Elections
Highlights So What? Economic stimulus will encourage key nations to pursue their self-interest – keeping geopolitical risk high. Why? The U.S. is still experiencing extraordinary strategic tensions with China and Iran … simultaneously. The Trump-Xi summit at the G20 is unlikely to change the fact that the United States is threatening China with total tariffs and a technology embargo. The U.S. conflict with Iran will be hard to keep under wraps. Expect more fireworks and oil volatility, with a large risk of hostilities as long as the U.S. maintains stringent oil sanctions. All of our GeoRisk indicators are falling except for those of Germany, Turkey and Brazil. This suggests the market is too complacent. Maintain tactical safe-haven positioning. Feature “That’s some catch, that Catch-22,” he observed. “It’s the best there is,” Doc Daneeka agreed. -Joseph Heller, Catch-22 (1961) One would have to be crazy to go to war. Yet a nation has no interest in filling its military’s ranks with lunatics. This is the original “Catch-22,” a conundrum in which the only way to do what is individually rational (avoid war) is to insist on what is collectively irrational (abandon your country). Or the only way to defend your country is to sacrifice yourself. This is the paradox that U.S. President Donald Trump faces having doubled down on his aggressive foreign policy this year: if he backs away from trade war to remove an economic headwind that could hurt his reelection chances, he sacrifices the immense leverage he has built up on behalf of the United States in its strategic rivalry with China. “Surrender” would be a cogent criticism of him on the campaign trail: a weak deal will cast him as a pluto-populist, rather than a real populist – one who pandered to China to give a sop to Wall Street and the farm lobby just like previous presidents, yet left America vulnerable for the long run. Similarly, if President Trump stops enforcing sanctions against Iranian oil exports to reduce the threat of a conflict-induced oil price shock that disrupts his economy, then he reduces the United States’s ability to contain Iran’s nuclear and strategic advances in the wake of the 2015 nuclear deal that he canceled. The low appetite for American involvement in the region will be on full display for the world to see. Iran will have stared down the Great Satan – and won. In both cases, Trump can back down. Or he can try to change the subject. But with weak polling and yet a strong economy, the point is to direct voters’ attention to foreign policy. He could lose touch with his political base at the very moment that the Democrats reconnect with their own. This is not a good recipe for reelection. More important – for investors – why would he admit defeat just as the Federal Reserve is shifting to countenance the interest rate cuts that he insists are necessary to increase his economic ability to drive a hard bargain with China? Why would he throw in the towel as the stock market soars? And if Trump concludes a China deal, and the market rises higher, will he not be emboldened to put more economic pressure on Mexico over border security … or even on Europe over trade? The paradox facing investors is that the shift toward more accommodative monetary policy (and in some cases fiscal policy) extends the business cycle and encourages political leaders to pursue their interests more intently. China is less likely to cave to Trump’s demands as it stimulates. The EU does not need to fear a U.K. crash Brexit if its economy rebounds. This increases rather than decreases the odds of geopolitical risks materializing as negative catalysts for the market. Similarly, if geopolitical risk falls then the need for stimulus falls and the market will be disappointed. The result is still more volatility – at least in the near term. The G20 And 2020 As we go to press the Democratic Party’s primary election debates are underway. The progressive wave on display highlights the overarching takeaway of the debates: the U.S. election is now an active political (and geopolitical) risk to the equity market. A truly positive surprise at the G20 would be a joint statement by Trump and Xi plus some tariff rollback. Whenever Trump’s odds of losing rise, the U.S. domestic economy faces higher odds of extreme policy discontinuity and uncertainty come 2021, with the potential for a populist-progressive agenda – a negative for financials, energy, and probably health care and tech. Yet whenever Trump’s odds of winning rise, the world faces higher odds of an unconstrained Trump second term focusing on foreign and trade policy – a potentially extreme increase in global policy uncertainty – without the fiscal and deregulatory positives of his first term. We still view Trump as the favored candidate in this race (at 55% chance of reelection), given that U.S. underlying domestic demand is holding up and the labor market has not been confirmed to be crumbling beneath the consumer’s feet. Still Chart 1 highlights that Trump’s shift to more aggressive foreign and trade policy this spring has not won him any additional support – his approval rating has been flat since then. And his polling is weak enough in general that we do not assign him as high of odds of reelection as would normally be afforded to a sitting president on the back of a resilient economy. This raises the question of whether the G20 will mark a turning point. Will Trump attempt to deescalate his foreign conflicts? Yes, and this is a tactical opportunity. But we see no final resolution at hand. With China, Trump’s only reason to sign a weak deal would be to stem a stock market collapse. With Iran, Trump is no longer in the driver’s seat but could be forced to react to Iranian provocations. Bottom Line: Trump’s polling has not improved – highlighting the election risk – but weak polling amid a growing economy and monetary easing is not a recipe for capitulating to foreign powers. The Trump-Xi Summit On China the consensus on the G20 has shifted toward expecting an extension of talks and another temporary tariff truce. If a new timetable is agreed, it may be a short-term boon for equities. But we will view it as unconvincing unless it is accompanied with a substantial softening on Huawei or a Trump-Xi joint statement outlining an agreement in principle along with some commitment of U.S. tariff rollback. Otherwise the structural dynamic is the same: Trump is coercing China with economic warfare amid a secular increase in U.S.-China animosity that is a headwind for trade and investment. Table 1 shows that throughout the modern history of U.S.-China presidential-level summits, the Great Recession marked a turning point: since then, bilateral relations have almost always deteriorated in the months after a summit, even if the optics around the summit were positive. Table 1U.S.-China Leaders Summits: A Chronology The last summit in Buenos Aires was no exception, given that the positive aura was ultimately followed by a tariff hike and technology-company blacklistings. Of course, the market rallied for five months in between. Why should this time be the same? First, the structural factors undermining Sino-American trust are worse, not better, with Trump’s latest threats to tech companies. Second, Trump will ultimately resent any decision to extend the negotiations. China’s economy is rebounding, which in the coming months will deprive Trump of much of the leverage he had in H2 2018 and H1 2019. He will be in a weaker position if they convene in three months to try to finalize a deal. Tariff rollback will be more difficult in that context given that China will be in better shape and that tariffs serve as the guarantee that any structural concessions will be implemented. Bottom Line: Our broader view regarding the “end game” of the talks – on the 2020 election horizon – remains that China has no reason to implement structural changes speedily for the United States until Trump can prove his resilience through reelection. Yet President Trump will suffer on the campaign trail if he accepts a deal that lacks structural concessions. Hence we expect further escalation from where we are today, knowing full well that the G20 could produce a temporary period of improvement just as occurred on December 1, 2018. The Iran Showdown Is Far From Over Disapproval of Trump’s handling of China and Iran is lower than his disapproval rating on trade policy and foreign policy overall, suggesting that despite the lack of a benefit to his polling, he does still have leeway to pursue his aggressive policies to a point. A breakdown of these opinions according to key voting blocs – a proxy for Trump’s ability to generate support in Midwestern swing states – illustrates that his political base is approving on the whole (Chart 2). Yet the conflict with Iran threatens Trump with a hard constraint – an oil price shock – that is fundamentally a threat to his reelection. Hence his decision, as we expected, to back away from the brink of war last week (he supposedly canceled air strikes on radar and missile installations at the last minute on June 21). He appears to be trying to control the damage that his policy has already done to the 2015 U.S.-Iran equilibrium. Trump has insisted he does not want war, has ruled out large deployments of boots on the ground, and has suggested twice this week that his only focus in trying to get Iran back into negotiations is nuclear weapons. This implies a watering down of negotiation demands to downplay Iran’s militant proxies in the region – it is a retreat from Secretary of State Mike Pompeo’s more sweeping 12 demands on Iran and a sign of Trump’s unwillingness to get embroiled in a regional conflict with a highly likely adverse economic blowback. The Iran confrontation is not over yet – policy-induced oil price volatility will continue. This retreat lacks substance if Trump does not at least secretly relax enforcement of the oil sanctions. Trump’s latest sanctions and reported cyberattacks are a sideshow in the context of an attempted oil embargo that could destabilize Iran’s entire economy (Charts 3 and 4). Similarly, Iran’s downing of a U.S. drone pales in comparison to the tanker attacks in Hormuz that threatened global oil shipments. What matters to investors is the oil: whether Iran is given breathing space or whether it is forced to escalate the conflict to try to win that breathing space. Chart 4Iran’s Rial Depreciated Sharply The latest data suggest that Iran’s exports have fallen to 300,000 barrels per day, a roughly 90% drop from 2018, when Trump walked away from the Iran deal. If this remains the case in the wake of the brinkmanship last week then it is clear that Iran is backed into a corner and could continue to snarl and snap at the U.S. and its regional allies, though it may pause after the tanker attacks. Chart 5More Oil Volatility To Come Tehran also has an incentive to dial up its nuclear program and activate its regional militant proxies in order to build up leverage for any future negotiation. It can continue to refuse entering into negotiations with Trump in order to embarrass him – and it can wait until Trump’s approach is validated by reelection before changing this stance. After all, judging by the first Democratic primary debate, biding time is the best strategy – the Democratic candidates want to restore the 2015 deal and a new Democratic administration would have to plead with Iran, even to get terms less demanding than those in 2015. Other players can also trigger an escalation even if Presidents Trump and Rouhani decide to take a breather in their conflict (which they have not clearly decided to do). The Houthi rebels based in Yemen have launched another missile at Abha airport in Saudi Arabia since Trump’s near-attack on Iran, an action that is provocative, easily replicable, and not necessarily directly under Tehran’s control. Meanwhile OPEC is still dragging its feet on oil production to compensate for the Iranian losses, implying that the cartel will react to price rises rather than preempt them. The Saudis could use production or other means to stoke conflict. Bottom Line: Given our view on the trade war, which dampens global oil demand, we expect still more policy-induced volatility (Chart 5). We do not see oil as a one-way bet … at least not until China’s shift to greater stimulus becomes unmistakable. North Korea: The Hiccup Is Over Chart 6China Ostensibly Enforces North Korean Sanctions The single clearest reason to expect progress between the U.S. and China at the G20 is the fact that North Korea is getting back onto the diplomatic track. North Korea has consistently been shown to be part of the Trump-Xi negotiations, unlike Taiwan, the South China Sea, Xinjiang, and other points of disagreement. General Secretary Xi Jinping took his first trip to the North on June 20 – the first for a Chinese leader since 2005 – and emphasized the need for historic change, denuclearization, and economic development. Xi is pushing Kim to open up and reform the economy in exchange for a lasting peace process – an approach that is consistent with China’s past policy but also potentially complementary with Trump’s offer of industrialization in exchange for denuclearization. President Trump and Kim Jong Un have exchanged “beautiful” letters this month and re-entered into backchannel discussions. Trump’s visit to South Korea after the G20 will enable him and President Moon Jae-In to coordinate for a possible third summit between Trump and Kim. Progress on North Korea fits our view that the failed summit in Hanoi was merely a setback and that the diplomatic track is robust. Trump’s display of a credible military threat along with Chinese sanctions enforcement (Chart 6) has set in motion a significant process on the peninsula that we largely expect to succeed and go farther than the consensus expects. It is a long-term positive for the Korean peninsula’s economy. It is also a positive factor in the U.S.-China engagement based on China’s interest in ultimately avoiding war and removing U.S. troops from the peninsula. From an investment point of view, an end to a brief hiatus in U.S.-North Korean diplomacy is a very poor substitute for concrete signs of U.S.-China progress on the tech front or opening market access. There has been nothing substantial on these key issues since Trump hiked the tariff rate in May. As a result, it is perfectly possible for the G20 to be a “success” on North Korea but, like the Buenos Aires summit on December 1, for markets to sell the news (Chart 7). Chart 7The Last Trade Truce Didn't Stop The Selloff Chart 8China Needs A Final Deal To Solve This Problem Bottom Line: North Korea is not a basis in itself for tariff rollback, but only as part of a much more extensive U.S.-China agreement. And a final agreement is needed to improve China’s key trade indicators on a lasting basis, such as new export orders and manufacturing employment, which are suffering amid the trade war. We expect economic policy uncertainty to remain elevated given our pessimistic view of U.S.-China trade relations (Chart 8). What About Japan, The G20 Host? Japan faces underrated domestic political risk as Prime Minister Abe Shinzo approaches a critical period in his long premiership, after which he will almost certainly be rendered a “lame duck,” likely by the time of the 2020 Tokyo Olympics. The question is when will this process begin and what will the market impact be? If Abe loses his supermajority in the July House of Councillors election, then it could begin as early as next month. This is a real risk – because a two-thirds majority is always a tall order – but it is not extreme. Abe’s polling is historically remarkable (Chart 9). The Liberal Democratic Party and its coalition partner Komeito are also holding strong and remain miles away from competing parties (Chart 10). The economy is also holding up relatively well – real wages and incomes have improved under Abe’s watch (Chart 11). However, the recent global manufacturing slowdown and this year’s impending hike to the consumption tax in October from 8% to 10% are killing consumer confidence. Chart 10Japan's Ruling Coalition Is Strong The collapse in consumer confidence is a contrary indicator to the political opinion polling. The mixed picture suggests that after the election Abe could still backtrack on the tax hike, although it would require driving through surprise legislation. He can pull this off in light of global trade tensions and his main objective of passing a popular referendum to revise the constitution and remilitarize the country. Chart 11Japanese Wages Up, But Consumer Confidence Diving We would not be surprised if Japan secured a trade deal with the U.S. prior to China. Because Abe and the United States need to enhance their alliance, we continue to downplay the risk of a U.S.-Japan trade war. Bloomberg recently reported that President Trump was threatening to downgrade the U.S.-Japan alliance, with a particular grievance over the ever-controversial issue of the relocation of troops on Okinawa. We view this as a transparent Trumpian negotiating tactic that has no applicability – indeed, American military and diplomatic officials quickly rejected the report. We do see a non-trivial risk that Trump’s rhetoric or actions will hurt Japanese equities at some point this year, either as Trump approaches his desired August deadline for a Japan trade deal or if negotiations drag on until closer to his decision about Section 232 tariffs on auto imports on November 14. But our base case is that there will be either no punitive measures or only a short time span before Abe succeeds in negotiating them away. We would not be surprised if the Japanese secured a deal prior to any China deal as a way for the Trump administration to try to pressure China and prove that it can get deals done. This can be done because it could be a thinly modified bilateral renegotiation of the Trans-Pacific Partnership, which had the U.S. and Japan at its center. Bottom Line: Given the combination of the upper house election, the tax hike and its possible consequences, a looming constitutional referendum which poses risks to Abe, and the ongoing external threat of trade war and China tensions, we continue to see risk-off sentiment driving Japanese and global investors to hold then yen. We maintain our long JPY/USD recommendation. The risk to this view is that Bank of Japan chief Haruhiko Kuroda follows other central banks and makes a surprisingly dovish move, but this is not warranted at the moment and is not the base case of our Foreign Exchange Strategy. GeoRisk Indicators Update: June 28, 2019 Our GeoRisk indicators are sending a highly complacent message given the above views on China and Iran. All of our risk measures, other than our German, Turkish, and Brazilian indicators, are signaling a decrease geopolitical tensions. Investors should nonetheless remain cautious: Our German indicator, which has proven to be a good measure of U.S.-EU trade tensions, has increased over the first half of June (Chart 12). We expect Germany to continue to be subject to risk because of Trump’s desire to pivot to European trade negotiations in the wake of any China deal. The auto tariff decision was pushed off until November. We assign a 45% subjective probability to auto tariffs on the EU if Trump seals a final China deal. The reason it is not our base case is because of a lack of congressional, corporate, or public support for a trade war with Europe as opposed to China or Mexico, which touch on larger issues of national interest (security, immigration). There is perhaps a 10% probability that Trump could impose car tariffs prior to securing a China deal. Chart 12U.S.-EU Trade Tensions Hit Germany Chart 13German Greens Overtaking Christian Democrats! Germany is also an outlier because it is experiencing an increase in domestic political uncertainty. Social Democrat leader Andrea Nahles’ resignation on June 2 opened the door to a leadership contest among the SPD’s membership. This will begin next week and conclude on October 26, or possibly in December. The result will have consequences for the survivability of Merkel’s Grand Coalition – in case the SPD drops out of it entirely. Both Merkel and her party have been losing support in recent months – for the first time in history the Greens have gained the leading position in the polls (Chart 13). If the coalition falls apart and Merkel cannot put another one together with the Greens and Free Democrats, she may be forced to resign ahead of her scheduled 2021 exit date. The implication of the events with Trump and Merkel is that Germany faces higher political risk this year, particularly in Q4 if tariff threats and coalition strains coincide. Meanwhile, Brazilian pension reform has been delayed due to an inevitable breakdown in the ability to pass major legislation without providing adequate pork barrel spending. As for the rest of Europe, since European Central Bank President Mario Draghi’s dovish signal on June 18, all of our European risk indicators have dropped off. Markets rallied on the news of the ECB’s preparedness to launch another round of bond-buying monetary stimulus if needed, easing tensions in the region. Italian bond spreads plummeted, for instance. The Korean and Taiwanese GeoRisk indicators, our proxies for the U.S.-China trade war, are indicating a decrease in risk as the two sides moved to contain the spike in tensions in May. While Treasury Secretary Steve Mnuchin notes that the deal was 90% complete in May before the breakdown, there is little evidence yet that any of the sticking points have been removed over the past two weeks. These indicators can continue to improve on the back of any short-term trade truce at the G20. The Russian risk indicator has been hovering in the same range for the past two months. We expect this to break out on the back of increasing mutual threats between the U.S. and Russia. The U.S. has recently agreed to send an additional 1000 rotating troops to Poland, a move that Russia obviously deems aggressive. The Russian upper chamber has also unanimously supported President Putin’s decree to suspend the Intermediate Nuclear Forces treaty, in the wake of the U.S. decision to do so. This would open the door to developing and deploying 500-5500 km range land-based and ballistic missiles. According to the deputy foreign minister, any U.S. missile deployment in Europe will lead to a crisis on the level of the Cuban Missile Crisis. Russia has also sided with Iran in the latest U.S.-Iran tension escalation, denouncing U.S. plans to send an additional 1000 troops to the Middle East and claiming that the shot-down U.S. drone was indeed in Iranian airspace. We anticipate the Russian risk indicator to go up as we expect Russia to retaliate in some way to Poland and to take actions to encourage the U.S. to get entangled deeper into the Iranian imbroglio, which is ultimately a drain on the U.S. and a useful distraction that Russia can exploit. In Turkey, both domestic and foreign tensions are rising. First, the re-run of the Istanbul mayoral election delivered a big defeat for Turkey’s President Erdogan on his home turf. Opposition representative Ekrem Imamoglu defeated former Prime Minister Binali Yildirim for a second time this year on June 23 – increasing his margin of victory to 9.2% from 0.2% in March. This was a stinging rebuke to Erdogan and his entire political system. It also reinforces the fact that Erdogan’s Justice and Development Party (AKP) is not as popular as Erdogan himself, frequently falling short of the 50% line in the popular vote for elections not associated directly with Erdogan (Chart 14). This trend combined with his personal rebuke in the power base of Istanbul will leave him even more insecure and unpredictable. Second, the G20 summit is the last occasion for Erdogan and Trump to meet personally before the July 31 deadline on Erdogan’s planned purchase of S-400 missile defenses from Russia. Erdogan has a chance to delay the purchase as he contemplates cabinet and policy changes in the wake of this major domestic defeat. Yet if Erdogan does not back down or delay, the U.S. will remove Turkey from the F-35 Joint Strike Fighter program, and may also impose sanctions over this purchase and possibly also Iranian trade. The result will hit the lira and add to Turkey’s economic woes. Geopolitically, it will create a wedge within NATO that Russia could exploit, creating more opportunities for market-negative surprises in this area. Finally, we expect our U.K. risk indicator to perk up, as the odds of a no-deal Brexit are rising. Boris Johnson will likely assume Conservative Party leadership and the party is moving closer to attempting a no-deal exit. We assign a 21% probability to this kind of Brexit, up from our previous estimate of 14%. It is more likely that Johnson will get a deal similar to Theresa May’s deal passed or that he will be forced to extend negotiations beyond October. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com France: GeoRisk Indicator U.K.: GeoRisk Indicator Germany: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator Russia: GeoRisk Indicator Korea: GeoRisk Indicator Taiwan: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator What's On The Geopolitical Radar? Section III: Geopolitical Calendar
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Highlights So What? Geopolitical risks are not about to ease. Why? Fiscal policy becomes less accommodative next year unless politicians act. Financial conditions give President Trump room to expand his tariff onslaught. Our Iran view is confirmed by rapid escalation of tensions – war risk is high. The odds of a no-deal Brexit have risen. Feature The AUD-JPY cross and copper-to-gold ratio – two market indicators that flag global growth and risk-on sentiment – are hovering over critical points at which a further breakdown would catalyze a renewed flight to quality (Chart 1). Chart 1Risk-On Indicators Breaking Down? Global sentiment remains depressed amid a rash of negative economic surprises and bonds continue to rally despite a more dovish outlook from the Fed (Chart 2). Chart 2Global Sentiment Remains Depressed The cavalry is on the way: European Central Bank President Mario Draghi oversaw a dramatic easing of monetary policy on June 18, driving the Italian-German sovereign bond spread down to levels not seen since before the populist election outcome of March 2018 (Chart 2, bottom panel). The Federal Reserve adjusted its policy rate projections to countenance an interest rate cut in the not-too-distant future. More needs to be done, however, to sustain the optimism that has propelled the S&P 500 and global equities upward since the volatility catalyzed by President Donald Trump’s announcement of a tariff rate hike on May 6. Political and geopolitical risks are higher, not lower, since that time as market-negative scenarios are playing out with U.S. policy, Iran, and Brexit, while we take a dim view of the end-game of the U.S.-China negotiations despite recent improvements. Fiscal And Trade Uncertainties This year’s growth wobbles have occurred in the context of expansive fiscal policy in the developed markets. Next year, however, the fiscal thrust (the change in the cyclically adjusted budget balance) is projected to decline in the U.S. and Japan and nearly to do so in Europe (Chart 3). We expect President Trump and the House Democrats to raise spending caps (or at least keep spending at current levels) and thus prevent the budget deficit from contracting in FY2020 – this is their only substantial point of agreement. But this at best neutralizes what would otherwise be a negative fiscal backdrop. Meanwhile it is not at all clear that Brussels will relax its scrutiny of member states seeking to cut taxes and boost spending, such as Italy. Japanese Prime Minister Abe Shinzo would need to arrange for the Diet to pass a new law to avoid the consumption tax hike from 8% to 10% on October 1. He can pull this off, especially if the U.S. trade war escalates – or if he decides to turn next month’s upper house election into a general election and needs to boost his popularity. But as things currently stand in law, the world’s third biggest economy will face a deep fiscal pullback next year (Chart 3, bottom panel). In short, DM fiscal policy will not really become contractionary in 2020, but this is a view and not yet a reality (Chart 4). Chart 3Fiscal Pullback Likely Next Year Chart 4Only The U.S. Is Profligate Meanwhile China’s stimulus is still in question – in fact it remains the major macro question this year. The efficacy of China’s stimulus is declining ... An escalating trade war will bring greater stimulus but also greater transmission problems. Since February we have argued that the Xi administration has shifted to sweeping fiscal-and-credit stimulus in the face of the unprecedented external threat posed by the Trump administration (Charts 5A and 5B). We expect China’s credit growth to continue its upturn in June and in H2. Ultimately, we think the whole package will be comparable to 2015-16 – and anything even close to that will prolong the global economic expansion. We do not see a massive 2008-style stimulus occurring unless relations with the U.S. completely collapse and a global recession occurs. Chart 5AStimulus Amid The Trade War The catch – as we have shown – is that the efficacy of China’s stimulus is declining over time because of over-indebtedness and bearish sentiment in China’s private sector. These tepid animal spirits stem from epochal changes: Xi’s reassertion of communism and America’s withdrawal of strategic support for China’s rise. An escalating trade war will bring greater stimulus but also greater transmission problems. The magnitude of the tariffs that President Trump is threatening to impose on China, Mexico, the EU, and Japan is mind-boggling. We illustrate this with a simple simulation of duties collected as a share of total imports under different scenarios (Chart 6). China and Mexico are fundamentally different from the EU and Japan and hence the threat of tariffs will continue to weigh on markets for Trump’s time in office – China because of a national security consensus and Mexico because of the Trump administration’s existential emphasis on curbing illegal immigration. But we still put the risk of auto tariffs (or other punitive measures) on Europe at 45% if Trump seals a China deal. The odds are lower for Japan but it is still at risk. Global supply chains are shifting – a new source of costs and uncertainty for companies – as a slew of recent news has highlighted. Already 40% of companies surveyed by the American Chamber of Commerce in China say they are relocating to Southeast Asia, Mexico, and elsewhere (Chart 7). If the G20 is a flop – or results in nothing more than a pause in tariffs for another three-month dialogue – relocations will gain steam, forcing companies’ bottom lines to take a hit. Even in the best case, in which the Trump-Xi summit produces a joint statement outlining a “deal in principle” accompanied by a rollback of the May 10 tariff hike, uncertainty will persist due to President Trump’s unpredictability, China’s incentive to wait until after the U.S. election, and Trump’s incentive to corner the “China hawk” platform prior to the election. We maintain that, by November 2020, there is a roughly 70% chance of further escalation. At least the U.S.-China conflict is nominally improving. The same cannot be said for other geopolitical risks discussed below: the U.S. and Iran are flirting with war; the U.S. presidential election is injecting a steady trickle of market-negative news; the chances of a no-deal Brexit are rising; and Trump may turn on Europe at a moment when it lacks leadership. This list assumes that Russia takes advantage of American distraction by improving domestic policy rather than launching into a new foreign adventure – say in Ukraine or Kaliningrad. If there is any doubt as to whether political risk can outweigh more accommodative monetary policy, remember that President Trump actually can remove Chairman Jerome Powell. Legally he is only allowed to do so “for cause” as opposed to “at will.” But the meaning of this term is a debate that would go to the Supreme Court in the event of a controversial decision. Meanwhile the stock market would dive. Now, this is precisely why Trump will not try. But the implication, as with Congress and the border wall, is that Trump is constrained on domestic policy and hence tariffs are his most effective tool to try to achieve policy victories. With an ebullient stock market and a Fed that is adjusting its position, Trump can try to kill two birds with one stone: wring concessions from trade partners while forcing the FOMC to keep responding to rising external risks. Bottom Line: Central banks are riding to the rescue, but there is only so much they can do if global leaders are tightening budgets and imposing barriers on immigration and trade. We remain tactically cautious. Oh Man, Oh Man, Oman Iran has swiftly responded to the Trump administration’s imposition of “maximum pressure” on oil exports. The shooting down of an American drone that Tehran claims violated its airspace on June 20 is the latest in a spate of incidents, including a Houthi first-ever cruise missile attack on Abha airport in Saudi Arabia. Two separate attacks on tankers near the Strait of Hormuz (Map 1) demonstrate that Iran is threatening to play its most devastating card in the renewed conflict with the U.S. Hormuz ushers through a substantial share of global oil demand and liquefied natural gas demand (Chart 8). The amount of spare pipeline capacity that the Gulf Arab states could activate in the event of a disruption is merely 3.9 million barrels per day, or 6 million if questionable pipelines like the outdated Iraqi pipeline in Saudi Arabia prove functional (Table 1). Table 1No Sufficient Alternatives To Hormuz A conflict with Iran could cause the biggest oil shock of all time. Even if this spare capacity were immediately utilized, a conflict could cause the biggest oil shock of all time – considerably bigger than that of the Iranian Revolution (Chart 9). We have shown in the past that Iran has the military capability of interrupting the flow of traffic in Hormuz for anywhere from 10 days to four months. A preemptive strike by Iran would be most effective, whereas a preemptive American attack would include targets to reduce Iran’s ability to retaliate via Hormuz. The impact on oil prices ranges from significant to devastating. Needless to say, blocking the Strait of Hormuz would initiate a war so Iran is attempting to achieve diplomatic goals with the threats themselves – it will only block the strait as a last resort, say if it is convinced that the U.S. is about to attack anyway. As the experience of President Jimmy Carter shows, Americans may rally around the flag during a crisis but they will also kick a president out of office for higher prices and an economic slowdown. President Trump cannot be unaware of this precedent. The intention of his Iran policy is to negotiate a “better deal” than the 2015 one – a deal that includes Iran’s regional power projection and ballistic missile capabilities as well as its nuclear program. The problem is that Trump has already been forced to deploy a range of forces to the region, including additional troops (albeit so far symbolic at 2,500) (Chart 10). He is also sending Special Representative for Iran, Brian Hook, to the region to rally support among Gulf Cooperation Council. The week after Hook will court Britain, Germany, and France, three of the signatories of the 2015 deal. Trump ran on a campaign of eschewing gratuitous wars in the Middle East – a popular stance among war-weary Americans (Chart 11) – but there is a substantial risk that he could get entangled in the region. First, he is adopting a more aggressive foreign policy to attempt to compensate for the lack of payoff in public opinion from the strong economy. Second, Iran is not shrinking from the fight, which could draw him deeper into conflict. Third, there is always a high risk of miscalculation when nations engage in such brinkmanship. Chart 10Is The 'Pivot To Asia' About To Reverse? The Iranian response has been, first, to reject negotiations. When Trump sent a letter to Rouhani via Japanese Prime Minister Abe Shinzo, Abe was rebuffed – and one of the tankers attacked near Oman was a Japanese flagged vessel, the Kokuka Courageous. This is a posture, not a permanent position, as the Iranian release of an American prisoner demonstrates. But the posture can and will be maintained in the near term – with escalation as the result. Second, Iran is increasing its own leverage in any future negotiation by demonstrating that it can sow instability across the region and bring the global economy grinding to a halt. Iran cannot assume that Trump means what he says about avoiding war but must focus on the United States’ actions and capabilities. Cutting off all oil exports is a recipe for extreme stress within the Iranian regime – it is an existential threat. Therefore, the Iranians have signaled that the cost of a total cutoff will be a war that will cause a global oil price shock. The Iranian leaders are also announcing that they are edging closer to walking away from the 2015 nuclear pact (Table 2). If so, they could quickly approach “breakout” capacity in the uranium enrichment – meaning that they could enrich to 20% and then in short order enrich to 90% and amass enough of this fuel to make a nuclear device one year thereafter. The Trump administration has reportedly reiterated that this one-year limit is the U.S. government’s “red line,” just as the Obama administration had done. Table 2Iran Threatens To Walk Away From 2015 Nuclear Deal This Iranian threat is a direct reaction to Trump’s decision in May not to renew the oil sanction waivers. Previously the Iranians had sought to preserve the 2015 deal, along with the Europeans, in order to wait out Trump’s first term. These developments push us to the brink of war. Iran is retaliating with both military force and a nuclear restart. This comes very close to meeting our conditions for an American (and Israeli) retaliation that is military in nature. Diagram 1 is an update of our decision tree that we have published since last year when Trump reneged on the 2015 deal. The window to de-escalate is closing rapidly. The Appendix provides a checklist for air strikes and/or the closure of Hormuz. Diagram 1Iran-U.S. Tensions Decision Tree At very least we expect to see the U.S. attempt to create a large international fleet to assert freedom of navigation in the Persian Gulf and Strait of Hormuz. While Iran may lay low during a large show of force, it will later want to demonstrate that it has not been cowed. And it has the capacity to retaliate elsewhere, including in Iraq, an area we have highlighted as a major geopolitical risk to oil supply. The U.S. government has already reacted to recent threats there from Iranian proxies by pulling non-essential personnel. Iran has several incentives to test the limits of conflict if the U.S. insists on the oil embargo. First, tactically, it seeks to deter President Trump, take advantage of American war-weariness, drive a wedge between the U.S. and Europe, and force a relaxation of the sanctions. This would also demonstrate to the region that Iran has greater resolve than the United States of America. This goal has not been achieved by the recent spate of actions, so there is likely more conflict to come. Second, President Hassan Rouhani’s government is also likely to maintain a belligerent posture – at least in the near term – to compensate for its loss of face upon the American betrayal of the 2015 nuclear deal. Rouhani negotiated the deal against the warnings of hardline revolutionaries. The 2020 majlis elections make this an important political goal for his more reform-oriented faction. Negotiations with Trump can only occur if Rouhani has resoundingly demonstrated his superiority in the clash of wills. Structurally, Iran faces tremendous regime pressures in the coming years and decades because of its large youth population, struggling economy, and impending power transition from the 80 year-old Supreme Leader Ali Khamanei. A patriotic war against America and its allies – while not desirable – is a risk that Khamenei can take, as an air war is less likely to trigger regime change than it is to galvanize a new generation in support of the Islamic revolution. For oil markets the outcome is volatility in the near term – reflecting the contrary winds of trade war and global growth fears with rising supply risks. Because we expect more Chinese stimulus, both as the trade talks extend and especially if they collapse, we ultimately share BCA’s Commodity & Energy Strategy view that the path of least resistance for oil prices is higher on a cyclical horizon, as demand exceeds supply (Chart 12). We remain long EM energy producers relative to EM ex-China. Chart 12Crude Oil Supply-Demand Balance Should Send Prices Higher Bottom Line: The risk of military conflict has risen materially. This also drastically elevates the risk of a supply shock in oil prices that would kill global demand. The U.S. Election Adds To Geopolitical Risk The 2020 U.S. election poses another political risk for the rising equity market. The Democratic Party’s first debate will be held on June 26-27. The leftward shift in the party will be on full display, portending a possible 180-degree reversal in U.S. policy if the Democrats should win the election, with the prospect of a rollback of Trump’s tax cuts and deregulation of health, finance, and energy. The uncertainty and negative impact on animal spirits will be modest if current trends persist through the debates. Former Vice President Joe Biden remains the frontrunner despite having naturally lost the bump to his polling support after announcing his official candidacy (Chart 13). Biden is a known quantity and a centrist, especially compared to the farther left candidates ranked second and third in popular support– Vermont Senator Bernie Sanders and Massachusetts Senator Elizabeth Warren. Biden is not only beating Sanders in South Carolina, which underscores the fact that he is competitive in the South and hence has a broader path to the White House, but also in New Hampshire, where the Vermont native should be ahead (Chart 14). These states hold the early primaries and caucuses and if Biden maintains his large lead then he will start to appear inevitable very early in the primary campaign next year. Hence a poor showing in the debate on June 27 is a major risk to Biden – he should be expected to be eschew the limelight and play the long game. Elizabeth Warren, by contrast, has the most to gain as she appears on the first night and does not share a stage with the other heavy hitters. If she or other progressive candidates outperform then the market will be spooked. The market could begin to trade off the polls. All of these candidates are beating Trump in current head-to-head polling – Biden is even ahead in Texas (Chart 15). This means that any weakness from Biden does not necessarily offer the promise of a Trump victory and policy continuity. The Democrats also have a powerful demographic tailwind. The just-released projections from the U.S. Census Bureau reveal how Trump’s narrow margins of victory in the swing states in 2016 are in serious jeopardy in 2020 as a result of demographics if he does not improve his polling among the general public (Chart 16). We still give Trump the benefit of the doubt as the incumbent president amid an expanding economy, but it is essential to recognize that his popular approval rating is reminiscent of a president during recession – i.e. one who is about to lose the White House for his party (Chart 17). Even if there is not a recession, an increase in unemployment is likely to cost him the election – and even a further decrease in unemployment cannot guarantee victory (Chart 18). This is why we see Trump making a bid to become a foreign policy president and seek reelection on the basis that it is unwise to change leaders amid an international crisis. We still give Trump the benefit of the doubt ... but his popular approval rating is reminiscent of a president during recession. The race for the U.S. senate is extremely important for the policy setting from 2021. If Republicans maintain control, they will be able to block sweeping Democratic legislation – which is particularly relevant if a progressive candidate should win the White House. However, if Democrats can muster enough votes to remove a sitting president with a strong economy – including a strong economy in the key senate swing races (Chart 19) – then they will likely win over the senate as well. Chart 19Hard To Win The Senate In 2020 While Key States Prosper Bottom Line: The 2020 election poses a double risk to the bull market. First, the Democratic primary campaign threatens sharp policy discontinuity, especially if and when developments cause Biden to drop in the polls (dealing a blow to centrism or the political establishment). Second, Trump’s vulnerability makes him more likely to act aggressive on the international stage, whether on trade, immigration, or national security, reinforcing the risks outlined above with regard to China, Iran, Mexico, and even Europe. Rising Odds Of A No-Deal Brexit Former Mayor of London and former foreign secretary Boris Johnson looks increasingly likely to seal the Conservative Party leadership contest in the United Kingdom. It is not yet a done deal, but the shift within the party in favor of accepting a “no deal” exit is clear. None of the remaining candidates is willing to forgo that option. The newest development advances us along our decision tree in Diagram 2, altering the conditional probabilities for this year’s events. We expect the next prime minister to try to push a deal substantially similar to outgoing Prime Minister Theresa May before attempting any kamikaze run as the October 31 deadline approaches. The attempt to leverage the EU’s economic weakness will not produce a fundamental renegotiation of the exit deal, but some element of diplomatic accommodation is possible as the EU seeks to maintain overall stability and a smooth exit if that is what the U.K. is determined to accomplish. Diagram 2Brexit Decision Tree Hence the prospect of passing a deal substantially similar to outgoing Prime Minister Theresa May’s deal is about 30%, roughly equal to the chance of a delay (28%). These options are believable as the new leader will have precious little time between taking the reins and Brexit day. The EU can accept a delay because it ultimately has an interest in keeping the U.K. bound into the union. Public opinion polling is not conducive to the new prime minister seeking a new election unless the change of face creates a massive shift in support for the Conservatives, both by swallowing the Brexit Party and outpacing Labour. If the purpose is to deliver Brexit, then the risk of a repeat of the June 2017 snap election would seem excessive. Nevertheless, the Tories’ working majority in parliament is vanishingly small, at five MPs, so a shift in polling could change the thinking on this front. The pursuit of a no-deal exit would create a backlash in parliament that we reckon has a 21% chance of ending in a no-confidence motion and new election. Bottom Line: The odds of a crash Brexit have moved up from 14% to 21% as a result of the leadership contest. The threat that the U.K. will crash out of the EU is not merely a negotiating ploy, although it will be a last resort even for the new hard-Brexit prime minister. Public opinion is against a no-deal Brexit, as is the majority of parliament, but the risk to the U.K. and EU economies will loom large over global risk assets in the coming months. Investment Conclusions Political and geopolitical risks to the late-cycle expansion are rising, not falling. U.S. foreign policy remains the dominant risk but U.S. domestic policy pre-2020 is an aggravating factor. Easing financial conditions give President Trump more ammunition to use tariffs and sanctions. Meanwhile our view that this summer will feature “fire and fury” between the U.S. and Iran has been confirmed by the tanker attacks in Oman. Tensions will likely escalate from here. Ultimately, we believe Trump is more likely to back off from the Iran conflict than the China conflict. This is part of our long-term theme that the U.S. really is pivoting to China and geopolitical risk will rotate from the Middle East to East Asia. But as highlighted above, the risk of entanglement is very high due to Trump’s approach and Iran’s incentives to raise the stakes. Oil prices will not resume their upward drift until Chinese stimulus is reconfirmed – and even then they will continue to be volatile. We remain cautious and are maintaining our safe-haven tactical trades of long gold and long JPY/USD. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix
Highlights Currency markets continue to fight a tug of war between weak incoming data but easier financial conditions. Our thesis remains that the path of least resistance for the dollar is down, but the rising specter of global market volatility suggests it could catapult to new highs before ultimately reversing. Most of our pro-cyclical trades have been put offside in this environment of rising volatility. Maintain tight stops until more evidence emerges that global growth has bottomed. Large net short positioning in the Swiss franc and yen, together with cheap valuations, make them attractive from a contrarian standpoint. Hold on to CHF/NZD positions recommended on April 26. Feature Our thesis remains that global growth is in a volatile bottoming process. However, incoming data pretty much across the globe has been very weak, with the latest specter of a global trade war suggesting that economic softness could linger for longer than we originally anticipated. Given the shifting market dynamics, it is important to revisit our thesis on how to be positioned in currency markets. We do so this week via the lens of the Australian dollar, one of the market’s favorite short positions. Future reports will focus on additional global growth barometers, and when to time the shift towards a more pro-cyclical stance. Positive Divergences Chart I-1Global Growth Barometers Flashing Amber On the surface, most data points appear negative for the Aussie dollar. Typical reflation indicators such as commodity prices, emerging market currencies, and industrial share prices are breaking down after a nascent upturn earlier this year. One of our favorite indicators on whether or not easing liquidity conditions will lead to higher growth are the CRB Raw Industrials index-to-gold, copper-to-gold, and oil-to-gold ratios. It is disconcerting that these indicators have moved decidedly lower together with U.S. bond yields, another global growth barometer (Chart I-1). On a similar note, currencies in emerging Asia that sit closer to the epicenter of Chinese stimulus are breaking down. This suggests that so far, policy stimulus in China has not been sufficient to lift global growth, and/or the transmission mechanism towards higher growth is not working. Not surprisingly, the Australian dollar has been breaking down at a rapid pace, putting our long AUD/USD position offside. We will respect our stop-loss at 0.68 if breached, but a few indicators suggest the bearish view on the Australian dollar is very late: Chart I-2Australian Stocks Hitting New Highs Election Results: The recent general election outcome was a big surprise to the market, and has eased risks to both the country’s banks and housing market. The center-left Labour party, which moved further to the left in this electoral cycle, was defeated by a substantial margin. This has a few important implications. First, “negative gearing” – the practice of using investment properties that are generating losses to offset one’s income tax bill – will remain in place. This was a big overhang on the housing market, which likely exacerbated the downturn in Aussie house prices. Second, the capital gains tax exemption from selling properties will probably not be reduced from 50% to 25%, as previously pledged. Finally, the Liberal-National coalition government will maintain the policy of reimbursing investors for corporate taxes paid by the underlying company. This keeps the incentive for retirees to own high dividend-yielding equities such as those of Australian banks. Australian equities hit a new cyclical high following the election results. This suggests the return on capital for Aussie companies may have inched higher following the more pro-market leadership shift (Chart I-2). At low levels of interest rates, fiscal policy is much more potent than monetary policy. Interest Rates: The latest Reserve Bank Of Australia (RBA) minutes suggest that rate cuts are back on the agenda. But the question is, with the markets pricing in two rate cuts by the end of this year, does it still pay to be short the Aussie dollar on widening interest rate differentials? More importantly, fiscal policy is set to become decisively loose this year. The new government is slated to introduce income tax cuts as early as July. This is skewed towards lower-income households, meaning the fiscal multiplier may be larger than what the Australian economy is normally accustomed to. Meanwhile, infrastructure spending will remain high, which will be very stimulative for growth in the short term. At low levels of interest rates, fiscal policy is much more potent than monetary policy, and the RBA will be loath to cut rates more than is currently expected by the market, at a time when consumer indebtedness remains quite high, and policy rates are already close to rock-bottom levels. The key for the RBA will be the job market, which at the moment remains a pillar of support for the Aussie economy. Job growth is accelerating, and labor force participation is hitting fresh highs (Chart I-3). So long as these trends continue, the RBA can afford to remain on the sidelines for a while longer. Meanwhile, while Aussie rates continue to drift downward, it has not been particularly profitable to buy U.S. Treasurys on a hedged basis (Chart I-4). Chart I-3Australia Employment Remains Robust Chart I-4It is Expensive To Short The Aussie Housing Market: For more than two decades, the Australian dollar has tended to be mostly driven by external conditions, especially the commodity cycle. But for the first time in several years, domestic factors have joined in to exert powerful downward pressure on the currency. The Australian Prudential Regulation Authority (APRA) has been on a mission to surgically deflate the overvalued housing market, while engineering a soft landing in the economy. Initially, their macro-prudential measures worked like a charm, as owner-occupied housing activity remained resilient relative to “investment-style” housing. What has become apparent now is that the soft landing intended by the authorities has rapidly morphed into a housing crash (Chart I-5). This is negative for consumption, both via the wealth effect and as well as for the outlook for residential construction activity. Chart I-5Could Australian Housing Bottom Soon? The good news is that policy is supposed to become supportive for Aussie homebuyers at the margin, with the government slated to introduce new initiatives to help first-time homebuyers. Should labor market improvements continue, it will also help household income levels. Over the past few decades, house prices in Australia have generally staged V-shaped recoveries when at this level of contraction. Betting on at least some stabilization going forward seems reasonable. Commodity Prices: One bright spot for the Aussie dollar has been rising terms of trade. Admittedly, most measures of Chinese (and global) growth remain weak. However, there have been notable improvements in recent months that suggest economic velocity may be picking up: Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. Intuitively, these tend to lead overall industrial production. If these advance any further, they will begin to exceed GDP growth, indicating a renewed mini-cycle (Chart I-6). Production of electricity and steel, all inputs into the overall manufacturing value chain, are inflecting higher. In recent months, both steel and iron ore prices have been soaring. Many commentators have attributed these increases to supply bottlenecks and/or seasonal demand. However, it is evident from both the manufacturing data and the trend in prices that demand is also playing a role. Meanwhile, Beijing’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix (Chart I-7). Given that the reduction – if not the outright elimination – of pollution is a long-term strategic goal in China, this will be a multi-year tailwind. As the market becomes more liberalized and long-term contracts are revised to reflect higher spot prices, the Aussie dollar will get a boost. Chart I-6Some Green Shoots From China Chart I-7Australian LNG Will Buffet Terms Of Trade Valuation: In terms of currency performance, a lot of the bad news already appears priced in to the Australian dollar, which is down 15% from its 2018 peak, and 38% from its 2011 peak. Meanwhile, Australian dollar short positions appeared to have already hit a nadir. This suggests outright short AUD bets are at risk from either upside surprises in global growth or simply the forces of mean reversion (Chart I-8). One of our favorite metrics for the Australian dollar’s fair value is its real effective exchange rate relative to its terms of trade. On this basis, the Aussie dollar is cheap by about 10% (Chart I-9). Chart I-8Short AUD: ##br##A Consensus Trade Chart I-9AUD Is Attractive From A Terms Of Trade Perspective China Credit Cycle: We have discussed at length how a revival in the Chinese credit cycle will help global and Australian growth. On the real estate front, residential property sales remain soft, but evidence from tier-1 and even tier-2 cities is signaling that this may be behind us, given robust sales. Over the longer term, the ebb and flow of property sales have usually been in sync across city tiers. A revival in the property market will support construction activity and investment. Chart I-10How Long Will The Weakness In China Last? House prices have been rising to the tune of 10%-15% year-on-year, and may be sniffing an eventual pick-up in property volumes. Finally, Chinese retail sales including those of durable goods remain very weak. Car sales are deflating at the fastest pace in over two decades. But the latest VAT cut by the government is being passed through to consumers, with an increasing number of car manufacturers cutting retail prices. This should help retail sales (Chart I-10). Other Global Growth Barometers Investors looking for more clarity on the global growth picture from the April and May data prints remain in a quandary. And the preliminary European PMI numbers this morning offered no glimmers of hope. That said, the most volatile components of euro area growth tend to be investment and net exports. Should they both pick up on the back of stronger external demand, GDP could easily gravitate towards 1.5%-2%, pinning it well above potential. The German PMI is currently among the weakest in the euro zone. But forward-looking indicators suggest we may be on the cusp of a V-shaped bottom over the next month or so (Chart I-11). Chart I-11German Manufacturing Might Be At The Cusp Of A V-Shaped Recovery The broad message is that global growth is in the midst of volatile bottoming process. However, before evidence of this fully unfolds, markets are likely to be swayed by the ebbs and flows of higher-frequency data. We recommend maintaining a pro-cyclical bias at the margin, but having tight stop losses as well as positions in both the Swiss franc and yen as insurance. Housekeeping Our buy-limit order on the British pound was triggered at 1.30 on March 29th. As we argued at the time, the pound was sitting exactly where it was after the 2016 referendum results, but the odds of a hard Brexit had significantly fallen. Since then, policy-induced volatility has led to a significant depreciation in the pound, with our position at risk of being stopped out at our 1.25 stop-loss this week. Given the rising specter of political volatility, we will respect our stop-loss if breached at 1.25. On the domestic front, economic surprises in the U.K. relative to both the U.S. and euro area continue to soar. The reality is that the pound and U.K. gilt yields should be much higher – solely on the basis of hard incoming data. Employment growth has been holding up very well, wages are inflecting higher, and the average U.K. consumer appears in decent shape (Chart I-12). The CPI data this week confirm that the domestic environment is hardly deflationary. That said, given the rising specter of political volatility, we will respect our stop-loss if breached at 1.25. Chart I-12Hold GBP/USD, But Stand Aside At 1.25 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 soft: The Michigan consumer sentiment index jumped to 102.4 in May. However, the Chicago Fed national activity index fell to -0.45 in April. The Redbook index increased by 5.4% year-on-year in May. Existing home sales contracted by 0.4% month-on-month to 5.2 million in April. Moreover, new home sales fell by 6.9% month-on-month in April. The Markit composite index fell to 50.9 in April. The manufacturing and services PMI fell to 50.6 and 50.9 respectively. Importantly, this a just a nudge above the 50 boom/bust level. DXY index initially increased by 0.3%, then plunged on the weak PMI data, returning flat this week. The FOMC minutes released on Wednesday reiterated that the recent drop in core inflation is mostly transitory, and that no strong evidence exists for a rate change in either direction. With the forward market already pricing an 82% probability of a rate cut this year, any hawkish shift by the Fed will be a surprise. However, this will not necessarily be bullish for the dollar, if accompanied by a global growth bottom. We remain of the view that the path of least resistance for the dollar is down. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mixed: Headline consumer price inflation was unchanged at 1.7% year-on-year in April, while core inflation increased to 1.3%. The current account balance narrowed to a surplus of 24.7 billion euros in March. However, this was above expectations. German GDP was unchanged at 0.6% year-on-year in Q1. The euro area Markit composite PMI was flat at 51.6 compared to the last reading of 51.5. Below the surface, both the manufacturing and services PMIs fell to 47.7 and 52.5, respectively. German composite PMI was held up at 52.4 by the services component that came in at 55. However, the manufacturing component fell to 44.3. German IFO current assessment dropped to 100.6 in May, and the business climate dropped to 97.9. In France, the Markit composite PMI came in at 51.3. The manufacturing and services PMIs both increased, to 50.6 and 51.7 respectively. This was the one bright spot in euro area data. EUR/USD has been flat this week, with recent data being on the softer side. The PMI data remain subdued, in particular. Meanwhile, political uncertainties continue to weigh on investors’ sentiment. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: Q1 annualized GDP grew by 2.1% quarter-on-quarter, well above estimates. Industrial production fell by 4.3% year-on-year in March, but was higher than the previous reading of -4.6% in February. Capacity utilization fell by 0.4% month-on-month in March. Exports contracted by 2.4% year-on-year in April, while imports increased by 6.4% year-on-year. The total trade balance thus narrowed from ¥528 billion to ¥64 billion. Notably, the exports to China fell by 6.3%, while exports to the U.S. increased by 9.6%. Machinery orders fell by 0.7% year-on-year in March. Nikkei manufacturing PMI fell below 50, coming in at 49.6 in May. USD/JPY fell by 0.5% this week. Yutaka Harada, a dovish member of the BoJ, warned during a news conference that by hiking the consumption tax rate at this critical juncture, Japan could risk sliding into a recession. With core CPI far from its 2% target, more monetary easing is probably exactly what the doctor ordered. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been firm: The Rightmove house price index increased by 0.1% year-on-year in May. The orders component of the CBI industrial trends survey decreased to -10 in May. Retail sales increased by 3% year-on-year in April. Producer prices and input prices increased by 2.1% and 3.8%, year-on-year respectively in April. Headline inflation and core inflation increased by 2.1% and 1.8% year-on-year in April, both below expectations. GBP/USD decreased by 0.6% this week. Teresa May offered MPs a vote on a second referendum on Brexit, which considers a tighter customs union with the EU. The ongoing Brexit chaos has increased volatility in the pound. Report Links: Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly negative: ANZ Roy Morgan weekly consumer confidence index increased to 117.2 this week. Westpac leading index fell by 0.1% month-on-month in April. Completed construction work fell by 1.9% in Q1. AUD/USD fell by 0.3% this week. During this week’s federal election, the coalition government led by Prime Minister Scott Morrison won. Besides the political development, the RBA governor Philip Lowe gave a speech on Monday, highlighting external shocks to Australian economy. He also expressed the positive outlook for Australian economy in the second half of 2019 and 2020, supported by the ongoing capex in infrastructure and resources sectors, together with strong population growth. More importantly, he mentioned that the RBA would consider the case for lower interest rates, which is a dovish shift from previous speeches. We are long AUD/USD with a tight stop at 0.68. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Credit card spending growth missed expectations, coming in at 4.5% year-on-year in April. Retail sales increased by 0.7% quarter-on-quarter in Q1. Retail sales excluding autos increased by 0.7% quarter-on-quarter in Q1. NZD/USD fell by 0.3% this week. NZD/USD is currently trading at a 7-month low around 0.65. A bleak external picture is worrisome for the kiwi. We continue to favor the AUD/NZD cross, from a strategic standpoint. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been solid: Retail sales increased by 1.1% month-on-month in March. In particular, retail sales excluding autos increased by 1.7% month-on-month, well above estimates. USD/CAD appreciated by 0.3% this week. The better-than-expected retail sales data in March sparked a small rally in the loonie. However, the rally proved to be short-lived following softer oil prices. Positive data surprises in Canada will have to be sustained for the loonie to find some measure of support. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in the Switzerland have been positive: Money supply (M3) growth was unchanged at 3.5% year-on-year in April. Industrial production increased by 4.3% year-on-year in Q1, albeit lower than the last reading of 5.1%. USD/CHF fell by 0.8% this week. As we argued in last week’s research note, the increasing global market volatility has reignited interest in the Swiss franc. We continue to recommend the franc as an insurance policy amid rising geopolitical risk. 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 There was little data out of Norway this week: The unemployment rate came in at 3.5% in March, well below consensus of 3.7% and the previous reading of 3.8%. USD/NOK fell by 0.4% this week. Rising geopolitical risks will be supportive of the oil market and put a floor under the krone. Aside from the U.S.-Iran tensions, the world faces the prospect of the loss of Venezuelan production, and significant outages in Libya, which are all bullish. Meanwhile, Norway remains one of few G10 countries that can hike interest rates in the near term. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Capacity utilization increased by 0.5% in Q1. Moreover, the unemployment rate fell to 6.2% in April. This was well below expectations of 6.8% and the previous month’s reading of 7.1%. USD/SEK fell by 0.3% this week. While we favor both the NOK and SEK against the U.S. dollar, near-term factors are more bullish for the krone. Our long NOK/SEK position is currently 4.38% in the money. Stick with it. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades
Highlights So What? Markets remain complacent about U.S.-China trade. Why? The U.S. has escalated the trade war by threatening sanctions on key Chinese tech firms. Chinese President Xi Jinping is preparing his domestic audience for protracted struggle. U.S. domestic politics do not prohibit, and likely encourage, a tough stance on China. Farmers are not a constraint on Trump — economic growth is. Go long spot gold and JPY-USD. Feature Markets remain complacent. Chart 1 suggests that while the combination of unilateral trade tariffs and spiking U.S. 10-year Treasury yields was enough to sink the S&P 500 in 2018, the former alone cannot do so today. Chart 1Tariffs Alone Not Enough To Sink Equities? Wrong. Specifically, the increase in the Section 301 tariff rate from 10% to 25% on $200 billion worth of Chinese imports and the threat of a new 25% tariff on the remaining $300 billion worth of Chinese imports in just a month’s time has only led to a 3% pullback in equities since May 3. That was the last trading day prior to President Donald Trump’s infamous tweet about hiking the tariff. Unlike the trade war escalation in October through November of last year, the Federal Reserve is no longer hiking rates, China’s economic indicators have bottomed, and U.S. equity investors have now fully imbibed the “Art of the Deal.” The consensus holds that the escalation of trade tensions with China is contained within the context of Trump’s well-known routine of inflicting pain and then compromising. We would wager that the bond market is right and equities are wrong. Equities will converge to the downside, unless the market receives a concrete positive catalyst that improves the near-term outlook for U.S.-China relations and hence global trade. The problem is that for equities such a catalyst could happen at any time in the form of additional Chinese stimulus. Therefore, higher volatility is the only guaranteed outcome. The sudden onslaught of U.S. pressure makes it harder for Chinese President Xi Jinping to offer structural concessions to his American counterpart without looking weak. It was easier to do so when the threat of tariffs was under wraps, as was the case between December 1 and May 5. This new obstacle informed our decision to close out our long China equities and long copper trades and downgrade our end-June trade deal probability from 50% to 40%. But the escalation of tensions makes stimulus more likely to surprise to the upside, which will at least partially offset the negative hit to global sentiment and the trade outlook. Waiting For A Positive Political Intervention Three negative geopolitical catalysts loom in plain sight, while investors are still waiting on a positive catalyst. The negatives: China has not yet announced retaliation to the U.S. Commerce Department’s blacklisting of Huawei and a handful of other Chinese tech firms; the U.S. could implement the blacklist within three months, increasing the risk of a broader “tech blockade” against China; and the U.S. authorities are prepared to extend tariffs to all Chinese goods in one month. Meanwhile there are no high-level talks currently scheduled between the principal Chinese and American negotiators as we go to press. This could change quickly. But if negotiating teams do not hold substantive meetings with positive reports afterwards, then investors cannot be sure that Presidents Donald Trump and Xi Jinping will speak to each other, let alone finalize a substantive trade deal, at the G20 in Japan on June 28-29. The macro backdrop is hardly encouraging: global export volumes are contracting and the dollar’s fall may be arrested amid a huge spike in global policy uncertainty. Any rebound in the greenback will pile additional pressure onto trade flows, at least until the market sees a substantial increase in Chinese stimulus (Chart 2). Furthermore, it is concerning that President Trump, a businessman president and champion of American manufacturing, is raising tariffs at a time when lending and factory activity are already slowing in the politically vital Midwestern states (Chart 3). The implication is that he is unfazed by economic risks and therefore less predictable. He is pursuing long-term national foreign policy objectives at the expense of everything else. This may be patriotic but it will be painful for global equity investors. Chart 2Trump Unfazed By Deteriorating Global Economy Chart 3Economic Activity Is Already Slowing Chart 4Markets Blasé About Looming Risks It is not only the S&P 500 that is failing to register the dangerous combination of weak global trade and escalating U.S.-China strategic conflict. Our colleague Anastasios Avgeriou of the BCA U.S. Equity Strategy points out that the “Ted spread,” the premium charged on interbank lending over the risk-free rate, is as docile as the safe-haven Japanese yen (Chart 4). President Xi Jinping, however, is not so blasé. He took a trip to Jiangxi province on May 20 to declare that China is embarking on a “new Long March.” This is a reference to the legendary strategic withdrawal executed by the early Chinese Communist Party in its civil war against the nationalists in 1934-35. It was an 8,000-mile slog across the rugged terrain of western and central China, peppered with battles against warlords and nationalists, in which nearly nine-tenths of the communist troops never made it. It is a historical event of immense propagandistic power used to celebrate the CPC’s resilience and ultimate triumph over corrupt and capitalist forces backed by imperialist Western powers. Most importantly, the Long March culminated in Mao Zedong’s consolidation of power over the party and ultimately the nation. In short, President Xi just told President Trump to “bring it on,” as he apparently believes that a conflict with the U.S. will strengthen his rule. The S&P 500 and the “Ted spread” are failing to register the dangerous combination of weak global trade and escalating U.S.-China strategic conflict. Trump, meanwhile, operates on a much shorter time horizon. He is coming closer to impeachment, as House Speaker Nancy Pelosi sharpens her rhetoric and negotiations over a bipartisan infrastructure bill collapse. Impeachment will fail and in the process will most likely help Trump’s reelection chances. But gridlock at home means that one of our top five “Black Swan” risks for 2019 is now being activated: Trump is at risk of becoming a lame duck and is therefore looking for conflicts abroad as a way of stirring up support at home. Bottom Line: The bad news in the trade war is all-too-apparent while good news is elusive. Yet key “risk off” indicators have hardly responded. We recommend going long JPY-USD on a cyclical basis on the expectation that the market will continue to have indigestion until a positive catalyst emerges in the trade talks. Trump’s Trade War Calculus The trade war is focused on China more so than other states – and Trump likely has the public backing for such a conflict. President Trump delayed any Section 232 tariffs on auto and auto parts imports this month as the China trade war escalated (Chart 5). This confirms our reasoning that the nearly 50/50 risk of tariffs on car imports from Europe and Japan (recently upgraded from 35%) is contingent on first wrapping up a China deal. Another signal that Trump is conscientious not to saddle the equity market with too many trade wars is the decision finally to exempt Canada and Mexico from Section 232 aluminum and steel tariffs (Chart 6). It is now possible for Canada to ratify the deal before parliament dissolves in late June and for the U.S. and Mexico to follow. American ratification will involve twists and turns as the Democrats raise challenges but their obstructionism is ultimately fruitless as it will not hurt Trump’s approval ratings and labor unions largely support the new deal. Meanwhile a major hurdle relating to Mexican labor standards has already been met. These are positive developments for these markets and yet they call attention to a critical point about the Trump administration’s trade strategy: Trump has not shown much willingness to compromise his trade demands with allies in order to secure their cooperation in pressuring China. The threat of car tariffs is still looming over Europe (and even Japan and South Korea). In fact, a united front among these players would have made it much harder for China to resist structural changes (Chart 7). Chart 6Canada And Mexico Are Off The Hook Chart 7A 'Coalition Of The Willing' Would Be More Effective Nevertheless, we have long held that China, not NAFTA or Europe, would be the focus of Trump’s ire because there is much greater consensus within the U.S. political establishment on the need for a more muscular approach to China grievances, and hence fewer constraints on Trump. This view has now come full circle, at least for the time being. Bear in mind that while Republicans and even Democrats have a favorable view of international trade, in keeping with an improving economy (Chart 8), the U.S. as a whole is more skeptical of free trade than most other countries (Chart 9). The economy is insulated and globalization has operated unchecked for several decades, generating resentment. This is especially relevant with China. Americans have an unfavorable view of China’s trade practices and China in general (Charts 10 and 11). This perception is getting worse as the great power competition heats up. Even a majority or near-majority of Democrats view China’s cyber-attacks, ownership of U.S. debt, environmental policies, and economic competition as causes of real concern (Chart 12). This means Trump is closer to the median voter when he is tough on China. The result is a lower chance of a “weak deal,” i.e. a short-term deal to reduce the trade deficit primarily through Chinese purchases of commodities, since this will be a political liability for Trump. He may be forced into such a deal if the market revolts (say 35% odds). But otherwise he will hold out for something better, which Xi Jinping may be unwilling to give. China, not NAFTA or Europe, is the focus of Trump’s ire. This is why we rank “no deal” at 50%, more likely than any kind of deal (40%), though there is some chance of an extension of talks beyond the June G20 (10%). Bottom Line: The delay of auto tariffs and progress in replacing NAFTA suggest that the Trump administration is cognizant of the negative market impact of its trade wars and the need to focus on China. However, the risks to Europe and Japan are not yet removed. And any Chinese concessions will be weaker than might otherwise have been possible had Trump created a “coalition of the willing” to prosecute China’s violations of global trading norms. A weak deal makes it more likely that strategic conflict is the result. Trump Beats Bernie Beats Biden? Or Vice Versa? U.S. domestic politics are also pushing Trump in the direction of conflict with China. The American voter’s distrust of China explains why former Vice President Joe Biden, and leading contender for the Democratic Party nomination in 2020, recently caught flak from both sides of the aisle for being soft on China. At a campaign stop in Iowa on May 1, Biden said, “China is going to eat our lunch? Come on, man … They’re not competition for us.” He has made similarly dovish comments in the recent past. It makes sense, then, that Trump is trying to link “Sleepy Joe” (as he calls Biden) with weakness on China and trade. Biden, who is still enjoying a very sizable bump to his polling a month after formally announcing his candidacy (Chart 13), is a direct threat to Trump’s electoral strategy of maximizing white blue-collar turnout and support, particularly in the Midwestern swing states. Biden was on the ticket when President Barack Obama won these states in 2008 and 2012. He is a native son of Pennsylvania. And he appeals to the same voters as a plain-talking everyman. Both Biden and Democratic Socialist Bernie Sanders of Vermont are beating Trump in the very early head-to-head polling for the 2020 presidential race. In fact, Sanders has a bigger lead over Trump than Biden in many of these polls (Chart 14). Yet Sanders has a narrower path to victory in the general election – he is heavily dependent on the Rustbelt, where he could either win based on repeating the 2016 results in a new demographic context (the “Status Quo” scenario in Chart 15), or by winning back the blue-collar voters who abandoned the Democrats for Trump in 2016 (the “Blue Collar Democrats” scenario). Sanders performed well in these states in the Democratic primary in 2016, whereas he struggled in the South. Chart 16Democrats Swung Too Far Left For Many Independents Biden, on the other hand, is capable of winning not only in these two scenarios, but also by rebuilding the Obama coalition. He has a better bid to win over the black community due to his close association with Obama and his command of Democratic Party machinery, plus potentially his choice of running mate (the “Obama vs. Trump” scenario). By this means Biden, unlike Sanders, can compete against Trump in the Sun Belt and South in addition to the Midwest. Therefore, it is all the more imperative for Trump to try to corner Biden and frame the debate about Biden early. Trump may also be betting that despite the head-to-head polling, Sanders is too far left for the median voter. While the Democratic Party swings sharply to the left, the median voter remains more centrist, judging by the fact that independent voters (who make up half the electorate now) only slightly favor Democrats over Republicans, a trend that is only slightly rising (Chart 16). Biden’s polling is strong enough that he holds out the prospect of winning the Democratic nomination relatively smoothly, without deepening the ideological split in the party too much. Whereas Trump would benefit in the general election if Democrats suffered an internal split over a bloody primary season in which Bernie Sanders clawed his way to the nomination. The hit to American farmers is probably not a significant political constraint on President Trump waging his trade war. The upshot is that Trump is vulnerable in U.S. politics and will attempt to take action to strengthen his position. Meanwhile if Biden’s position on trade changes then we will know that he reads the Midwestern voter the same way Trump does – as a protectionist. Bottom Line: Trump’s eagerness to attack Biden reveals the specific threat that Biden poses to Trump’s electoral strategy as well as Trump’s calculus that a belligerent position on China is a vote-getter in the key Midwestern swing states. We expect Biden to become more hawkish on China, which will emphasize the long-term nature of the U.S.-China struggle and confirm the median voter’s appetite for hawkish policy. American Farmers Unlikely To Alter The 2020 Playing Field Yet can Trump’s political base withstand the trade war? And can he possibly win the swing states if the trade war is escalating and damaging pocketbooks? There are many stories about farmers in the Midwest and other purple states who are deeply alarmed at Trump’s trade policies, prompting questions about whether he could be unseated there. American farmers have been among the hardest hit in the trade war. China was a major market for U.S. agricultural exports prior to the conflict (Chart 17). Since then U.S. agriculture has struggled, as exports to China have declined by more than 50% y/y in 2018 (Chart 18). Agricultural commodity prices are down ~10% since a year ago, with soybeans – the poster child of the conflict – trading at 10 year lows. Net farm incomes – a broad measure of profits – were on a downward trend prior to the trade war (Chart 19). While the USDA estimates that overall U.S. farm income will increase by 8.1% y/y this year, this follows a nearly 18% y/y decline in 2018 to reach the lowest level since 2002 (Chart 20). The recent escalation of the trade war will weigh on these incomes. A common narrative in the financial media is that this hit to American farmers is a significant political constraint on President Trump in waging his trade war. He could be forced to accept a watered-down deal with China to preserve this voting bloc’s support ahead of November 2020, the thinking goes. Possibly, but probably not because of farmers abandoning the Republican Party en masse. First of all, rural counties and small towns continued supporting the Republican Party in the 2018 midterms, at a time when the initial negative impact of the trade war was front-page news (Chart 21). Second, some of the key farm states are unlikely to be key swing states in the election. Take soybeans, for example. Prior to the trade war, nearly 60% of U.S. soybean exports, and more than a third of U.S. soybeans, ended up in China. Illinois is the top producer, followed by Iowa and Minnesota. Last year soybean production in these three states accounted for 15%, 13%, and 8% of total U.S. production, respectively. As such, agriculture and livestock products exports to China in 1Q2019 are down 76% y/y in Illinois and 97% y/y in Minnesota. However, Trump won Iowa by nearly 150 thousand votes, a 9.4% margin, and there are not enough farmers in the state to overturn that margin. The negative impact on soybeans could prevent Trump from picking up Minnesota, where he lost by only 1.5% of the vote. But Minnesota is unlikely to cost him the White House in 2020. The picture is different in the key swing states of Michigan, Pennsylvania, and Wisconsin. Farming accounts for only ~1% of jobs in Michigan, Ohio, and Pennsylvania – and 2.3% of jobs in Wisconsin – and thus farmers represent a small share of the voting bloc in these states (Chart 22). But Trump won Michigan by a mere 0.23% of the vote, Pennsylvania by 0.72%, and Wisconsin by 0.77%. If one-fifth of farmers in these states switched their vote, Trump’s 2016 margin of victory would vanish. Of course, manufacturers are a much larger voting bloc (Chart 23). And rural voters are unlikely to shift to the Democrats on such a large scale. Moreover, ag exports from these states have generally held up (Chart 24), the majority of their exports are destined for North America rather than China. The benefit from the recent thaw in North American trade relations will outweigh the loss of China as a market (Chart 25). The Trump administration is also producing an aid package worth at least $15 billion to shield farmers at least partially from the trade war impact.1 This compares to an estimated $12 billion loss in net farm income in 2018. Ultimately, Trump is much more threatened by other voting groups in these states. Young voters, women, minorities, suburbanites, and college-educated white voters all pose a threat to his thin margins if they turn out to vote and/or increase their support for the Democratic Party in 2020. A surge in Millennials, for instance, played the chief role in unseating Republican Governor Scott Walker in Wisconsin in 2018 (Chart 26). While midterm elections differ fundamentally from presidential elections, the Republicans lost 10 out of 12 significant elections in the Midwest during the midterms (Table 1). Table 1Republicans Lost Almost All Significant Midwest Elections In The Midterm It is true that the winning Democratic candidates in the six major statewide races in Michigan, Pennsylvania, and Wisconsin all had voters who believed Trump’s trade policies were more likely to “hurt” the local economy than help it, according to exit polls (Chart 27). At the same time, a majority of voters believed that the trade policies either “helped” the local economy or “had no impact,” as opposed to hurting it. And Democrats are somewhat divided on this issue. Health care, not the economy, was the primary concern of voters. Moreover, health care, not the economy, was the primary concern of voters, especially Democratic voters (Chart 28). Republicans cared more about the economy and tended to support Trump’s trade policies. In sum, unless the trade war causes a general economic slowdown that changes voter priorities, Trump’s chief threat in 2020 comes from urban and suburban voters angry over his attempt to dismantle the Affordable Care Act, rather than from farmers suffering from the trade war. The large bloc of manufacturing workers in the Midwestern battleground states helps to explain why Trump is willing to wage a trade war at such a critical time: loyal rural counties bear the brunt of the economic pain yet a tough-on-China policy could bring out swing voters from the manufacturing sector in suburbs and cities. Bottom Line: Trump could very well lose agriculture-heavy swing states in 2020, but it would not be because of losing his base among rural voters. Rather, it would be a result of a broader economic slowdown – or a superior showing of key demographic groups in favor of Democrats for other reasons like health care. The large bloc of manufacturing voters relative to Trump’s margins of victory helps to explain his aggressive posture on the trade war. Investment Conclusions Go long JPY-USD on a cyclical, 12-month horizon in the context of escalating trade war, complacent markets, and yet the prospect of additional Chinese stimulus improving global growth. This trade should be reinforced by the specific hurdles facing Japan over the next three to 18 months. While we would not be surprised if a trade agreement with the U.S. is concluded quickly, even ahead of any U.S.-China deal, nevertheless Japan faces upper house elections, a potential consumption tax hike, and preparations for a contentious constitutional revision and popular referendum on the cyclical horizon. On the expectation of greater Chinese stimulus, we are maintaining our long China Play Index call, which is up 2.2%. As a hedge against both geopolitical risk and the impact of Chinese stimulus over the cyclical horizon, go long spot gold. Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 While the plan is yet to be finalized, payments of ~$2/bushel to soybean farmers, $0.63/bushel to wheat farmers, and $0.04/bushel to corn farmers are under consideration. Unlike last year when the payments were distributed according to farmers’ current production, a potential modification to this year’s plan is that the payments will be distributed based on this years’ planted acreage and past yields.
Highlights So What? Odds of a total breakdown in U.S.-China relations are highly underrated. Why? The key market-relevant geopolitical event is Trump’s large risk appetite. Inflationary pressures resulting from the trade tariffs are not prohibitive for Trump’s trade war. Chinese stimulus will surprise to the upside, but a massive stimulus package will depend on talks collapsing and maximum tariffs. Markets will sell before they recover. We will maintain our current portfolio hedge of Swiss bonds and gold. Feature Chart 1Equities Sell, Safe Havens Rally Global equities have sold off and safe-haven assets caught a bid since the near-breakdown in U.S.-China trade negotiations on May 5 (Chart 1). Yet financial markets are still complacent, as the 2.8% drawdown to date on global equities and the S&P 500 does not yet reflect the depth of the geopolitical risk to sentiment and corporate earnings. To understand this risk we need to step away from the ups and downs of the trade negotiations and ask, What have we learned about U.S. policy over the past month and what does it mean for global markets on a cyclical and structural horizon? We have learned that in the lead-up to the 2020 election, President Trump is not seeking to protect his greatest asset – namely, a strong American economy – but rather to solidify his support through new ventures. By imposing the full brunt of sanctions on Iran and hiking the tariff rate on Chinese imports, Trump has made two highly significant decisions that could jeopardize the American voter’s pocketbook, with a full 18 months to go before November 3, 2020. Why has he done this? Because he believes the American economy can take the pain and he will achieve resounding foreign policy successes. These, he hopes, will make his reelection more likely. President Trump’s aggressive posture is a direct threat to the global equity bull market due to (1) higher odds of a negative shock to global trade when global growth is already weak, and (2) higher odds of an oil price shock due to a potential vicious spiral of Middle East conflict. Wreaking Havoc Historically, the United States thrives when the rest of the world is in chaos. This was obviously the case during World War I and II (Chart 2). But it also proved true in the chaotic aftermaths of the Soviet Union’s collapse and the global financial crisis, though the U.S. did suffer along with everyone else during the 2008-09 downturn. American equities have generally outperformed during periods of global chaos (Chart 3). Chart 2America Thrives Amid Global Chaos Chart 3U.S. Equities Outperform During Global Crises The reasons for U.S. immunity are well known: the U.S. has a large, insulated, consumer-driven economy; it has immense economic advantages enhanced by its dominance of North America; it has vast and liquid financial markets; and it is the world’s preponderant technological and military power. This position enables Washington to act more aggressively than other capitals in pursuit of the national interest – and to recover more quickly from mistakes. Chart 4U.S. Preponderance Declining It follows that there is an influential idea or myth that the country can or should exploit this advantage, when necessary or desirable, by “wreaking havoc” abroad. The prime example is the preemptive invasion of Iraq. In this way Washington can turn the tables on its opponents and keep them off balance. The Trump administration, regardless of Trump’s intentions, could soon become the epitome of this school of thought. First, it is true that, structurally, American preponderance has been decreasing: despite various crises, there has been sufficient peace and prosperity in the twenty-first century to see the rest of the world’s wealth, trade, and arms grow relative to the United States (Chart 4). With the rise of China and resurgence of Russia, U.S. global leadership is at risk and the Trump administration has adopted unorthodox policies to confront its rivals and try to reverse this process. Second, cyclically, President Trump is stymied at home after his Republican Party lost the House of Representatives in the 2018 midterm election. Scandals and investigations plague his inner circle. Unable to secure funding for his signature campaign promise – the southern border wall – Trump faces the risk of irrelevance. Foreign policy, especially trade policy, thus becomes the clearest avenue for him to try to notch up victories. Trump faces the risk of irrelevance. Foreign policy thus becomes the clearest avenue for him to try to notch up victories. Bottom Line: The key market-relevant event over the past month has been the Trump administration’s demonstration of voracious risk appetite. This is fundamentally a cyclical not tactical risk to the bull market due to tit-for-tat tariffs, sanctions, and provocations with rivals like China and Iran. Pocketbooks Versus Patriotism Trump’s vulnerability becomes clear by looking at our electoral Map 1, which highlights his excruciatingly thin margins of victory in the critical “swing states” in the 2016 election. We emphasize the margin of victory among white voters – which are slightly higher than the margins overall – because the Trump campaign courted the white working class specifically in a calculated strategy to swing the Midwest “Rustbelt” states and win the election. The problem for Trump is that while whites remain the majority of the eligible voting population, it is a declining majority due to demographic change. Demographics is not near-term destiny, but the vanishingly thin margins ensure that Trump cannot assume that he will win reelection without generating even more turnout and support among blue-collar whites in the key states. Job creation and rising incomes are the chief hope. The problem is that Trump’s tax cuts and the red-hot economy in 2018 did not prevent Republicans from getting hit hard in the midterm elections, especially in the Midwest. Moreover today’s resilient economy is not preventing the top two Democratic candidates, former Vice President Joe Biden and independent Vermont Senator Bernie Sanders, from beating Trump in head-to-head polling in the key swing states (Chart 5). Trump’s national approval rating, at about 44%, is nearly as good as it gets, but the indications from the Midwest are worrisome, especially because the economy has slowed. If the economy is not winning the argument on the campaign trail in 2020, Trump will need to have another leg to stand on. In addition to hammering home his attempts to build a wall on the border, Trump will highlight his economic nationalism. Protectionism has won the Rustbelt over the past three elections. As we have since 2016 argued, this now boils down to pressure on China. If Trump’s policies provoke China (or Iran) to take aggressive actions, he will have a pretext to exercise American power in a way that will likely create a rally-around-the-flag effect, at least in the short term. Elections do not normally hinge on foreign policy, but they certainly can. While President Trump may not actually want a war with Iran, he knows that George W. Bush cruised to victory amid the Afghan and Iraqi wars. Or he may have in mind 1964, when Lyndon B. Johnson crushed Barry Goldwater, an offbeat, ideological “movement candidate” (can anyone say Bernie Sanders?) in the face of a hulking communist menace, the Soviet Union. A conflict with China (or Iran) could serve similar purposes in 2020, either distracting the populace from a weakening economy or adding to an election bid centered on a reaccelerating economy. The problem is that a patriotic conflict with China or Iran is an insurance policy that threatens to undermine the health and safety of the very thing being insured: the U.S. economy. Indeed, U.S. stocks did not outperform after the September 11th attacks or during the Bush administration’s wars abroad. In essence, Trump is a gambler and is now going for broke. This constitutes a huge risk to the global economy and financial markets – a risk that was subdued just a month ago due to oil sanction waivers and tariff-free trade talks. Bottom Line: President Trump is courting international chaos because his policy priorities are tied down with gridlock and scandal at home. Aggressive foreign policy is a strategy to rack up policy victories and potentially expand his voter base, but it comes at the risk of higher policy uncertainty and negative economic impacts that could derail this year’s fledgling economic rebound and the long-running bull market. “No Deal” Is More Likely Than A Weak Deal It wasn’t just a tweet that sent volatility higher over the past two weeks. Most likely, President Trump decided to raise tariffs on China at the advice of his trade negotiators, who had become convinced that China was not offering deep enough concessions (“structural changes”) and was playing for time. This was always the greatest risk in the trade talks. China is indeed playing for time, as it has no security guarantee from the United States and therefore cannot embrace structural changes in the way that Japan did during the U.S.-Japanese trade war in the 1980s. Originally, the talks were set to last 90 days with the tariff hike by March 1. Trump was apparently determined not to lose credibility on this threat as China drew out the negotiations. Hence, he piled on the pressure to try to force a conclusion by the June 28-29 G20 summit in Japan, which has been the target date for our trade war probabilities over the past several months (Table 1). We have now adjusted those probabilities to upgrade the risk that talks collapse (50%) and downgrade the odds of a deal to 40% by that date. Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 The underlying calculation from the Trump administration is that a cosmetic, short-term deal – along the lines of the NAFTA renegotiation – will be difficult to defend on the campaign trail and hence politically risky. We upgraded the risk that talks collapse (50%) and downgraded the odds of a deal to 40% by end of June. If China agreed arbitrarily to increase imports from the U.S. by 10% by 2020, it would only increase the level of imports above the pre-trade war 2015-18 trend by $23 billion dollars in 2029 (Chart 6, panel 1). It would also have a minimal impact on the trade deficit. The deficit has increased so much in recent years that the impact of a 10% increase in exports by 2020 would merely offset the high point we reached during the trade war, leaving Trump with a mere $800 million per year by 2029 (Chart 6, panel 2). For commodities in particular – where China offered the largest purchases – the negative impact of the trade war has been so great that a 10% increase by 2020 over the status quo would fail to offset the recent damages over a ten-year period. China would have to increase imports by at least 17% to offset the trade war-induced decreases. If commodity imports were 30% higher in 2020 than otherwise, the impact 10 years down the line would amount to a mere $11 billion per year. These gains are smaller, as Chinese negotiators have long argued, than what could be made if the U.S. increased exports of advanced technology products to China. If the U.S. exported as many of these products to China as it does to the EU, as a share of EU GDP, it would amount to a $48 billion increase in exports. For Japan, the equivalent would be an $85 billion increase. Increasing the growth of these exports to China to match the recent trend of such exports globally would nearly double the amount sent to China by 2029, earning the U.S. an additional $60 billion that year (Chart 6, panel 3). The problem, of course, is that the confrontation with China is specifically focused on the latter’s technological acquisition and competition with the United States – it is precisely not about making reductions to the trade deficit at the expense of technological superiority. The tech war is more likely to derail the trade talks than the trade talks are likely to resolve the tech war. It is hugely significant that, at the moment of decision, President Trump sided with U.S. Trade Representative Robert Lighthizer and did not accept a deal focused on marginal improvements to the trade deficit. There was always a strong possibility – we previously put it at a 50% chance – that Trump would accept a short-term deal in order to get a “quick win” and minimize tariff pains ahead of the election, while punting the longer-term structural grievances until his second term when he would be less constrained by the economy. But this possibility has clearly fallen. We now put it at 35%, as shown in Table 1 above. Trump sees a shallow deal as a political liability. The most important takeaway from Table 1, however, is that the odds of a “Grand Compromise” have dropped to a mere 5%. Trump still may settle for a deal to reduce economic risks ahead of the election, but a grand compromise is very hard to get. Bottom Line: Our adjusted trade war probabilities suggest that global equities can fall further on a tactical horizon and that downside risks are grave, given a 50% chance that talks utterly collapse by the end of June. This would include a 30% chance of igniting an intense period of saber-rattling, sanctions, and Cold War-esque tensions that would cause a global flight to quality. Won’t The Trade War Turn Voters Against Trump? No. While geopolitical and political constraints push against a weak deal, the economic constraints of a failure to conclude a deal are not prohibitive. The latest tariff hike doubles the dollar magnitude of the tariffs, and an additional 25% tariff on the remaining $300 billion of imports would more than quadruple the magnitude of the tariffs from the April 2019 level (Chart 7). With all U.S. imports from China affected, price rises will percolate upward through all tradable industries and consumer goods. A few points are worth noting: The domestic value-add of Chinese exports to the U.S. is not as low as consensus holds. China’s manufacturing sector is highly competitive, comparable to the EU and Germany in the degree to which its exports to the U.S. incorporate foreign value (Chart 8). This means that Americans cannot substitute other goods for Chinese goods as easily as one might think. There remains a massive gulf between the nominal output of China’s manufacturing sector and the rest of Asia (Chart 9). Strategically it makes sense for the U.S. to want to decrease China’s share of American imports from Asia and reduce China’s centrality to the production process. But Asia cannot yet substitute for China. In practical terms this requires spreading China’s concentrated production system across the Indonesian archipelago. It is inefficient and will raise costs and import prices. Even in areas where China is lacking – such as technology, institutions, and governance – it still has a productivity advantage over the rest of Asia, pointing yet again to the cost-push inflationary consequences of an abrupt transition forced by tariffs (Chart 10). Chart 9Asia Cannot Replace China ... Yet Chart 10China's Productivity Beats Rest Of Asia Nevertheless, these cost factors are not so great as to force Trump into a weak deal. While the new and proposed tariff expansions will impact consumer goods more than the earlier batches that attempted to spare the consumer, the truth is that Chinese imports do not comprise a large share of the U.S. consumer basket (Chart 11). Chart 11American Shoppers Not Too Exposed To China Chart 12Goods Price Inflation Not An Immediate Risk Goods prices have been flat in the U.S., albeit in great part because of China, and they have fallen while the consumer price index and the real wage component of the CPI have risen by more than 20% since 2001 (Chart 12). Moreover, it is precisely in consumer goods where the American shopper does have considerable ability to substitute away from China – as opposed to the American corporation, which will have a harder time replacing Chinese-made capital goods quickly (Table 2). Thus, the risk impacts Wall Street differently than Main Street. Table 2Capital Goods Harder To Substitute Further, the median American household’s real income growth is still elevated (Chart 13). This comes on top of the fact that net household worth and the saving rate are both in good shape. President Trump has some leeway in waging his trade war. The risk, of course, is that this income growth is decelerating and Trump has given the tariffs 18 months to cause negative impacts for consumers prior to the election. He is also simultaneously wagering that the U.S.’s newfound energy independence – and his own ability to tap the strategic petroleum reserve – will prevent gasoline prices from spiking (Chart 14). This would occur as a result of any Iranian-backed attacks on oil production and export facilities across the Middle East. Chart 13American Household Still In Good Shape Chart 14Fuel Prices Already Rising Bottom Line: Inflationary pressures will result from trade tariffs (and Iranian sanctions) but they are not prohibitive for Trump thus far. This is not a recipe for cost-push inflation significant enough to trigger a recession or derail Trump’s reelection odds at present, but it is a risk that will need to be monitored. How Will China Respond? More Stimulus! The immediate ramification of a heightened trade war is deteriorating global trade and sentiment and hence slower global growth that pushes down prices. Indeed, the escalation of the trade war brings sharply into focus two long-running Geopolitical Strategy themes: Sino-American Conflict: U.S. and Chinese exports to each other have already sharply fallen off (Chart 15). Trade is interconnected so this will further depress global and Asia-ex-China exports. Chart 15Trade War Hurts Bilateral Trade ... And All Trade Chart 16Global Trade Already Rolling Over Apex of Globalization: Global trade as a whole is contracting as a result of the global slowdown, which the trade war has exacerbated (Chart 16). The negative impact on China is acute and threatens something akin to the global manufacturing recession of 2015 (Chart 17). Given that the trade war is now piling onto a merely fledgling rebound in Chinese and global growth this year, it is possible that the manufacturing slowdown could even get worse than 2015 and culminate in a global recession in our worst case scenario of a major strategic escalation. Preventing this outcome, China will increase fiscal-and-credit stimulus, which we have argued is likely to overshoot expectations this year due to trade war and the country’s desire to meet 2020 urban income goals (Chart 18). The magnitude should be comparable to the 2015-16 stimulus, unless a global recession is immediately in view, in which case it will be larger. Chart 17A Relapse Would Point Toward 2015-Sized Crisis It was the Xi administration that undertook the huge 2015-16 expansion of credit, so this magnitude is not out of the question. While Xi has attempted to contain leverage and reduce systemic financial risk, he is ultimately like his predecessors, most notably Jiang Zemin, in the sense that he will aim for social stability above all. Chart 18China Will Keep Stimulating The pain threshold of today’s policymakers has already been discovered, seeing how President Xi and the Politburo began easing policy in July 2018 after the U.S. implemented the initial Section 301 tariffs. The Chinese leaders were willing to tighten credit controls until this external risk materialized. The fact that the trade war is the proximate cause of heightened stimulus was confirmed in the wake of the Buenos Aires summit, where Xi chose to stimulate the economy further – resulting in a surge of credit in Q1 – as a way of improving China’s leverage vis-à-vis the United States in the 90-day talks. China will increase fiscal-and-credit stimulus … The magnitude should be comparable to the 2015-16 stimulus. In short, Xi and his government will stimulate first and ask questions later. Both fiscal and credit stimulus will be utilized, including traditional fiscal infrastructure spending and permissiveness toward shadow banking. A dramatic renminbi depreciation could occur but would be evidence that talks will fail (Chart 19). Chart 19Currency Agreement: Far From A Plaza Accord Stimulus will continue to be tactical, rolled out in piecemeal announcements, at least as long as the trade talks continue and there is a prospect of China’s economy rebounding without drastic measures. Only a total breakdown in negotiations – and collapse into outright Cold War – will prompt a massive stimulus package. Bottom Line: Chinese stimulus will surprise to the upside while talks are going, and it will increase dramatically if talks collapse. This will ultimately support global growth but it will not prevent market riots between a negative policy shock and the point at which markets are totally reassured about the magnitude of stimulus. How Will The Negotiations Proceed? Precariously. The risk of a strategic conflict is much higher than the markets are currently pricing. This is highlighted in Table 1 above, but there are additional reasons to have a high conviction on this point. We can demonstrate this by constructing a simple decision tree that outlines the step-by-step process by which the U.S. and China will proceed in their negotiations after the May 10 tariff rate hike (Diagram 1). To these we attach subjective probabilities that we believe are fair and slightly conservative. The result shows that it is not difficult to conclude that the conditional probability of a long-term, durable trade agreement is a mere 4%, whereas the conditional probability of an uncontained escalation in strategic tensions is as high as 59%! This is a much worse outcome than our actual view as expressed in Table 1. Diagram 1A Simple Decision Tree Says Geopolitical Risks Are Huge A similar exercise – an analysis of competing hypotheses conducted according to analytical techniques used by the U.S. intelligence community – reinforces the point that the most likely scenario is a major escalation in tensions, while the least likely is a “grand compromise” (Appendix). While our final trade war probabilities in Table 1 are not as pessimistic as these exercises suggest, the latter reinforce the point that the market is too sanguine. An increase in tariffs after five months of negotiations, with a threat to impose even more sweeping tariffs with a one-month deadline, is not conducive to Chinese concessions and therefore increases the odds of talks failing and an escalation in strategic conflict unprecedented in U.S.-China relations since the rupture from 1989-91. And this rupture would be considerably worse for the global economy. The Trump administration’s political logic is willing to accept such a conflict on the basis that a foreign policy confrontation can produce a rally-around-the-flag effect whereas a short-term deal that does not address significant technological and national security concerns is a political liability on the campaign trail. Yes, it is important that Presidents Trump and Xi are making verifiable preparations to attend the G20 summit in Japan. But they could cancel their attendance or snub each other at the event. In our view investors should wait for something more substantial to become more optimistic about political risk – such as public commitments to structural changes by China and a complementary tariff rollback schedule by the United States. Bottom Line: The odds of a total breakdown in U.S.-China relations and a Cold War-style escalation of strategic conflict are highly underrated. Markets will sell before they recover. Investment Implications Chart 20China's Nuclear Option Might Fizzle Equity markets are exposed to further downside in the short run. Even a minor escalation is not fully priced according to our Global Investment Strategy’s equity market forecasts based on our own geopolitical scenario probabilities (see Table 1 above). Our Chief Global Strategist Peter Berezin would recommend increasing exposure to risk if the S&P 500 falls 5% from current levels, other factors being equal. Cyclically, any trade agreement will fail to bring substantial benefits to the U.S.-China trade and investment outlook over a horizon beyond 12-24 months. The tech industries of the two countries will not benefit greatly from the deal. While multinational corporations exposed to the Asian manufacturing supply chain could suffer earnings downgrades from trade war, China’s stimulus will be a countervailing factor, particularly for commodities and commodity-oriented EMs. Therefore, we will keep our China Play Index and long Indonesia trades in place despite near-term risks. Ironically, U.S. treasuries can rally even when China is reducing its holdings, as global demand rises amid crisis (Chart 20). However, given that bonds have already rallied and we expect Chinese stimulus to come sooner rather than later, we will maintain our current portfolio hedge of Swiss bonds and gold, which is up 2%. We are closing our long small caps trade for a loss of 11.9%. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix
Highlights Foreign investors have been rushing into Indian equities in anticipation of a Modi win. While Modi’s chances are reasonable, he may not win an outright majority. Keep tactically underweighting Indian stocks for now. The structural outlook for Vietnam is strong and improving. A bottom in Vietnamese equities is in the making. Investors should overweight Vietnamese stocks within an EM equity portfolio. Feature Indian Equities: A Window Of Risk Remains Foreign investors have been rushing into Indian equities in anticipation of a win by current Prime Minister Narendra Modi in the upcoming general elections. As a result, Indian stocks have been outperforming the EM benchmark. Nevertheless, a window of risk for the Indian bourse remains. While Modi’s chances of winning the elections are reasonable, he and his party – the Bharatiya Janata Party, or BJP – may not win an outright majority in the lower house, as occurred in May 2014. While Modi’s chances of winning the elections are reasonable, he and his party – the Bharatiya Janata Party, or BJP – may not win an outright majority in the lower house, as occurred in May 2014. The basis for Modi not being able to win an outright majority is that rural area incomes have weakened substantially due to falling food prices (Chart I-1). Corroborating this distress in rural areas, stock prices of rural-exposed companies have massively underperformed urban-exposed ones (Chart I-2). Chart I-1India's Food Prices Have Been Falling Despite Low Rainfall Chart I-2Rural-Exposed Stocks Have Massively Underperformed Urban Stocks Even though both monetary and fiscal policies are easing, these macro policies always work with a time lag and will not improve domestic growth before the elections. A BJP-led minority-government will force Modi to increasingly rely on his allies in the National Democratic Alliance (NDA) coalition. The prime minister will then be forced to frequently offer concessions, watering down his reform agenda. The BJP’s allies in the NDA coalition are not necessarily as market-friendly. This is why we believe such an outcome would upset Indian financial markets after its most recent outperformance. Meanwhile, rural demand weakness has spilled over into the broader Indian economy. Passenger car sales, as well as sales of two- and three-wheelers are on the verge of contraction, and growth in tractor sales is falling sharply (Chart I-3). Chart I-3Indian Cyclical Growth Is Decelerating Chart I-4Indian EPS Growth Will Likely Contract Moreover, the bottom panel of Chart I-3 illustrates that the production of intermediate goods is contracting and manufacturing production is decelerating. Worryingly, the domestic growth slowdown has stalled EPS growth for the overall market, and net profit margins are falling (Chart I-4). The large-cap equity index has so far disregarded poor earnings performance, which magnifies the risk to Indian stocks if the BJP fails to win a majority government. Notably, small-cap stocks have failed to advance much and have not corroborated the rally in large-caps (Chart I-5). India’s stock market breadth is also poor, which is a bad omen for the sustainability of the current rally (Chart I-6). Chart I-5India Small Cap Stock Are Not Confirming The Rally Chart I-6India's Stock Market Breadth Is Poor Finally, rising oil prices will negatively impact India’s trade balance dynamics (Chart I-7, top panel). The stock market’s relative performance has diverged from the recent rise in oil prices – an unsustainable trend (Chart I-7, bottom panel). Investment Recommendations Chart I-7Higher Oil Prices Are Not Discounted By Indian Equities The Indian economy will remain weak over the next several months, which places Modi’s majority re-election bid at risk. Beyond the elections, fiscal and monetary easing will kick in and boost cyclical growth in the second half of the year. Food prices are also beginning to pick up due to below average rainfall (Chart I-1, page 1). The latter will revive rural income and by extension spending. We recommend tactically underweighting Indian stocks for now. A better entry point to upgrade will likely emerge in the next few months as euphoria surrounding the upcoming elections comes to an end and a growth slowdown is finally priced in. For fixed-income investors, we recommend continuing to bet on yield-curve steepening. A dovish central bank will cut interest rates and keep them low. This, along with fiscal easing, will revive growth later this year. A growth recovery and rising food inflation will lift the long end of the yield curve. Ayman Kawtharani, Associate Editor ayman@bcaresearch.com Vietnam: Structural Tailwinds Getting Stronger; Buy On A Dip Our negative call on Vietnamese stocks since last May has turned out well.1 The significant deceleration in export growth alongside the selloff in broader emerging markets has generated a double-digit drop in Vietnamese stock prices over the past 12 months (Chart II-1, top panel). Chart II-1Vietnamese Equities: An Upturn Is Ahead Looking forward, a new upturn in Vietnamese equities is in the making. The structural outlook for Vietnam is strong and improving. Investors should overweight Vietnamese stocks within an EM equity portfolio (Chart II-1, bottom panel). Shifting Supply Chain For some time, companies in China have been moving their supply chain to Vietnam due to its cheap labor, inexpensive land and supportive policies. The geopolitical confrontation between the U.S. and China that began last year has served to accelerate this process. The U.S. and China may soon reach a trade deal. This will give Chinese manufacturers and multinational companies more time to prepare for their relocation, but it will not stop the ongoing supply chain shift. Both multinationals and Chinese producers would prefer to have alternative supply chains that are not exposed to a potential re-escalation in geopolitical tensions between the U.S. and China in the years to come.2 Chart II-2 shows that Chinese companies have nearly tripled their foreign direct investment in Vietnam over the past nine months. The surge in relocations from the mainland has boosted land prices and wages in Vietnam significantly. For example, the rental price of industrial land at Giang Dien industrial park on a long-term lease of up to 50 years has risen as much as 50% to US$90 per square meter last October from US$60-70 a year ago. The relocations have occurred not only for low-value-added companies such as textile and footwear makers, but also for high-value-add companies like electronics assembly producers. According to the Chairman of Shenzhen-Vietnam Industrial Park, most of the companies that established factories in the park last year have been focused on light processing such as electronic assembly. Chart II-2Accelerating Supply Chain Shift Chart II-3Strong U.S. Imports From Vietnam Chart II-3 shows that U.S. imports from Vietnam have been much stronger than those from China and the rest of the world. This may be the result of both the accelerated supply chain shift last year and the structural competitiveness of Vietnamese goods. Vietnam continues to take market share from China in global markets such as footwear, garments and electronics (Chart II-4). Both multinationals and Chinese producers would prefer to have alternative supply chains that are not exposed to a potential re-escalation in geopolitical tensions between the U.S. and China in the years to come. In fact, rising FDIs have already led to a growth rebound in imports among foreign invested enterprises (FIE), heralding an export growth acceleration in the months ahead (Chart II-5). FIEs import most of the input materials they need to manufacture their goods, which are then exported overseas. This is why this segment’s imports lead export growth. Chart II-4Vietnam: Taking More Market Share From China Chart II-5Rising FIE Imports Herald Export Growth Acceleration Escaping A Global Slowdown In Smartphone Demand The biggest contributor to Vietnam’s current account and trade surplus has been the smartphone sector (Chart II-6). However, the ongoing downturn in global smartphone shipments may not affect Vietnam due to the latter’s gains in the global smartphone production and assembly market share: Vietnam mobile phone output (mostly Samsung smartphones) fell only slightly (1.2%) last year when Samsung smartphone shipments contracted by 8% (Chart II-7). This reflected Vietnam’s strong competitiveness relative to the other five countries where Samsung smartphones are manufactured: China, India, Brazil, Indonesia and South Korea. Over half of Samsung smartphones were produced in Vietnam last year. Chart II-6Phone Sector: The Biggest Driver Of Vietnamese Trade Surplus Chart II-7Vietnam May Withstand Well In A Global Smartphone Demand Slowdown Last December, Samsung closed its Chinese Tianjin plant. Without any additional production reductions in other plants, total Samsung capacity will be cut by about 7%. This further lowers the odds of a considerable production cut in Vietnam in the case of a further drop in global smartphone demand. Other Encouraging Signs Many other positive signs have emerged that point to a cyclical upturn ahead for Vietnam: Chart II-8Strong Domestic Demand Retail sales growth has been accelerating, and automobile sales have reached new highs, suggesting strong domestic demand (Chart II-8). Despite declining visitor arrivals, the country’s tourism revenue still grew at a robust 10% pace last year. In 2019, the country is expecting a 15% year-on-year growth in visitor arrivals. The Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), which came into force for Vietnam in January, and the EU-Vietnam Free Trade Agreement (EVFTA), which will take effect later this year, will be highly beneficial to the Vietnamese economy. Both headline and core inflation are low. The country’s foreign reserves also jumped by 14% over the past 12 months to a record high of US$63.5 billion, equivalent to 26% of GDP. Investment Recommendations We recommend buying Vietnamese equities on dips. Dedicated equity investors should overweight Vietnam in an EM equity portfolio: The Vietnamese property market is booming on surging income growth and low interest rates. The real estate sector accounts for 45% of the MSCI Vietnam Index and 28% of the VN All-Share Index. According to CBRE Vietnam, there was a sharp rise in overseas investors in Vietnamese real estate in 2018, particularly from China. The real estate services firm reported that Chinese customers accounted for 44% of total transactions in the first nine months of 2018. In 2017, there was a 21% year-on-year increase in Chinese buyers. Buoyant household income growth is positive for consumer staples stocks, which accounts for 34% of the MSCI Vietnam Index and 8% of the VN All-Shares Index. Buoyant household income growth is positive for consumer staples stocks, which accounts for 34% of the MSCI Vietnam Index and 8% of the VN All-Shares Index. Vietnamese corporate earnings will outpace broader EM EPS, warranting equity market outperformance (Chart II-9). Vietnam's inclusion into some influential EM equity indices would significantly boost interest from foreign investors (Chart II-10). Chart II-9Vietnamese Corporate Earnings Growth: Better Than EM Chart II-10Rising Interest From Foreign Investors Technically, it seems the correction in Vietnamese stocks is late, and that the equity market will resume its upturn sooner rather than later. Ellen JingYuan He, Associate Vice President Emerging Markets Strategy ellenj@bcaresearch.com Footnotes 1 Please see Frontier Markets Strategy Special Report titled “Vietnamese Equities: Take A Step Back For Now, ” dated May 15, 2018. Available at fms.bcaresearch.com. 2 Please see Geopolitical Strategy and China Investment Strategy Special Report titled “China-U.S. Trade: A Structural Deal?” dated March 6, 2019. Available at gps.bcaresearch.com. Equity Recommendations Fixed-Income, Credit And Currency Recommendations