mari van der Westhuizen, et al., “Face Masks Against COVID-19: An Evidence Review,” Preprints.org, (April 12, 2020); and Liang Tian, Xuefei Li, Fei Qi, Qian-Yuan Tang, Viola Tang, Jiang Liu, Zhiyuan Li, Xingye Cheng, Xuanxuan Li, Yingchen Shi, Haiguang Liu, and Lei-Han Tang, “Calibrated Intervention and Containment of the COVID-19 Pandemic,” arxiv.org (April 2, 2020). 4 “COVID-19 – Research Evidence Summaries,” Royal College of Paediatrics and Child Health; and Alison Boast, Alasdair Munro, and Henry Goldstein, “An evidence summary of Paediatric COVID-19 literature,” Don’t Forget The Bubbles (2020). 5 Hiroshi Nishiura, Hitoshi Oshitani, Tetsuro Kobayashi, Tomoya Saito, Tomimasa Sunagawa, Tamano Matsui, Takaji Wakita, MHLW COVID-19 Response Team, and Motoi Suzuki, “Closed environments facilitate secondary transmission of coronavirus disease 2019 (COVID-19),” medRxiv (April 16, 2020). 6 “Coronavirus: Arrests as California beachgoers defy lockdown,” Skynews (April 26, 2020); and “High-risk sex offender rearrested days after controversial release from OC Jail,” abc7.com (May 1, 2020). 7 Sun Hee Lee, Hyunjin Son, and Kyong Ran Peck, “Can post-exposure prophylaxis for COVID-19 be considered as an outbreak response strategy in long-term care hospitals?” International Journal of Antimicrobial Agents (April 25, 2020). 8 Brendan Borrell, “New York clinical trial quietly tests heartburn remedy against coronavirus,” Science (April 26, 2020). 9 In the simplest models, the herd immunity threshold is reached when P = 1-1/Ro, where P is the proportion of the population which has acquired immunity and Ro is the basic reproductive number. Assuming an Ro of 3.5, heard immunity will be achieved once more than 71.4% of the population has been infected (1-1/3.5). For further discussion on this, please refer to Global Investment Strategy, “Second Quarter 2020 Strategy Outlook: World War V,” dated March 27, 2020. 10 It is easiest to understand this point by considering a closed economy where savings, by definition, equals investment. Savings is the sum of private and public savings. Suppose the economy is depressed and the government increases public savings by either raising taxes or cutting spending. Since this action will further depress the economy, private investment will fall even more. But, since investment must equal total savings, private savings must decline more than proportionately with any increase in public savings. This happens because tighter fiscal policy leads to lower GDP. It is difficult to save if one does not have a job. To the extent that lower GDP reduces employment, it also tends to reduce private-sector savings. Global Investment Strategy View Matrix Risks To The U Risks To The U Current MacroQuant Model Scores Risks To The U Risks To The U

Highlights Over the past 24 hours the White House has taken several steps indicating that President Trump is adopting the “war president” posture in the run-up to the US election. The intensity of the US-China rivalry can escalate dramatically. We maintain our defensive tactical positioning and are going long US 10-year treasuries. Feature The phrase “World War III” or #WWIII went viral earlier this year in response to a skirmish between the US and Iran (Chart 1). Only four months later, the US and China are escalating a strategic rivalry that makes the Iran conflict look paltry by comparison (Chart 2). Chart 1US-Iran Tensions Were Just A Warm-Up #WWIII #WWIII Chart 2The Thucydides Trap The Thucydides Trap The Thucydides Trap Fortunately, the two great powers are constrained by the same mutually assured destruction that constrained the US and the Soviet Union during the Cold War. They are also constrained by the desire to prevent their economies from collapsing further. Unfortunately, the intensity of their rivalry can escalate dramatically before reaching anything truly analogous to the Berlin Airlift or Cuban Missile Crisis – and these kinds of scenarios are not out of the question. Safe haven assets will catch a bid and the recovery in US and global risk assets since the COVID selloff will be halted. We maintain our defensive tactical positioning and will close two strategic trades to book profits and manage risk. In the wake of the pandemic and recession, geopolitics is the next shoe to drop. The War President Over the past 24 hours the White House has taken several steps indicating that President Trump is adopting the “war president” posture in the run-up to the US election: Export controls: Trump has gone forward with new export controls on “dual-purpose” technologies – those that have military as well as civilian applications, in a delayed reaction to China’s policy of civil-military technological fusion. The Commerce Department has wide leeway in whether to grant export licenses under the rule – but it is a consequential rule and would be disruptive if enforced strictly. Supply chain de-risking: Trump is also going forward with new restrictions on the import of foreign parts for US power plants and electricity grid. The purpose is to remove risks from critical US infrastructure. COVID investigation: Trump has hinted that the novel coronavirus that causes the COVID-19 disease may have originated in the Wuhan Institute of Virology. The Director of National Intelligence issued a statement indicating that the Intelligence Community does not view the virus as man-made (not a bio-weapon), but is investigating the potential that the virus transferred to humans at the institute. The State Department had flagged the institute for risky practices long before COVID. Trump avoided the bio-weapon conspiracy theory and is focused on the hypothesis that the laboratory’s investigations into rare coronaviruses led to the outbreak. New tariffs instead of reparations: Director of the National Economic Council Larry Kudlow denied that the US would stop making interest and principal payments on some Chinese holdings of US treasuries. He said that the “full faith and credit of the United States’ debt obligation is sacrosanct. Absolutely sacrosanct.” Trump denied that this form of reparations, first floated by Republican Senator Marsha Blackburn of Tennessee, was under consideration. Instead he suggested that new tariffs would be much more effective, raising the threat for the first time since the Phase One trade deal was agreed in principle in December. Strategic disputes: Tensions have flared up in specific, concrete ways across the range of US-Chinese relations – in the cyber-realm, psychological warfare, Korean peninsula, Taiwan Strait, and South China Sea. These could lead to sanctions. The war president posture is one in which President Trump recognizes that reelection is extremely unlikely in an environment of worse than -4.8% economic growth and likely 16% unemployment. Therefore he shifts the basis of his reelection to an ongoing crisis and appeals to Americans’ patriotism and desire for continuity amid crisis. Bottom Line: Protectionism is not guaranteed to work, and therefore it was not ultimately the path Trump took last year when he still believed a short-term trade deal could boost the economy. Now the bar to protectionism has been lowered. The Decline Of US-China Relations President Trump may still be bluffing, China may take a conciliatory posture, and a massive cold war-style escalation may be avoided. However, it is imprudent to buy risk assets on these reasons today, when the S&P 500’s forward price-to-earnings ratio stands at 20.15. It is more prudent to prepare for a historic escalation of tensions first, buy insurance, then reassess. Why? Because the trajectory of US-China relations is empirically worsening over time. US household deleveraging and the Chinese shift away from export-manufacturing (Chart 3) broke the basis of strong relations during the US’s distractions in Iraq and Afghanistan and China’s “peaceful rise” in the early 2000s. US consumers grew thriftier while Chinese wages rose. Not only has China sought economic self-sufficiency as a strategic objective since General Secretary Xi Jinping took power in 2012, but the Great Recession, Trump trade war, and global pandemic have accelerated the process of decoupling between the two economies. Decoupling is an empirical phenomenon, and it has momentum, however debatable its ultimate destination (Chart 4). Obviously policy at the moment is accelerating decoupling. Chart 3The Great Economic Divorce The Great Economic Divorce The Great Economic Divorce Chart 4Decoupling Is Empirical Decoupling Is Empirical Decoupling Is Empirical The US threat to cease payments on some of China’s Treasury holdings is an inversion of the fear that prevailed in the wake of 2008, that China would sell its treasuries to diversify away from dependence on the US and the greenback. China did end up selling its treasuries, but the US was not punished with higher interest rates because other buyers appeared. The US remains the world’s preponderant power and ultimate safe haven (Chart 5). By the same token, Trump and Kudlow naturally poured water on the threat of arbitrarily stopping payments because that would jeopardize America’s position. Chart 5Treasuries Can't Be Weaponized By Either Side... Treasuries Can't Be Weaponized By Either Side... Treasuries Can't Be Weaponized By Either Side... Chart 6... But Tariffs Can And Will Be ... But Tariffs Can And Will Be ... But Tariffs Can And Will Be Instead Trump is threatening a new round of trade tariffs. Since the US runs a large trade deficit with China, and China is more exposed to trade generally, the US has the upper hand on this front. But it is important to notice that US tariff collections as a share of imports bottomed under President Obama (Chart 6). The US shift away from free trade toward protectionism occurred in the wake of the 2008 financial crisis. President Trump then popularized and accelerated this policy option in an aggressive and unorthodox way. Trade tariffs are a tool of American statecraft, not the whim of a single person, who may exit the White House in January 2021 anyway. The retreat from globalization is not a passing fancy. Today’s recession also marks the official conclusion of China’s historic 44 year economic boom – and hence a concrete blow to the legitimacy of the ruling Communist Party (Chart 7). The more insular, autarkic shift in the Communist Party’s thinking is not irreversible, but there are no clear signs that Xi Jinping is pivoting toward liberalism after eight years in power. Chart 7Recession Destabilizes The 'G2' Powers Recession Destabilizes The 'G2' Powers Recession Destabilizes The 'G2' Powers China’s unemployment rate has been estimated as high as 20.5% by Zhongtai Securities, which then retracted the estimate (!). It is at least at 10%. Moreover 51 million migrant workers vanished from the job rolls in the first quarter of the year. Maximum employment is the imperative of East Asian governments, especially the Communist Party, which has not dealt with joblessness since the late 1990s. The threat to social and political stability is obvious. The party will take extraordinary measures to maintain stability – not only massive stimulus but also social repression and foreign policy distraction to ensure that people rally around the flag. Xi Jinping has tried to shift the legitimacy of the party from economic growth to nationalism and consumerism, the “China Dream.” But the transition to consumer growth was supposed to be smooth. Financial turmoil, the trade war, and now pandemic and recession have forced the Communist Party off the training wheels well before it intended. Xi’s communist ideology, economic mercantilism, and assertive foreign policy have created an international backlash. The US is obviously indulging in nationalism as well. A stark increase in inequality and political polarization exploded in President Trump’s surprise election on a nationalist and protectionist platform in 2016 (Chart 8). All candidates bashed China on the campaign trail, but Trump was an anti-establishment leader who disrupted corporate interests and followed through with his tariff threats. The result is that the share of Americans who see China’s power and influence as a “major threat” to the United States has grown from around 50% during the halcyon days of cooperation to over 60% today. Those who see it as a minor threat have shrunk to about a quarter of the population (Chart 9). Chart 8A Measure Of Inequality In The US A Measure Of Inequality In The US A Measure Of Inequality In The US Chart 9US Nationalism On The Rise #WWIII #WWIII Chart 10Broad-Based Anti-China Sentiment In US #WWIII #WWIII As with US tariff policy, the bipartisan nature of US anger toward China is significant. More than 60% of Democrats and more than 50% of young people have an unfavorable view of China. College graduates have a more negative opinion than the much-discussed non-college-educated populace (Chart 10). Already it is clear, in Joe Biden’s attack ads against Trump, that this election is about who can sound tougher on China. The debate is over who has the better policy to put “America first,” not whether to put America first. Biden will try to steal back the protectionist thunder that enabled Trump to break the blue wall in the electorally pivotal Rust Belt in 2016 (Map 1). Biden will have to win over these voters by convincing them that he understands and empathizes with their Trumpian outlook on jobs, outsourcing, and China’s threats to national security. He will emphasize other crimes – carbon emissions, cyber attacks, human rights violations – but they will still be China’s crimes. He will return to the “Pivot to Asia” foreign policy of his most popular supporter, former President Barack Obama. Map 1US Election: Civil War Lite #WWIII #WWIII Bottom Line: Economic slowdown and autocracy in China, unprecedented since the Cultural Revolution, is clashing with the United States. Broad social restlessness in the US that is resolving into bipartisan nationalism against a peer competitor, unprecedented since the struggle with the Soviets in the 1960s, is clashing with China. Now is not the time to assume global stability. Constraints Still Operate, But Buy Insurance The story outlined above is by this time pretty well known. But the “Phase One” trade deal allowed global investors to set aside this secular story at the beginning of the year. Now, as Trump threatens tariffs again, the question is whether he will resort to sweeping, concrete, punitive measures against China that will take on global significance – i.e. that will drive the financial markets this year. Trump is still attempting to restore his bull market and magnificent economy. As long as this is the case, a constraint on conflict operates this year. It is just not as firm or predictable. Therefore we are looking for three things. Chart 11Trump May Seek A Crisis ‘Bounce’ To Popularity #WWIII #WWIII First, will President Trump’s approval rating benefit so much from his pressure tactics on China that he finds himself driven into greater pressure tactics? This raises the risk of policy mistakes. Second, will Trump’s approval rating fall into the doldrums, stuck beneath 43%, as the toll of the recession wears on him and popular support during the health crisis fades? “Lame duck” status would essentially condemn him to electoral loss and incentivize him to turn the tables by escalating the conflict with China. Presidents are not very popular these days, but a comparison with Trump’s two predecessors shows that while he can hardly obtain the popularity boost that Obama received just before the 2012 election, he could hope for something at least comparable to what George W. Bush received amid the invasion of Iraq (Chart 11). (Trump has generally been capped at 46% approval, the same as his share of the popular vote in 2016.) The reason this is a real risk, not a Shakespearean play, is outlined above: however cynical Trump’s political calculus, he would be reasserting US grand strategy in the face of a great power that is attempting to set up a regional empire from which, eventually, to mount a global challenge. Thus if he is convinced he cannot win the election anyway, this risk becomes material. Investors should take seriously any credible reports suggesting that Trump is growing increasingly frustrated with his trailing Biden in head-to-head polls in the swing states. Third, will China, under historic internal stress, react in a hostile way that drives Trump down the path of confrontation? China has so far resorted to propaganda, aircraft carrier drills around the island of Taiwan, and maritime encroachments in the South China Sea – none of which is intolerably provocative to Trump. A depreciation of the renminbi, a substantial change to the status quo in the East or South China Seas, or an attempt to vitiate US security guarantees regarding US allies in the region, could trigger a major geopolitical incident. A fourth Taiwan Strait crisis is fully within the realm of possibility, especially given that Taiwan’s “Silicon Shield” is fundamentally at stake. While we dismiss rumors of Kim Jong Un’s death in North Korea, any power vacuum or struggle for influence there is of great consequence in today’s geopolitical context. Aggressive use of tariffs always threatened to disrupt global trade and financial markets, but tariffs function differently in the context of a global economic expansion and bull market, as in 2018-19, than they do in the context of a deep and possibly protracted recession. Trump has a clear political incentive to be tough on China, but an equally clear financial and economic incentive to limit sweeping punitive measures and avoid devastating the stock market and economy. If events lower the economic hurdle, then the political incentive will prevail and financial markets will sell. Bottom Line: However small the risk of Trump enacting sweeping tariffs, the downside is larger than in the 2018-19. The stock market might fall by 40%-50% rather than 20% in an all-out trade war this year. Investment Takeaways Go tactically long US 10-year treasuries. Book a 9.7% profit on our long 30-year US TIPS trade. Close long global equities (relative to US) for a loss of 3.8%.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com  

Highlights Our COVID Unrest Index reveals that Turkey, the Philippines, Brazil, and South Africa are the major emerging markets most at risk of significant social unrest. China, Russia, Thailand, and Malaysia are the least at risk – in the short run. Stay tactically overweight developed market equities relative to emerging markets. Go tactically short a basket of “EM Strongmen” currencies relative to the EM currency benchmark. Short the rand as well. Feature Chart 1Stimulus-Fueled Markets Ignore Reality Stimulus-Fueled Markets Ignore Reality Stimulus-Fueled Markets Ignore Reality With global fiscal stimulus now estimated at 7% of GDP, and central banks in full debt monetization mode, the S&P 500 is at 2940 and rallying toward 3000. It is not only largely ignoring the global pandemic and recession. It is as if the trade war never occurred, China is not shrinking, and WTI crude oil prices have never gone negative (Chart 1). In recent reports we have argued that “geopolitics is the next shoe to drop” – specifically that President Trump’s electoral challenges and the vulnerability of America’s enemies make for a volatile combination. But there are also more mundane geopolitical consequences of the recession that asset allocators must worry about. Such as government change and regime failure. COVID-19 and government lockdowns have exacted a heavy economic toll on households and political systems now face heightened risk of unrest. In many cases emerging market countries were already vulnerable, having witnessed outbreaks of civil unrest in 2019. Fear of contracting the virus, plus various isolation measures, will tend to suppress street movements in the near term. This year’s “May Day” protests will be minor compared to what we will see in coming years. But significant unrest will sprout as the containment measures are relaxed and yet economic problems linger. And bear in mind that the biggest bouts of unrest in the wake of the 2008 crisis did not occur until 2011-13. In this report we introduce our “COVID Unrest Index” for emerging economies, which shows that Turkey, the Philippines, Brazil, and South Africa face substantial unrest that can trigger or follow upon market riots. Introducing The COVID Unrest Index At any point in time, social and political instability depends on economic conditions such as unemployment and inflation, structural problems such as inequality, and governance issues such as corruption. In the post-COVID recessionary environment, additional factors such as health care capacity also carry weight. To identify markets that are most likely to face unrest, we created a COVID Unrest Index (Table 1). The overall ranking is determined by five factors: Table 1Our COVID-19 Social Unrest Index Where Will Social Unrest Explode? Where Will Social Unrest Explode? Initial Economic Conditions: A proxy for economic policy’s ability to respond to the crisis. This factor includes the fiscal balance and sovereign debt – which determine "fiscal space" – as well as the current account balance, public foreign currency debt as a percent of GDP, foreign debt obligations as a percent of exports, and foreign funding requirements as a percent of foreign currency reserves. Health Capacity And Vulnerability: A proxy for both a population’s vulnerability to COVID and its health care capabilities. Vulnerability to the pandemic is captured by COVID-19 deaths per million, share of the population over the age of 65, and likelihood of dying from an infectious disease. Health infrastructure is measured by life expectancy at age 60 and health expenditure per capita. Economic Vulnerability To Pandemic: A proxy for the magnitude of the COVID-specific shock to the individual economy. This factor takes into account a country’s dependence on revenue from tourism and its dependence on inflows from remittances. Household Grievances: A proxy for economic hardship faced by households, captured by the GINI index, which measures income inequality, and the “misery index,” which consists of the sum of inflation and unemployment. Governance: A proxy the captures the quality of governance from the World Bank’s World Governance Indicators – specifically the ability to participate in selecting government, likelihood of political instability or politically-motivated violence, and perceptions of corruption. The country ranking for the COVID Unrest Index is constructed by first standardizing the variables, then transforming them such that higher readings are associated with more favorable conditions. Finally, the five factors are averaged for each country to produce individual scores. Turkey: A Shambles On Europe’s Doorstep Turkey is the most likely to face mass discontent in the near future. It has all the ingredients for unrest: poor standing across all factors and the weakest governance score. From an economic standpoint, its foreign currency reserves are critically low while its foreign debt obligations are relatively elevated (Chart 2). This spells trouble for the lira, which will only further add to the grievances of households already burdened by a high misery index. Chart 2AEmerging Markets Face Debt Troubles Even With The Fed’s Help Where Will Social Unrest Explode? Where Will Social Unrest Explode? Chart 2BEmerging Markets Face Debt Troubles Even With The Fed’s Help Where Will Social Unrest Explode? Where Will Social Unrest Explode? President Erdogan has rejected suggestions of aid from the IMF. Fearing a revival of the main opposition Republican People’s Party (CHP), especially in the wake of his party’s losses in the 2019 municipal elections, he has banned cities that are run by the CHP from raising funds toward virus response efforts. This right is reserved only for cities run by his Justice and Development Party (AKP). Given that Erdogan does not face reelection until 2023, the move to suppress the opposition reflects general weakness and portends a long period of suppression and political conflict. Erdogan’s handling of the outbreak has also seen its share of failures. While he has opted for only a partial lockdown, a 48-hour full lockdown was announced on April 10 only hours in advance, resulting in crowds of people rushing to purchase necessities. Interior minister Suleyman Soylu tried to resign, but was prevented by Erdogan, breeding speculation about Soylu’s motives. Soylu may have sought to distance himself from the president’s handling of the crisis to preserve his image as a potential successor to the president, rivaling Erdogan’s son-in-law, Finance Minister Berat Albayrak. The point is that Erdogan is already facing greater political competition. Former ally and minister of foreign affairs and economy Ali Babacan recently launched a new party, the Democracy and Progress Party (DEVA). He has criticized the government’s stimulus package and decision to hold back on requesting IMF aid. Erdogan is also challenged by his former prime minister Ahmet Davutoglu, who broke away from the AKP to form his own Future Party late last year. The obvious risk to Erdogan is that these opposition groups create a viable political alternative that voters can flock to – and they could form a united front amid national economic collapse. Brazil and South Africa have large twin deficits. Erdogan’s response, repeatedly, has been to harden his stance and double down on populist and unorthodox policies. These have not helped his popular standing, as we have chronicled over the past several years. At home his policies are generating excessive money supply and a large budget deficit (Chart 3). Abroad he has gotten the military more deeply involved in Syria, Libya, and maritime conflicts. The result is stagflation with the potential for negative political surprises both at home and abroad. Chart 3Twin Deficits Flash Red For Emerging Markets Where Will Social Unrest Explode? Where Will Social Unrest Explode? Chart 4Turkish Political Risk Has Room To Rise Turkish Political Risk Has Room To Rise Turkish Political Risk Has Room To Rise Our GeoRisk Indicator for Turkey shows that risks are rising as the lira falls relative to its underlying economic fundamentals (Chart 4). But it will fall further from here. Positive signs would be accepting IMF aid, cutting off the foreign adventures, selling off government assets, and restoring fiscal and monetary orthodoxy. But it is just as likely that Erdogan resorts to even more desperate moves, including a greater confrontation with Greece and Europe by encouraging more refugee flow-through into Europe. Erdogan has always been more popular than his Justice and Development Party, but after ruling since 2003, and now facing a nationwide crisis, his rule is increasingly in jeopardy. His scramble to survive the election in 2023 will be all the more dangerous to governance. Bottom Line: We booked gains on our short lira trade earlier this year but the fundamental case for the short remains intact, so we include it in our short “EM Strongmen” currency basket discussed at the end of this report. The Philippines: Yes, Governance Matters The Philippines is next at risk of instability. It is particularly vulnerable to a pandemic recession due to its dependence on remittance inflows and tourism for foreign currency (Chart 5) as well as its poor health infrastructure (Chart 6). While it is not in a vulnerable position in terms of foreign currency obligations, its double deficit (see Chart 3) means that significant stimulus will come at the expense of the currency. Chart 5Pandemics Hurt Tourism, Recessions Hurt Remittances Where Will Social Unrest Explode? Where Will Social Unrest Explode? Chart 6AEmerging Markets Face COVID-19 Without Developed Market Health Systems Where Will Social Unrest Explode? Where Will Social Unrest Explode? Chart 6BEmerging Markets Face COVID-19 Without Developed Market Health Systems Where Will Social Unrest Explode? Where Will Social Unrest Explode? President Rodrigo Duterte remains extremely popular even though the Philippines is suffering one of the worst outbreaks in Asia. Socioeconomic Planning Secretary Ernesto Pernia has resigned from his post due to disagreement over containment measures. Pernia’s vision of a partial lockdown contrasted with Duterte’s militarized containment approach – which includes the granting of extraordinary emergency powers.1 Meanwhile the lockdowns imposed on the capital and southern Luzon provinces will remain in place until at least May 15 after which Duterte indicated it will be gradually lifted. While Duterte will in all likelihood remain in power until the end of his term in 2022, he is using his popularity to secure a preferred successor. He is less capable of getting through a constitutional amendment that extends presidential term limits – he has the votes in Congress, but a popular referendum is not a sure bet given the economic crisis. He is widely believed to be grooming his daughter Sara or former aide Senator Bong Go for the presidential post, with speculation that he may run as vice president on the same ticket. Turkey and the Philippines have poor governance, putting them alongside international rogue states. Any hit to his popularity that upends his succession plan poses existential risks to Duterte as he has racked up many influential enemies and could face criminal charges if an opposing administration succeeds him. This risk will likely induce him to tighten control further in an attempt to maintain order and crack down on dissent. Autocratic moves will weigh on the Philippines’ governance score which is already among the poorest in our pool of emerging countries (Chart 7). Chart 7Governance Matters For Investors Over The Long Run Where Will Social Unrest Explode? Where Will Social Unrest Explode? Chart 8Duterte Signaled Top In Philippine Equity Outperformance Duterte Signaled Top In Philippine Equity Outperformance Duterte Signaled Top In Philippine Equity Outperformance Does governance matter? Yes, at least in the case of strongmen in regimes with weak institutions. Look at Philippine equities relative to emerging market equities since Duterte first rose onto the scene, prompting us to go short (Chart 8). Duterte obliterated the country’s current account surplus just as we expected and its currency has suffered as a result. For now, the Philippines’ misery index is not yet at a level that strongly implies widespread unrest (Chart 9), but the general context does, especially if constitutional maneuvers backfire. At 4% of GDP, the proposed COVID-19 stimulus package comes on top of the fact that Duterte’s “build, build, build” infrastructure plan already required massive fiscal spending. But the weak currency and higher unemployment will increase the misery index and chip away at the president’s popularity. If the people turn against Duterte, they will remove him in a “people power” movement, as with previous leaders. Chart 9Inequality, Unemployment, And Inflation Are A Deadly Brew Where Will Social Unrest Explode? Where Will Social Unrest Explode? The Philippines is also highly vulnerable to the emerging cold war between the US and China. Administrations are now flagrantly aligned with one great power or the other. This means that foreign meddling should be expected. Duterte could get Chinese assistance, which erodes Philippine sovereignty and its security alliance with the United States, or he could eventually suffer from anti-Chinese sentiment, which invites Chinese pressure tactics. Either course will inject a risk premium over the long run. The US is popular in the Philippines, especially with the military, and overt Chinese sponsorship will eventually trigger a backlash. Bottom Line: The lack of legislative or popular constraints on Duterte makes it more likely that he will undertake autocratic moves to stay in power – economic orthodoxy will suffer as a result. The Philippines will also see a sharp increase in policy uncertainty directly as a consequence of the secular rise in US-China tensions in the coming months and years. Brazil: Will Bolsonaro Become A Kamikaze Reformer? Chart 10Bolsonaro’s Handling Of Pandemic Gets Panned Where Will Social Unrest Explode? Where Will Social Unrest Explode? In Brazil, President Jair Bolsonaro’s “economy first” approach and dismissal of the pandemic as a “little flu” has not improved his popularity (Chart 10). His approval rating is languishing in the 30% range, lower than all modern presidents save the interim government of Michel Temer in the previous episode of the country’s ongoing national political crisis. The pandemic, and Bolsonaro’s response, have fractured his cabinet and precipitated a new episode in the crisis. The clash between the president and the country’s state governors and national health officials, who enjoy popular support, has led to the dismissal of Health Minister Luiz Henrique Mandetta and the resignation of the popular Justice Minister Sergio Moro. We have highlighted Moro as a linchpin of Bolsonaro’s anti-corruption credibility and hence one of the three pillars of his political capital. This pillar is now cracking, making Bolsonaro’s administration less capable going forward. Bolsonaro’s firing of the head of the federal police, Mauricio Valeixo, the catalyst for Moro’s resignation, has led to a Supreme Court authorization for an investigation into whether Valeixo’s dismissal can be attributed to corruption or obstruction of justice. A guilty verdict could force Congress to take up impeachment, an issue on which Brazilians are split. Earlier this week the president was forced to withdraw the appointment of Alexandre Ramagem – a Bolsonaro family friend – as the new head of the federal police after a minister of the supreme federal court blocked the appointment due to his close personal relationship with the president. Brazil’s structural reform and fiscal discipline are on the backburner given the need for massive emergency spending to shore up GDP growth. Reforms are giving way to the “Pro-Brazil Plan,” which seeks to restore the economy through investments in infrastructure. The absence of the economy minister, Paulo Guedes, from the unveiling of this plan has led to speculation over Guedes’ future. Guedes is the key reformer in Bolsonaro’s cabinet and as important for the administration’s economic credibility as Moro was for its anti-corruption credibility. Brazil’s macro context is egregious. Its large public debt load – mostly denominated in local currency – raises the odds that the central bank will monetize the debt at the expense of the exchange rate, which has already weakened since the beginning of the year. Moreover, Brazil’s ability to pay near term debt service obligations is in a precarious position as the pullback in export revenues will weigh on its ability to service debt (see Chart 2). Our Emerging Markets Strategy estimates that Brazil is spending 16% of GDP on fiscal measures that will push gross public debt-to-GDP ratio well above 100% by the end of 2020 (Chart 11). Chart 11Highly Indebted Emerging Markets Have Limited Fiscal Room For Maneuver Where Will Social Unrest Explode? Where Will Social Unrest Explode? Given that Brazil already suffers from a relatively elevated misery index (see Chart 9), these macro challenges will translate into greater pain for Brazilian households and hence a political backlash down the road. The three pillars of Bolsonaro’s political capital have cracked: order, anti-corruption, and structural reform. The hope for investors interested in Brazil now rests on Bolsonaro becoming a kamikaze reformer. That is, after the immediate crisis subsides, his low popularity may force him to try painful structural reforms that no leader with political aspirations would attempt. So far he is taking the populist route of short-term measures to try to stay in power. Chart 12Bolsonaro's Meltdown Portends Melt-Up In Brazilian Political Risk Bolsonaro's Meltdown Portends Melt-Up In Brazilian Political Risk Bolsonaro's Meltdown Portends Melt-Up In Brazilian Political Risk Another sign of worsening governance is that military influence in civilian politics is partially reviving. This element of the country’s recent political turmoil has flown under the radar but will become more prominent if the administration falls apart and the only officials with sufficient credibility to fill the vacuum are military officials such as Vice President Hamilton Mourão. Financial markets may force leaders to make tough decisions to stave off a debt crisis, but risk assets will sell in the meantime as the lid on the country’s political risk has blown off and currency depreciation is the most readiest way to boost nominal GDP growth. Our political risk gauge will continue spiking – this reflects currency weakness relative to fundamentals (Chart 12). Bottom Line: Last fall we argued that Brazil was “just above stall speed” and that we would give the Bolsonaro administration the benefit of the doubt if it maintained three pillars of political capital: civil order, corruption crackdown, and structural reform. All three are collapsing amid the current crisis. As yet there is no sign that Bolsonaro is taking the “kamikaze reform” approach – that may be a positive catalyst but would require his administration to break down further. South Africa: Quantitative Easing Comes To EM South Africa faces an 8%-10% contraction in growth for 2020 and President Cyril Ramaphosa has overseen a large monetary and fiscal stimulus. The South African Reserve Bank has committed to quantitative easing in a bid to boost liquidity in the local financial market. South Africa’s highly leveraged households and those who mostly participate in the formal economy will find relief in lower debt-servicing costs and better access to credit. However, the large informal economy, and the rising number of unemployed, will not reap the same benefit from accommodative measures. This last group will benefit more from fiscal policy measures, such as social grants to low-income households. Ramaphosa recently announced a fiscal spending package totaling R500 billion, or 10% of GDP. Social grants to the poor and unemployed are all set to increase, which should help reduce the economic burden low-income households will face over the short term. The problem is that South Africa is extremely vulnerable to this crisis. Well before COVID the country suffered from low growth, persistently high unemployment, rising debt levels, and an increasing cost of social grants. The pandemic has increased dependency on these grants. South Africa is the most unequal society in the world (Chart 9 above) and runs large twin deficits on its fiscal and current accounts (see Chart 3). As the government’s financing needs rise, its ability to keep providing to low-income households will diminish. Yet the ruling African National Congress (ANC) is required to keep up social payments to stave off discontent and maintain its voter base – which consists of poor, mostly rural voters. The ANC must decide whether to implement stricter austerity measures after the immediate crisis to contain the fiscal fallout, which will bring unrest forward, or continue on an unsustainable path and face a market revolt. The latter option is clear from the decision to embrace quantitative easing, which further undermines the currency. Political pressure is mostly stemming from the left-wing – the Economic Freedom Fighters – which prevents Ramaphosa from taking a hard line on economic and fiscal policy. Bottom Line: There have been isolated protests across the country against the government’s draconian lockdown, and social grievances have the potential to boil over in the coming years given the long rule of the ANC and the country’s dire economic straits. Investment Implications It is too soon to buy into risky emerging market assets at a time when a deep recession is spreading across the world, extreme uncertainty persists over the COVID-19 pandemic, and the political and geopolitical fallout is transparently negative for major emerging markets. Remain overweight developed market equities relative to emerging market equities, at least over a tactical (three-to-six month) time horizon. Emerging market losers are countries with poor macro fundamentals, weak health care systems, specific competitive disadvantages during a global pandemic, high levels of inflation and unemployment, and ineffective social and political institutions. Turkey, the Philippines, and Brazil rank high on our list both because of their problems and because they are major markets. Chart 13Short Our 'EM Strongman' Currency Basket Short Our 'EM Strongman' Currency Basket Short Our 'EM Strongman' Currency Basket Not coincidentally these countries each have “strongman” leaders who have pursued unorthodox polices and ridden roughshod over institutional checks and balances. In each case, the leader is doubling down on populism while exacerbating structural weaknesses that already existed. Apparently greater financial punishment is necessary before policies are adjusted and buying opportunities emerge. Thus we recommend investors short our “EM Strongman Basket” consisting of the Turkish lira, the Brazilian real, and the Philippine peso, relative to the EM currency benchmark, over a tactical horizon. These currencies outperformed the EM benchmark until 2016 when they began to underperform – a trend that looks to continue (Chart 13). These leaders could get away with a lot more during a global bull market than during a bear market. It will take time for Chinese and global growth to revive this year. And their policies suggest bad news will precede good news. We would also recommend tactically shorting the South African rand on the same basis. While Russia, China, and Thailand also have strongman leaders, their countries have much better fundamentals, as our COVID Unrest Index shows. However, we do not have a bright outlook for these countries’ political stability over the long run. Russia, like all oil producers, stands to suffer in this crisis, despite its positive score on our index. In a previous report, “Drowning In Oil,” we highlighted how the petro-states face serious risks of government change, regime failure, and international conflict. This is clear with Iran and Venezuela in the above charts, and also includes Iraq, Algeria, Angola, and Nigeria. Our preferred emerging markets – from the point of view of political risk as well as macro fundamentals – are Thailand, Malaysia, South Korea, and Mexico. We warn against Taiwan due to geopolitical risk, although its fundamentals are positive. We are generally constructive on India, but it is susceptible to unrest, which we will assess in future reports. Roukaya Ibrahim Editor/Strategist Geopolitical Strategy roukayai@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 On April 16, Duterte ordered quarantine violators be arrested without warning. According to the UN, over one hundred thousand people have been arrested for violating curfew orders. The Philippines along with China, South Africa, Sri Lanka, and El Salvador were singled out by the UN High Commissioner for Human Rights are using unnecessary force to enforce the lockdowns and committing human rights violations in the veil of coronavirus restrictions. Duterte’s greenlight on a “shoot to kill” order against those participating in protests in violation of lockdown followed small-scale demonstrations in protest of Duterte’s handling of COVID-19.

Highlights Kim Jong Un’s sickness or death is a matter of speculation and it is best to remain skeptical for now. If Kim dies or is incapacitated, it is a serious concern for North Korean and hence regional stability – and not only in the medium and long term. A North Korean power vacuum could trigger a major relapse in US-China relations. Even if Kim is healthy, his negotiations with President Trump could affect US-China relations or Trump’s reelection chances this year. US-China tensions could also break down separately this year – watch for yuan depreciation or for Trump to lose public approval. The South China Sea and Taiwan Strait are also non-negligible risks that could derail US-China relations before the US election. Feature If North Korean leader Kim Jong Un dies, it is a risk to global stability. We have no insight on Kim’s health or whereabouts but we do know that North Korea is relevant to global investors – it is no longer a joke – because US-China relations are no longer stable. Korean political risk has been on an uptrend since the second summit between Kim and President Trump in Hanoi, Vietnam was cut short without any agreement (Chart 1). Chart 1Korean Political Risk Already On An Uptrend Due To Pandemic, Recession, US-China Tensions Korean Political Risk Already On An Uptrend Due To Pandemic, Recession, US-China Tensions Korean Political Risk Already On An Uptrend Due To Pandemic, Recession, US-China Tensions A dispute over North Korea could trigger a relapse in US-China relations that threatens the global equity rebound. Remain Skeptical As we go to press it is still unknown whether Kim is sick, well, living, or dying. What is known is that Kim failed to make a public appearance on Kim Il Sung Day, April 15, a noteworthy absence. China has sent a group of officials from the Communist Party’s Liaison Department, including medical doctors, according to Reuters – the most objective sign yet that something in North Korea has gone amiss. Japan’s Shukan Gendai on April 26 quoted an unnamed Chinese official saying that Kim was in a “vegetative state” after having stents put in his arteries after a heart attack. This corroborates (or repeats) the story that originally broke in South Korean newspaper Daily NK on April 21, saying that Kim was in grave condition after complications from heart surgery. Neither the Daily NK nor the Shukan Gendai are premium papers and the Daily NK also had to correct its original story which it attributed to “multiple” North Korean sources when in fact it only had one source. The US think tank 38 North on April 26 identified Kim’s elite passenger train at Wonsan but neither 38 North nor Reuters can confirm that Kim is actually in Wonsan. Kim was last seen in public on April 11 in Pyongyang, the day before Kim’s alleged surgery on April 12, but North Korean state press has reported on him conducting a range of activities since that date, albeit without video footage or anything that would disprove his incapacity. South Korean officials at the highest levels have repeatedly denied that they have intelligence of anything “special” happening in North Korea. South Korean assets are untroubled by the rumors (Chart 2). US President Donald Trump, and Pentagon officials, have also cast doubt on rumors that Kim is sick or dying – although various White House officials and Senator Lindsey Graham of South Carolina have implied something is wrong. Frequently it occurs that a temporary absence of autocratic leaders like Kim or Chinese President Xi Jinping causes the global media to speculate about illness, death, or intrigue. The lack of transparency of such regimes gives rise to a cottage industry of political watchers who interpret a leader’s every movement. Usually these rumor cycles amount to nothing. Absence of evidence (a leader’s failure to appear at an event) is not evidence of absence (the leader’s death). Still, the longer North Korea goes without offering definitive proof that Kim is alive, the greater the concerns will mount. One thing that we find unusual is the positioning of Kim’s sister, Kim Yo Jong. Kim Yo Jong was removed from the Politburo of the Korean Worker’s Party shortly after the failed Hanoi summit last year. She was reinstated as an alternate member on April 11 this year, in what was probably Kim Jong Un’s last credible public appearance. This gave rise to a surge of interest in her as a rising star, reflected in Google searches on April 12. These searches have spiked much more dramatically now that Kim Jong Un’s health is in question (Chart 3). Chart 2Korean Assets Not Responding Much To Kim Rumors Korean Assets Not Responding Much To Kim Rumors Korean Assets Not Responding Much To Kim Rumors Chart 3Why Was Kim Yo-Jong Rehabilitated Just Before Kim’s Alleged Surgery? North Korean Rumors: Significant ... If True North Korean Rumors: Significant ... If True The timing of her reinstatement, promptly followed by rumors about Kim’s health, is strange. North Korea’s political legitimacy is based on the Kim family dynasty. Her political recovery and promotion would be necessary to prepare her for any heightened role in the event of Kim’s incapacity or death. The purpose of the Politburo meeting was apparently to address the COVID-19 pandemic and delay a meeting of the legislature, the Supreme People’s Assembly. While rumors have focused on Kim’s cardiac event, we would not rule out the possibility that he has contracted COVID-19. Global leaders certainly are not immune to the disease, as evidenced by UK Prime Minister Boris Johnson. Reports also cite Kim's past periods of illness in 2012-14, although it is doubtful that his previous troubles with gout have any connection to a heart attack this month. What Is At Stake If Kim Exits The Scene For investors, the important thing to recognize is that North Korea is no longer irrelevant, no longer a geopolitical “red herring,” as we outlined in a series of reports in 2016 and 2017. Rather it is a critical moving part in a growing strategic conflict between the US and China. North Korea is a nuclear-armed state and a personalized autocracy with no clear succession plan, a stability risk on China’s border, and a national security risk to the United States and its allies Japan and South Korea. Pyongyang is in the midst of a multi-year, high-stakes diplomatic negotiation with its Northeast Asian neighbors and the United States. Diplomacy has not, thus far, gone off the rails. While Pyongyang has pushed the envelope with minor nuclear and missile activities, and by contesting Trump’s claims of exchanging letters, it has not abandoned negotiations with President Trump since 2017 by testing nuclear devices or intercontinental ballistic missiles, or by threatening to attack the US. South Korea’s legislative election on April 15 reinforced the leadership of President Moon Jae In and his left-leaning Democratic Party, marking a rebound for Moon due to his handling of the pandemic. This marks a boost to his “Moonshine” policy of diplomacy and economic integration with the North, another factor conducive to the continuation of diplomacy (Chart 4). However, any instability now would occur at a time of extreme vulnerability both within North Korea and abroad. North Korean growth is already facing a historic downturn unlike anything since the collapse of the Soviet Union (Chart 5). Chart 4Peaceniks Still Winning In South Korea North Korean Rumors: Significant ... If True North Korean Rumors: Significant ... If True Chart 5North Korean Instability Is Likely Regardless Of Kim's Health North Korean Instability Is Likely Regardless Of Kim's Health North Korean Instability Is Likely Regardless Of Kim's Health President Trump’s policy of “maximum pressure” sanctions has the North’s economy in a vise (Chart 6). For the past few years China has enforced sanctions on the North to cooperate with the United States. Beijing has reduced fuel exports and coal imports, according to official statistics (Chart 7). Chart 6Sanctions Have Damaged The Regime Sanctions Have Damaged The Regime Sanctions Have Damaged The Regime Chart 7China's Sanctions Enforcement Is Critical China's Sanctions Enforcement Is Critical China's Sanctions Enforcement Is Critical Even if China were not enforcing sanctions, North Korea’s economic conditions would be drastically deteriorating due to the COVID-19 pandemic, which has pushed China into what may well be the first recession since the 1970s (Chart 8). Thus if North Korea does end up having a leadership problem, investors should not assume that the regime will remain stable, in the near, medium, or long term. A power struggle broke out in China immediately upon Chairman Mao’s death in 1976. And when Kim Jong Un took power in December 2011, he struggled to consolidate power over the party, state, and military at first. He notoriously executed his uncle in December 2013 amid these internal struggles, which may have involved insubordinate military actions. His older brother Kim Jong Chol, or his sister Kim Yo Jong, would have more trouble consolidating power given that they were not Kim Jong Il’s choice for successor and would enter the supreme office in an extremely unstable time both at home and abroad. A succession process could also lead to external risks relatively quickly. North Korea’s historic surprise attack on the South Korean corvette, the Chonan, occurred in March 2010. Kim Jong Il was known to be preparing for his exit and for Kim Jong Un’s succession, so the regime sought to demonstrate strength while the world was distracted with a global financial crisis. If US-China relations were stable, there would be at least one substantial basis for believing that a North Korean crisis could be prevented from causing a crisis in other foreign relations. But US-China relations are not stable – they have deteriorated since the global financial crisis, as symbolized here by China’s diversifying away from US treasury holdings (Chart 9). The average US tariff rate on Chinese imports has risen from 5% to 15% under President Trump, who is threatening to impose additional punitive measures on China, such as export controls, as the two sides quarrel over the pandemic and recession. Chart 8Chinese Slowdown A Threat To Pyongyang Chinese Slowdown A Threat To Pyongyang Chinese Slowdown A Threat To Pyongyang President Trump’s signature foreign policy initiative – as opposed to trade initiative – has consisted of negotiations with North Korea over denuclearization and eventual peace. If these negotiations fall apart, President Trump will suffer in a substantial way that will at least marginally harm his reelection chances on November 3. Chart 9US-China Relations Fundamentally Unstable US-China Relations Fundamentally Unstable US-China Relations Fundamentally Unstable If the negotiations result in a “magnificent” deal this year, they could help those chances. Negotiations could face a test before that time, if either side abandons negotiations or gets cold feet before agreeing to a deal. Chart 10Brinkmanship Results In US Shows Of Force Brinkmanship Results In US Shows Of Force Brinkmanship Results In US Shows Of Force Testing periods in the current relationship involve shows of US military strength, as in the summer of “fire and fury” in 2017, and as the US also showed in a similar summer of fire and fury with Iran in 2019 (Chart 10). Shows of force typically are a source of passing volatility, at best, in global financial markets. But in this year’s context the risk of broader US-China strategic competition would amplify that impact, even if it is transient. Investment Takeaways For global investors, what matters is if a North Korean crisis destabilizes the region and if US-China relations destabilize for this or any other reason. If Kim dies, we expect instability to ensue in North Korea eventually, if not immediately, and this would entail some degree of instability among the major powers. The US and China would seek to shape the outcome on the peninsula – China has already sent a team of officials. Washington and Beijing have a shared interest in preventing regime collapse, but they have a high level of distrust and different aims for the regime that might emerge in the aftermath. Tensions would get extremely high amid a power vacuum in North Korea. To gauge the durability of the US-China détente, the phase one trade deal signed in January, we are monitoring the CNY-USD exchange rate and President Trump’s approval rating (Chart 11). Renminbi depreciation is possible to ease pressure on China’s weak economy, but it would break the deal entirely, given that most other elements of the deal are either interrupted by the recession (goods purchases) or unverifiable (intellectual property protections). Chart 11Yuan Depreciation Or Falling Trump Approval Threaten Global Equities Yuan Depreciation Or Falling Trump Approval Threaten Global Equities Yuan Depreciation Or Falling Trump Approval Threaten Global Equities Meanwhile President Trump only has an incentive to refrain from punitive measures as long as he believes his economy and election chances are salvageable. If this changes, and he is stuck in the 42% approval range or below, he may become a “lame duck” and attempt to turn the tables. Aggressive scapegoating of China, which has attracted widespread American disfavor, is a possible tactic for him to outmaneuver his rival, former Vice President Joe Biden, who is allegedly soft on China. We have long argued that US-China tensions would spill over to strategic disputes in China’s periphery and cause a higher risk-premium in global equities and risk assets exposed to this relationship. The current fragile environment of pandemic and recession makes a risk-off more likely by rendering both the US and China more vulnerable. We have held that the Taiwan Strait was more likely than the Korean peninsula to be the site of a crisis this year, but Kim Jong Un’s death would change that calculation. Two final points. First, North Korea has a long and distinguished history of feigning weakness in order to get foreign aid. If the great powers think it is on the verge of collapse then they will offer aid and possibly sanctions relief. With the pandemic and recession, we could eventually learn that Kim is alive and well, but that North Korea wants assistance with the pandemic. As outlined above, it is still possible that Kim’s health is fine, and yet that a failure of diplomacy with President Trump results in significant saber-rattling this year. Second, all of the above demonstrates the seriousness of geopolitical risk in East Asia stemming from US-China competition. Distrust is growing on a secular level and is seeing a near-term spike due to COVID and the US election. As a consequence, we take any North Korean instability seriously. But we also see potential for conflicts to emerge in the Taiwan Strait or the South China Sea, where a standoff between China, its rival territorial claimants, and the US is already underway. We remain tactically defensive and continue to recommend the Japanese yen as a hedge. We are adding JPY-EUR to this mix. On a longer-term horizon we recommend investors remain long selective international equities and commodities. For now we remain overweight Korean equities relative to Taiwanese, but we will close this trade on any confirmation that Kim is dead or incapacitated. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com

Highlights The collapse in oil prices supercharges the geopolitical risks stemming from the global pandemic and recession. Low oil prices should discourage petro-states from waging war, but Iran may be an important exception. Russian instability is one of the most important secular geopolitical consequences of this year’s crisis. President Trump’s precarious status this election year raises the possibility of provocations or reactions on his part. Europe faces instability on its eastern and southern borders in coming years, but integration rather than breakup is the response. Over a strategic time frame, go long AAA-rated municipal bonds, cyber security stocks, infrastructure stocks, and China reflation plays. Feature Chart 1Someone Took Physical Delivery! Someone Took Physical Delivery! Someone Took Physical Delivery! Oil markets melted this week. Oil volatility measured by the Crude Oil ETF Volatility Index surpassed 300% as WTI futures for May 2020 delivery fell into a black hole, bottoming at -$40.40 per barrel (Chart 1). Our own long Brent trade, initiated on 27 March 2020 at $24.92 per barrel, is down 17.9% as we go to press. Strategically we are putting cash to work acquiring risk assets and we remain long Brent. The forward curve implies that prices will rise to $35 and $31 per barrel for Brent and WTI by April 2021. We initiated this trade because we assessed that: The US and EU would gradually reopen their economies (they are doing so). Oil production would be destroyed (more on this below). Russia and Saudi Arabia would agree to production cuts (they did). Monetary and fiscal stimulus would take effect (the tsunami of stimulus is still growing). Global demand would start the long process of recovery (no turn yet, unknown timing). On a shorter time horizon, we are defensively positioned but things are starting to look up on COVID-19 – New York Governor Andrew Cuomo has released results of a study showing that 15% of New Yorkers have antibodies, implying a death rate of only 0.5%. The US dollar and global policy uncertainty may be peaking as we go to press (Chart 2). However, second-order effects still pose risks that keep us wary. Chart 2Dollar And Policy Uncertainty Roaring Dollar And Policy Uncertainty Roaring Dollar And Policy Uncertainty Roaring Geopolitics is the “next shoe to drop” – and it is already dropping. A host of risks are flying under the radar as the world focuses on the virus. Taken alone, not every risk warrants a risk-off positioning. But combined, these risks reveal extreme global uncertainty which does warrant a risk-off position in the near term. This week’s threats between the US and Iran, in particular, show that the political and geopolitical fallout from COVID-19 begins now, it will not “wait” until the pandemic crisis subsides. In this report we focus on the risks from oil-producing economies, but we first we update our fiscal stimulus tally. Stimulus Tsunami Chart 3Stimulus Tsunami Still Building Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Policymakers responded to COVID-19 by doing “whatever it takes” to prop up demand (Chart 3). Please see the Appendix for our latest update of our global fiscal stimulus table. The latest fiscal and monetary measures show that countries are still adding stimulus – i.e. there is not yet a substantial shift away from providing stimulus: China has increased its measures to a total of 10% of GDP for the year so far, according to BCA Research China Investment Strategy. This includes a general increase in credit growth, a big increase in government spending (2% of GDP), a bank re-lending scheme (1.5% of GDP), an increase in general purpose local government bonds (2% of GDP), plus special purpose bonds (4% of GDP) and other measures. On the political front, the government has rolled out a new slogan, “the Six Stabilities and the Six Guarantees,” and President Xi Jinping said on an inspection tour to Shaanxi that the state will increase investments to ensure that employment is stabilized. This is the maximum reflationary signal from China that we have long expected. The US agreed to a $484 billion “fourth phase” stimulus package, bringing its total to 13% of GDP. President Trump is already pushing for a fifth phase involving bailouts of state and local governments and infrastructure, which we fully expect to take place even if it takes a bit longer than packages that have been passed so far this year. German Chancellor Angela Merkel has opened the way for the EU to issue Eurobonds, in keeping with our expectations. Germany is spending 12% of GDP in total – which can go much higher depending on how many corporate loans are tapped – while Italy is increasing its stimulus to 3% of GDP. As deficits rise to astronomical sums, and economies gradually reopen, will legislatures balk at passing new stimulus? Yes, eventually. Financial markets will have to put more pressure on policymakers to get them to pass more stimulus. This can lead to volatility. In the US the pandemic is coinciding with “peak polarization” over the 2020 election. Lack of coordination between federal and state governments is increasing uncertainty. Currently disputes center on the timing of economic reopening and the provisioning bailout funds for state and local governments. Senate Majority Leader Mitch McConnell is threatening to deny bailouts for American states with large, unfunded public pension benefits (Chart 4A). He is insisting that the Senate “push the pause button” on coronavirus relief measures; specifically that nothing new be passed until the Senate convenes in Washington on May 4. He may then lead a charge in the Republican Senate to try to require structural reforms from states in exchange for bailouts. Estimates of the total state budget shortfall due to the crisis stand at $500 billion over the next three years, which is almost certainly an understatement (Chart 4B). Chart 4AUS States Have Unfunded Liabilities Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 4BUS States Face Funding Shortfalls Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Could a local government or state declare bankruptcy? Not anytime soon. Technically there is no provision for states to declare bankruptcy. A constitutional challenge to such a declaration would go to the Supreme Court. One commonly cited precedent, Arkansas in 1933, ended up with a federal bailout.1 A unilateral declaration could conceivably become a kind of “Lehman moment” in the public sector, but state governors will ask their legislatures to provide more fiscal flexibility and will seek bailouts from the federal government first. The Federal Reserve is already committed to buying state and local bonds and can expand these purchases to keep interest rates low. Washington would be forced to provide at least short-term funding if state workers started getting fired in the midst of the crisis because of straightened state finances – another $500 billion for the states is entirely feasible in today’s climate. Constraints will prevail on the GOP Senate to provide state bailout funds. This conflict over state finances could have a negative impact on US equities in the near term, but it is largely a bluff – McConnell will lose this battle. The fundamental dynamic in Washington is that of populism combined with a pandemic that neutralizes arguments about moral hazard. Big-spending Democrats in the House of Representatives control the purse strings while big-spending President Trump faces an election. Senate Republicans are cornered on all sides – and their fate is tied to the President’s – so they will eventually capitulate. Bottom Line: The global fiscal and monetary policy tsunami is still building. But there are plenty of chances for near-term debacles. Over the long run the gargantuan stimulus is the signal while the rest is noise. Over the long run we expect the reflationary efforts to prevail and therefore we are long Treasury inflation-protected securities and US investment grade corporate bonds. We recommend going strategically long AAA-rated US municipal bonds relative to 10-year Treasuries. Petro-State Meltdown Since March we have highlighted that the collapse in oil prices will destabilize oil producers above and beyond the pandemic and recession. This leaves Iran in danger, but even threatens the stability of great powers like Russia. Normally there is something of a correlation between the global oil price and the willingness of petro-states to engage in war (Chart 5). Chart 5Petro-States Cease Fire When Oil Drops Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) When prices fall, revenues dry up and governments have to prioritize domestic stability. This tends to defer inter-state conflict. We can loosely corroborate this evidence by showing that global defense stocks tend to be correlated with oil prices (Chart 6). Global growth is the obvious driver of both of these indicators. But states whose budgets are closely tied to the commodity cycle are the most likely to cut defense spending. Chart 6Global Growth Drives Oil And Guns Global Growth Drives Oil And Guns Global Growth Drives Oil And Guns Russia is case in point. Revenues from Rostec, one of Russia’s largest arms firms, rise and fall with the Urals crude oil price (Chart 7). The Russians launch into foreign adventures during oil bull markets, when state coffers are flush with cash. They have an uncanny way of calling the top of the cycle by invading countries (Chart 8). Chart 7Oil Correlates With Russian Arms Sales Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 8Russian Invasions Call Peak In Oil Bull Markets Russian Invasions Call Peak In Oil Bull Markets Russian Invasions Call Peak In Oil Bull Markets Chart 9Turkish Political Risk On The Rise Turkish Political Risk On The Rise Turkish Political Risk On The Rise In the current oil rout, there is already some evidence of hostilities dying down in this way. For instance, after years of dogged fighting in Yemen, Saudi Arabia is finally declaring a ceasefire there. Turkey, which benefits from low oil prices, has temporarily gotten the upper hand in Libya vis-à-vis Khalifa Haftar and the Libyan National Army, which depends on oil revenues and backing from petro-states like Russia and the GCC. Of course, Turkey’s deepening involvement in foreign conflicts is evidence of populism at home so it does not bode well for the lira or Turkish assets (Chart 9). But it does highlight the impact of weak oil on petro-players such as Haftar. However, the tendency of petro-states to cease fire amid low prices is merely a rule of thumb, not a law of physics. Past performance is no guarantee of future results. Already we are seeing that Iran is defying this dynamic by engaging in provocative saber-rattling with the United States. Iran And Iraq The US and Iran are rattling sabers again. One would think that Iran, deep in the throes of recession and COVID-19, would eschew a conflict with the US at a time when a vulnerable and anti-Iranian US president is only seven months away from an election. Chart 10US Maximum Pressure On Iran US Maximum Pressure On Iran US Maximum Pressure On Iran Iran has survived nearly two years of “maximum pressure” from President Trump (Chart 10), and previous US sanction regimes, and has a fair chance of seeing the Democrats retake Washington. The Democrats would restart negotiations to restore the 2015 nuclear deal, which was favorable to Iran. Therefore risking air strikes from President Trump is counterproductive and potentially disastrous. Yet this logic only holds if the Iranian regime is capable of sustaining the pain of a pandemic and global recession on top of its already collapsing economy. Iran’s ability to circumvent sanctions to acquire funds depended on the economy outside of Iran doing fine. Now Iran’s illicit funds are drying up. This could lead to a pullback in funding for militant proxies across the region as Iran cuts costs. But it also removes the constraint on Iran taking bolder actions. If the economy is collapsing anyway then Iran can take bigger risks. Furthermore if Iran is teetering, there may be an incentive to initiate foreign conflicts to refocus domestic angst. This could be done without crossing Trump’s red lines by attacking Iraq or Saudi Arabia. With weak oil demand, Iran’s leverage declines. But a major attack would reduce oil production and accelerate the global supply-demand rebalance. Iran’s attack on the Saudi Abqaiq refinery last September took six million barrels per day offline briefly, but it was clearly not intended to shut down that production permanently. Threats against shipping in the Persian Gulf bring about 14 million barrels per day into jeopardy (Chart 11). Chart 11Closing Hormuz Would Be The Biggest Oil Shock Ever Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Iran-backed militias in Iraq have continued to attack American assets and have provoked American air strikes over the past month, despite the near-war scenario that erupted just before COVID. Iranian ships have harassed US naval ships in recent days. President Trump has ordered the navy to destroy ships that threaten it; Iranian commander has warned that Iran will sink US warships that threaten its ships in the Gulf. There is a 20% chance of armed hostilities between the US and Iran. Why would Iran be willing to confront the United States? First, Iran rightly believes that the US is war-weary and that Trump is committed to withdrawing from the Middle East. But this could prompt a fateful mistake. The equation changes if the US public is incensed and Trump’s election campaign could benefit from conflict. Chart 12Youth Pose Stability Risk To Iran Youth Pose Stability Risk To Iran Youth Pose Stability Risk To Iran Second, the US is never going to engage in a ground invasion of Iran. Airstrikes would not easily dislodge the regime. They could have the opposite effect and convert an entire generation of young, modernizing Iranians into battle-hardened supporters of the Islamic revolution (Chart 12). This is a dire calculation that the Iranian leaders would only make if they believed their regime was about to collapse. But they are quite possibly the closest to collapse that they have been since the 1980s and nobody knows where their pain threshold lies. They are especially vulnerable as the regime approaches the uncharted succession of Supreme Leader Ali Khamanei. Since early 2018 we have argued that there is a 20% chance of armed hostilities between the US and Iran. We upgraded this to 40% in June 2019 and downgraded it back to 20% after the Iranians shied from direct conflict this January. Our position remains the same 20%. This is still a major understated risk at a time when the global focus is entirely elsewhere. It will persist into 2021 if Trump is reelected. If the Democrats win the US election, this war risk will abate. The Iranians will play hard to get but they are politically prohibited from pursuing confrontation with the US when a 2015-type deal is available. This would open up the possibility for greater oil supply to be unlocked in the future, but sanctions are not likely to be lifted till 2022 at earliest. Russia Russia may not be on the verge of invading anyone, but it is internally vulnerable and fully capable of striking out against foreign opponents. Cyberattacks, election interference, or disinformation campaigns would sow confusion or heighten tensions among the great powers. The Russian state is suffering a triple whammy of pandemic, recession, and oil collapse. President Vladimir Putin’s approval rating has fallen this year so far, whereas other leaders in the western world have all seen polling bounces (even President Trump, slightly) (Chart 13). Putin postponed a referendum designed to keep him in office through 2036 due to the COVID crisis. In other words, the pandemic has already disrupted his carefully laid succession plans. While Putin can bypass a referendum, he would have been better off in the long run with the public mandate. Generally it is Putin’s administration, not his personal popularity, that is at risk, but the looming impact on Russian health and livelihoods puts both in jeopardy (Chart 14) and requires larger fiscal outlays to try to stabilize approval (Chart 15). Chart 13Putin Saw No COVID Popularity Bump Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 14Russian Regime Faces Political Discontent Russian Regime Faces Political Discontent Russian Regime Faces Political Discontent Moreover, regardless of popular opinion, Putin is likely to settle scores with the oligarchs. The fateful decision to clash with the Saudis in March, which led to the oil collapse, will fall on Igor Sechin, Chief Executive of Rosneft, and his faction. An extensive political purge may well ensue that would jeopardize domestic stability (Chart 16). Chart 15Russia To Focus On Domestic Stability Russia To Focus On Domestic Stability Russia To Focus On Domestic Stability Chart 16Russian Political Risk Will Rise Russian Political Risk Will Rise Russian Political Risk Will Rise Russian tensions with the US will rise over the US election in November. The Democrats would seek to make Russia pay for interfering in US politics to help President Trump win in 2016. But even President Trump may no longer be a reliable “ally” of Putin given that Putin’s oil tactics have bankrupted the US shale industry during Trump’s reelection campaign. The American and Russian air forces are currently sparring in the air space over Syria and the Mediterranean. The US has also warned against a malign actor threatening to hack the health care system of the Czech Republic, which could be Russia or another actor like North Korea or Iran. These issues have taken place off the radar due to the coronavirus but they are no less real for that. Venezuela We have predicted Venezuela’s regime change for several years but the oil meltdown, pandemic, and insufficient Russian and Chinese support should put the final nail in the regime’s coffin. Hugo Chavez’s rise to power, the last “regime change,” occurred as oil prices bottomed in 1998. Historically the Venezuelan armed forces have frequently overthrown civilian authorities, but in several cases not until oil prices recovered (Chart 17). Chart 17Venezuelan Coups Follow Oil Rebounds Venezuelan Coups Follow Oil Rebounds Venezuelan Coups Follow Oil Rebounds The US decision to designate Nicolas Maduro as a “narco-terrorist,” to deploy greater naval and coast guard assets around Venezuela, to reassert the Monroe Doctrine and Roosevelt Corollary, and to pull Chevron from the country all suggest that Washington is preparing for regime change. Such a change may or may not involve any American orchestration. Venezuela is an easy punching-bag for President Trump if he seeks to “wag the dog” ahead of the election. Venezuela would be a strategic prize and yet it cannot hurt the US economy or financial markets substantially, giving limited downside to President Trump if he pursues such a strategy. Obviously any conflict with Venezuela this year is far less relevant to global investors than one with Iran, North Korea, China, or Russia. Regime change would be positive for oil supply and negative for prices over the long run. But that is a story for the next cycle of energy development, as it would take years for government and oil industry change in Venezuela to increase production. The US election cycle is a critical aggravating factor for all of these petro-state risks. Shale producers are going bankrupt, putting pressure on the economy and some swing states. The risk of a conflict arises not only from Trump playing “wag the dog” after the crisis abates, but also from other states provoking the president, causing him to react or overreact. The “Other Guys” Oil producers outside the US, Canada, gulf OPEC, and Russia – the “other guys” – are extremely vulnerable to this year’s global crisis and price collapse. Comprising half of global production, they were already seeing production declines and a falling global market share over the past decade when they should have benefited from a global economic expansion. They never recovered from the 2014-15 oil plunge and market share war (Chart 18). Angola (1.4 million barrels per day), Algeria (one million barrels per day), and Nigeria (1.8 million barrels per day) are relatively sizable producers whose domestic stability is in question in the coming years as they cut budgets and deplete limited forex reserves to adjust to the lower oil price. This means fewer fiscal resources to keep political and regional factions cooperating and provide basic services. Algeria is particularly vulnerable. President Abdelaziz Bouteflika, who ruled as a strongman from 1999, was forced out last year, leaving a power vacuum that persists under Prime Minister Abdelaziz Djerad, in the wake of the low-participation elections in December. An active popular protest movement, Hirak, already exists and is under police suppression. Unemployment is high, especially among the youth. Neighboring Libya is in the midst of a war and extremist militants within Libya and North Africa would like to expand their range of operations in a destabilized Algeria. Instability would send immigrants north to Europe. Oil production will be reduced involuntarily as well as voluntarily this year due to regime failures. Brazil is not facing the risk of state failure like Algeria, but it is facing a deteriorating domestic political outlook (Chart 19). President Jair Bolsonaro’s popularity was already low relative to most previous presidents before COVID. His narrow base in the Chamber of Deputies got narrower when he abandoned his political party. He has defied the pandemic, refused to endorse social distancing or lockdown orders by local governments, and fired his Health Minister Luiz Henrique Mandetta. Chart 18Petro-States: 'Other Guys' Face Instability Petro-States: 'Other Guys' Face Instability Petro-States: 'Other Guys' Face Instability Chart 19Brazilian Political Risk Rising Again Brazilian Political Risk Rising Again Brazilian Political Risk Rising Again Brazil has a high number of coronavirus deaths per million people relative to other emerging markets with similar health capacity and susceptibility to the disease. This, combined with sharply rising unemployment, could prove toxic for Bolsonaro, who has not received a bounce in popular opinion from the crisis like most other world leaders. Thus on balance we expect the October local elections to mark a comeback for the Worker’s Party. The limited fiscal gains of Bolsonaro’s pension reform are already wiped out by the global recession, which will set back the country’s frail recovery from its biggest recession in a century. The country is still on an unsustainable fiscal path. Bolsonaro does not have a strong personal commitment to neoliberal structural reform, which has been put aside anyway due to the need for government fiscal spending amid the crisis. Unless Bolsonaro’s popularity increases in the wake of the crisis – due to backlash against the state-level lockdowns – the economic shock is negative for Brazil’s political stability and economic policy orthodoxy. Bottom Line: Our rule of thumb about petro-states suggests that they will generally act less aggressive amid a historic oil price collapse, but Iran may prove a critical exception. Investors should not underestimate the risk of a US-Iran conflict this year. Beyond that, the US election will have a decisive impact as the Democrats will seek to resume the Iranian nuclear deal and Iran would eventually play ball. Venezuela is less globally relevant this year – although a “wag the dog” scenario is a distinct possibility – but it may well be a major oil supply surprise in the 2020s. More broadly the takeaway is that oil production will be reduced involuntarily as well as voluntarily this year due to regime failures. Investment Takeaways Obviously any conflict with Iran could affect the range of Middle Eastern OPEC supply, not just the portion already shuttered due to sanctions on Iran itself. Any Iran war risk is entirely separate from the risk of supply destruction from more routine state failures in Africa. These shortages have been far less consequential lately and have plenty of room to grow in significance (Chart 20). The extreme lows in oil prices today will create the conditions for higher oil prices later when demand recovers, via supply destruction. Chart 20More Unplanned Outages To Come Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Chart 21European Political Risk No Longer Underrated European Political Risk No Longer Underrated European Political Risk No Longer Underrated An important implication – to be explored in future reports – is that Europe’s neighborhood is about to get a lot more dangerous in the coming years, as the Middle East and Russia will become less stable. Middle East instability will result in new waves of immigration and terrorism after a lull since 2015-16. These waves would fuel right-wing political sentiment in parts of Europe that are the most vulnerable in today’ crisis: Italy, Spain, and France (Chart 21). This should not be equated with the EU breaking apart, however, as the populist parties in these countries are pursuing soft rather than hard Euroskepticism. Unless that changes the risk is to the Euro Area’s policy coherence rather than its existence. Finally Russian domestic instability is one of the major secular consequences of the pandemic and recession and its consequences could be far-reaching, particularly in its great power struggle with the United States. We are reinitiating a strategic long in cyber security stocks, the ISE Cyber Security Index, relative to the S&P500 Info Tech sector. Cyberattacks are a form of asymmetrical warfare that we expect to ramp up with the general increase in global geopolitical tensions. The US’s recent official warning against an unknown actor that apparently intended to attack the health system of the Czech Republic highlights the way in which malign actors could attempt to capitalize on the chaos of the pandemic. We also recommend strategic investors reinitiate our “China Play Index” – commodities and equities sensitive to China’s reflation – and our BCA Infrastructure Basket, which will benefit from Chinese reflation as well as US deficit spending. China’s reflation will help industrial metals more so than oil, but it is positive for the latter as well. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1 John Mauldin, "Don't Be So Sure That States Can't Go Bankrupt," Forbes, July 28, 2016, forbes.com.   Section II: Appendix : GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator UK UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Appendix Table 1 The Global Fiscal Stimulus Response To COVID-19 Drowning In Oil (GeoRisk Update) Drowning In Oil (GeoRisk Update) Section III: Geopolitical Calendar

Highlights Over the past year we have discussed “peak polarization” for the United States with many clients. We have held the contrarian view that political animosities within the US are nearing their peak. Feature Prior to COVID-19 we argued that polarization would either peak this year, with the US election, or in roughly two years – a scenario in which President Donald Trump won reelection and an epic partisan battle ensued with House Democrats over his second-term policy priority (probably the southern border wall). The global pandemic and recession have changed things. They are accelerating the peaking process, as a domestic consensus is forming on Big Government, border controls, and protectionism against China. It is also less likely that President Trump will scrape through with a narrow victory in November – rather, he will win or lose decisively. Policy consensus and a decisive electoral outcome should reduce polarization in the coming years. The risk to this view is that President Trump is reelected for a second time without a majority of the popular vote and then attempts major cuts to social spending to correct the country’s gargantuan budget deficits. This risk is vastly overrated. A corollary of our view is that US polarization will hit a boiling point in this election year. Polarization will remain extreme until the election results are confirmed, settled, and done. The conflict between Trump and the Democratic governors over when to reopen the virus-plagued economy is case in point. For investors, this view implies that, in the very near term, the dollar and global safe-haven flows will remain strong, defensive plays have further to run, and US equities will continue to outperform global. But over the long run, the dollar is already at extreme highs and global equities outside the US offer better value. The COVID Confederacy When we chose our theme for this year’s presidential election, “Civil War Lite,” we argued that the US faced a host of social and political challenges that would come to head by November 3. These challenges could manifest in violent social unrest or in an electoral or constitutional crisis that harmed government legitimacy. We did not expect COVID-19, but it has created exactly what our Civil War Lite theme implies: a clash between federal and state governments over who has the final say in the American system. Specifically, the Democratic-led states on the east and west coast are quarreling with the Trump administration over how and when to reopen their economies in the wake of tough “shelter in place” measures that have ground the economy to a halt in order to stem the pandemic. For the first time since the great realignment of US politics in the 1930s, the US is having an historic nationwide crisis in which the Republicans are asserting an overriding federal government and the Democrats are insisting on states’ rights. United States governors have formed two coalitions to determine when and how to reopen. On the West Coast, California Governor Gavin Newsom joined with the governors of Oregon and Washington states to set up a working group. On the East Coast – the epicenter of the pandemic in the US – Andrew Cuomo, Governor of New York, joined with his counterparts from New Jersey, Massachusetts, Connecticut, Delaware, Rhode Island, and Pennsylvania to set up a similar working group. Governor Cuomo fought a war of words with President Trump over who has the authority to invoke and revoke emergency health and security actions. President Trump declared, “When somebody is the president of the United States, the authority is total.” Cuomo rebuked him by saying, “we have a constitution … we don’t have a king.” Trump replied by suggesting that Cuomo and his fellow governors were engaging in “mutiny” and implied that he could use his enormous powers and funds as head of the federal government to decide the conflict. The conflict between President Trump and the “COVID Confederacy” heightens uncertainty in the near term. All parties have since softened their tone. Cuomo said he did not want confrontation, President Trump said that he would “authorize” all fifty governors to reopen their economies, and Newsom asserted his executive authority over California without addressing Trump’s comments directly. This conflict may be overrated from the point of view of long-term American stability – President Trump is not about to impose a naval blockade like Abraham Lincoln. But it is not overrated in the near term for financial markets. That is because the reopening plan remains undecided. The “COVID Confederacy,” as we facetiously call it, makes up a combined 38% of US gross domestic product (Table 1), which is shown here in our flow-based cartogram of the United States (Map 1). Each state is colored red or blue according to its Republican or Democratic Party Electoral College vote in 2016, and it is sized proportionally to its economic output. Map 1The COVID Confederacy: States That May Break With Federal Government Over Quarantines US: Peak Polarization US: Peak Polarization Table 1The COVID Confederacy As Share Of GDP US: Peak Polarization US: Peak Polarization We think this conflict matters because it heightens the uncertainty over the duration of quarantine measures, and hence the sufficiency of fiscal stimulus and the length of time until economic normalization. Markets do not like uncertainty. Second, the conflict could still escalate, given that President Trump could still try to push for an earlier economic opening than the Blue States are ready for. Third, even assuming that all sides recognize they need to cooperate amid crisis, the US election still hangs in the balance and the decision to open the economy will increase the death count and thus hypercharge the political contest. Bottom Line: We expect US politics to weigh on US and hence global equities in the near term, as they have already rallied by 24% since their trough in March. When And How Will The US Reopen? How will Trump’s conflict with the Democratic governors be resolved? President Trump is in an impossible situation. Reopening the economy earlier will lead to an increase in deaths – the US will move toward or past Sweden in Chart 1. This is in an election environment in which each death will be heavily politicized while the dangers of deeper recession will be more abstract. Not reopening the economy will add to the US’s historic losses in employment, production, and retail sales (Chart 2). Chart 1Reopening Will Improve Economy But Increase Deaths Per Million US: Peak Polarization US: Peak Polarization Chart 2Delayed Reopening Will Weigh On Stocks Delayed Reopening Will Weigh On Stocks Delayed Reopening Will Weigh On Stocks Even in the best-case scenario, in which the economy starts to reopen in May, mitigation efforts succeed, and deaths are limited, Trump will still be left with large-scale unemployment and recession. Historically unemployment is the best indicator for which direction the president’s approval will ultimately go (Chart 3). And bear in mind that interior Republican states will be at risk of subsequent outbreaks because they are on a later time frame for the virus peak and yet are most likely to comply with Trump’s reopening plan. The implication is that Trump is constrained and will ultimately decide to maintain the lockdowns longer than he is implying (May 1), and longer than the market expects. He would not want to be seen as losing the fight to the virus. As we go to press, Trump is finalizing “Opening Up America Again” guidelines. Leaving decisions to governors could mean accepting longer lockdowns. Chart 3AUnemployment Rate Leads The Way For Presidents Unemployment Rate Leads The Way For Presidents Unemployment Rate Leads The Way For Presidents Chart 3BUnemployment Rate Leads The Way For Presidents Unemployment Rate Leads The Way For Presidents Unemployment Rate Leads The Way For Presidents Meanwhile the Democratic governors who make up the COVID confederacy have a perverse incentive to hold out longer in maintaining strict social distancing. If they reopen too soon, deaths go up and they suffer the political consequences. Yet in normalizing the economy they risk helping Trump get reelected. To be sure, the governors cannot cut off their own economies to spite Trump. But they can continue to drag their feet. First, to show that they are “more competent” leaders who “rely on science” and thus ensure that Trump takes the blame for the increase in deaths. Second, because Trump’s declaration of “total authority” forces them to defend their power and prerogative as governors – this is a constitutional constraint on President Trump. A major problem for Trump is that, unlike Abraham Lincoln, he is asserting total authority over the states not to fight and win the war (in this case, against the virus), but to ease the recession. This is a risky position because subsequent outbreaks will hurt him. Public opinion polling suggests that 64% of voters think the government should prioritize fighting the virus while 29% think it should prioritize rebooting the economy – and this split is 51% versus 43% among Republicans (Chart 4). Chart 4Voters More Afraid Of Virus Than Recession US: Peak Polarization US: Peak Polarization Business leaders at the first meeting of Trump’s “Great American Economic Revival Industry Groups” testified that premature opening is counterproductive if virus testing is inadequate. It is risky for their employees, threatens dire legal consequences down the road, and may need to be reversed. To be sure, economic pressure will change voters’ and business leaders’ minds eventually. The Democratic governors will capitulate as demand for loosening grows. They may be bickering over a one or two week difference in reopening timelines. Testing is improving markedly, and New York is on track to be much better equipped to handle the required testing in the month of May. Still, there is a great risk that the governors delay at least two weeks beyond Trump’s timeline. And a two-week delay with these states costs, at minimum, $237 billion, or 3% of their GDP this year. There is also a risk that the dispute escalates and Trump resorts to coercion to pressure the states to reopen sooner, creating more uncertainty. If the federal government loosens guidance and Trump uses the “bully pulpit” to speed up reopening, the overall effectiveness of the state lockdowns will decline. This could cause the governors to tighten controls before they loosen them, or it could even cause the federal government to reverse course. House Democrats have cooperated on fiscal stimulus (see Appendix) with President Trump and Senate Republicans because they would not dare delay relief for households merely to undermine the president. But the political logic works differently for Democratic state governors when it comes to reopening the economy – they benefit politically from saving lives and opposing President Trump. Bottom Line: Ultimately the COVID confederacy of Democratic states will suffer immense pressure to reopen, so their contest with Trump may only amount to one or two weeks’ difference. But this “Civil War Lite” can get worse before it gets better. Investors face rising uncertainty over the coming month over the pace and extent of US reopening. Peak Polarization Chart 5Why We Called 2020 ‘Civil War Lite’ US: Peak Polarization US: Peak Polarization We chose our election theme because of the extreme levels of polarization in US politics. These will come to a head with the November 3, 2020 general election. It cannot be overstated that today’s polarization is empirically extreme – this is not subjective. Our quantitative election model shows that more and more states have a near-certain probability of sending their Electoral College votes to the party they already favor – meaning that these states are uncompetitive in the election due to the fixed opinion of voters (Chart 5, top panel). The difference in Republican and Democratic approval of the president is soaring far above the high points of the past forty years (Chart 5, bottom panel), a very simple sign of polarization. The most rigorous measure of polarization in American political science shows that polarization is the highest since the Civil War in the 1860s (a time when these data lose applicability). It is comparable to the Reconstruction era in the 1870s and the populist era in the early 1900s (Chart 6). Our quantitative model relies on leading economic indicators as of February and thus still gives President Trump victories in New Hampshire and Wisconsin. It predicts him winning the White House with 273 Electoral College votes, only a three-seat margin over the required 270 to win the Oval Office.1 The economic collapse will hurt his odds as data come in, as is clear when we “shock” our model with a 2008-sized slowdown (Chart 7). Chart 6US Polarization The Highest Since The Civil War US Polarization The Highest Since The Civil War US Polarization The Highest Since The Civil War Chart 7Our US Election Quant Model Shows A Tight Race US: Peak Polarization US: Peak Polarization The clearest and simplest sign of polarization is the long-term decline in presidential approval ratings and increase in disapproval ratings. Approval has not hit the low point, when George W. Bush presided over a financial meltdown on top of a foreign military quagmire, but it is near Truman and Nixon-era lows (Chart 8A). Chart 8AA Very Simple View Of US Political Polarization US: Peak Polarization US: Peak Polarization The lesson from this last chart is that Americans most approve of their presidents during times of prosperity at home and peace abroad, such as the late 1950s and early 1960s, the late 1980s (as the Soviets collapsed), and the late 1990s, during the post-Cold War “peace dividend.” Yet Trump’s first three years in office, despite peace and prosperity, did not witness a huge increase in approval. Extreme polarization will come to a head with the November election. Disapproval is even more telling. Historically, the disapproval rating peaks at a crisis point and then dramatically subsides – with a series of lower and lower peaks – in the subsequent years. This was true after the Korean War and Truman administration scandals, the Watergate scandal and Nixon’s resignation, and the first Iraq war and 1990-91 recession. But in the case of the Great Recession, polarization only briefly declined before it rapidly began mounting again, reaching a post-2008 peak under President Trump (Chart 8B). Chart 8BA Very Simple View Of US Political Polarization US: Peak Polarization US: Peak Polarization The last point suggests that the US was building toward a new crisis point and COVID-19 has created that moment. The question is whether Trump’s approval ultimately goes up or down as a result, and whether the nation bands together in the wake of the election as it did after past crisis elections (e.g. 1932, 1952, 1968, 1976). House Democrats and Republicans have cooperated on stimulus packages, as mentioned, but this cooperation will give way to cut-throat competition as the acute crisis subsides and the election approaches. Bottom Line: US polarization is historically extreme and will intensify ahead of the election. Election And Reconstruction Prior to COVID there were three main scenarios for polarization to escalate further in the 2020-22 period: Trump Narrowly Reelected: It is inherently rare for a president to win the Electoral College vote without winning the popular vote. It happened in 2000 and 2016, marking the polarized times. If it happened again it could easily be accompanied with vote recounts or Supreme Court intervention, like in 2000, or foreign meddling. Such a crisis would push polarization higher, once again emphasizing the parallel with the 1870s, such as the 1876 “Stolen Election.” Trump Narrowly Defeated: The same could be said if Trump were to lose narrowly. Disputed vote recounts, or faithless electors in the Electoral College, or other unexpected incidents would give rise to accusations of a Deep State coup d'état against President Trump, leaving his supporters disaffected. Wag The Dog: It is also conceivable that an international crisis could occur in which the President is accused of “wagging the dog,” orchestrating a rally-around-the-flag effect to get reelected. Our top contenders for such an event are Venezuela, Iran, or North Korea. The crisis has Iran even closer to the brink and it is continuing to spar with the US in the Gulf and in Iraq (Charts 9A & 9B). A war of choice would heighten polarization, particularly at a time when the public is war-weary. (Obviously a genuine, non-manipulated war could also occur, but it would reduce not heighten polarization.) Chart 9AIran Was Extremely Vulnerable … Iran Was Extremely Vulnerable... Iran Was Extremely Vulnerable... Chart 9B… Even Prior To COVID-19 US: Peak Polarization US: Peak Polarization COVID-19 has changed the outlook because it is much more likely now that Trump loses the election – yet it is also more likely that if he wins, he wins the popular vote. Chart 10Public View Of Trump’s Handling Of Pandemic Unclear Thus Far US: Peak Polarization US: Peak Polarization Trump is more likely to lose because he faces recession and charges of mishandling the pandemic. The “bounce” in his approval rating has already subsided (Chart 10). The bounce in his and Republican support have subsided faster than that of other comparable world leaders and ruling parties. Trump’s polling bounce was also extremely small relative to other major presidential bounces in modern history – especially bounces derived from an exogenous crisis that was not the president’s fault, like COVID. “Enemy” shocks tend to create a 20%-30% boost to approval (Table 2). This is especially worrisome evidence for Trump. Table 2Trump’s Crisis Polling Bounce Compared To Previous Presidential Bounces US: Peak Polarization US: Peak Polarization And yet Trump is more likely than he was prior to COVID to see his approval rise above 50% and win the popular vote. He briefly polled above 50% during the bounce. Look at Chart 10 again – his approval bounce is bottoming at 45%, higher than last year’s lows. There is still a 35% chance that Trump guides the country through the crisis and is rewarded at the voting booth. There are four reasons we still give Trump a 35% chance of winning. First, COVID itself is obviously not Trump’s fault (nor is it Xi Jinping’s). Second, the economy is going to benefit from historic stimulus. Third, COVID reinforces Trump’s major policy themes: tighter borders and more domestic manufacturing. Fourth, Biden is a weak challenger. Most importantly, a new national consensus is forming regardless of the US election outcome. The crisis has led to border shutdowns and highlighted the risk of globalization and border insecurity. Note that US policy on immigration first tightened under President Obama (Chart 11). In the post-COVID environment, candidate Biden will not be willing to be accused of wanting open borders. So this likely is an abiding theme in US politics – Biden will be more pro-immigration than Trump, but he will have to have some limits to protect against any future Trumpian populists. Chart 11AUS Will Tighten Immigration Laws One Way Or Another US: Peak Polarization US: Peak Polarization Chart 11BUS Will Tighten Immigration Laws One Way Or Another US: Peak Polarization US: Peak Polarization The COVID crisis has also exacerbated US-China tensions, urging “decoupling” and calling attention to US reliance on China to make testing kits, protective equipment, and key pharmaceuticals (Chart 12). As we have argued before, the US containment policy toward China began under President Obama’s “Pivot to Asia” and is likely to continue under a Biden administration, particularly in the wake of COVID. Biden will be less tariff-happy than Trump, but he cannot win the Rust Belt, and keep it, if he is soft on China. What about fiscal policy? The great debate is over taxes and spending. And yet COVID has laid the starkest divisions to rest. Trump was never a “limited government” Republican, but if he wins reelection on this basis there is very little chance that he will revert to a pre-COVID Republican position of slashing social spending and taxes. First, Democrats may still keep the House. Second, like Boris Johnson in the UK, Trump would need to solidify the new conservative beachhead among the working class. This would require fiscal accommodation, i.e. limited spending retrenchment, despite the extraordinary stimulus of the pandemic. Biden, for his part, will raise taxes but not as much as Democrats may desire due to the need for economic recovery. Thus polarization is much more likely to fall in the wake of COVID and the US election on a new policy consensus of more secure borders, trade protectionism, and greater government spending. This new consensus will be reinforced by the more left-leaning ideology of the Millennial generation, which will reinforce the shift toward Big Government that is occurring under a Baby Boomer Republican president (Chart 13). Chart 12US Will Diversify Supply Chain Away From China US Will Diversify Supply Chain Away From China US Will Diversify Supply Chain Away From China Chart 13The Democratic Party Ascendancy US: Peak Polarization US: Peak Polarization In the meantime the election conflict, rather than this new consensus, will dominate the national scene. Bottom Line: If Trump loses because of his handling of the pandemic and recession, it will likely be a landslide. Polarization will decrease, just as after earlier boiling points. His followers will be discouraged, leaving only a rump of loyalists. A new Democratic consensus is likely to emerge that incorporates policies that Obama and Trump had in common on borders and manufacturing. Polarization is likely to fall on a new policy consensus of more secure borders, trade protectionism and greater government spending.  If Trump wins because of his handling of the crisis, he is not likely to squeak by narrowly in the election. In this scenario he has by definition received a swell of support for his conduct amid a historic crisis. He would grow his mandate. This will reduce polarization under a new Big Government Republican consensus. Investment Takeaways Tactically we remain long defensive plays. We see no immediate end to dollar strength, safe haven flows, and US equity outperformance until the US pandemic stabilizes and a clear path for economic reopening begins to unfold. Even if US equities fall because of US political uncertainty this year, they can outperform international equities at least until Chinese and global growth stabilize and turn up. Strategically, we remain overweight global equities relative to US equities on the basis of relative valuations and looming US policy headwinds arising from more government intervention, more redistribution, and more on-shoring. China’s stimulus should help lift international equities over a one-year horizon. Note that in the near term this US equity underweight may continue to be offside. Housekeeping We are throwing in the towel on our long EUR-USD trade, which has lost 2% since inception, and our long German consumer services trade, which is down 6%. We are also closing our long Thai bonds trade relative to Malaysia for a miniscule gain of 1.4 basis points. We still recommend both of these markets as strong emerging market plays. Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Over the past several months the model showed a tie, 269-269, which would have given Trump the victory through an arcane congressional process for selecting the president. Appendix: The Global Fiscal Stimulus Response To COVID-19 US: Peak Polarization US: Peak Polarization