Israel

Highlights Geopolitical risk is rising once again after a big drop-off in risk during the pandemic and snapback. The Biden administration faces three critical foreign policy tests: China/Taiwan, Russia/Ukraine, and Israel/Iran. Russia could stage a military incursion into Ukraine that would cause a risk-off event. However, global markets would get over it relatively quickly since a total invasion of all Ukraine is unlikely. Iran is nearing the “breakout” threshold of uranium enrichment which will prompt more Israeli demonstrations of its red line against nuclear weaponization. Iran will retaliate. So far our view is on track that tensions will escalate prior to the resolution of a US-Iran deal by August. Taiwan is the most market relevant of all geopolitical risks – but the South China Sea is another scene of US-China saber-rattling. A crisis here is most important if connected to Taiwan. Go long CAD-RUB and CHF-GBP. Feature Chart 1Traffic In The World’s Most Dire Straits British Prime Minister Harold Macmillan, quoting Sir Winston Churchill, once said, “Jaw-jaw is better than war-war.”1 President Joe Biden would undoubtedly prefer jaw-jaw as he faces three imminent foreign policy tests that raise tail-risks of war: Chinese military intimidation of Taiwan, a Russian military build-up on the Ukrainian border, and Iranian acceleration of its nuclear program. All of these areas are heating up simultaneously and a crisis incident could easily occur, causing a pullback in bond yields and equity markets. One way of illustrating the seriousness of these conflicts is to look at the volume of global trade that goes through the relevant geographic chokepoints: the Taiwan Strait, the Strait of Malacca, the Strait of Hormuz, and the Bosphorus Strait (Chart 1). Oil and petroleum products serve as a proxy for overall traffic. The recent, short-lived blockage of the Suez Canal provides an inkling of the magnitude of disruption that is possible if conflict erupts in one of these global bottlenecks. In this report we review recent developments in Biden’s foreign policy tests. Our views are mostly on track. Investors should prepare tactically for more geopolitical risk to be priced into global financial markets, motivating safe-haven flows and potentially a general equity pullback. Cyclically the bull market will continue, barring the worst-case scenarios. Biden’s Three Foreign Policy Tests Biden’s three foreign policy tests are all intensifying as we go to press: China/Taiwan: China is continuing a high-intensity pace of “combat drills” and live-fire drills around the island of Taiwan.2 The US is sending a diplomatic delegation to Taiwan against Beijing’s wishes and is set to deliver a relatively large arms sale to the island. Yet Washington has sent John Kerry, its “climate czar,” to Beijing to set up a bilateral summit between Presidents Biden and Xi Jinping for Earth Day, in a bid to find common ground. Biden’s overarching review of US China policy is due sometime in May. Russia/Ukraine: Russia has amassed more than 85,000 troops on its border with Ukraine and in Crimea, the largest build-up since it invaded Ukraine in 2014-15. Russia has withdrawn its ambassador to Washington and warned that it will retaliate if the US imposes any new sanctions. The US is doing just that, with new sanctions leveled in response to Russian cyberattacks and election interference, including a block on sales of Russian ruble-denominated sovereign bonds from June. Hence Russian retaliation is looming. Israel/Iran: Shortly after the March 23 election, Israel sabotaged the underground Natanz Fuel Enrichment Plant in Iran, prompting the Iranians to declare that they will retaliate on Israeli soil. They also claim they will now enrich uranium to a 60% level, which pushes them close to the 90%-plus levels needed to make a nuclear device. American and Israeli officials had previously signaled that Iran would reach “breakout” levels of weapons-grade uranium between April and August. Negotiations are underway but the process will be beset by attacks. We have written extensively on the Taiwan dynamic this year as it is the most relevant for global investors. In this report we will update the Russian and Iranian situations first and then proceed to China. Bottom Line: Geopolitical risk is back after a reprieve during the pandemic. The new US administration faces three serious foreign policy tests at once. Financial markets have mostly ignored the rise in tensions but we expect safe-haven assets to catch a bid in the near term. However, we have not yet altered our bullish cyclical view. So far we are still in the realm of “jaw-jaw” rather than “war-war,” as we explain in the rest of this report. Stay Short Russia And EM Europe The return of the Democratic Party to power in Washington has led to an immediate increase in US-Russian tensions. The Biden administration is eschewing a diplomatic reset and instead pursuing great power competition. The US is increasing its arms sales and NATO military drills with Ukraine. It is imposing sanctions over Russian cyberattacks and election interference, including taking a long-awaited step against the purchase of ruble bonds. Washington could also force Germany to cancel the Nord Stream II pipeline. However, there are also mitigating signs. President Biden has offered to hold a bilateral summit with President Vladimir Putin in a third country and the two may meet at his Earth Day summit. The US Navy also called back the USS Donald Cook and USS Roosevelt destroyers from going into the Black Sea, after Moscow warned that any American warships in that sea would be in danger, especially if they go near Crimea. Washington’s new volley of sanctions are not truly tantamount to Russian interference in American elections and they do not include new measures on Nord Stream II. An American move to insist that Germany cancel Nord Stream before construction ends would provoke Russia to retaliate. The purpose of Nord Stream is to bypass Ukraine and cement direct economic ties between Russia and Germany. Germany’s government continues to support the project despite Russia’s build-up on the border with Ukraine and suppression of political dissidents. If the US vetoes the pipeline then it is denying Russia access to legitimate trade and restricting Russia’s export options to the Ukrainian route. If the US simultaneously increases military cooperation with Ukraine then it is implicitly trying to control Russia’s energy access to Europe. Russia will likely retaliate by punishing Ukraine. Russia could take aggressive action in Ukraine or elsewhere regardless of what the US does on Nord Stream or in its Ukraine outreach. Russia is struggling with a weak domestic economy and social unrest. Moscow has a record of foreign adventurism when popular support wanes. Moreover legislative elections loom in September. Thus Russia may have an independent reason to stir up conflict in Ukraine, at least for the next half year, that cannot be deterred. Judging by capabilities, Russia has deployed enough troops to stage a military incursion into the breakaway Donbass region of Ukraine. The Russian army build-up on the border is the largest since 2014 – large enough to put most of Russian-speaking Ukraine at risk. A full-scale Russian invasion of all of Ukraine is unlikely but not impossible. It would be extremely costly both in blood and treasure – not only in occupying a hostile Ukraine but also in unifying the West against Russia, the opposite of what Moscow is trying to accomplish (Chart 2). Moscow will want to avoid this outcome unless the US shuts down Nord Stream or tries to bring Ukraine into NATO. Chart 2Russia’s Constraints Over Ukraine From the market’s point of view, intensified fighting in Ukraine between the government and Russian-backed rebels is status quo. This is inevitable and will not have a major impact on global equities. The invasion of Crimea in 2014 led to a maximum 2% drawdown in the S&P 500. It was the shooting down of Malaysian Airline 17, not Russia’s invasion of Ukraine, that shook up financial markets in 2014. Global equities fell by 2.7%, Eurostoxx 500 by 6.2% and Russian equities by 10.7%. Note that the Russian military did ultimately participate in the fighting in 2014-15, it was not only Russian-backed separatists, so global financial markets can stomach that kind of conflict fairly well as long as it is limited to Ukraine, especially disputed regions, and as long as the US and NATO do not get involved. They are disinclined to fight for Ukraine, leaving it vulnerable. A larger flight to safety would occur if Russia pursued the total conquest of all of Ukraine. This is small probability but high impact. It would cause a major global risk-off because it would raise the risk of a larger war on the continent for the first time since World War II. Russia is obsessed with Ukraine from the point of view of grand strategy and national security and will take at least some military action if it deems it necessary. Investors should be prepared for escalation – though neither Washington nor Moscow has yet taken a fatal step. It is important to watch for any aggressive Ukrainian actions but Ukraine is not the main driver of action. The current situation is reminiscent of that in the Republic of Georgia in 2008, when Russia provoked President Mikhail Saakashvili into taking action against separatists that Russia then used as a pretext for intervening and breaking away Abkhazia and South Ossetia. While Ukrainian President Volodymyr Zelenskiy could be baited into a conflict, it is also true that fear of getting baited could result in hesitation that allows Russia to seize the initiative, as occurred in Ukraine in 2014. So for the Ukrainians it is “damned if you do, damned if you don’t.” Russia’s actions will largely depend on its own interests. So far Russian equities have lagged other emerging market equities and the commodity rally, which may partly reflect elevated political and geopolitical risk (Chart 3). The trend for Russian equities can easily get worse from here. Given Russia’s interest in conflict with the West ahead of the September elections, Russian-Ukrainian tensions could persist for most of this year. A major military campaign becomes more probable after mid-May when the weather improves. Russian currency and assets will remain under pressure. We recommend going long the Canadian dollar relative to the Russian ruble. The ruble will underperform commodity currencies as a whole, including the Mexican peso, if Russia intervenes militarily, judging by the Crimea conflict in 2014 (Chart 4). Meanwhile Canadian and Mexican currencies should benefit from the fact that the US economy is hyper-stimulated and rapidly vaccinating. Chart 3Russia Lagged Commodity Rally Chart 4Favor Loonie And Peso Over Ruble Chart 5Long DM Europe / Short EM Europe We continue to overweight developed Europe and underweight emerging Europe (Chart 5). Poland, Hungary, the Czech Republic, Romania, and the Baltic states will see a risk premium due to current tensions. The Czech Republic faces considerable political uncertainty surrounding its legislative election in October, an opportunity for Russia to interfere or for anti-establishment (albeit pro-EU) parties to rise to power. What would it take for Biden and Putin to de-escalate? The US and NATO could diminish Ukraine relations, downgrade democracy promotion and psychological counter-warfare, and allow Nord Stream to be completed. Russia could reduce its troop presence on the border and lend a helping hand on the Iranian nuclear deal and Afghanistan withdrawal. This is a risk to our view. Bottom Line: Russia and emerging European markets are some of the few truly cheap markets in the emerging market equity universe (Table 1). Yet the current geopolitical context looks to keep them cheap. For now investors should be prepared for the West’s conflict with Russia to escalate in a major way. At minimum we need to know whether the US will halt Nord Stream II’s construction before taking a more bullish view on EM Europe. Table 1Geopolitical Risk Helps Keep Russia And EM Europe Cheap The worst-case scenario of a full-blown Russian conquest of Ukraine has a small probability but cannot be ruled out. Iran Negotiations: First Explosions, Then A Nuclear Deal Israel has not put together a government after its March 23 election, although Prime Minister Benjamin Netanyahu has the opportunity to lead a government again which means no change in national policy so far. Moreover the Israeli public and political establishment are unified in their opposition to Iran’s regional and nuclear ambitions. Immediately after the Iranians inaugurated new centrifuges at the Natanz nuclear facility, on April 11, the Israelis allegedly sabotaged the facility underground facility in an attack that was supposedly not limited to cyber means and that deactivated a range of centrifuges. An Iranian scientist fell into a crater and hurt himself. The Iranians have vowed retaliation on Israeli soil. More fundamentally their politics are shifting in a hardline direction, to be confirmed with the election of a hawkish president in June, which will exacerbate the mutual antagonism. This power transition is a major reason we have identified the inauguration in August as a key deadline for the US to rejoin the 2015 nuclear deal (the Joint Comprehensive Plan of Action). If the Biden administration cannot get it done by that time then a much more dangerous, multi-year negotiation will get underway. The Israeli attack has not stopped negotiations in the short term, however. The second round of talks begins in Vienna as we go to press. The US has also confirmed it will withdraw from Afghanistan on September 11, which says to Iran that Biden is determined to reduce the US’s strategic footprint in the region, reinforcing the US desire for a deal. The Israelis will continue to underscore their red line against the Iranian nuclear and missile programs in the coming months through clandestine attacks. However, they were not able to stop the US from signing a nuclear deal with Iran in 2015 and they are not likely to stop the US today. They are still bound by a fundamental constraint. Israel needs to maintain its alliance with the United States, which ensures its long-term security against both Iran and the Middle East’s general instability (Chart 6). The Iranians will retaliate against Israel, making it likely that this summer will feature tit-for-tat attacks. These could include critical infrastructure. Iran may also continue its campaign against enemies in Iraq and Saudi Arabia, thus triggering unplanned oil outages and pushing up the oil price. A glance at Israeli, Saudi Arabian, and UAE stock markets suggests that global investors have largely ignored the geopolitical risks so far but may be starting to respond to the likely escalation in conflict prior to any US-Iran deal (Chart 7). Chart 6Israel’s Constraints Over Iran The US, Germany, France, Russia, and China are all officially on board with getting the Iranians back into compliance with the deal. A return to compliance would need to be phased with US sanctions relief. The Iranians demand that the US ease sanctions first, since it was the US that unilaterally walked away from the deal and re-imposed sanctions in 2018. Chart 7Saudi, UAE, Israeli Stocks Signal Danger Ultimately Biden is capable of making the first move since the American public shows very little concern about Iran. Biden himself is acting on behalf of a strong consensus in Washington that an Iranian deal is necessary to stabilize the region and enable the US to devote more strategic attention to Asia Pacific. Will Russia and China support the Iranian deal, given their simultaneous conflicts with the United States? As long as the US and Iran are satisfied with returning to the existing deal – which begins to expire in 2025 – there is little need for Russia or China to do anything. However, if Washington wants a better deal, then it will have to make major concessions to Moscow and Beijing. A new and better deal would require years to negotiate. Chart 8Russo-Chinese Cooperation Grows Russia and China supported the original nuclear deal because they saw an opportunity to limit the proliferation of nuclear weapons, which dilutes their own power. A Middle Eastern nuclear arms race is not in their interest. Iran is also a useful strategic partner for Russia and China in the Middle East and they are not averse to seeing Iran’s economy grow stronger in order to perpetuate its regime. They are wagering that liberalization of the Iranian economy will not result in liberalization of its politics – it certainly did not in the case of Russia or China – and therefore they will still have an ally but it will be more economically sound and influential. The Russo-Chinese strategic partnership has grown dramatically over the past decade. Both countries share an interest in undermining US global leadership and stoking American internal divisions. Both share an interest in reducing the US military presence near their borders, particularly in strategic territories and seas that they consider essential to their security and political legitimacy. Russia increasingly depends on Chinese demand for its exports and Chinese investment for developing its resources. Neither country trusts the other’s currency for trade but both have a shared interest in diversifying away from the US dollar (Chart 8). Chart 9China Offers Helping Hand On Iran? In cooperating with the US on Iran, Russia and China will expect the US to respect their demands on strategic areas much closer to their core interests. If the Biden administration continues to upgrade its trade and defense relations with Ukraine and Taiwan then Moscow and Beijing will push back aggressively and could at that point prevent or undermine any deal with Iran. China is at least officially enforce sanctions on Iran (Chart 9). Its strategic partnership with Iran is constantly in a state of negotiation – until the US clarifies its sanctions regime. Clearly China hopes to extract concessions from the Americans for cooperation on nuclear threats. This is also the case with North Korea, where a missile crisis would be useful for China’s purposes in creating the need for Chinese arbitration. China sees a chance to persuade Biden to remove restrictions imposed by President Trump. If the Biden administration’s hawkishness on China is confirmed in the coming months, then China’s willingness to cooperate will presumably change. Bottom Line: Israel is underscoring its red lines against Iranian nuclear weaponization and this will cause an increase in conflict this spring and summer. But it is not yet preventing the US and Iran from renegotiating the 2015 nuclear deal. We still expect Biden to agree to a deal by August. Taiwan And The South China Sea For global financial markets the most important test facing Biden lies in the US-China relationship and tensions over the Taiwan Strait. We will not rehash our recent research and arguments on this issue. Suffice it to say that we see a 60% chance of some kind of crisis over the next 12-24 months, including a 5% chance of full-scale war. The odds of total war can rise rapidly in the event of domestic Chinese instability, a game-changing US arms sale, or a Taiwanese declaration of independence. The greatest deterrent to a full Chinese attack on Taiwan – the reason for our current 5% odds – is that it would result in a devastating blowback against the Chinese economy. China’s trade with the developed world, in addition to Taiwan, makes up 63% of exports, or 11% of GDP (Chart 10). Beijing is ultimately willing to pay this price – or any price – to “unify” the country. But it will not do so frivolously. Each passing year gives China greater global economic leverage and greater military capability over Taiwan. Chart 10China’s Constraints Over Taiwan China is increasing its purchases of US treasuries, which waned during the trade war (Chart 11). China often increases purchases when interest rates rise and markets have seen a rapid increase in treasury yields since the vaccine discovery in November. There is no indication from this point of view that China is preparing for outright war with the United States, although this is admittedly a limited measure that could be misleading.   What about a crisis other than war? What do we mean when we say “some kind of crisis” over Taiwan? A major gray zone would be economic sanctions or an economic embargo. While China cut back on tourism after Taiwan’s nominally pro-independence party won the election in 2016, and all tourism ground to a halt with COVID-19, there is no evidence of a broader embargo so far (Chart 12). This could change overnight. While US law forbids an embargo on Taiwan, this is precisely an area where Beijing might wish to test the US’s commitment. Chart 11China Buys More US Treasuries The current high pressure on Taiwan stems in large part from the confluence of new US export controls and the global semiconductor shortage. China cannot yet meet its domestic demand for semiconductors and it cannot develop advanced computer chips fast enough without the US and its allies (Chart 13). Chart 12No Embargo On Taiwan (Yet) If the Biden administration pursues a full technological blockade then China may be forced to take tougher action on Taiwan. But if Biden pursues a more defensive strategy then a new equilibrium will develop that spares China the risks of war. Chart 13China's Demand For Semiconductors The US and China are simultaneously escalating their naval confrontation in the South China Sea, particularly around the Philippines. US and Chinese aircraft carrier groups and other ships have been circling each other as Beijing attempts to intimidate the Philippines and shake its trust in the defense treaty with the US. China claims the South China Sea as its own – and its efforts to deny the US access will be met with US assertions of freedom of navigation, which could lead to sunken ships. The strategic importance of the South China Sea is similar to that of the Taiwan Strait: Chinese control of these bodies of water would threaten Taiwan’s, Japan’s, and South Korea’s supply security while weakening America’s strategic position in the region. We have long highlighted the elevated risks of proxy war for Vietnam and the Philippines but these are hardly issues of global concern compared with Northeast Asia’s security. While Taiwan is far more relevant to global investors, due to the semiconductor issue, there are ample opportunities for a crisis to erupt in the South China Sea. A crisis in this sea cannot be dismissed as marginal because it could involve direct US-China conflict or, worst case, it could be a prelude to action on Taiwan, as China would seek to control the approaches to the island. The final risk in this region is that North Korea has restarted ballistic missile tests. As stated above, a crisis would be well-timed from China’s point of view. For investors, however, North Korea is largely a distraction from the critical Taiwan Strait. It could feed into any risk-off sentiment. Bottom Line: US-China relations are still unsettled and a clash could emerge over the South China Sea and Korean peninsula just as it could emerge over the Taiwan Strait. The Taiwan Strait remains the most significant geography. A direct US-China clash in the South China Sea could cause a global selloff but the markets would recover quickly, unless it is linked to a conflict over Taiwan. Investment Takeaways Geopolitical risk is reviving after a reprieve during the COVID-19 pandemic. That does not mean that frictions will lead straight into war. Diplomacy is possible. If the US, China, Russia, and Iran choose “jaw-jaw” over “war-war” then the global equity rally will see another leg up. From a tactical point of view, however, our arguments above should demonstrate that at least one of Biden’s early foreign policy tests is likely to escalate into a geopolitical incident that prompts negative impacts either in regional or global equity markets. Markets are not prepared for these risks to materialize. Standard measures of global policy uncertainty have fallen sharply for most countries. It is notable that two of the few countries in the world seeing rising policy uncertainty are China and Russia. The latter is likely due to domestic instability – which is a major motivator for an aggressive foreign policy (Chart 14). Chart 14AGlobal Policy Uncertainty Will Revive Chart 14BGlobal Policy Uncertainty Will Revive Global fiscal stimulus remains exceedingly strong – it is likely to peak this year. Chart 15 shows the latest update in fiscal stimulus for select countries, comparing the COVID-19 crisis to the 2008 financial crisis. There are some notable changes to previous versions of this chart, mostly due to revisions in GDP after last year’s shock, revisions in tax revenues due to the rapid economic snapback, and revisions to the timing and size of stimulus packages. The Biden administration’s $2.3 trillion infrastructure plan is obviously not included. The second panel of Chart 15 shows the changes in the IMF’s estimates from October 2020 to April 2021. Essentially the fiscal stimulus in 2020 was overestimated, as many measures did not kick in and the economic snapback was better than expected, whereas the 2021 stimulus is larger than expected. Russia and China are notable for tightening policy sooner than others – leading to a reduction in IMF estimates of fiscal stimulus for both years. Chart 15Revising Our Global Fiscal Stimulus Chart Commodities have been a major beneficiary of the global recovery (Chart 16). Chinese growth is likely to decelerate this year which will spark a pullback, even aside from geopolitical crises. However, from a cyclical perspective commodities, especially industrial metals, should benefit from limited supply and surging demand. Geopolitical crises and even wars would first be negative but then positive for metals. Chart 16Commodities To Benefit From Geopolitical Conflict Notably the US is embracing industrial policy alongside China and the EU. In particular the US is joining the green energy race with Biden’s $2.3 trillion American Jobs Plan containing about $370 billion in green initiatives and likely to pass Congress later this year. Symbolically Biden will emphasize the US’s attempt to catch up with Chinese and European green initiatives via his hosting of a global summit on April 22-23 for Earth Day. A brief word on the British pound. We took a tactical pause on our cyclically bullish view of the pound in February in anticipation of the Scottish parliamentary election on May 6. A strong showing by the Scottish National Party could lead to a second independence referendum. This party is flagging in the polls but independence sentiment has ticked back up, reinforcing our point that a nationalist surprise could take place at the ballot box (Chart 17). Once we have clarity on the prospect of a second referendum we will have a clearer view on the pound over the medium term. Chart 17Pound Sees Short-Term Risk From Scots Election Chart 18Long CHF-GBP For A Tactical Trade In the near term, we continue to pursue tactical safe-haven trades and hedges. Our tactical long Swiss franc trade was stopped out at 5% on March 25. But our Foreign Exchange Strategist Chester Ntonifor has since highlighted that the franc is excessively cheap (Chart 18). This time we recommend a tactical long CHF-GBP, which has an attractive profile in the context of geopolitical risk, taken together with the British political risk highlighted above.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 “Jaw-Jaw Is Best, Macmillan Finds,” New York Times, January 30, 1958, nytimes.com. 2 Taiwan – Province of China.

Highlights The bull market in US-Iran tensions was never resolved, and now a series of suspicious explosions in Iran raises the possibility that tensions will re-escalate. Iran’s interest lies in waiting out Trump so that a Democratic victory in the US election can restore the US-Iran strategic détente agreed in 2015. However, both the Trump administration and US ally Israel are applying “maximum pressure” on Iran and could go on the offensive at a time when Trump’s odds of re-election are collapsing. Israel cannot engage in a full-fledged war with Iran alone but it would have American backing for pressure tactics through the duration of Trump’s term. A “wag the dog” scenario is not inconceivable because the US and Israel have long-term national security interests at stake while Iran is on the verge of economic collapse. Investors should prepare for near-term global equity volatility and safe-haven demand for a number of reasons but a major escalation in Iran would add to the list. Stay long Brent crude oil. Feature Since May 2018 we have argued that US-Iran tensions will remain market-relevant. We downgraded the odds of US air strikes from 40% in June 2019 to 20% in January of this year after Iran’s lackluster retaliation to the US assassination of its top military commander. Now things are heating up again due to a series of extremely suspicious explosions in Iran that may or may not be linked to Israel and the United States. The COVID-19 pandemic, oil price rout, and global recession have reinforced this bull market in US-Iran tensions by weakening and destabilizing the entire Shia Crescent, from Lebanon to Iran. They have also pushed President Trump dangerously close to “lame duck” status, which reduces the constraints on conflict with Iran for the remainder of his term. In this report we update our Iran view by looking at whether the Trump administration or Israel could attempt to “wag the dog,” i.e. provoke a conflict with Iran to boost Trump’s re-election odds or achieve some long-term strategic objectives while Trump is still in power. We have long held the view that Iran poses a market-relevant geopolitical risk and now the mysterious attacks in Iran suggest it could be materializing. Nothing is confirmed, but it is wise for investors to monitor these developments in case they escalate. Geopolitical incidents often cause buying opportunities but they can create substantial equity drawdowns first. Cyber-Rattling In The Middle East A string of mysterious explosions and fires at military and economic facilities have rocked Iran in recent days (Table 1). Table 1Iran Hit By A String Of Mysterious Attacks The most significant of these incidents is the July 2 explosion at the Natanz nuclear facility – Iran’s main uranium enrichment facility, which houses a new centrifuge assembly center.1 The fire resulted in a significant setback to the development and production of advanced IR-6 and IR-8 centrifuges used to enrich uranium – by up to two years. Iranian officials initially downplayed the incidents as unsuspicious accidents. However the Natanz explosion was too significant to cast off. Iran’s state-run news agency IRNA declared that the Natanz incident may be the work of foreign countries, “especially the Zionist regime [Israel] and the US,” and vowed Iranian retaliation if sabotage is proven to be the case. Similarly, the New York Times reported that an anonymous Middle Eastern intelligence official – rumored to be Mossad chief Yossi Cohen – called the incident the work of Israel.2 Israel’s response to these allegations has been oblique, but the accusation is not far-fetched. Israel has a successful history of halting the advancement of nuclear programs in the region. Mossad’s Operation Opera destroyed Iraq’s only known nuclear facility in 1981, and Operation Outside the Box bombed a suspected nuclear reactor at the Kibar site in Syria in 2007. Israeli intelligence has also previously been accused of targeting Iran’s missile program – with the assassination of four Iranian nuclear scientists between 2010 and 2012. Israel is also believed to be involved, with the US, in Operation Olympic Games, the Stuxnet cyber attacks that stunted Iran’s uranium enrichment program circa 2010. Iran’s ballistic missile program and alleged nuclear weapons ambitions remain Israel’s greatest long-term strategic threat in the region. More recently, Iran and Israel have been locked in a series of cyber-attacks. Israel claims to have foiled an Iranian attack on its water facilities in April which attempted a cyber break on water control systems. A May 9 cyberattack on Iranian shipping hub Shahid Rajaae – through which half of Iran’s maritime trade traverses – is seen as Israeli retaliation. Most recently, Israel’s Mossad revealed that it thwarted Iranian attempts to attack Israeli diplomatic missions in Europe. These attacks come as the US increases pressure on UN Security Council members to support the indefinite extension of the UN arms embargo against Iran, which is scheduled to expire on October 18.3 But other signatories to the 2015 Iranian nuclear agreement – China, Russia, Germany, Britain, and France – argue that since the US withdrew from the Joint Comprehensive Plan of Action (JCPA), its threat to invoke a “snapback” provision of the deal to reimpose former UN sanctions on Iran is not legally valid. The other JCPA signatories remain committed to the deal, arguing for its necessity in order to continue IAEA inspections that prevent Iran from developing nuclear weapons. They are biding their time to see if Trump is re-elected before deciding anything. Iran has moved further from the JCPA’s requirements since announcing, on January 5, 2020, that it will no longer comply with restrictions to its nuclear program (Table 2). The risk is that unless controlled, this will eventually significantly reduce Iran’s “breakout time” – the time required to acquire enough fissile material for one bomb. The nuclear deal aimed to maintain at least a one-year breakout time, and this is generally understood to be the US’s “red line.” Table 2Iran No Longer Complying With 2015 Nuclear Deal Despite some non-compliance, Iran is still permitting IAEA inspectors to monitor and verify its nuclear activities. Yet the IAEA Board of Governors passed a resolution, requesting Iran’s cooperation in the investigation into possible undeclared nuclear materials and sites.4 Chart 1Iran's Sphere Of Influence In Collapse As tensions with US and Israel escalate, Tehran has been keen to highlight its military capabilities. Revolutionary Guard Navy Commander Rear Admiral Alireza revealed the existence of onshore and offshore underground missile sites along the Persian Gulf and Gulf of Oman, holding advanced long-range missiles and new weapons, more capable of launching attacks against enemies. Escalating tensions raise the likelihood of retaliation as Iran reconsiders its “strategic patience” policy.5 Tehran had been playing the waiting game, especially since Trump’s decision to assassinate Quds Force chief Qassem Soleimani in January. Iran has an interest in avoiding confrontation in the months ahead of the US election on November 3. Iran’s attack on Saudi Arabia in September 2019 led to a boost in Trump’s approval rating. A major conflict today would cause a patriotic rally around the president at a time when he is beset with negative opinion over the coronavirus response and poor race relations. Iran has an interest in Joe Biden winning the presidency in November. Biden would likely restore the US-Iran deal, which would remove sanctions and allow Iran to open its economy. However, neither the Trump administration nor the Israeli government share that interest. The latest attacks raise the possibility that the US and/or Israel are going on the offensive. This could force Iran to retaliate. Iranian moderates are already suffering domestically. Iran’s hardline parliamentarians were never on board with the nuclear deal and criticized President Hassan Rouhani when President Trump pulled out of it in May 2018. This past weekend Foreign Minister Javad Zarif, an ally of Rouhani whose reputation also rests on the deal, was heckled as he addressed the parliament. As of February, parliament is mostly comprised of hardliners.6 Iran is also on shaky ground in the Shia Crescent. Lebanon and Iraq – the two countries most entrenched in Iran’s sphere of influence – have been experiencing civil unrest. Protesters in both countries initially took to the streets last fall in demonstration of anger over government corruption, the sectarian based political system, and poor economic conditions. The pandemic and recession have breathed new life into these movements. The Lebanese pound collapsed on the parallel market since October, and some groups have called for the disarmament of Iran-backed Hezbollah (Chart 1). Meanwhile a June cabinet decision in Iraq to cap the amount and number of state salaries and pension payments collected – in attempt to buttress the country’s ailing finances – fueled outrage. Iraq’s Prime Minister Mustafa al-Kadhimi is also in a tussle with Iran-backed paramilitary forces as he attempts to curb their influence and bring them under state control.7 Chart 2Iran Has Little To Lose Thus a timid stance by Iran in face of foreign attacks will not go down well. Instead, with oil production having collapsed, the economy in shambles, and its sphere of influence in turmoil, Tehran has little to lose in protecting what is left of its nuclear program and deterring American or Israeli aggression (Chart 2). With few options left, Iran is likely to move further away from its “strategic patience” in response to the uptick in “maximum pressure.” Bottom Line: Tensions are escalating between Tehran and Washington/Tel Aviv. Cyber attacks are likely to increase in the lead up to the expiration of the arms embargo on October 18 and US elections this fall. Iran may be forced to abandon its policy of “strategic patience” if its foes sabotage its nuclear capabilities. Expect the conflict to spillover to Iran’s proxies in the region – Iraq, Lebanon, and Syria. So What? Massive monetary and fiscal stimulus and continued commitment from OPEC 2.0 on the supply side will keep oil prices moving higher this year. Barring a second COVID-19 wave, our Commodity & Energy Strategists expect oil markets to rebalance beginning in 3Q2020, with Brent prices averaging $40/bbl this year and $65/bbl in 2021 (Chart 3). We remain long Brent which is up 70.55% since initiation in March.   The escalation in tensions in the Persian Gulf is an upside risk to this assessment. That said, with major oil producers now operating significantly below capacity in compliance with the OPEC 2.0 production agreement, the net impact on oil prices will likely be muted and short-lived. Production can be increased to fill gaps. As demonstrated by the recent acts of sabotage in Iran and Israel, the increase in geopolitical tensions globally will manifest in cyberattacks, supporting cyber stocks. Our strategically long ISE Cyber Security Index relative to the S&P500 Info Tech sector trade is up 2% since initiation in April (Chart 4). Chart 3Oil Markets On The Way To Recovery Chart 4Buy Cybersecurity Stocks Finally, we should note that Iran is not the only geopolitical risk that could explode amid the US election cycle. China is the greater risk. But President Trump faces fewer financial and economic constraints in a conflict with Iran than he does in a conflict with China. A conflict with Iran could change the game ahead of the election at a time when Trump is beset with the coronavirus and social unrest. His opinion polling would benefit from a rally around the flag, as it did in September 2019. The risk for Trump is that this bump may not last long. Americans are less concerned about Iran than China and Russia and Trump himself has benefited from American weariness of Middle Eastern wars. All we can say for certain is that the US election is of critical strategic importance to several major and minor powers. Trump’s allies and enemies know that the next six months offer their best chance to take actions that either affect the election or exploit the current alignment of US foreign policy relative to a Democratic Party alignment. While China probably prefers Biden, it can deal with either ruling party. Whereas Israel has a unique opportunity to advance its objectives under Trump and Iran has a clear imperative to remove Trump from office.   Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The damaged building was constructed in 2013 to be a site for the development of advanced centrifuges. Work there was stopped in 2015 as per requirements of the JCPA, but was restarted when the US withdrew from the deal in 2018. 2 Meanwhile a group of dissidents from within Iran’s military and security forces, calling themselves Homeland Cheetahs, claimed responsibility for the Natanz attack. However, it is possible that the claim was made with the intention to mislead. Please see Jiyar Gol, "Iran blasts: What is behind mysterious fires at key sites?" BBC News, July 6, 2020. 3 The draft US resolution bans Iran from supplying, selling, or transferring weapons after the October 18 expiration of the embargo. It bans UN member states from purchasing Iranian arms or permitting citizens to train or provide financial resources or assistance to Iran without Security Council approval. 4 This resolution, introduced by France, Germany, and the UK, refers to an undeclared uranium metal disc, potential fuel-cycle-related activities such as uranium processing and conversion, and suspected storage of nuclear material. Iran’s parliament responded by issuing a statement signed by 240 out of the 290 members which called the resolution excessive and requested that Iran halt voluntary implementation of additional protocol and change inspections 5 Iran’s state-run news agency IRNA published the following commentary in response to the Natanz explosion: "The Islamic Republic of Iran has so far tried to prevent intensifying crises and the formation of unpredictable conditions and situation … the crossing of red lines of the Islamic Republic of Iran by hostile countries, especially the Zionist regime and the US, means that strategy … should be revised." 6 In addition, 120 out of the 290 parliamentarians signed and delivered a motion to the presiding board of the assembly, requesting that Rouhani be summoned for questioning. The presiding board may not issue the summons and is unlikely to result in Rouhani’s impeachment as Khamenei has requested unity amid high foreign tensions. It nonetheless reflects Rouhani’s weakened position ahead of next year’s elections. 7 Hisham al-Hashemi, an advisor to Prime Minister Mustafa al-Kadhimi who had advised the government on reducing the influence of Iran-backed militias in Iraq, was killed on July 6, days after receiving threatening telephone calls from militias.