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Article20 Mar 2018

Geopolitical Headwinds: U.S., Iran, and North Korea Time to Worry?

Citi GPS Opinion
After a period of disinterest, investors have recently taken notice of political risks. First came the shift in U.S. trade policy (and fear of Chinese retaliation) and then the departure of two key advisers to U.S. President Trump: National Economic Council head Gary Cohn, who had opposed the tariff bill, and Rex Tillerson, Secretary of State, who had opposed President Trump’s often-stated intention to nullify the diplomatic deal on Iran, known as the Joint Comprehensive Plan of Action (JPCOA).

Both officials had been widely regarded as moderating influences within the White House. Secretary Tillerson’s departure has sparked speculation about the potential for a more hawkish stance on foreign and security policy following the nomination of CIA Director Mike Pompeo for Secretary of State, given Pompeo’s past criticism of the Iran deal and other remarks, as well as lack of diplomatic experience.

If Pompeo’s appointment is approved by Congress (not a given, with Republican Congressman Rand Paul threatening to block him), he will take on the role of U.S. Secretary of State at a crucial juncture in U.S. foreign and security policy, with especially high stakes in relations with Iran, North Korea, and Russia and uncertainty about the
U.S. role in resolving global disputes.

Storm in a Teacup, or Alarm Bells?

Separating political noise from market signals in an era of “Tweetstorms”, unconventional leadership, and low public trust has possibly never been more challenging. In a relatively constructive environment of global growth, a bull market, and maybe even a boost to animal spirits, history suggests investors would merely pay passing attention to geopolitical risks, which historically elude efforts to price. Citi’s Global Equity Strategist has also flagged the fact that we are in the midst of a transition from a low-volatility market to a more fragile, high-volatility market (see Welcome to Phase 3). The concurrence of heightened global political risks occurring simultaneously with a reduced capacity for markets to absorb them is concerning. Will geopolitical risks grow in their potential to impact markets following the withdrawal of Quantitative Easing (QE)? Or will a rising geopolitical risk temperature prompt an extension of QE?

Certainly the previous decade of central bank liquidity has done much to act as a buffer preventing political risks from translating into volatility and from becoming systemic. Will this last? And has it blinded investors to anticipating how political risks can become relevant for markets and the global economy?

We have been cautious in our approach to highlighting political risks with the potential to move markets, noting previously that it would likely take a large-scale macro global political event risk to disrupt markets (see 2018 Global Political Outlook for more commentary).

With this in mind, in our view, the convergence of geopolitical risks in the next six months
— also the run-up to what are likely to be hotly-contested November U.S. Mid-term elections and continuing uncertainty around the Mueller investigation over alleged interference in the 2016 U.S. presidential elections — bears careful watching.

When Is It Time To Worry?

Here we focus on the intersection between the U.S. political calendar and the top two geopolitical challenges for the Trump Administration: the future of the JCPOA with Iran, and the surprise agreement of bi-lateral U.S.-Democratic People’s Republic of Korea (DPRK) talks. We conclude with wild cards and a hypothesis about investor ambivalence.
The month of May will see at least two crucial signposts, with the JCPOA coming up for review May 12th, and talks between Washington and Pyongyang planned for late May.
We regard the future of the Iran deal as an acute crisis for the U.S. Administration, and the landmark bi-lateral talks between President Trump and North Korea’s Kim Jung-Un as a challenge but also bearing the glimmer of an opportunity to break the longstanding standoff over the DPRK’s ballistic missile program.

The outcomes of negotiations over both geopolitical hotspots have the potential to move markets, as well as significantly impact relations between the U.S. and its allies in Europe, the Middle East, Japan and South Korea, and relations with Russia and China.

Iran: Top of Pompeo’s In-Tray

The deal to curtail Iran’s nuclear program, agreed during the Obama Administration, has long been criticized for failing to address wider concerns over Iran’s conduct in the region and the ability to monitor its nuclear program after the agreement concludes, although the UN watchdog the International Atomic Energy Agency (IAEA) has repeatedly declared Tehran to be complying with the conditions.

President Trump has — by his own account, reluctantly — extended the JCPOA agreement upon its periodic requirement to renew, pressuring European partners to pass more sanctions in the meantime. But we do not expect Trump to sign the waiver extension on May 12th, a decision which would lead to a “SnapBack” of the statutory sanctions put in place by the U.S. Congress in 2012 and amended in 2013. This would require other countries to “significantly reduce” imports of Iranian crude but there is not a legal definition for how much is “significant”, or a definition of what is “crude”. In addition, it is not clear of the 180 days from May 12th would be an initial review period or whether countries will have to reduce purchases in this time relative to the 180 days prior to May 12th.

Such a move might also mean Iran itself withdraws from the agreement, although we expect the regime to attempt to buy time and gauge options before making a dramatic move. A U.S. withdrawal would be a boost to hardliner critics of President Rouhani, elected on a platform of bringing the country out of the sanctions regime, and could prompt a resurgence of protests. As such, Iran may actually be making moves to attempt to de-escalate tensions — recently Iranian “fast boats” have stopped harassing U.S. ships in the Persian Gulf.
An end to the Iran deal could have a wide range of implications. Beyond a hit to Iran’s oil export volumes and revenues, the risk of military attacks on Iran’s nuclear facilities could begin to rise (though broadly, pursuing economic sanctions is an alternative to military action), and along with it, the potential for an oil price spike in parallel with the 1-3 months of aerial bombardment that such an operation would require.

A May extension if Iran waivers remains a binary affair, but even without an extension, there remains the 180-day period to consider, and then the volumes affected are in question — it would not likely be the ~1-m b/d of lost supply seen over 2012-2016 but more like the 250-350-k b/d, affecting mostly oil imported by Japan, South Korea, and perhaps one or two countries in Europe…and some of this could be reallocated by Iran to other trade partners. Meanwhile, Saudi Arabia, Russia, and a handful of OPEC countries have been holding off from the market since cutting their production from January 1, 2017 to support oil prices, and would be keen to return these barrels to market sooner. Thus, the probabilities, potentially protracted time period, and the limited oil supply volume impact would combine to mean that oil price spikes ahead of Iran sanctions could remain muted.

Washington’s European partners, already dismayed by the perceived fraying of the Trans-Atlantic relationship, are also likely to take a dim view of the notion of further military conflict in the region, not least given the direct political consequences for Europe in the face of heightened refugee flows. A U.S. withdrawal from the Iran deal could also undermine U.S. credibility in striking future diplomatic agreements.

By contrast, Saudi Arabia, which regards Iran as its regional adversary, will likely applaud the move, as will Israel. Taking Iranian oil supplies off the market again would please Moscow, and in the view of Citi commodities strategists, be bullish for oil prices.

The Iran deal is certainly far from comprehensive, but it has served to put a floor under Mideast political risks in the 3 years of its existence. Modifying it would be extremely difficult, with unanimity amongst all parties required.

The tools in the diplomat’s toolbox are few: diplomacy, sanctions and conflict. With Iran, diplomacy and sanctions have both been tried.

U.S.-North Korea Talks: Breakthrough or Blowback?

Amid the spike in tensions that followed North Korea’s six ballistic missile tests in 2017, investors have reacted positively to the prospect of direct bi-lateral talks between President Trump and North Korean leader Kim Jung Un. The new South Korean government sees itself as deserving the credit for creating the conditions for the meeting, while both Japan and China, in the words of former U.S. National Security Council Chief for Asia Victor Cha, are likely suffering “diplomatic whiplash” as a result of the sudden shift away from open debate in Washington about “bloody nose” military strikes on North Korean nuclear facilities.

To be sure, the threat of military force and sense of uncertainty over Washington’s intentions may also have increased North Korea’s willingness to risk meeting. But is this time really different?

We think the short- to medium-term positive impact of resuming diplomacy will be to limit headline risks. Whilst actively engaged in talks, a military attack will be off the table.

In terms of the prospects for success, Trump’s highly personalized negotiating style and the US administration’s maximalist position, demanding North Korea’s commitment to total de-nuclearization, also bring considerable room for softening of the US stance and altering the previous dynamics.

Trump’s lack of adherence to any previous diplomatic path could open up the potential for a “big bang” deal that could provide the assurances of regime stability and recognition the Pyongyang craves in exchange for a commitment to slowing its nuclear weapons program (though uncomfortably similar to the structure of the unloved Iran deal in this respect). The talks would bring together two highly unconventional leaders in a construct not seen previously and one where both could stand to gain considerable prestige.

Although the potential for a breakthrough is non-negligible, we think it is not higher than 10%. We fear that the extremely short time frame to prepare for the talks — weeks compared to the seven years of groundwork laid by Henry Kissinger before Nixon’s famous visit to China — plus the shortage of regional and diplomatic expertise in the current Administration limit the prospects of success.

Engaging in talks that fail or that result in an agreement that North Korea eventually violates or attempts to alter (as has historically been the case) would leave the U.S. with very little option other than military force.

These high stakes are the primary explanation for why previous U.S. administrations have declined North Korea’s perennial request for a bi-lateral meeting. Without the preparation of a clear agenda, including an objective for the talks (as yet none has been set), the risk that Pyongyang merely buys itself more time and/or uses the opportunity to score domestic political points is high.

Wild Cards and the New Narrative:

Have Investors Learned to Love Autocracy and Populism?

The domestic political environment in the U.S. is highly uncertain, ranging from the stream of senior personnel changes in the White House — many of which will require Congressional approval to replace — to the uncertainty over the outcome of the Mueller investigation and likely direction of Midterms, with the potential for a change in the composition of Congress potentially bringing impeachment risks.

We do not think that President Trump will ultimately remove Special Prosecutor Robert Mueller, who is investigating alleged interference in the 2016 U.S. presidential elections, despite the “Twitterstorm” that has increased speculation.

Simply put, the dismissal of Mueller is a red line when it comes to respect for rule of law for enough senior Congressional Republicans (let alone Democrats) such that firing him would, as Republican Lindsey Graham has said, “be the beginning of the end of his presidency”. Indeed, if the Mueller investigation fails to find wrongdoing, it would mark the end of what has been a major drain on the Trump presidency. Pressure from the Mueller investigation as well as the allegations from Britain of a Russian government role in the recent assassination attempt in Salisbury is likely to intensify the potential for further sanctions against Russia.

Nevertheless, U.S. political uncertainty could act as a further drag to a bull market that has started to show signs of flagging, especially if the Mueller investigation results in high-profile indictments.

The timing for the investigation’s conclusion is completely unknown, but if the outcome is negative for the White House and the results come in the weeks or months before November Midterms, the political impact could be magnified. Evidence suggests that the impact of scandals on political parties can last from 1-2 election cycles, and hit the party, not just the leader(s) involved.

Against this backdrop, China’s Xi has been declared President for Life, and Russia’s Vladimir Putin has won re-election for another 6-year term, leaving him in power until 2024, if not longer.

De-Democratization Appears to be Gaining Strength, While Challenges to the Global Free Trade System and “Democratic Peace” Proliferate

We find it curious that financial markets, which expanded dramatically through the end of the Cold War and the military buildup that accompanied it, free trade and global norms following the fall of the Berlin Wall, have seemingly become comfortable with the erosion of independent institutions, curtailing of the press, rising inequality and declining respect for rule of law. These risk factors may also mean greater risk of state-to-state as well as asymmetric conflict.

The contrast between the previous economic and market narrative espousing the benefits of new emerging market middle classes, transparency and accountability in government and the move from economic rights to political rights and civil liberties now seems desperately quaint and outmoded. Have investors learned to love autocracy and populism, so long as it is right-wing?
Perhaps — at least as long as the current disconnect between the performance of the global economy and financial markets and the state of politics and socio-economic risks prevails. When that changes, it will be time to find a new narrative.

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