Japan
This morning, the Flash PMI saw a stabilization in the European manufacturing sector. Euro area manufacturing PMI moved up to 47 from 46.5, and in Germany, it rose to 43.6 from 43.2. In Japan, the manufacturing PMI also stabilized, inching 0.1 points higher…
Deteriorating demographics is a key reason why inflation has remained subdued. The Japanese population peaked in 2009 and, over the past eight years, has shrunk on average by 0.2%, or 220,000 people, a year. Furthermore, the working-age population (25-64) has…
Japan’s labor market appears very tight. The unemployment rate is 2.3%, the lowest since the early 1990s, and the jobs-to-applications ratio is 1.61, the highest since the 1970s. And yet wage growth has remained stagnant, averaging only 0.5% over the past…
The market clearly does not believe that Bank of Japan (BoJ) Governor Haruhiko Kuroda can raise inflation to the BoJ’s target of 2%, despite negative interest rates and massive quantitative easing. The 5-year/5-year forward CPI swap rate, a proxy for…
Japan’s financial sector is one of the country’s longstanding problems. After Japan’s 1980s bubble burst, the BoJ aggressively cut rates from 6% to 0.5% over the span of eight years. Long-term rates also fell. Falling interest rates reduced Japanese…
Highlights Duration: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Relative Value In Global Government Debt: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds. Feature Reflexivity Chart 1A Brief Inversion The decline in global bond yields has been unrelenting, and it took on a life of its own last week when the U.S. 2-year/10-year slope briefly inverted (Chart 1). After the inversion, the 30-year U.S. Treasury yield broke below 2% and the 10-year yield broke below 1.50%. The average yield on the 7-10 year Global Treasury Index closed at 0.49% last Thursday, just above its all-time low of 0.48% (Chart 1, bottom panel). There’s an interesting self-fulfilling prophesy that can take hold when the yield curve inverts. Investors interpret the inversion as a signal of weaker economic growth ahead. They then bid up long-dated bond prices causing the curve to invert even more. This sort of circular reasoning can cause bond yields to disconnect from the trends in global economic data, often severely. While recession fears have benefited government bonds, risky assets – equities and corporate bonds – have experienced relatively minor pain. The S&P 500’s recent sell-off pales in comparison to the one seen late last year (Chart 2). Meanwhile, corporate bond spreads remain well below early-2019 peaks. Risky assets have clearly benefited from the drop in bond yields, as markets price-in a future where central banks ease monetary policy in response to weaker economic growth, and where that easing is sufficient to keep equities and credit well supported. Chart 2Low Yields Support Risk Assets I Chart 3Low Yields Support Risk Assets II Further evidence of this dynamic is presented in Chart 3. The chart shows the sensitivity of daily changes in the U.S. 10-year Treasury yield to changes in the S&P 500 for each year since 2010. The sample is split into days when the S&P 500 rose and when it fell. For example, in 2010 the sensitivity on “up days” was 2.6, meaning that on days when the S&P 500 rose, the 10-year yield rose 2.6 basis points for every 1% increase in the S&P 500. Similarly, the sensitivity in 2010 on “down days” was 3.2. This means that the 10-year yield fell 3.2 bps for every 1% drop in the equity index. The main takeaway from Chart 3 is how dramatically the sensitivities have shifted in 2019. The yield sensitivity on “up days” has fallen sharply – down to 0.8. This means that yields barely rise on days when equities move up. Meanwhile, the sensitivity on “down days” has shot higher, to just under 4. This means that yields fall a lot on days when equities sell off. The perception of easier monetary policy has been the main support for risk assets this year. The logical interpretation of these trends is that the perception of easier monetary policy has been the main support for risk assets this year. Global Growth Needed At present, we are stuck in an environment where aggressively easy monetary policy and low bond yields are the sole supports for risky assets. In turn, falling bond yields are stoking concerns about the economy, leading to even easier monetary policy. Only one thing can bust us out of this pattern, and that’s a resurgence of global manufacturing growth. Unfortunately, there is little evidence that this is taking place (Chart 4). The Global Manufacturing PMI is now down to 49.3, below the 2016 trough of 49.9 (Chart 4, top panel). U.S. Industrial Production growth remains weak, but is showing signs of stabilization above the 2016 trough (Chart 4, panel 2). European Industrial Production, on the other hand, continues to contract (Chart 4, panel 3). The downtrend in our favorite real-time indicator of global manufacturing – the CRB Raw Industrials index – remains unbroken (Chart 4, bottom panel). However, even though evidence of a turnaround in global manufacturing is scant, we expect a rebound near the end of this year, for the following reasons: Global financial conditions have eased this year, the result of aggressive central bank stimulus. Financial conditions are easier now than they were in 2018, and much easier than they were prior to the 2015/16 global growth slowdown (Chart 5, top panel). China has started to ease credit conditions in response to U.S. tariffs and the slowdown in growth. So far, stimulus has been tepid relative to 2015/16 levels, but it should ramp up in the coming months.1 Many large important segments of the global economy remain unaffected by the global manufacturing slowdown. The U.S. consumer continues to spend: Core retail sales are growing at a robust 5% year-over-year rate, and consumer sentiment remains elevated (Chart 5, panels 2 & 3). Even in the Eurozone, the service sector has not experienced the same pain as manufacturing (Chart 5, bottom panel). Fiscal policy will remain a tailwind for economic growth this year and next. Last week, there were even rumors of increased fiscal thrust from Germany if the growth slowdown persists.2 Strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary. On the whole, we expect that the above 4 factors will lead to a rebound in global manufacturing growth near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon, but the global growth indicators shown in Chart 4 will need to rebound first. Chart 4Global Growth Indicators Chart 5Catalysts For Economic Recovery Inflation Puts Pressure On Powell Chart 6Strong Inflation Could Complicate The Fed's Message Strong U.S. inflation prints during the past two months add an interesting wrinkle to the macro landscape. Core U.S. inflation grew at an annualized rate of 3.55% in July, following an annualized rate of 3.59% in June (Chart 6). However, these strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary. This exacerbated the flattening of the yield curve and sent long-dated TIPS breakeven inflation rates lower. Our sense is that the Fed is chiefly concerned with re-anchoring inflation expectations (Chart 6, bottom panel). This probably means that another rate cut is coming in September, and that Chairman Powell will do his best to sound accommodative in his Jackson Hole address on Friday. However, recent strong inflation data could prompt Powell to sound more hawkish than the market would like, causing yield curves to flatten and risky assets to fall. Bottom Line: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation & The Zero Lower Bound Perhaps the most straightforward way to think about country allocation within a portfolio of developed market government bonds is to classify the different markets as either “high beta” or “low beta”. Chart 7 shows the trailing 3-year sensitivity of major countries’ 7-10 year bond yields relative to the global 7-10 year yield.3 The U.S. and Canada have the highest betas, followed by the U.K. and Australia. Germany has a beta close to one, and Japan’s beta is the lowest. Chart 7Global Yield Beta In other words, if global growth falters and global bond yields decline, U.S. and Canadian bond markets should perform best, followed by the U.K. and Australia. German bonds should perform in line with the global index, and Japanese bonds should underperform the global benchmark. What makes this approach to portfolio allocation even better is that the calculation of trailing betas is not really necessary. A very similar ordering of countries – from “high beta” to “low beta” – is achieved by simply ranking the markets from highest yielding to lowest yielding. High yielding countries, like the U.S. and Canada, have the most room to ease monetary policy in response to a negative growth shock. This means that yields in those countries will respond most to global growth fluctuations. On the other hand, the entire Japanese yield curve is already pinned near the effective lower bound. Even in the event of a negative growth shock, there is little scope for easier Japanese monetary policy, and JGB yields will be relatively unaffected. Chart 8High Beta Countries Are Most Sensitive To Economic Growth It’s interesting to note in Chart 7 that while German yields are actually below JGB yields, bunds remain somewhat less defensive than the Japanese market. This is because the German term structure has only recently moved to the effective lower bound, and investors likely still retain some hope that an improvement in global growth could lead to European policy tightening at some point in the future. This belief is largely absent in Japan, where the term structure has been pinned at the lower bound for many years. Chart 8 provides some further evidence of the split between “high beta” and “low beta” bond markets. It shows that the bond markets with the highest yields are also the most sensitive to trends in global growth, as proxied by the Global Manufacturing PMI. U.S. bond yields are highly correlated with the Global PMI, while Japanese bond yields are hardly correlated at all. It follows that if the slowdown in global growth continues and all nations’ yield curves converge to Japanese levels, then the overall economic sensitivity of global bond yields will decline. Bottom Line: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Looking For Positive Carry Yield curves have undergone dramatic shifts in recent months, in terms of both level and shape. Not only have curves for the major government bond markets shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape (Charts 9A-9F). With that in mind, in this week’s report we look for the best “positive carry” opportunities in global government bond markets. Yield curves for the major government bond markets have shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape. We use the term carry to mean the expected return from a given bond assuming an unchanged yield curve. This is essentially the combination of yield income (i.e. coupon return) and the price impact of rolling down (or up) the yield curve. For the purposes of this report, we assume a 12-month investment horizon and incorporate the impact of currency hedging into each security’s yield income. Rolldown ‘U’ shaped yield curves mean that bonds near the base of the ‘U’ currently suffer from negative rolldown, while the rolldown for long maturities is often highly positive. Table 1 shows that rolldown is currently negative for all 2-year bonds, but especially for U.S. and Canadian debt. The U.S. and Canada have the highest policy rates within developed markets, so it’s not surprising that the front-end of their yield curves are also the most steeply inverted. In other words, their yield curves are pricing-in that they have more room to cut rates than other countries. Table 112-Month Rolldown* (%) For A Long Position In Government Bonds In general, rolldown is relatively modest for most 5-year and 7-year maturities. The exceptions being German 5-year debt and Aussie 7-year debt, which benefit from 31 bps and 45 bps of positive rolldown, respectively. As mentioned above, rolldown is currently very positive for long maturity debt. In fact, a 10-year U.K. bond offers a whopping 85 bps of rolldown on a 12-month horizon. Yield Income & Overall Carry As mentioned above, rolldown is only one part of a bond’s carry. The other is the yield an investor earns over the course of the investment horizon – the yield income. Because we assume that investors hedge the currency impact of their bond positions, this yield income also depends on the native currency of the investor. Therefore, we show yield income and overall carry below from the perspective of investors in each of the major currency blocs (USD, EUR, JPY, GBP, CAD, AUD). USD Investors Being the global high yielder, USD investors benefit the most from currency hedging. That is, USD investors earn a lot of additional income on their currency hedges, making non-U.S. bonds look more attractive. Unsurprisingly, carry is most positive at the long-end of yield curves (Tables 2 & 3). Table 2In USD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 3In USD: 12-Month Carry (%) For A Long Position In Government Bonds EUR Investors The polar opposite of USD investors, EUR-based investors give up a lot of return through currency hedging. This makes the potential for positive carry much less. In any case, the best positive carry opportunities still lie in German, Japanese and Australian 30-year bonds. U.K. and Japanese 10-year bonds are also attractive (Tables 4 & 5). Table 4In EUR: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 5In EUR: 12-Month Carry (%) For A Long Position In Government Bonds JPY Investors Yen-based investors currently have more opportunities to earn positive carry than those based in euros. But these opportunities remain confined to long-maturity debt. Once again, the standouts are Japanese, German and Australian 30-year bonds, and also U.K. and Japanese 10-year debt (Tables 6 & 7). Table 6In JPY: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 7In JPY: 12-Month Carry (%) For A Long Position In Government Bonds GBP Investors Currency hedges work more in favor of GBP than EUR or JPY. As a result, GBP-based investors see more opportunities to earn positive carry (Tables 8 & 9). Table 8In GBP: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 9In GBP: 12-Month Carry (%) For A Long Position In Government Bonds CAD Investors As with USD-based investors, CAD-based investors also benefit from currency hedging. All securities continue to offer positive carry when hedged into CAD (Tables 10 & 11). Table 10In CAD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 11In CAD: 12-Month Carry (%) For A Long Position In Government Bonds AUD Investors AUD-based investors also see positive carry across the entire global bond space, after factoring-in the impact of currency hedging (Tables 12 & 13). Table 12In AUD: 12-Month Yield Income* (%) For A Long Position In Government Bond Table 13In AUD: 12-Month Carry (%) For A Long Position In Government Bonds Bottom Line: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds. Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Trump Interruption”, dated August 13, 2019, available at usbs.bcaresearch.com 2 https://www.bloomberg.com/news/articles/2019-08-16/germany-ready-to-raise-debt-if-recession-hits-spiegel-reports 3 We calculate betas using average yields from the Bloomberg Barclays Global Treasury Master index. Fixed Income Sector Performance Recommended Portfolio Specification
Highlights The failure of the dollar to break out amid one of the most bullish fundamental catalysts in months suggests that many opposing tectonic forces are at play. Our bias is that short-term and longer-term investors are caught in a tug-of-war. Longer-term headwinds are a deteriorating balance-of-payment backdrop. Shorter-term tailwinds are ebbing global growth. Traders who have become accustomed to buying the dollar as a safe haven should be cognizant that correlations could be shifting amid the fall in global bond yields. The yen and gold remain the currencies of choice in this environment. Despite economic headwinds, the BoJ has historically needed an external shock to act, suggesting the path towards additional stimulus will be lined with a stronger yen. Our bias is that USD/JPY could weaken to 100 in the next three-to-six months, especially if market volatility spikes further. If global growth eventually picks up, the yen will surely weaken on its crosses, but could still strengthen versus the dollar. The reversal in the EUR/GBP is worth monitoring. Aggressive investors can short the pair now for a trade. Feature Chart I-1A Worrisome Development Consider the events over the last few weeks: U.S. President Donald Trump blindsided investors by firing a new salvo in the trade war. China retaliated by depreciating the RMB below the psychologically important 7 level. In Argentina, a heavy loss for reformist Mauricio Macri has sent the peso down almost 40% this year. Venezuela is now completely shut off from the U.S., given continued friction between the regime of incumbent Nicolás Maduro and Juan Guaidó. In Europe, Boris Johnson has all but assured us that he is taking the U.K. out of the EU, sending the pound to near post-referendum lows. And on the global economic front, July manufacturing data was dismal across the board. This is nudging the U.S. 10-year versus 2-year Treasury yield curve into inversion, adding to the recessionary indicators that have accumulated so far (Chart I-1). Both gold and the yen have bounced in sympathy with these developments, but the trade-weighted dollar (either using the DXY or the Federal Reserve’s broader measure) is up only circa 1% over the last month. Had a currency manager taken a one-month leave of absence, this setup would be incredibly perplexing upon return. Has the investment landscape changed, or are both traders and algorithmic platforms sitting on the sidelines given thin summer trading? More importantly, has the dollar lost its crown as a safe-haven currency? The answers to these questions are obviously very important for the cyclical view on the dollar. Is This Time Different? It is too early to tell if the dollar’s muted response is just the lagged effect of thin summer trading, or a signal towards much bigger opposing forces at play. What we can infer is that both short-term and longer-term investors are caught in a tug-of-war, currently in a stalemate. The short-term boost for the dollar comes from the fact that global growth is weak and the U.S. economy has the upper hand, given the smaller contribution from the manufacturing sector to GDP. Meanwhile, U.S. interest rates, while falling, remain among the most attractive in the developed world. Portfolio flows into the U.S. economy is the ultimate link between global growth and the dollar. The caveat is that these bullish factors are slowly ebbing. We have argued in past reports that global growth will soon bottom, if past correlations between monetary stimulus and economic growth hold. Meanwhile, the Federal Reserve is slated to become more dovish, which will remove an important tailwind for the dollar (Chart I-2). The latest comments from Olli Rehn, governor of the Finnish central bank and member of the ECB’s rate-setting committee, suggests that significant stimulus will be forthcoming in September. This should keep a bid under the DXY index. However, investors also understand that other governments are unlikely to sit pat and watch their trading partners wage a currency war. Political pressure towards lower rates is now as high as it has ever been (Chart I-3), a change from the past. Chart I-2The U.S. Yield Advantage Is Fading Chart I-3Political Pressure To Cut Rates But why has the dollar not strengthened more in the interim, given that bullish forces remain present? The answer lies in underlying portfolio flows into the U.S. economy, which is the ultimate link between global growth and the dollar. Everyone understands the standard feedback loop between global growth and the greenback. The U.S., being a relatively closed economy, sees outflows when global growth is improving. This is because capital tends to gravitate to higher-yielding currencies that are more levered to the manufacturing cycle. And during risk-off environments, that capital finds its way back home – the so-called “home-bias” – that boosts the dollar. This has been the story for most of the last two decades. However, things began to shift a few years ago. Following cascading crises (in Europe, Japan and even some commodity-producing countries, for example), interest rates outside the U.S. began to fall rapidly, and the U.S. bond market became one of the most attractive in yield terms. For example, at the onset of 2014, 10-year bond yields were at 4.4% in Australia while they were sitting at 3% in the U.S. Today, a 10-year Australian bond yields 0.9% while 10-year Treasurys are at 1.5%. The implication is that the U.S. dollar has now become an object of carry trades itself, as confirmed by current positioning data (Chart I-4). However, here comes the important crux. It is difficult for the dollar to act as both a safe-haven and a carry currency, because the forces that drive both move in opposite directions. For one, safe-haven assets tend to be lower-yielding, but also during episodes of capital flight, investors choose to repatriate capital to pay down debt, with creditor nations having the upper hand. And given that U.S. investors have already been repatriating close to $300 billion in assets over the past 12 months (in part because of better returns, but also because of the 2017 Trump tax cuts), the dollar’s safe-haven bid has partially evaporated. Traders who have been used to buying the dollar as a safe haven should be cognizant that correlations may have shifted amid the fall in global bond yields. Flows into the U.S. capital markets are instructive. What has been supporting capital flows into the U.S. are agency, corporate, and Treasury bond purchases, with foreign investors already stampeding out of U.S. equities at the fastest pace on record (Chart I-5). This is because the starting point for the U.S. is an equity market that is one of the most overvalued, dictating that subsequent returns will pale by historical comparison. Chart I-5Banks Have Been Supporting U.S. Inflows Meanwhile, cracks are beginning to appear in the Treasury market, one of the last pillars of support for U.S. inflows. Foreign officials have already been exiting the U.S. bond market for both geopolitical and balance-of-payment concerns, but private purchases still remain robust. However, the latest data shows that net foreign private purchases of U.S. Treasury bonds have rolled over from about $220 billion dollars earlier this year to about $200 billion currently. Ebbs and flows in the U.S. Treasury market have historically had a great track record of capturing major turning points in the U.S. bond yields over the last decade (Chart I-6). To be sure, these flows are still positive, with June data robust, but they are rolling over. It is likely that July and August data will be stronger, given the drop in yields. However, long Treasurys and long dollar positions are some of the most crowded trades today. The bottom line is that if the dollar cannot rise under a bullish near-term backdrop, it is likely to fall hard when these fundamental forces evaporate. Monitoring the bond-to-gold ratio is a good way to gauge where the balance of forces are shifting, and the picture is not constructive for dollar bulls (Chart I-7). Meanwhile, currencies such as the Japanese yen or even the Swiss franc, which have been used to fund carry trades, remain ripe for further short-covering flows. Chart I-6What Happens When Bond Investors Flee? Chart I-7Unsustainable Divergence Bottom Line: Traders who have been used to buying the dollar as a safe haven should be cognizant that correlations may have shifted amid the fall in global bond yields. Stay Short USD/JPY Should the selloff in global risk assets persist, the yen will strengthen further. On the other hand, if global growth does eventually pick up, the yen could weaken on its crosses but strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. Economic data from Japan over the past few weeks suggests the economy is not yet succumbing to pressures of weak external growth (Chart I-8). The services PMI remains relatively high compared to manufacturing, vehicles sales are accelerating at a 7% year-on-year pace and bank lending is still robust. The labor market also remains relatively tight, with Tokyo office vacancies hitting post-crisis lows. The preliminary print of second quarter GDP growth slowed to 1.8% from 2.2%, but this was entirely driven by the external sector. A return towards deflationary pressures will eventually force the Bank of Japan’s hand, but the yen will strengthen in the interim. What these developments suggest is that the hurdle for delaying the consumption tax is now extremely high. And since the late 1990s, every time Japan’s consumption tax has been hiked, the economy has slumped by an average of over 1.3% in subsequent quarters. A return towards deflationary pressures will eventually force the Bank of Japan’s hand, but the yen will strengthen in the interim. This is because the BoJ will need to come up with even more unconventional policies, something that requires time. Total annual asset purchases by the BoJ are currently running at about ¥22 trillion, while JGBs purchases are running below ¥20 trillion. This is a far cry from the central bank’s soft target of ¥80 trillion, and unlikely to change anytime soon, since JGB yields are trading near the floor of the central bank’s range (Chart I-9). Chart I-8Japan Is Fine For Now Chart I-9The BoJ Is Out Of Bullets It is important to remember why deflation is so pervasive in Japan, making the BoJ’s target of 2% a bit of a pipedream if it stands pat. The overarching theme for prices in Japan is a rapidly falling (and rapidly ageing) population, leading to deficient demand (Chart I-10). Meanwhile, domestically, an aging population (that tends to be the growing voting base), prefers falling prices. What is needed is to convince the younger generation to save less and consume more, but that is almost impossible when high debt levels lead to insecurity about the social safety net. Hence the reason for the consumption tax, which has historically been deflationary. Chart I-10Deflation Is Pervasive In Japan On the other side of the coin, the importance of financial stability to the credit intermediation process has been a recurring theme among Japanese policymakers, with the health of the banking sector an important pillar. YCC and negative interest rates have been anathema for Japanese net interest margins and share prices (Chart I-11). This, together with QE, has pushed banks to search for yield down the credit spectrum. Any policy shift that is increasingly negative for banks could easily tip them over. This suggests the shock needed for either the BoJ or the government to act has to be “Lehman” like. The eventual bottom in global growth is a key risk to a long yen position. However, inflows into Japan could accelerate, given cheap equity valuations and improved corporate governance that has been raising the relative return on capital. The propensity of investors to hedge these purchases will dictate the yen’s path. The traditional negative relationship between the yen and the Nikkei still holds but has been weakening in recent years. Over the past few years, an offshoring of industrial production has been marginally eroding the benefit of a weak yen/strong Nikkei. If a company’s labor costs are no longer incurred in yen, then the translation effect for profits is reduced on currency weakness (Chart I-12). Chart I-11Japan: More Easing Will Kill Banks Chart I-12The Nikkei And Yen Have Diverged Bottom Line: Inflation expectations are falling to rock-bottom levels in Japan, at a time when the BoJ may be running out of policy bullets. Meanwhile, the margin of error for the BoJ is non-trivial, since a small external shock could tip the economy back into deflation. The BoJ will eventually act, but it may first require a riot point (Chart I-13). Remain short USD/JPY. Chart I-13What More Could The BoJ Do? Housekeeping Chart I-14Look To Sell EUR/GBP Tactical investors could try selling EUR/GBP for a trade ahead of our actual limit-sell at 0.95. The ever-shifting political landscape warrants tight stops, but despite all the noise, economic surprises in the euro area are rolling over relative to the U.K., which usually benefits the pound (Chart I-14). Finally, the Norges bank has chosen to remain on hold, though has begun to sound less hawkish. We remain long NOK/SEK but are ready to take profits on any sign a currency war is intensifying, or that oil prices are headed much lower. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been robust: Headline and core inflation both edged up 10 bps to 1.8% and 2.2% year-on-year respectively in July. Mortgage applications surged by 21.7%, reversing prior weakness in the MBA Purchase Index. NY Empire State manufacturing index increased to 4.8 in August; The Philly Fed manufacturing index fell to 16.8, still well above the consensus of 9.5. Retail sales jumped by 0.7% month-on-month in July, up from downwardly-revised 0.3% in June. Nonfarm productivity grew by 2.3% quarter-on-quarter in Q2; The unit labor costs went up 2.4% quarter-on-quarter. Real hourly earnings in July however, slowed to 1.3% year-on-year. Industrial production fell by 0.2% month-on-month in July. DXY index appreciated by 0.6% this week. Consumer prices rebounded in July, mostly driven by shelter, and medical care services. This marginally lowered the prospect for more aggressive rate cuts by the Federal Reserve. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Focusing On the Trees But Missing The Forest - August 2, 2019 Global Growth And The Dollar - July 19, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area continue to deteriorate: ZEW sentiment fell to -43.6 in August, the lowest since 2012. Preliminary GDP yearly growth was flat at 1.1% year-on-year in Q2, even though the German economy stagnated. Industrial production contracted by 2.6% year-on-year in June. Employment growth slowed to 1.1% year-on-year in Q2. EUR/USD fell by 0.9%, following the relatively soft data. However, if the world economy avoids recession, it will be tough for data to deteriorate meaningfully from current levels. We believe that manufacturing data will get a boost once global growth stabilizes. Meanwhile, the euro is currently trading at an attractive discount to its fair value. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: Producer prices contracted by 0.6% year-on-year in July. Core machinery orders increased by 12.5% year-on-year in June, while preliminary machine tool orders for July fell by 33% year-on-year, from -38% the prior month. Industrial production contracted by 3.8% year-on-year in June. Capacity utilization fell by 2.6% year-on-year in June. USD/JPY appreciated by 0.3% this week. Japanese data was notable healthier in June, suggesting that weakness in July was exacerbated by external factors. That said, long yen bets are in an enviable “heads I win, tails I do not lose too much” position, as posited in the front section of this bulletin. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 There was a flurry of data out of the U.K. this week, most of which were firm: Preliminary GDP growth fell to 1.2% year-on-year in Q2, from the previous 1.8%. This was mostly driven by investment that contracted by 1.6%. This makes sense given Brexit uncertainties. Exports contracted by 3.3% quarter-on-quarter in Q2, but imports fell 12.9% quarter-on-quarter. The total trade balance increased to £1.78 billion in June. The unemployment rate nudged up to 3.9% in June, but the labor report was robust. Weekly earnings soared by 3.9%. Headline and core inflation moved up to 2.1% and 1.9% year-on-year respectively in July. Lastly, total retail sales increased by 3.3% year-on-year in July. GBP/USD has been flat this week. While GDP data was clearly negative, the drop in the pound is clearly improving the balance of payments backdrop for the U.K. Our bias is that the pound could soon rebound once the Brexit chaos settles. Short EUR/GBP at 0.95. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been positive: NAB business confidence edged up to 4 in July, from 2. Westpac consumer confidence also rebounded by 3.6% month-on-month in August. Consumer inflation expectations increased to 3.5% in August. The employment report was robust. The unemployment rate was unchanged at 5.2% in July; 34.5 thousand full-time jobs and 6.7 thousand part-time jobs were created; Participation rate was little changed at 66.1%. Wages remained at 2.3% year-on-year in Q2. AUD/USD fell by 0.4% this week. The Aussie is a very ripe candidate for mean reversion, once the appropriate catalysts fall in place. Net speculative positions on the Aussie dollar are very close to a bearish nadir. We continue to favor the Aussie dollar from a contrarian perspective. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There is scant data from New Zealand this week: Net migration to New Zealand fell to 3100 in June. House sales increased by 3.7% year-on-year in July. NZD/USD fell by 0.5% this week. We remain bearish on the kiwi due to decreasing net migration, and falling terms-of-trade. Remain long AUD/NZD as a strategic holding. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Housing starts came in at 222K in July from 246K. Building permits decreased by 3.7% month-on-month in June; Existing home sales increased by 3.5% month-on-month in July. The labor report was poor. Unemployment increased to 5.7% in July. 11.6 thousand full-time jobs and 12.6 part-time jobs were lost in the month of July. Average hourly wages however, soared by 4.5% year-on-year in July, from the previous 3.6%. Bloomberg nanos confidence index fell to 57.8 over the past week. USD/CAD increased by 0.7% this week. A combination of robust wage growth, accommodative fiscal policy, and low interest rates, has supported the Canadian housing market in the summer. Moreover, energy prices should hook up which will benefit CAD. We remain positive on the loonie in the near-term. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Unemployment rate was stable at 2.3% in July. Producer and import prices contracted by 1.7% year-on-year in July. USD/CHF has been flat this week. The terms-of-trade in Switzerland soared to 128 in June from the previous 117 in May. We continue to favor the franc due to a positive current account, and its safe-haven allure. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mostly positive: Headline inflation was stable at 1.9% year-on-year in July, while core inflation fell slightly to 2.2% year-on-year in July. Producer prices contracted by 8.6% year-on-year in July. The trade balance widened to NOK 6.5 billion in July. USD/NOK increased by 1% this week. The Norges Bank kept interest rates unchanged yesterday at 1.25%, and said the policy outlook has become more uncertain amid rising global risks. The central bank guidance had been irrefutably hawkish prior to yesterday. The current dovish shift reflects more uncertainties in the global market and energy prices. Remain long NOK/SEK for now, while earning a positive carry. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Household consumption decreased by 0.3% year-on-year in June. Unemployment rate nudged up to 6.3% in July. Headline and core inflation both fell to 1.7% year-on-year in July. USD/SEK increased by 0.5% this week. The July inflation has been the lowest since early last year, mostly due to a slowdown in the prices of transport, recreation and culture, and durable goods. That said, disinflation is now a global phenomenon. We remain long SEK/NZD as a relative value trade. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades
Highlights So What? Tariffs and currency depreciation will likely lead to military saber-rattling in Asia Pacific. Why? President Trump is not immune to the market’s reaction to his trade war escalation. Yet China’s currency depreciation is a major escalation and the near-term remains fraught with danger for investors. Military shows of force and provocations could crop up across Asia Pacific, further battering sentiment or delaying trade talks. Remain short CNY-USD, short the Hang Seng index, long JPY-USD, and long gold. Overweight the U.S. defense sector relative to global stocks. Feature The Osaka G20 tariff ceasefire has collapsed; U.S. President Donald Trump is threatening tariffs on all Chinese imports; the People’s Bank of China has allowed the renminbi to depreciate beneath the important 7.0 exchange rate to the dollar; and the United States has formally labeled China a “currency manipulator.” What a week! The spike in volatility is likely to be accompanied by a rise in credit risk, as measured by the TED spread (Chart 1). Safe havens like gold, treasuries, and the Japanese yen are rallying in a classic risk-off episode, while messengers of global growth like copper, the Australian dollar, and the CRB raw industrials index are stumbling (Chart 2). Only green shoots in Chinese trade and German manufacturing have kept the selloff in check this week by improving the cyclical outlook despite elevated near-term risks. Chart 1So Much For The Osaka G20 Tariff Ceasefire! Chart 2Key Risk-On/Risk-Off Indicators Breaking Down While we anticipated the re-escalation of U.S.-China tensions, now is the time to take stock and reassess. President Trump is a political animal. While he has demonstrated a voracious risk appetite throughout the year, he is ultimately focused on reelection in November 2020. The United States will survive without a trade deal by then, but Trump may not. Presumably, Trump’s reason for increasing pressure on China throughout 2019 is to secure a deal by the end of the year. This would be to see China’s concessions translate into trade perks for the U.S. markets and economy in 2020 by the time he hits the campaign trail. The experience of Q4 2018 suggests that Trump changed his negotiating tack after U.S. equities fell by only 4% from their peak – but we consider an equity correction a clear pain threshold (Chart 3). Trump is closely associated with the economic fortunes of the country, even more so than the average president. Bear markets tend to coincide with recessions. Trump – beset by controversy and scandal at home – must assume that a recession will be the coup de grâce. Chart 3Where Is President Trump's Pain Threshold? Chart 4Will Huawei Ban Hit The Tech Sectors? Investors will get some clarity next week when the Commerce Department decides whether to renew the general temporary license for American companies to trade with Chinese telecoms giant Huawei. A full denial of the license would signal that Trump is unconcerned with recession and reelection probabilities and focusing exclusively on the national security threat from China. It would send technology sectors and the broader equity market into a plunge on both sides of the Pacific (Chart 4) and could significantly increase the risk that the global economy begins a downturn. Positive signals are scarce as we go to press: New tariff is on track: The U.S. Trade Representative is preparing a final list of $300 billion in goods to fall under a new 10% tariff, despite reports that Trump overrode USTR Robert Lighthizer in announcing the new tariff. This does not guarantee that the tariff will go into effect on September 1 but it does make it more likely than not. Huawei is under pressure: Office of Management and Budget has disqualified Huawei from any U.S. government contracts as of August 13 – a ban to be extended to any third parties contracting Huawei as of the same date next year. This is not encouraging for Huawei but it is a separate and more limited determination from that of the Commerce Department. Still, we expect the Trump administration to take some moves to offset the ongoing trade escalation. While we are inclined to think the new tariff will take effect, Huawei will likely get a reprieve in the meantime. This will help to ensure that the September trade talks in Washington, DC go forward. The administration has an interest in keeping the trade negotiations alive. Furthermore, there is some evidence that President Trump is recognizing the need to calm other “trade wars” to mitigate the impact of the central China trade war. In September the administration will attempt ratification of the USMCA in Congress – we still think this is slightly favored to go through. We also expect a U.S.-Japan trade agreement to materialize rapidly – likely at the UN General Assembly from September 17-30. Another positive sign is that the European Union has agreed to expand beef imports from the United States. Real movement on agriculture, while China cancels U.S. ag imports, implies that President Trump is less likely to impose car tariffs on Europe for national security reasons on November 13-14.1 The problem is that the fallout from China’s currency depreciation and the new tariffs will hit the market before anything else, which means we remain tactically bearish. Heightened trade tensions are also likely to spill into the strategic sphere in the near term. Saber-rattling – military shows of force and provocations – will increase the geopolitical risk premium across the globe, especially in East Asia. A frightening U.S.-China clash may ultimately encourage real compromises in the trade negotiations, but the market would get the negative news first. If Washington does not make any reassuring moves but expands the current policy assault on China – including through a Huawei ban – then we will consider shifting to a defensive posture cyclically as well as tactically. Bottom Line: We recognize that President Trump may be forced by the risk of a recession to relax the trade pressure and accept some kind of China deal – we may upgrade this 40% chance if and when the U.S. veers toward an equity bear market. In the meantime we expect further negative fallout from the past week’s aggressive maneuvers by both sides. Currency War Assuming that an equity correction is inevitable at some point and that Trump goes crawling back to the Chinese for trade talks: How will they respond? Will Xi Jinping, the strongman general secretary of a resurgent Communist Party, return to talks and reassure global markets at Trump’s beck and call? Or will he refuse, let the market do what it will, and let Trump hang? By letting the currency drop … Beijing is expressing open defiance. The renminbi’s depreciation – through PBoC inaction on August 5, then through action on August 8 – is a warning that Trump is approaching the point of no return. His initial grievance has always been Chinese “currency manipulation” but until now he has refrained from formally leveling this accusation (only using it on Twitter). By letting the currency drop well beneath the level at which Trump was inaugurated (6.8 CNY-USD), and beyond the global psychological threshold, Beijing is expressing open defiance and threatening essentially to break off negotiations. Chart 5China Sends Warning Via Currency Depreciation The effect of continued depreciation would be to offset the effect of tariffs and ease financial conditions in China. This is fully in keeping with our view that China has opted for stimulus over reform this year. China is likely to follow up with further cuts to banks’ reserve requirement ratios and a cut to the benchmark policy interest rate (Chart 5). The July Politburo statement showed a greater willingness to stimulate the economy and it occurred prior to Trump’s new volley of tariffs. Currency appreciation is the surest way to rebalance China’s economy toward household consumption and obviate a strategic conflict with the United States. By contrast, yuan depreciation will exacerbate the U.S. trade deficit and give Trump’s Democratic rivals convenient evidence that the “Art of the Deal” is counterfeit. How far will the renminbi fall? Chart 6 updates our back-of-the-envelope calculation of the implication from different tariff scenarios assuming that the equilibrium bilateral exchange rate depreciation will equal the tariffs collected as a share of total exports to the United States. (10% tariff on $259 billion = $25.9 billion, which is 5% of $509 billion total.) The yuan is now approaching Scenario D, 25% tariffs on the first half of imports and 10% on the second half, which points toward 7.6 CNY-USD. There are reasons to believe that this simple framework won’t apply, at least in terms of the magnitude of the impact, but it gives an indication of considerable downward pressure. Chart 6The Yuan Will Fall, But Not Freely Chester Ntonifor of our Foreign Exchange Strategy sees the yuan falling to around 7.3-7.4 if the new tariffs are applied based on the fact that the 25% tariff on $250 billion worth of goods produced a roughly 10% decline in the bilateral exchange rate. Our Emerging Markets Strategy also expects about a 5% drop in the CNY-USD. Having tightened capital controls during the last bout of depreciation in 2015-16, China is probably capable of controlling the pace of depreciation, preventing capital outflows from becoming a torrent, by selling foreign exchange reserves, further tightening capital controls, or utilizing foreign currency forward swaps. But Asian currencies, global trade revenues in dollars, and EM currencies and risk assets will suffer – and they have more room to break down from current levels.2 Meanwhile even a modest drop in the renminbi – amid a return to dovish monetary policy in global central banks – has revived concerns about a global currency war. A rising dollar is anathema to President Trump, who aims to reduce the trade deficit, encourage the on-shoring of manufacturing, and maintain easy financial conditions for the U.S. economy. Table 1U.S. Demands On China In Trade Talks Chart 7U.S. Allies' Share Of Treasuries Rises Trump’s decision to slap a sweeping new tariff on China – reportedly at the objection of all of his trade advisers except the ultra-hawkish Peter Navarro (Table 1) – was at least partly driven by his desire to see the Fed cut rates beyond the 25 basis point cut on July 31 and weaken the dollar. Yet the escalation of the trade war weighs on global trade and growth, which will push the dollar up. This reinforces the above argument that Trump will probably seek to offset the recent trade war escalation with some mitigating moves. Beyond inducing the Fed to cut further, it is difficult for President Trump to drive the dollar down. The Treasury Department can intervene in foreign exchange markets, but direct intervention does not have a successful track record. Interventions usually have to be sterilized (expansion of the money supply externally must be addressed at home by mopping up the new liquidity), which in the context of free-moving global capital means that any depreciation will be short-lived. An unsterilized intervention would be extremely unorthodox and is unlikely short of a major crisis and breakdown in institutional independence. The U.S. could attempt to engineer an internationally coordinated currency intervention, as we have highlighted in the past. But it is highly unlikely to succeed this time around. The U.S. is less dominant of a military and economic power than it was when it orchestrated the Smithsonian Agreement of 1971 and the Plaza Accord of 1985. Neither the European nor the Japanese economies are in a position to tighten monetary policy or financial conditions through currency appreciation. While China weans itself off treasuries, U.S. allies and others fill the void. Indeed, after a long period in which American allies declined as a share total holders of treasuries – as China and emerging markets increased their forex reserves and treasury holdings momentously – allies are now taking a greater share (Chart 7). Chart 8China Diversifies While It Depreciates China is driving down the yuan not by buying more treasuries but by buying other things – diversifying away from the USD into alternative reserve currencies and hard assets, such as gold and resources tied to the Belt and Road Initiative (Chart 8). As trade, globalization, and global growth have slowed down, and as China’s growth model and the U.S.-China special relationship expire, global dollar liquidity is shrinking. Dollar liquidity is the lifeblood of the global financial system and the consequence is to tighten financial conditions, including via equity markets (Chart 9). The solution would be a trade deal in which China agrees to reforms to pacify the U.S., including an appreciation renminbi, while the U.S. abandons tariffs, enabling global trade, growth, commodity prices, and dollar liquidity to recover. Yet China was never likely to agree to a new Plaza Accord because it is delaying reform to its economy in order to maintain overall political stability – and the financial turmoil of 2015-16 only hardened this position. Chart 9Dollar Liquidity A Risk To Global Equities Moreover Japan in 1985 was already a subordinate ally and had a security guarantee from the United States that was not in question. By contrast, China today is asserting its “equality” as a nation with the U.S., and has no guarantee that Americans are not demanding economic reforms so as to debilitate China’s political stability and strategic capability. After tariffs and currency war comes saber-rattling. Comparing China to Japan in the decades leading up to the Plaza Accord shows how remote of a possibility this solution is: China’s currency has been moving in precisely the opposite direction (Chart 10). Chart 10So Much For Plaza Accord 2.0 The Plaza Accord is a useful analogy for another reason: it marked the peak in Japanese market share in the U.S. economy. In Japan’s case, currency appreciation was the primary mover, while Japan also relocated production to the United States. Chart 11The Real Analogy With The Plaza Accord In China’s case, if currency appreciation is ruled out and production is not relocated due to a failure to secure a trade agreement, then U.S. protectionism will remain the primary means of capping China’s share of the market (Chart 11). The dollar will remain strong and this will continue to weigh on global markets. Bottom Line: China’s recent currency depreciation is a warning signal to the U.S. that the trade negotiations could be broken off. There is further downside if the U.S. implements the new tariffs or hikes tariff rates further. The renminbi is unlikely to enter a freefall, however, because China maintains tight capital controls and is stimulating its economy. It is doubtful that the Trump administration can engineer a depreciation of the dollar through a multilateral agreement. It lacks the geopolitical heft of the 1970s-80s, and it does not have a strategic understanding with China that would enable Beijing to make the same degree of concessions that Tokyo made in 1985. Saber-Rattling After tariffs and currency depreciation, the next likeliest manifestation of strategic tensions lies in the military sphere. While the U.S. threatens to cut off Chinese tech companies like Huawei, Beijing has signaled that countermeasures would include an embargo on U.S. imports of rare earth elements and products.3 When China implemented a partial rare earth export ban on Japan (Chart 12), the context was a maritime-territorial dispute in the East China Sea in which military and strategic tensions were also escalating. The threat to industry only amplified these tensions. There are several locations in East Asia where conditions are ripe for clashes and incidents that could add to negative global sentiment. Indeed, saber-rattling has already begun in Hong Kong, Taiwan, the Koreas, and the East and South China Seas. The following areas are the most likely to darken the outlook for U.S.-China negotiations: Direct U.S.-China tensions: The U.S. and China have experienced several minor clashes since the beginning of the Trump administration. The near-collision of a Chinese warship with the USS Decatur occurred in October 2018, after the implementation of the first sweeping tariff on $200 billion worth of goods – a period of tensions very similar to that of today.4 October 1 marks the 70th anniversary of the People’s Republic of China, an event that will be marked by outpourings of nationalism and a flamboyant military parade displaying advanced new weapons. The government in Beijing will be extremely sensitive in the lead-up to this anniversary, leading to tight domestic controls of news and media, hawkish rhetoric, and the potential for provocations on the high seas. Hong Kong and Taiwan: Chinese officials, including the People’s Liberation Army garrison commander in Hong Kong, the director of the Office of Hong Kong and Macao Affairs, and the city’s embattled Chief Executive Carrie Lam have warned in various ways that if unrest spirals out of control, it could result in mainland China’s intervention. A large-scale police exercise in Shenzhen, Guangdong, just across the water, has highlighted Beijing’s willingness to take forceful action. The deployment of mainland troops would likely lead to casualties and could trigger sanctions from western countries that would have common cause on this issue. The Tiananmen Square incident shows that such an event could lead to a non-negligible hit to domestic demand and foreign exports under sanctions (Chart 13). Hong Kong is obviously a much smaller share of total exports to China these days, but when combined with Taiwan – where there could also be a hit to sentiment from Hong Kong unrest and possibly separate economic sanctions – the impact could be substantial (Chart 14). Chart 13Mainland Intervention In Hong Kong Could Prompt Sanctions Chart 14HK/Taiwan A Significant Share Of Greater China Trade Why would Taiwan get worse as a result of Hong Kong? Unrest in Hong Kong has already galvanized opposition to the mainland’s policies in Taiwan, where the presidential election polling has shifted in incumbent President Tsai Ing-wen’s favor (Chart 15). Beijing has imposed new travel restrictions and held a number of intimidating military exercises, while the U.S. has increased freedom of navigation operations in the Taiwan Strait. These trends could worsen over the next year. Japan and the East China Sea: Japan’s top military official – General Koji Yamazaki – recently warned that Chinese military intrusions are increasing around the disputed Senkaku (Diaoyu) islands in the East China Sea. He called particular attention to China’s change of the Coast Guard from civilian to military control, which he said posed new risks of escalation in disputed waters. Japan itself may have an interest in a more confrontational stance over the coming year. The Japanese government has seen a rise in public opposition to its plan to revise the constitution to enshrine the Self-Defense Forces and thus move toward a more “normal” Japanese military and security posture (Chart 16). A revival of trouble in the South China Sea: China has not reduced its assertive foreign policy in order to win regional allies amid its conflict with the United States. On the contrary, it has continued asserting itself to the point of alienating governments that have largely sought to warm up to the Xi administration, including both Vietnam and the Philippines. The Vietnamese have engaged in a month-long standoff over alleged Chinese encroachments in its Exclusive Economic Zone. And a clash near Sandy Cay in the Spratly Islands is forcing Philippine President Rodrigo Duterte, who has otherwise avoided confrontation with China, to address President Xi over the international court decision in 2016 that ruled out China’s claims of sovereignty over the disputed islands. The South China Sea is important because it is a vital supply line for all of the countries in the region. Even if the United States washed its hands of Beijing’s efforts to control the sea lanes, U.S. allies would still face a security threat that would drive tensions in these waters. This is a formidable group of Asian nations that China fears will seek to undermine it (Chart 17). And of course the Americans are not washing their hands of the region but actually reasserting their interest in maintaining a western Pacific defense perimeter. The Korean peninsula: North Korea has resumed testing short-range missiles, causing another hiccup in U.S. attempts at diplomacy (Chart 18). These tensions have the potential to flare as the U.S.-China trade talks deteriorate, since Beijing has offered cooperation on North Korea’s missile and nuclear program as a concession. Chart 17U.S. Asian Allies Formidable Chart 18North Korean Provocations Still Low-Level Ultimately North Korea needs to be part of the U.S.-China solution, so as long as tensions rise it sends a negative signal regarding the status of talks. And vice versa. South Korea is another case in which China is not reducing its foreign policy aggressiveness in order to win friends. On July 23, a combined Russo-Chinese bomber exercise over the disputed Dokdo (Takeshima) islands in the Sea of Japan led to interception by both Korean and Japanese fighter jets and the firing of hundreds of warning shots. The incident reveals that South Korean President Moon Jae-in is not seeing an improvement in relations with these countries despite his more pro-China orientation and his attempt to engage with North Korea. It also shows that while South Korea’s trade spat with Japan can persist for some time, it may take a back seat to these rising security challenges. As long as North Korean tensions rise it sends a negative signal regarding U.S.-China talks. Chart 19Russia May Need To Distract From Domestic Unrest Russia, like China, is feeling immense domestic political pressure, including large protests, that may result in greater foreign policy aggression (Chart 19). And as China and Russia tighten their informal alliance in the face of a more aggressive U.S., American allies face new operational pressures and the potential for geopolitical crises will rise. Bottom Line: The whole panoply of East Asian geopolitical risks is heating up as U.S.-China tensions escalate. While the U.S. and China may engage in direct provocations or miscalculations, their East Asian neighbors are implicated in the breakdown of the regional strategic order. A crisis in any of these hotspots could jeopardize the already unfavorable context for any U.S.-China trade deal over the next year, especially during rough patches like the very near term. Investment Implications Chart 20A Strategic Investment The potential for saber-rattling in the near term – on top of a series of critical U.S. decisions that could mitigate or exacerbate the increase in tensions surrounding the new tariff hike – argues strongly against altering our tactically defensive positioning at the moment. In this environment we advise clients to stick with our two strategic defense plays – long the BCA global defense basket in absolute terms, and long S&P500 Aerospace and Defense equities relative to global equities. The U.S. Congress’s newly agreed bipartisan budget deal provides a substantially improved fiscal backdrop for American defense stocks, which are already breaking out amid positive fundamentals. A host of non-negligible geopolitical risks speaks to the long-term nature of this trade (Chart 20). Our U.S. Equity Strategy recently reaffirmed its bullish position on this sector. We maintain that the U.S. and China have a 40% chance of concluding a trade agreement by November 2020. Note, however, that even a “no deal” scenario does not entail endless escalation. Presidents Trump and Xi could agree to another tariff ceasefire; negotiations could even lead to some tariff rollback in 2020. That would be, after all, Trump’s easiest way to “ease” trade policy amid recession risks. Nevertheless, our highest conviction call is not about whether there will be a deal, but that any trade truce that is reached will be shallow – an attempt to mitigate the trade war’s damage, save face, and bide time for the next round in U.S.-China conflict. We give only a 5% chance of a “Grand Compromise” by November 2020 that greatly expands the U.S.-China economic and corporate earnings outlook over the long haul. In this sense the ultimate trade deal will be a disappointment for markets. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 At the signing ceremony President Trump reminded his European interlocutors that the risk of car tariffs is not yet off the table. He concluded the celebration saying, “Congratulations. And we’re working on deal where the European Union will agree to pay a 25 percent tariff on all Mercedes-Benz’s, BMWs, coming into our nation. So, we appreciate that. I’m only kidding. (Laughter.) They started to get a little bit worried. They started — thank you. Congratulations. Best beef in the world. Thank you very much.” 2 See Emerging Markets Strategy Weekly Report, “EM: Into A Liquidation Phase?” August 8, 2019, ems.bcaresearch.com. 3 The national rare earth association holding a special working meeting and pledging to support any countermeasures China should take against U.S. tariffs. See Tom Daly, “China Rare Earths Group Supports Counter-Measures Against U.S. ‘Bullying,’” Reuters, August 7, 2019. 4 Military tensions are already heating up as Beijing criticizes the U.S. over the new Defense Secretary Mark Esper’s claim during his Senate confirmation hearings that new missile defense may be installed in the region in the coming years. This comes in the wake of the U.S. withdrawal from the 1987 Intermediate-Range Nuclear Forces Treaty, partly due to China’s not being a signatory of the agreement. Missile defense is a long-term issue but these developments feed into the current negative atmosphere.
Highlights So What? Key geopolitical risks remain unresolved and most of the improvements are transitory. Maintain a cautious tactical stance toward risk assets. Why? U.S.-China relations remain the preeminent geopolitical risk to investors and President Trump remains a wild card on trade. Japan’s rising assertiveness in the region will also produce clashes with the Koreas and possibly also with China. USMCA ratification is not a red herring for investors. We expect USMCA will pass by year’s end but our conviction level is low. Trump’s threat to withdraw from NAFTA cannot be entirely ruled out. Remain long JPY-USD and overweight Thailand relative to EM equities. Feature Chart 1U.S. And Chinese Policy Growing More Simulative We maintain our cautious tactical stance toward risk assets despite improvements to the cyclical macro outlook. American and Chinese monetary and fiscal policy are growing more stimulative on the margin – an encouraging sign for the global economy and risk assets. We have frequently predicted this combination as a positive factor for the second half of the year and 2020. With the Federal Reserve likely to deliver a 25 basis point interest rate cut on July 31, the market is pricing in positive policy developments (Chart 1). Yet in the U.S., long-term fiscal and regulatory policies are increasingly uncertain as the Democratic Party primary and 2020 election heat up. And in China, the trade war continues to drag on the effectiveness of the government’s stimulus drive. President Trump remains a wild card on trade: the resumption of U.S.-China talks is precarious and will be accompanied by heightened uncertainty surrounding Mexico, Canada, Japan, and Europe in the near term. Even the USMCA’s ratification is not guaranteed, as we discuss below. Even more pressing are the dramatic events taking place in East Asia: Hong Kong, Japan, the Koreas, Taiwan, and the South and East China Seas. These events each entail near-term uncertainty amid the ongoing slowdown in trade and manufacturing. Our long-running theme of geopolitical risk rotation from the Middle East to East Asia has come to fruition, albeit at the moment geopolitical risk is rising in both regions due to the simultaneous showdown between Iran and the United States and United Kingdom. The market recognizes that geopolitical risks are unresolved, according to this month’s update of our currency- and equity-derived GeoRisk Indicators. This is in keeping with the above points. We regard most of the improvements as transitory – especially the drop in risk in the U.K., where Boris Johnson is now officially prime minister. We are therefore sticking with our cautious trade recommendations despite our agreement with the BCA House View that the cyclical outlook is improving and is positive for global risk assets on a 12-month horizon. What Is Happening To East Asian Stability? A raft of crises has struck East Asia, a region known for political stability and ease of doing business throughout the twenty-first century after its successful recovery from the financial crisis of 1997. The thawing of Asia’s frozen post-WWII conflicts is a paradigm shift with significant long-term consequences for investors. The fundamental drivers are as follows: China’s rise is not peaceful: President Xi Jinping has reasserted Communist Party control while pursuing mercantilist trade policy and aggressive foreign policy. The populations of Hong Kong and Taiwan have reacted negatively to Beijing’s tightening grip, exposing the difficulty of resolving serious political disagreements given unclear constitutional frameworks. Recent protests in Hong Kong are even larger than those in 2014 and 1989 (Table 1). Table 1Hong Kong: Recent Protests The Largest Ever America’s “pivot” is not peaceful: The United States is determined to respond to China’s rise, but political polarization has prevented a coherent strategy. The Democrats took a gradual, multilateral path emphasizing the Trans-Pacific Partnership while the Republicans have taken an abrupt, unilateral path emphasizing sweeping tariffs. Underlying trade policy is the increased use of “hard power” by both parties – freedom of navigation operations, weapons sales, and alliance-maintenance. America is threatening the strategic containment of China, which China will resist through alliances and relations with Russia and others. Japan’s resurgence is not peaceful: Japan’s “lost decades” culminated in the crises and disasters of 2008-11. Since then, Japan’s institutional ruling party – the Liberal Democrats – have embraced a more proactive vision of Japan in which the country casts off the shackles of its WWII settlement. They set about reflating the economy and “normalizing” the country’s strategic and military posture. The result is rising tension with China and the Koreas. Korean “reunion” is not peaceful: North Korea has seen a successful power transition to Kim Jong Un, who is attempting economic reforms to prolong the regime. South Korea has witnessed a collapse among political conservatives and a new push to make peace with the North and improve relations with China. The prospect of peace – or eventual reunification – increases political risk in both Korean regimes and provokes quarrels between erstwhile allies: the North and China, and the South and Japan. Southeast Asia’s rise is not peaceful: Southeast Asia is the prime beneficiary in a world where supply chains move out of China, due to China’s internal development and American trade policy. But it also suffers when China encroaches on its territory or reacts negatively to American overtures. Higher expectations from the U.S. will increase the political risk to Taiwan, South Korea, Vietnam, and the Philippines. This is the critical context for the mass protests in Hong Kong and the miniature trade war between Japan and South Korea, and other regional risks. Which conflicts are market-relevant? How will they play out? The U.S.-China Conflict The most important dynamic is the strategic conflict between the U.S. and China. Its pace and intensity have ramifications for all the other states in the region. Because the Trump administration is seeking a trade agreement with China, it has held off from unduly antagonizing China over Hong Kong and Taiwan. President Trump has not fanned the flames of unrest in Hong Kong and has maintained only a gradual pace of improvements in the Taiwan relationship.1 But if the trade war escalates dramatically, Beijing will face greater economic pressure, growing more sensitive about dissent within Greater China, and Washington may take more provocative actions. Saber-rattling could ensue, as nearly occurred in October 2018. Currently events are moving in a more market-positive direction. Next week, the U.S. and China are expected to resume face-to-face trade negotiations between principal negotiators for the first time since May. China is reportedly preparing to purchase more farm goods – part of the Osaka G20 ceasefire – while the Trump administration has met with U.S. tech companies and is expected to allow Chinese telecoms firm Huawei to continue purchasing American components (at least those not clearly impacting national security). We are upgrading the odds of a trade agreement by November 2020 to 40% from 32% in mid-June. With this resumption of talks, we are upgrading the odds of a trade agreement by November 2020 to 40%, from 32% in mid-June (Diagram 1). Of this 40%, we still give only a 5% chance to a durable, long-term deal that resolves underlying technological and strategic disputes. The remaining 35% goes to a tenuous deal that enables President Trump to declare victory prior to the election and allows President Xi Jinping to staunch the bleeding in the manufacturing sector. Diagram 1U.S.-China Trade War Decision Tree (Updated July 26, 2019) Note that these odds still leave a 60% chance for an escalation of the trade war by November 2020. Our conviction level is low when it comes to the two moderate scenarios. Ultimately, Presidents Trump and Xi can agree to a trade agreement at the drop of a hat – no one can stop Xi from ordering large imports from the U.S. or Trump from rolling back tariffs. Our conviction level is much higher in assigning only a 5% chance of a grand compromise and a 36% chance of a cold war-style escalation of tensions. We doubt that China will offer any structural concessions deeper than what they have already offered (new foreign investment law, financial sector opening) prior to finding out who wins the U.S. election in 2020. Beijing is stabilizing the economy even though tariffs have gone up. As long as this remains the case, why would it implement additional painful reforms? This would set a precedent of caving to tariff coercion – and yet Trump could renege on a deal anytime, and the Democrats might take over in 2020 anyway. The one exception might be North Korea, where China could do more to bring about a diplomatic agreement favorable to President Trump as part of an overall deal before November 2020 – and this could excuse China from structural concessions affecting its internal economy. The takeaway is that U.S.-China trade issues are still far from resolved and have a high probability of failure – and this will be a source of strategic tension within the region over the next 16 months, particularly with regard to Taiwan, the Koreas, and the South China Sea. Hong Kong And Taiwan August can be a crucial time period for policy changes as Chinese leaders often meet at the seaside resort of Beidaihe to strategize. This year they need to focus on handling the unrest in Hong Kong, and the Taiwanese election in January, as well as the trade war with the United States. Protests in Hong Kong have continued, driven by underlying socio-economic factors as well as Beijing’s encroachment on traditional political liberties. Even the groups that are least sympathetic to the protesters – political moderates, the elderly, low-income groups, and the least educated – are more or less divided over the controversial extradition bill that prompted the unrest (Chart 2). This reveals that the political establishment is weak on this issue. Chief Executive Carrie Lam is clinging to power, as Beijing does not want to give the impression that popular dissent is a viable mechanism for removing leaders. But she has become closely associated with the extradition bill and will likely have to go in order to satiate the protesters and begin the process of healing. As long as Beijing refrains from rolling in the military and using outright force to crush the Hong Kong protests, the unrest should gradually die down, as the political establishment will draw support for its concessions while the general public will grow weary of the protests – especially as violence spreads. Hong Kong has no alternative to Beijing’s sovereignty. The scene of action will soon turn to Taiwan, where the January 2020 election has the potential to spark the next flashpoint in Xi Jinping’s struggle to consolidate power in Greater China. A large majority of Taiwanese people supports the Hong Kong protests – even most supporters of the pro-mainland Kuomintang (KMT) (Chart 3). This dynamic is now affecting the Taiwanese election slated for January 2020. The relatively pro-mainland KMT has been polling neck-and-neck with the ruling Democratic Progressive Party (DPP), which has struggled to gain traction throughout its term given diplomatic and economic headwinds stemming from the mainland. Similarly, while popular feeling is still largely in favor of eventual independence, pro-unification feeling has regained momentum in an apparent rebuke to the pro-independence ruling party (Chart 4). However, the events in Hong Kong have changed things by energizing the democratic and mainland-skeptic elements in Taiwan. President Tsai Ing-wen is now taking a slight lead in the presidential head-to-head opinion polls despite a long period of lackluster polling (Chart 5). A close election increases the risk that policymakers and activists in Taiwan, mainland China, the United States, and elsewhere will take actions attempting to influence the election outcome. Beijing will presumably heed the lesson of the 1996 election and avoid anything too aggressive so as not to drive voters into the arms of the DPP. However, with Hong Kong boiling, and with Beijing having already conducted intimidating military drills encircling Taiwan in recent years, there is a chance that past lessons will be forgotten. The United States could also play a disruptive role, especially if trade talks deteriorate. If the KMT wins, then anti-Beijing activists will eventually begin gearing up for protests themselves, which in subsequent years could overshadow the Sunflower Movement of 2013. If the DPP prevails, Beijing may resort to tougher tactics in the coming years due to its fear of the province’s political direction and the DPP’s policies. In sum, while the Hong Kong saga is far from over and has negative long-run implications for domestic and foreign investors, Taiwan is the greater risk because it has the potential not only to suffer individually but also to become the epicenter of a larger geopolitical confrontation between China and the U.S. and its allies. This would present a more systemic challenge to global investors. Japan And “Peak Abe” Japan’s House of Councillors election on July 21 confirmed our view that Prime Minister Shinzo Abe has reached the peak of his influence. Abe is still popular and is likely to remain so through the Tokyo summer Olympics next year (Chart 6). But make no mistake, the loss of his two-thirds supermajority in the upper house shows that he has moved beyond the high tide of his influence. Having retained a majority in the upper house, and a supermajority in the much more powerful lower house (House of Representatives), Abe’s government still has the ability to pass regular legislation (Chart 7). If he needs to drive through a bill delaying the consumption tax hike on October 1 due to a deterioration in the global economic and political environment, he can still do so with relative ease. While the Hong Kong saga is far from over ... Taiwan is the greater risk. Clearly, the election loss will not impact Abe’s ability to negotiate a trade deal with the United States, which we expect to happen quickly – even before a China deal – albeit with some risk of tariffs on autos in the interim. The problem is that Abe’s final and greatest aim is to revise Japan’s American-written, pacifist constitution for the first time. This requires a two-thirds vote in both houses and a majority vote in a popular referendum. While Abe can still probably cobble together enough votes in the upper house, the election result makes it less certain – and the dent in popular support implies that the national referendum is less likely to pass. Constitutional revision was always going to be a close vote anyway (Chart 8). If Abe falls short of a majority in that referendum, then he will become a lame duck and markets will have to price in greater policy uncertainty. Even if he succeeds – which is still our low-conviction baseline view – then he will have reached the pinnacle of his career and there will be nowhere to go but down. His tenure as party leader expires in September 2021 and the race to succeed him is already under way. Hence, some degree of uncertainty should begin creeping in immediately. Abe’s departure will leave the Liberal Democrats in charge – and hence Japanese policy continuity will be largely preserved. But the entire arc of events, from now through the constitutional revision process to Abe’s succession, will raise fundamental questions about whether Abe’s post-2012 reflation drive can be sustained. We have a high conviction view that it will be, but Japanese assets will challenge that view. What of the miniature trade war between Japan and South Korea? On July 4, Japan imposed export restrictions on goods critical to South Korea’s semiconductor industry in retaliation for a South Korean court ruling that would set a precedent requiring Japanese companies such as Mitsubishi and Nippon Steel to pay reparations for the use of forced Korean labor during Japanese rule from 1910-45. Chart 9Japan Has A Stronger Hand In The Mini Trade War Japan has the stronger hand in this dispute from an economic point of view (Chart 9). While the unusually heavy-handed Japanese trade measures partly reveal the influence of President Trump, who has given a license for U.S. allies to weaponize trade, it also reflects Japan’s growing assertiveness. Abe’s government may have believed that a surge of nationalism would help in the upper house election. And the constitutional referendum will be another reason to stir nationalism and a recurring source of tension with both Koreas (as well as with China). Therefore, Japanese-Korean tensions and punitive economic measures could persist well into 2020. Bottom Line: U.S.-China relations remain the preeminent geopolitical risk to investors, especially if the Taiwan election becomes a lightning rod. Japan’s rising assertiveness in the region will also produce clashes with the Koreas and possibly also with China. We are playing these risks by remaining long JPY-USD and overweight Thailand relative to EM equities, as Thailand is more insulated than other East Asian economies to trade and China risks. Keep An Eye On The USMCA Last week we highlighted U.S. budget negotiations and argued that the result would be greater fiscal accommodation. The results of the just-announced budget deal are depicted in Chart 10. One side effect is an increased likelihood of eventual tariffs on Mexico if the latter fails to staunch the influx of immigrants across the U.S. southern border, since President Trump has largely failed to secure funding for his proposed border wall. Meanwhile, the administration’s legislative and trade focus will turn toward ratifying the U.S.-Mexico-Canada trade agreement (USMCA). There is an increased likelihood of eventual U.S. tariffs on Mexico ... since President Trump has largely failed to secure funding for his proposed border wall. Ratification is not a red herring for investors, since Trump could give notice of withdrawal from NAFTA in order to hasten USMCA approval, which would induce volatility. Moreover, successful ratification could embolden him to take a strong hand in his other trade disputes, while failure could urge him to concede to a quick deal with China. Chart 11Trade Uncertainty Supports The Dollar Further, trade policy uncertainty in the Trump era has correlated with a rising trade-weighted dollar (Chart 11), so there is a direct channel for trade tensions (or the lack thereof) to influence the global economy at a time when it badly needs a softer dollar – in addition to the negative effects of trade wars on sentiment. The signing of the USMCA trade agreement by American, Mexican, and Canadian leaders last November effectively shifted negotiations from the international stage to the domestic stage. Last month Mexico became the first to ratify the deal. The delay in the U.S. and Canada reflects their more challenging domestic political environments ahead of elections, especially in the United States. Ratification in the U.S. has been stalled by Speaker of the House Nancy Pelosi, who is locked in stalemate with the Trump administration. She is holding off on giving the green light to present the agreement to Congress until Democrats’ concerns are addressed (Diagram 2). Trump, meanwhile, is threatening to withdraw from NAFTA – a declaration that cannot be entirely ruled out, even though we highly doubt he would actually withdraw at the end of the six-month waiting period. Diagram 2Pelosi Is Stalling USMCA Ratification Process Republicans are looking to secure the USMCA’s passage before the 2020 campaign goes into full force in order to claim victory on one of Trump’s key 2016 campaign promises. The administration’s May 30 submission of the draft Statement of Administrative Action (SAA) to Congress initiated a 30-day waiting period that must pass before the administration can submit the text to Congress. But the administration is unlikely to put the final bill to Congress before ensuring that House Democrats are ready to cooperate.2 House democrats are in a position of maximum leverage and are using the process to their political advantage. House Democrats are in a position of maximum leverage – since they do not need the deal to become law – and are using the process to their political advantage. If the bill is to be ratified through the “fast action” Trade Protection Authority (TPA), which forbids amendments and limits debate in Congress, then now is their only chance to make amendments to the text, which was written without their input. Even in the Democrat-controlled House, there is probably enough support for the USMCA to secure its passage. There are 51 House Democrats who were elected in districts that Trump won or that Republicans held in 2018, and are inclined to pass the deal. Moreover 21 House Democrats have been identified from districts that rely heavily on trade with Canada and Mexico (Chart 12).3 If these Democrats vote along with all 197 Republicans in favor of the bill, it will pass the House. This is a rough calculation, but it shows that passage is achievable. What is more, there is a case to be made for bipartisan support for USMCA. Trump’s trade agenda has some latent sympathy among moderate Democrats, and Democrats within Trump districts, unlike his border wall. Democrats will appear obstructionist if they oppose the bill. Unlike trade with China, American voters are not skeptical of trade with Canada – and the group that thinks Mexico is unfair on trade falls short of a majority (Chart 13). Since enough Democrats have a compelling self-interest in securing the deal, and since Trump and the GOP obviously want it to pass, we expect it to pass eventually. The question is whether it can be done by year’s end. Once the bill is presented to Congress and passes through the TPA process, it will become law within 90 days. Assuming that the bill is presented to the House in early September, when Congress reconvenes after its summer recess, the bill could be ratified before year-end. Otherwise, without the expedited TPA process, the bill will no longer be protected against amendment and filibuster, leaving the timeline of ratification vulnerable to extensive delay. The above timeline may be too late for Canada’s Prime Minister Justin Trudeau, who faces general elections on October 21. The ratification process has already been initiated, as Trudeau would benefit from wrapping up the entire affair prior to the national vote.4 However, the process most recently has been stalled in order to move in tandem with the U.S., so that parliament does not ratify an agreement that the U.S. fails to pass. Canadian Foreign Affairs Minister Chrystia Freeland has indicated that parliament is not likely to be recalled for a vote unless there is progress down south. This leaves the Canadian ratification process at the mercy of progress in the U.S. – and ultimately Speaker Pelosi’s decision. The current government faces few hurdles in getting the bill passed (Chart 14). The next step is a final reading in the House where the bill will either be adopted or rejected. If it is approved, the bill will then proceed to the Senate where it will undergo a similar process. If the bill is passed in the same form in the House and Senate, it will become law. Chart 15...But Trudeau's Party Is At Risk Failure to ratify the deal before the election means it will be set aside and reintroduced in the next parliament. The Liberal Party is by no means guaranteed to win a majority in the election – our base case has Trudeau forming the next government, but the race is close (Chart 15). A Conservative-led parliament would be likely to pass the bill, but it would likely be delayed to 2021 at that point due to American politics. We suspect that Trudeau will eventually stop delaying and push for Canadian ratification. This would pressure Pelosi and the Democrats to go ahead and ratify, when they are otherwise inclined to reopen negotiations or otherwise delay until after November 2020. If this gambit succeeded, Trudeau would have forced total ratification prior to October 21, which would give him a badly needed boost in the election. He can always go through the frustration of re-ratifying the deal in his second term if the Democrats insist on changes, but not if he does not survive for a second term – so it is worth going forward at home and trying to pressure Pelosi into ratification in September or early October. Bottom Line: In light of Canada’s October election and the U.S. 2020 election cycle, USMCA faces a tight schedule. A delay into next year risks undermining the ratification effort, as we enter a period of hyper-partisan politics amid the 2020 presidential campaigns. This makes the third quarter a sweet spot for USMCA ratification. While we ultimately expect that it will make it through, each passing day raises the odds against it. GeoRisk Indicators Update: July 26, 2019 All ten GeoRisk indicators can be found in the Appendix, with full annotation. Below are the most noteworthy developments this month. U.K.: As expected, Boris Johnson sealed the Conservative party leadership contest. This was largely priced in by the markets and as such did not result in a big shift in our risk indicator. Johnson has stated that he is willing to exit the EU without a deal and it is undeniable that the odds of a no-deal Brexit have increased. Nevertheless, the odds of an election are also rising as Johnson may galvanize Brexit support under the Conservative Party even as Bremain forces are divided between the rising Liberal Democrats and a Labour Party hobbled by Jeremy Corbyn’s leadership. The odds that Johnson is willing to risk his newly cemented position on a snap election – having seen what happened in June 2017 – seem overstated to us, but we place the odds at about 21%. As for a no-deal exit, opinion polling still suggests that the median British voter prefers a soft exit or remaining in the EU. This imposes constraints on Johnson, as he may ultimately be forced to try to push through a plan similar to Theresa May’s, but rebranded with minimal EU concessions to make it more acceptable – or risk a no-confidence vote and potential loss of control. We maintain that GBP will stay weak, gilts will remain well-bid, and risk-off tendencies will be reinforced. France: Our French indicator points toward a significant increase in political risk over the last month. President Macron’s government has recently unveiled the pension system overhaul that he promised during the 2017 campaign. The reform, which is due to take effect in 2025, encourages citizens to work longer, as their full pension will come at the age of 64 – two years later than under current regulations. French reform efforts have historically prompted significant social unrest. Both the 1995 Juppé Plan and the 2006 labor reforms were scrapped as a result of unrest, and the 2010 pension reform strikes forced the government to cut the most controversial parts of the bill. Labor unions have already called for strikes against the current bill in September. However, no pain, no gain. Unrest is a sign that ambitious reforms are being enacted, and Macron’s showdown with protesters thus far is no more dramatic than the unrest faced by the most significant European reform efforts. The 1984-85 U.K. miners’ strike led to over 10,000 arrested and significant violence, but resulted in the closures of most collieries, weakening of trade union power, and allowed the Thatcher government to consolidate its liberal economic program. German labor reforms in the early 2000s led to strikes, but marked a turning point in unemployment and GDP trends (Chart 16), and succeeded in increasing wages and pushing people back into the labor force (Chart 17). And the 2011 Spanish reforms under PM Rajoy led to the rise of Indignados, student protesters occupying public spaces, but ultimately helped kick-start Spain’s recovery. Investors should therefore not fear unrest, and we expect any related uncertainty to abate in the medium term. Chart 16Hartz IV Reforms Were Also Accompanied By Unrest... Chart 17...But Were Ultimately Favorable Note that Macron is doubling down on reforms after the experience of the Yellow Vest protests, just as his favorability has rebounded to pre-protest levels. While Macron’s approval is nearly the lowest compared to other French presidents at this point in their terms (Chart 18), he does not face an election until 2022, so he has the ability to trudge on in hopes that his reform efforts will bear fruit by that time. Spain: Our Spanish indicator is showing signs of increasing tensions as Prime Minister Pedro Sanchez attempts to form a government. After ousting Mariano Rajoy in a vote of no confidence in June 2018, Sanchez struggled to govern with an 84-seat minority in Congress. The Spanish Socialist Workers’ Party’s (PSOE) proposed budget plan was voted down in Congress in February, forcing Sanchez to call a snap election for April 28 in which PSOE secured 123 seats. The PSOE leader failed the first investiture vote on July 23 – and the rerun on July 25 – with less votes in his favor than his predecessor Mariano Rajoy received during the 2015-2016 government formation crisis (Chart 19). In the first investiture vote, Sanchez secured 124 votes out of the 176 he needed to be sworn in as prime minister. This led to a second round of voting in which Sanchez needed a simple majority, which he failed to do with 124 affirmative, 155 opposing votes, and 67 abstentions. Going forward, Sanchez has two months to obtain the confidence of Congress, otherwise the King may dissolve the government, leading to a snap election. The Spanish government is more fragmented today than at any point during the last 30 years (Chart 20). Even if Pedro Sanchez’s PSOE were to successfully negotiate a deal with Podemos and its partner parties, the coalition would still require support from nationalist parties such as Republican Left of Catalonia or Basque Nationalist Party to govern. These will likely require major concessions relating to the handling of Catalonian independence, which, if rejected by PSOE, will result in yet another gridlocked government. The next two months will see a significant increase in political risk, and we assign a non-negligible chance to another election in November, the fourth in four years. Turkey: Investors should avoid becoming complacent on the back of the stream of encouraging news following the Turkey-Russia missile defense system deal. Our indicator is signaling that the market is pricing a decrease in tensions, and President Trump has stated that sanctions will not be immediate. Nevertheless, we would be wary. Congress is taking a much tougher stance on the issue than President Trump: The U.S. administration already excluded Turkey from the F-35 stealth fighter jet program; Senators Scott (R) and Young (R) introduced a resolution calling for sanctions; Senator Menendez (D) stated that merely removing Turkey from the F-35 program would not be enough; The new Defense Secretary nominee Mark Esper said that he was disappointed with Turkey’s “drift from the West”; And U.S. Secretary of State Mike Pompeo expressed confidence that President Trump would impose sanctions. Under CAATSA, a law that targets companies doing business with Russia, the U.S. must impose sanctions on Turkey over the missile deal, but does not have a timeline to do so. The sanctions required are formidable, and the U.S. has already imposed sanctions on China for a similar violation. If President Trump is not going forward with sanctions now, he still could proceed later if Turkey does not improve U.S. relations in some other way. From Turkey’s side, Foreign Minister Mevlut Cavusoglu threatened retaliation if the U.S. were to impose sanctions. Turkey is also facing increasing tensions domestically. Erdogan suffered a stinging rebuke in the re-run of the Istanbul mayoral election. This defeat has left Erdogan even more insecure and unpredictable than before. On July 6, he fired central bank governor Murat Cetinkaya using a presidential decree, which calls the central bank’s independence into question. He may reshuffle his cabinet, which could make matters worse if the appointments are not market-friendly. As domestic tensions continue to escalate, and when the U.S. announces sanctions, we expect the lira to take yet another hit and add to Turkey’s economic woes. Diagram 3Brazil: Pension Reform Timeline Chart 21Brazil Faces A Fiscal Deficit Despite Pension Reform Brazil: Brazilian risks are likely to remain elevated as the country faces crunch-time over the controversial pension reform on which its fiscal sustainability depends. Although the Lower House voted overwhelmingly in support of the reform on July 11, the bill needs to make it through another Lower House vote slated for August 6. The bill will then proceed to at least two more rounds of voting in the Senate (by end-September at the earliest), with a three-fifths majority required in each round before being enshrined in Brazil’s constitution (Diagram 3). The whole process will likely be delayed by amendments and negotiations. The estimated savings of the bill in its current form are about 0.9 trillion reals, down from the 1.236 trillion reals originally targeted, which risks undermining the effort to close the fiscal deficit. Our colleagues at BCA’s Emerging Markets Strategy still forecast a primary fiscal deficit in four years’ time (Chart 21).5 Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 For instance, the U.S.’s latest $2.2 billion arms package does not include F-16 fighter jets to Taiwan, and F-35s have entirely been ruled out. The Trump administration sent Paul Ryan, rather than a high-level cabinet member, to inaugurate the new office building of the American Institute in Taiwan for the 40th anniversary of the Taiwan Relations Act. At the same time, the Trump administration is threatening a more substantial upgrade of relations through more frequent arms sales, the Taiwan Travel Act (2018), and the Asia Reassurance Initiative Act (2018). 2 The risk is that history repeats itself. In 2007, then President George W. Bush sent the free-trade agreement with Colombia to Congress prior to securing Pelosi’s approval. She halted the fast-track timeline and the standoff lasted nearly five years. 3 Please see Gary Clyde Hufbauer, “USMCA Needs Democratic Votes: Will They Come Around?” Peterson Institute For International Economics, May 15, 2019, available at piie.com. 4 Bill C-100, as it is known, has already received its second reading in the House of Commons and has been referred to the Standing Committee on International Trade. 5 Please see BCA Research’s Emerging Markets Strategy Weekly Report titled “On Chinese Banks And Brazil,” dated July 18, 2019, available at ems.bcaresearch.com. Appendix Geopolitical Calendar