Sectors

Executive Summary Energy and National Security Will Drive the Market Our 2022 key views are broadly on track. Biden’s shift from domestic to foreign policy is dominating the other views.   However, Democrats still have a 65% chance of passing a reconciliation bill that will raise taxes to pay for green energy and prescription drug caps. Then gridlock will set in. The US is developing a new national consensus. Generational change is promoting the shift to proactive fiscal policy to address the country’s social unrest and rising foreign policy challenges. Polarization is still at peak levels in the short term but will fall over the coming decade as the US pursues “nation building” at home while confronting geopolitical rivals. The return of Big Government is being priced into the bond market today. But it will be Limited Big Government, as the sharp spike in inflation today will provoke a backlash. Recommendation Inception Level Inception Date Return Long Aerospace And Defense Vs. Broad Market (Cyclical)   30-Mar-22   Long Oil And Gas Transportation And Storage Vs. Broad Market (Cyclical)   30-Mar-22   Long Refinitive Renewable Energy Vs. Broad Market (Tactical)   30-Mar-22   Bottom Line: Investors dedicated to the US market should stay tactically defensive. Cyclically favor the new US policy consensus on national defense, infrastructure, cyber security, and energy security. Feature The title of our annual outlook was “Gridlock Begins Before The Midterms.” We argued that Biden would still have some room for legislative maneuver in the first half of 2022 but that checks and balances would grow as the year went on. Checks will grow due to (1) the looming midterm elections; (2) Biden’s falling political capital and need to rely on executive action; (3) rising foreign policy challenges. Of these, foreign policy has proven decisive, with Russia invading Ukraine and the US and Europe imposing economic sanctions. The resulting energy shock is adding to inflation, weighing on consumer confidence, stock market multiples, and investor sentiment (Chart 1). Having said that, we also argued that congressional Democrats still had enough political capital to pass a watered-down fiscal 2022 budget reconciliation bill before the scene of action shifted to the White House. The second quarter is the last chance for this prediction to come true – and we are sticking with our 65% odds. The reconciliation bill will be even more watered down than we expected. But the point is that fiscal policy – especially tax hikes – can still move markets in the second quarter, even though inflation, the Fed, and the war will have a bigger influence. Chart 1US Seeks National Security And Energy Security Related Report  US Political Strategy2022 Key Views: Gridlock Begins Before The Midterms The war in Europe is clearly the most important political, geopolitical, and policy dynamic for investors this year. It is prompting some important congressional action that speaks to Biden’s room for maneuver in the first half of the year. In so doing it reinforces our long-term themes of “Peak Polarization” and “Limited Big Government.” As Americans face rising foreign policy challenges, a new bipartisanship is emerging, particularly on industrial and trade policy. Checking Up On Our Three Key Views For 2022 Here are our three key trends for 2022 with comments about their development over the past three months: 1.   From Single-Party Rule To Gridlock: We argued that the Biden administration would pass a watered-down reconciliation bill on a party-line vote by June at latest. Then Congress would grind to a halt for election campaigning, to be followed by Republicans taking one or both chambers of Congress, restoring gridlock and making it hard to pass major legislation from the second half of 2022 through 2024. This view is still generally on track. The basis for believing that a bill will still pass is that the Democrats are in trouble in the midterms and badly need a legislative victory. Public opinion polls suggest they face a beating reminiscent of President Trump and the Republicans in 2018 (Chart 2). Democrats trail Republicans in enthusiasm. Only about 45% of Democrats and 42% of Biden voters are enthusiastic to vote, while 50% of Republicans and 54% of Trump voters are enthusiastic. Men, who lean Republican, are more enthusiastic than women, by 51% to 38%, according to the pollster Morning Consult.1 With the economy and foreign policy rising as the most important issues of the election, Democrats have lost their key issues of health care and the pandemic. Notably Democrats have also lost ground on traditional strengths like education. However, the Ukraine war has put a new emphasis on energy security which Democrats are harnessing to repackage their climate agenda. Hence Democrats will make a last-ditch effort to pass a reconciliation bill before the summer campaigning gets under way. The “Build Back Better” plan was always going to be watered down but now it will be extensively revised. The bill will now have to be closer to neutral in its impact on the deficit so as not to feed inflation. Public opinion polls back in January, when the bill was primarily a social welfare bill, showed 61% of political independents in favor, not to mention 85% of Democrats. A majority of independents supported the bill even when asked about each provision separately and when the tax hikes were made plain.2 By halting progress on the left-wing version of the bill that the House of Representatives passed late last year, West Virginia Senator Joe Manchin saved his party from passing a highly stimulative fiscal bill in the middle of the biggest outbreak of inflation since the 1980s, when the output gap was virtually closed (Chart 3). Chart 2Democrats Not Faring Much Better Than Trump Republicans In 2018 Chart 3Output Gap Closed, No More Stimulus Needed Now Manchin will face a “Build Back Slimmer” bill that will be harder to oppose when Congress comes back from Easter.3 Our research over the past year suggests that Manchin is likely to vote for a bill that meets his main demands. The bill will be crafted for his approval. Manchin supports corporate tax hikes, funding for green energy transition (as long as it is not punitive toward certain sources or technologies), and a cap on prescription drug costs.4 Tax hikes, such as a minimum 15% corporate tax rate on book earnings, will be included, albeit diluted from the original proposals. Most investors have forgotten about the risk of tax hikes altogether so stock investors may not be happy that the US is hiking taxes amid inflation. Earnings estimates for the year are not reflecting any negative news, whether energy shock, or weak consumer confidence, or new taxes (Chart 4). If the bill fails to pass, equity investors may well cheer, since they are worried about inflation rather than deflation and the bill will not truly be deficit-neutral. Chart 4Inflation, War, Potentially Tax Hikes Will Weigh On Earnings Estimates Given Democrats’ thin majorities in both houses (222 versus 210 seats in the House and 50 versus 50 seats in the Senate), a single defection in the Senate can derail the bill, so we cannot have high conviction that it will pass. We are sticking with our 65% subjective odds. Passage of a reconciliation bill will slightly help Democrats’ fortunes ahead of the midterm but Republicans are still highly likely to win at least the House of Representatives. So the transition to gridlock will still occur. Only very rarely do ruling parties gain seats in the midterms. Biden’s loss of support among women voters is a tell-tale sign that trouble looms, as was the case for the Obama administration at this stage in its first term (Chart 5). The implication for financial markets is that the budget reconciliation bill will bring a negative surprise in the form of tax hikes that will weigh on bullish or pro-cyclical sentiment in the second quarter, at least marginally. Chart 5Women Like Biden Less Than Obama, Who Suffered Midterm Losses Chart 6Biden's Energy Shock 2.   From Legislative To Executive Power: Similarly we anticipated a transition from legislative action to executive action over the course of 2022. After the budget reconciliation bill is decided, the president will have to rely on executive action to achieve any policy goals. We expected this trend to derive from Biden’s regulatory aims as well as from the need to respond to rising geopolitical challenges, especially the energy shock (Chart 6). This shock is the single biggest reason for the market consensus that Democrats will lose Congress this year. The chief equity sector winner was the energy industry, as we expected. Now Biden needs to encourage rather than discourage supply. Until Biden decides whether to lift sanctions on Iran, volatility will prevail in energy markets. But Biden will condone domestic energy production, with a view to alleviating shortages prior to 2024. He will abandon his left wing and adopt the Obama administration’s permissiveness toward domestic energy, which will help oil and natural gas rig counts to rise (Chart 7). Renewable energy policy will gain traction as it will now clearly be seen in the context of national security and energy security. It also combines trade policy with national security in the form of exports to allies. The US now has a free pass to help Europe diversify away from Russian energy. Not that the US can replace Russia but merely that it can make a dent in both oil and liquefied natural gas (Chart 8). Subsidies for green energy are still likely but not a carbon tax or punitive measures toward the fossil fuel industry. Chart 7Biden Revives Obama Truce With O&G Chart 8US Helps Europe Diversify Away From Russia 3.   From Domestic To Foreign Policy: We fully expected Biden to be forced to pay attention to foreign affairs in 2022, despite his desire to focus on the voter ahead of midterms. We argued that he would maintain a defensive or reactive foreign policy since he would not want to create higher inflation ahead of the midterms and yet oil producers like Russia or Iran would go on offensive due to energy shortage. While Biden has imposed harsh sanctions on Russia, we still define his foreign policy as defensive rather than offensive. First, Biden is reacting to a Russian attack and will not sabotage a ceasefire. Second, Biden is carving out exceptions to US sanctions rather than disciplining or coercing allies into adopting US policy. The administration’s chief foreign policy aim is to refurbish US alliances. Hence the US condones the EU’s continued energy imports from Russia, thus ensuring that Russian energy makes it into the global market, unless the Russians cut natural gas exports (Chart 9). Nevertheless a risk to our view is that Biden will start to adopt a more offensive foreign policy, especially if Democrats are floundering ahead of the midterms. He could turn more aggressive about sanction enforcement if Russia starts bombarding Kyiv again. Or he could slap broad sanctions on China for helping Russia bypass sanctions. To be clear, we fully expect secondary sanctions on China, based on US record of doing so, but we expect them to be targeted rather than broad (Table 1). Chart 9Russian Energy Still Reaches Global Market Table 1US Will Slap China With Sanctions Over Russia – Sooner Or Later Foreign policy will define US politics and policy in 2022. What matters for markets is whether the energy supply shock gets worse as a result of Biden’s handling of Russia and Iran. A worse energy shock will amplify stock market volatility. On one hand, if Biden suffers a humiliating foreign policy defeat, it will reinforce the negative trends for Democrats in the 2022-24 cycle. Since Republicans, especially former President Trump, would be expected to pursue an offensive rather than defensive foreign and trade policy (e.g. toward Iran’s nuclear program and China’s economy), global economic policy uncertainty would rise and investor risk appetite would fall in this situation (Chart 10). On the other hand, investors will be surprised if Biden achieves a remarkable domestic or foreign policy success that boosts Democrats’ odds in 2022. An early ceasefire in Ukraine combined with a reconciliation bill would give Biden and Democrats a boost. Global policy uncertainty might rise anyway but it would not be super-charged and it would be flat-to-down relative to US policy uncertainty. Democrats could conceivably retain control of the Senate in the latter case. Our quantitative election model says Democrats have a 49% chance of retaining the Senate (Chart 11). This means the election is too close to call, though subjectively we would agree with the model and bet on the Republicans since they only need to gain one seat on a net basis. The model shows Georgia and Arizona flipping back to the Republican side. If the economy and opinion polling improve between now and November, the swing states will see higher probabilities of Democrats staying in power but the model is trending against Democrats and shows their odds of victory falling in every state. Chart 10US Political Outlook Affects Relative Policy Uncertainty Chart 11Senate Race Too Close To Call, But Quant Model Now Tips Republicans Anything that pares Democrats’ expected losses in Congress will cause US economic policy uncertainty to rise since it goes against the consensus view. Moreover if Republicans only win the House, they will be obstructionist and disruptive in 2023-24, whereas if they win all of Congress they will have to produce bills and try to compromise with Biden. Thus a Republican House but Democratic Senate would imply an increase in policy uncertainty. By contrast, anything that hurts the Democrats will reinforce current expectations and imply that tax hikes might fail, or that they will freeze after the reconciliation bill, which would be marginally positive for US equity investors in an inflationary context. Bottom Line: Democrats still have a 65% subjective chance of passing a reconciliation bill that raises taxes. Investors should favor defensives over cyclicals. Checking Up On Our Strategic Themes For The 2020s Our central long-term thesis is that generational change, social instability, and foreign policy threats are generating a new national consensus in the United States, particularly on economic policy. Hence US political polarization is peaking in the short run and will decline over the long run. The new consensus rests on proactive fiscal policy and a larger government role in the economy to reduce social unrest and improve national security. Table 2 shows our three strategic US political themes. The past year’s inflation surge and the Ukraine war will affect these themes, so we make the following points: Table 2US Political Strategy Structural Themes 1.   Millennials/Gen Z Rising: Labor market participation is recovering rapidly from the pandemic. However, workers older than 55 years are not rejoining rapidly, implying that retirees are staying retired and not yet chasing rising wages. Prime age women, however, are rejoining the work force, in a sign that as kids get back to school mothers can return to work (Chart 12). The implication is that the labor shortage will continue for the foreseeable future due to the generational transition but not due to any shift toward traditional values or lifestyles among young women. 2.   Peak Polarization: Polarization has fallen after the 2020 election, as expected, but will likely stay at or near peak levels over the 2022-24 election cycle (Chart 13). Chart 12Generational Shift Evident In Labor Participation Chart 13Polarization Near Peak Levels But Will Fall Over Long Run For example, Biden’s reconciliation bill will feed polarization in 2022, since it can only pass on a party-line vote. But its tax and spending programs will have majority support, will redirect funds from corporations that pay low effective tax rates toward corporations that provide renewable energy solutions. Domestic manufacturing will benefit. Another example: Another Biden-Trump showdown in 2024 will fuel polarization but 2024 or 2028 and subsequent elections will see fresh faces with updated policy platforms. The merging of trade protectionism and renewable energy exemplifies the new policy evolution. Again, with polarization at historic levels, domestic terrorism of whatever stripe is a pronounced risk in 2022 and the coming years. But any significant political violence will ultimately drive a new national consensus in favor of federalism. 3.   Limited Big Government: The story of the 2000s and 2010s was the revival of Big Government, first in the George W. Bush national security state, then in the Barack Obama liberal spending tradition, then in the big spending Republican tradition with Trump, and finally in the liberal tradition again with Biden. The combination of popular discontent at home and great power struggle abroad means that the US is unlikely to slash either social programs or defense spending. As for tax hikes, aggressive tax hikes are impractical. Biden may pass some tax hikes but the budget deficit will continue to expand over the long run (Chart 14). At the same time, the shift to Big Government is occurring with an American context. The geography, constitution, and political system militate against centralization. The return of inflation means that fiscal conservatism will also make a comeback, starting with Republicans in the House in 2023, who will oppose new spending as a standard opposition tactic. So while Big Government has returned, and bond investors are pricing this sea change by pushing up Treasury yields, nevertheless the market will also need to price the fact that the growth of government still faces structural limits. Chart 14Reconciliation Bill Will Have Miniscule Impact On Budget Outlook These structural themes face crosswinds in 2022. The Millennials and younger generations will not carry the day in the midterm election – the Baby Boomers and Greatest Generation will. Peak polarization will bring negative surprises for investors over the 2022-24 election cycle and potentially even in 2024-28 if Trump is reelected. A Democratic reconciliation bill will expand government programs in 2022, while Republicans will revert to big spending ways if they gain full control of government again in 2025. Nevertheless the evidence suggests that generational change, peak polarization, and limited big government will prevail over time. The younger generations favor more proactive fiscal policy. Fiscal policy will address social unrest and geopolitical threats. But big government will drive inflation, which will in turn force voters to impose limits on government over the long run. Bottom Line: The US will opt to inflate away its debt over the long run – but it will also need growth and some structural reform once the ills of inflation become fully absorbed by voters. The huge bout of inflation in 2022 is only the beginning of this political process, though it will also accelerate the process. Investment Takeaways Stocks tend to be flattish ahead of midterm elections. This includes elections when a united government becomes gridlocked as is likely in 2022-23. Equities tend to perform better after election uncertainty passes. The transition from single-party government to gridlock also tends to imply higher yields until after the election is over, at which point yields decline (Chart 15). Single-party governments can manipulate fiscal policy to try to stay in power. Chart 15Stocks Tend To Be Flat, Bond Yields High, Until After Midterm Elections Defensives are outperforming cyclicals on slowing growth, rising interest rates, rising labor costs and energy prices, and rising uncertainty. Our worst call for Q1 was our tactical long growth over value stocks. We made this trade knowing it went against our strategic approach, which has favored value over growth since we launched the US Political Strategy in January 2021. Our reasoning was that a geopolitical crisis would cause a temporary spike in energy prices but a longer drop in bond yields. In fact bond yields rose anyway. We still think tech is increasingly attractive, especially after the corporate minimum tax passes. The brief inversion of the 2-year/10-year yield curve suggests the US economy is flirting with recession. Other parts of the curve are not yet confirming this signal and there can be a long lead time between inversion and recession. However, there is not yet a ceasefire in Ukraine and certainly not a durable ceasefire. The US and Iran do not yet have a deal to avoid a major increase in geopolitical tensions. The risk of a bigger energy shock from Russia or Iran or both is significant and could shorten the cycle. We recommend going strategically long S&P 500 oil and gas transportation and storage relative to the broad market. We also recommend taking advantage of the lull in fighting in Ukraine to join our Geopolitical Strategy in going strategically long US defense stocks relative to the broad market. Tactically we recommend going long renewable energy since the Democrats’ pending reconciliation bill will benefit from broader public recognition of the need for the energy security of both the US and its allies (Chart 16). Chart 16Go Long Defense, Energy Storage, And Renewables Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     See “National Tracking Poll,” Morning Consult and Politico, #2202029, February 5-6, 2022, assets.morningconsult.com. 2     Admittedly this poll is by a left-leaning organization but polling throughout 2021 supports the general conclusion that a majority of political independents support the key proposals. See Anika Dandekar and Ethan Winter, “Majority of Voters Still Want the Build Back Better Act Passed,” Data for Progress, January 4, 2022, dataforprogress.org. 3    See Nick Sobczyk and Nico Portuondo, “Democrats eye ‘Build Back Slimmer’ on reconciliation,” E&E News, March 24, 2022, eenews.net. 4    See Eugene Daniels, “The Left Gears Up to Take on Manchin Again,” Politico, March 29, 2022, politico.com. See also “Regan, McCarthy, Wyden talk revival of BBB,” The Fence Post, March 25, 2022, thefencepost.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Executive Summary China’s Business Cycle Has Not Bottomed Recent data showed a substantial improvement in the economy in the first two months of the year. However, the optimism is not well supported by other industry and high-frequency data. China’s exports were resilient, while infrastructure investment also rebounded sharply on the back of front-loaded fiscal stimulus. Nonetheless, domestic demand in China remains in the doldrums. Housing market indicators show a further deterioration in home sales and prices in January and February. Consumption in tourism during the Chinese New Year and service sector activities were also weaker compared with the same period last year. While we expect policymakers to roll out more measures to shore up domestic demand, China’s economy will likely have a choppy bottom in the first half of 2022. We maintain our neutral position on Chinese onshore stocks in a global portfolio. In absolute terms, we are cautious and are looking for a better price entry point in Q2. Bottom Line: Economic data in the first two months of the year sent mixed signals, which suggests that China’s economy has not reached a solid bottom. Feature Newly released economic data from January and February (i.e. industrial production, fixed-asset investment, retail sales and property investment) all generated sizable positive surprises. However, other industry and high-frequency data sent conflicting messages. The improvement in China’s total social financing (TSF) in the past few months has been due to local government (LG) bond issuance (Chart 1). Corporate credit showed little advancement, while household loans were extremely weak (Chart 2). In addition, further contracting home sales paint a bleak picture of housing demand. Soft readings in the service sector Purchasing Managers' Index (PMI) and core consumer price index (CPI) suggest that consumption remains sluggish. Chart 1The Credit Impulse Continued To Trend Down (Excluding LG Bond Issuance) Chart 2No Improvement In Corporate Or Household Demand For Credit Beijing is stepping up its pro-growth stimulus, particularly on the fiscal front. However, the country will unlikely undergo a strong recovery in its business cycle without a major reversal in the housing market and an improvement in demand from the private sector. Moreover, recent lockdowns to tame surging domestic COVID-19 cases amid China’s zero-tolerance pose major downside risks to the near-term economic outlook. Chinese equities sold off in response to lockdown news despite the release of better economic data earlier this month, highlighting investors’ weak sentiment. Chart 3China's Business Cycle Has Not Bottomed We maintain our neutral view on China’s onshore stocks relative to their global peers, but we are cautious on Chinese equities in absolute terms.  On a cyclical time horizon (6 to 12 months), there are increasing odds that Chinese policymakers will stimulate the economy more aggressively, particularly in the 2nd half of the year. However, it is too early to turn bullish on Chinese equities (Chart 3). The ongoing war in Ukraine and elevated oil prices, coupled with risks of further lockdowns in China and a prolonged downturn in domestic demand, present significant near-term risks to the performance of Chinese equities. Investors should closely watch for more reflationary efforts from Beijing and we believe a better entry point to upgrade Chinese stocks may emerge in Q2.   Qingyun Xu, CFA Associate Editor qingyunx@bcaresearch.com Near-Term Outlook For The Housing Market Remains Bleak Real estate investment growth in January-February was surprisingly strong, according to data from China’s National Bureau of Statistics. However, headline growth in real estate investment deviates from the continued weaknesses in other housing market indicators (Chart 4). In addition, data on the production of some key construction materials showed little improvement (Chart 5). Chart 4Conflicting Signals From The January-February Housing Market Indicators Chart 5Data On Building Materials Also Deviate From Strong Investment Growth In Real Estate Demand for housing remains lackluster. February’s medium- to long-term household loan growth, which is mainly mortgage loans and is highly correlated with home sales, plunged to an all-time low (Chart 6). Meanwhile, the deep contraction in home sales growth continued in February, and sentiment among home buyers remains downbeat (Chart 6, bottom panel) Chart 6Demand For Housing Remains In The Doldrums Chart 7Policymakers Are Trying To Avoid Further Inflating The Housing Price Bubble Although authorities have reiterated that they want to stabilize the property market, the policy measures have been only fine-tuned. Regional governments have been allowed to initiate their own housing policies and some cities have eased processes for home purchases.1 However, given that maintaining stable home prices is an overarching goal and China’s leadership is trying to avoid further inflating the home price bubble, it is doubtful that the government will allow significant re-leveraging in the property market (Chart 7). Chart 8 shows that funds to real estate developers have slowed to the lowest level since 2010, which will further dampen housing construction. Chart 8Housing Construction Activities Will Weaken Further In 1H22 Chart 9The Latest Spike In Domestic COVID Cases Will Weigh On Home Sales Moreover, high-frequency floor space sold data shows a broad-based decline in housing sales in tier-one, two and three cities through mid-March (Chart 9). The latest spike in China’s domestic COVID-19 cases and regional lockdowns will likely weigh on home sales in the short term. Property investment and construction will remain at risk without a decisive rebound in home sales. A Disrupted Recovery In Household Consumption Both retail and online sales of consumer goods held up better than expected in January and February (Chart 10). However, the subdued underlying data highlight that the strong reading in retail sales in the first two months of the year may be less than meets the eye. Chart 10Although Growth In Retail Sales Rebounded In January-February... Chart 11...Service Sector Activities Still Struggle To Return To Pre-Pandemic Levels Service sector and passenger activities are still well below their pre-pandemic levels, two years after the first COVID lockdowns in early 2020 (Chart 11). Consumption in tourism during the Chinese New Year holiday was weaker than last year. Households’ propensity to spend also showed few signs of rebounding (Chart 12 & 13). Chart 12Travel Consumption Was Weak During The Chinese New Year Chart 13Households’ Propensity To Consume Continues To Trend Down Furthermore, both core and service CPI weakened in February, reflecting lackluster demand from consumers (Chart 14). Labor market dynamics have also worsened and the unemployment rate, particularly among young workers, has risen rapidly since the beginning of the year (Chart 15).  Chart 14Weak Core And Service CPIs In February Suggest Lackluster Household Demand Chart 15Labor Market Situation Is Worsening The ongoing fight against mounting new COVID cases in China will likely drag down service sector activities in the coming months (Chart 16A & 16B). Importantly, the new round of lockdowns and mobility restrictions are primarily in busier and more developed coastal metropolitans, such as Shenzhen and Shanghai. Therefore, the negative impact from social activity restrictions will be more substantive compared with previous lockdowns. Chart 16AEscalating New Cases In China Will Constrain Domestic Consumption Chart 16BEscalating New Cases In China Will Constrain Domestic Consumption Strong Rebound In Manufacturing Investment Growth In January-February Probably Not Sustainable A strong rebound in the growth of manufacturing investment helped to support overall fixed-asset investment in the first two months of the year (Chart 17). Robust external demand for China’s manufacturing goods has likely contributed to the pickup in manufacturing output and helped to sustain Chinese manufacturers’ near-maximum capacity (Chart 18). Chart 17Strong Pickup In Manufacturing Investment Growth Chart 18Robust Exports Support Chinese Manufacturing Output And Capacity Utilization While the volume of manufacturing output increased, prices that producers charge consumers have rolled over (Chart 19). Historically, prices have been more important in driving corporate profits than the volume of output. In addition, a strong RMB and sharply climbing shipping costs will also weigh on Chinese exporters’ profitability (Chart 20). Chart 19Manufacturing Output Picked Up While Prices Rolled Over Chart 20Strong RMB And Rising Shipping Costs Will Reduce Chinese Exporters' Profitability Chart 21Manufacturing Sector's Profit Margins Will Be Further Squeezed The elevated prices of oil and global industrial metals will continue to disproportionally benefit upstream industries, which are mainly composed of commodity producers. Meanwhile, the manufacturing sector’s profit margins will be squeezed by rising input costs and sluggish final demand (Chart 21). Chinese manufacturers’ profit growth will likely weaken through 1H22 and the downtrend may be exacerbated by the ongoing struggle to contain COVID cases.  The impact from recent lockdowns in the northern city of Jilin (an auto production center), Shenzhen (a high-tech manufacturing production and export hub), and Shanghai (a city with major ports and a key logistics provider) will disrupt China’s manufacturing production and curb investment in the near term. Infrastructure Sector Will Remain A Bright Spot Through 1H22 Related Report  China Investment StrategyAiming High, Lying Low Infrastructure investment staged a strong recovery in January-February on the back of front-loaded fiscal stimulus (Chart 22). LG bond issuance started to accelerate last November and will boost both traditional and new-economy infrastructure spending at least through 1H22. Our calculations suggest that fiscal thrust will rise to more than 2% of GDP this year, a sharp reversal from last year’s negative impulse of 2% (Chart 23). Chart 22Fiscal Stimulus Is At Work Chart 23Fiscal Thrust In 2022 Could Reach More Than 2% Of GDP Chart 24Subdued Shadow Bank Activities Will Limit The Magnitude Of Rebound In Infrastructure Investment However, shadow bank activity, which historically had a tight correlation with infrastructure investment, remains downbeat (Chart 24). February’s reading of shadow bank credit was extremely weak, highlighting that local governments still face constraints in off-balance sheet leveraging through local government financing vehicles (LGFVs). The trend in shadow bank loans bears close attention in the coming months because it will signal whether the central government will allow more backdoor financing to help local governments fund their infrastructure projects. A continued soft reading in shadow bank activities will likely limit the upside in infrastructure investment growth. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary     Footnotes 1     Guangzhou lowered its down-payment ratio from 30% to 20%, along with a 20bp cut in mortgage rates. Zhengzhou marginally relaxed home purchase restrictions by allowing families who bring elderly relatives to live in the city to buy one extra home and also lifted the “definition of second home ownership by physical unit & mortgage history”. ​​​​​​​ Strategic Themes Cyclical Recommendations

Executive Summary Expansion In European Defense European yields have significant upside on a structural basis. European government spending will remain generous, which will boost domestic demand; meanwhile, lower global excess savings will lift the neutral rate of interest and structurally higher inflation will boost term premia. A short-term pullback in yields is nonetheless likely; however, it will not short-circuit the trend toward higher yields on a long-term basis. CYCLICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Favor European Aerospace & Defense Over European Benchmark 3/28/2022     Favor European Aerospace & Defense Over Other Industrials 3/28/2022     Bottom Line: Investors should maintain a below-benchmark duration in their European fixed-income portfolios. Higher yields driven by robust domestic demand and strong capex also boost the appeal of industrial, materials, and financials sectors. Aerospace and defense stocks are particularly appealing.     The economic impact of the war in Ukraine continues to drive the day-to-day fluctuations of the market; however, investors cannot ignore the long-term trends in the economy and markets. The direction of bond yields over the coming years is paramount among those questions. Does the recent rise in yields only reflect the current inflationary shock caused by both supply-chain impairments and commodity inflation—that is, is it finite? Or does that rise mirror structural forces and therefore have much further to run? We lean toward yields having more upside over the coming years, propelled higher by structural forces. As a result, we continue to recommend investors structurally overweight sectors that benefit from a rising yield environment, such as financials and industrials, while also favoring value over growth stocks. The defense sector is particularly attractive. Three Structural Forces Behind Higher Yields The current supply-chain disruptions and inflation crises have played a critical role in lifting European yields. However, a broader set of factors underpins our bearish bond view—namely, the lack of fiscal discipline accentuated by the consequences of the Ukrainian war, the likely move higher in the neutral rate of interest generated by lower savings, and the long-term uptrend in inflation. Profligate Governments Chart 1 Larger government deficits will contribute to higher European yields. Europe is not as fiscally conservative as it was before the COVID-19 crisis. Establishment politicians must fend off pressures caused by voters attracted to populist parties willing to spend more. Consequently, IMF estimates published prior to the Ukrainian war already tabulated that, for the next five years, Europe’s average structurally-adjusted budget deficit would be 2.4% of GDP wider than it was last decade (Chart 1). Chart 2Expanding Military Spending The Ukrainian crisis is also prompting a fiscal response that will last many years. Europe does not want to stand still in the face of the Russian threat. Today, Western Europe’s military spending amounts to 1.5% of GDP, or €170 billion. This is below NATO’s threshold of 2% of GDP. Rebuilding military capacity will take large investments. Thus, European nations are likely to move toward that target and even go beyond. Conservatively, if we assume that military spending hits 2% of GDP by the end of the decade, it will rise above €300 billion (Chart 2). Weaning Europe off Russian energy will also prevent a significant fiscal retrenchment. This effort will take two dimensions. The first initiative will be to build infrastructures to receive more LNG from the rest of the world to limit Russian intake. Constructing regasification and storage facilities as well as re-directing pipeline networks be costly and require additional CAPEX over the coming years. The second initiative will be to double-up on green initiatives to decrease the need for fossil fuel. The NGEU funds are already tackling this strategic goal. Nonetheless, the more than €100 billion reserved for renewable energy and energy preservation initiatives was only designed to kick-start hitting the EU’s CO2 emission target for 2050. Accelerating this process not only helps cutting the dependence on Russian energy, but it is also popular with voters. The path of least resistance is to invest in that sphere and to increase such investment beyond the current sums from the NGEU program. The last fiscal push is likely to be more temporary. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU. Accommodating that many individuals will be costly and will add to government spending across the region. Even if mostly transitory, this spending will have an important impact on activity. Larger fiscal deficits push yields higher for two reasons. Greater sovereign issuance that does not reflect a negative shock to the private sector will need to offer higher rates of returns to attract investors. Moreover, greater government spending will boost aggregate demand, which increases money demand. As a result, the price of money will be higher than otherwise, which means that interest rates will rise—as will yields. Decreasing Global Excess Savings Decreasing global excess savings will put upward pressure on the global neutral rate of interest, a phenomenon Peter Berezin recently discussed in BCA’s Global Investment Strategy service. This process will be visible in Europe as well. The US will play an important role in the process of lifting global neutral rates because the dollar remains the foundation of the global financial system. Compared to last decade, the main drag on US savings is that household deleveraging is over. As households decreased their debt load following the global financial crisis, a large absorber of global savings vanished, putting downward pressure on the price of those savings. Today, US households enjoy strong net worth equal to 620% of GDP and have resumed accumulating debt (Chart 3). Consequently, the downward trend in US total private nonfinancial debt loads has ended. The US capex cycle is likely to experience a boost as well. As Peter highlighted, the US capital stock is ageing (Chart 4). Moreover, the past five years have witnessed three events that underscore the fragility of global supply-chains: a disruptive Sino-US trade war, a pandemic, and now a military conflict. This realization is causing firms to move from a “just-in-time” approach to managing supply-chains to a “just-in-case” one. The process of building redundancies and localized supply chains will add to capex for many years, pushing up ex-ante investments relative to savings, and thus, interest rates. Chart 3US Households Are Done Deleveraging Chart 4An Ageing US Capital Stock China’s current account surplus is also likely to decline. For the past two decades, China has been one of the largest providers of savings to the global economy. This is a result of an annual current account surplus that first averaged $150 billion per year from 2000 to 2010 and then $180 billion from 2010 to 2020, and now stands at $316 billion. Looking ahead, China wants to use fiscal policy more aggressively to support demand, which often boosts imports without increasing exports. Also, more domestically-oriented supply chains around the world will limit the growth of Chinese exports. This combination will compress Chinese excess savings, which will place upward pressure on the global neutral rate of interest. Europe is not immune to declining savings. Over the past ten years, the Euro Area current account surplus has averaged €253 billion. Germany’s current account surplus stood at 7.4% of GDP before the pandemic. Those excess savings depressed global rates in general and European ones especially (Chart 5). As in the US, Europe’s capital stock is ageing and needs some upgrade (Chart 6). Moreover, greater government spending boosts aggregate demand. Because investment is a form of derived demand, stronger overall spending promotes capex to a greater extent. Thus, Europe’s public infrastructure push will lift private capex and curtail regional excess savings beyond the original drag from wider fiscal deficits. Additionally, the European population is getting older and will have to tap into their excess savings as they retire. This process will further diminish Europe’s current account surplus, that is, its excess savings. Chart 5Excess Savings Cap Relative Yields Chart 6An Ageing European Capital Stock Too Structurally Higher Inflation BCA believes that the current inflation surge is temporary and mostly reflects a mismatch between demand and supply. However, we also anticipate that, once this inflation climax dissipates, inflation will settle at a level higher than that prior to COVID-19 and will trend higher for the remainder of this decade. Labor markets will tighten going forward because policy rates remain well below neutral interest rates. Output gaps will close because of robust government spending and capex. This will keep wage growth elevated in the US and reanimate moribund salary gains in the Eurozone (Chart 7). This process, especially when combined with less efficient global supply chains and lower excess savings (which may also be thought of as deficient demand), will maintain inflation at a higher level than in the past two decades. Higher inflation will lift yields for two main reasons. First, investors will require both greater long-term inflation compensation and higher policy rates than in the past. Second, higher inflation often generates greater economic volatility and policy uncertainty, which means that today’s minimal term premia will increase over time (Chart 8). Together, these forces will create a lasting upward drift in yields. Chart 7European Wages Will Eventually Revive Chart 8Term Premia Won't Stay This Low Bottom Line: European yields will sport a structural uptrend for the remainder of the decade. Three forces support this assertion. First, European government spending will remain generous, supported by infrastructure and military spending. Second, global excess savings will recede as US consumer deleveraging ends, global capex rises, and the Chinese current account surplus narrows. Europe will mimic this process in response to an ageing population, greater government spending, and capex. Finally, inflation is on a structural uptrend, which will warrant higher term premia across the world. Not A Riskless View There are two main risks to this view, one in the near-term and one more structural. The near-term risk is the most pertinent for investors right now. Global yields may have embarked on a structural upward path, but a temporary pullback is becoming likely. As Chart 9 highlights, the expected twelve-month change in the US policy rate is at the upper limit of its range of the past three decades. Historically, when the discounter attains such a lofty level, a retrenchment in Treasury yields ensues, since investors have already discounted a significant degree of tightening. The same is true in Europe, where the ECB discounter is also consistent with a temporary pullback in German 10-year yields (Chart 10). Chart 9Discounters Point To A Treasury Rally... Chart 10... And A Bund Rally Chart 11A Mixed Message Investor positioning confirms the increasing tactical odds of a yield correction. The BCA Composite Technical Indicator for bonds is massively oversold, which often anticipates a bond rally (Chart 11). This echoes the signals from the JP Morgan surveys that highlight the very low portfolio duration of the bank’s clients. However, the BCA Bond Valuation Index suggests that bonds remain expensive. Together, these divergent messages point toward a temporary bond rally, not a permanent one. The longer-term risk is regularly highlighted by Dhaval Joshi in BCA’s Counterpoint service. Dhaval often shows that the stock of global real estate assets has hit $300 trillion or 330% of global GDP. Real estate is a highly levered asset class and global cap rates have collapsed with global bond yields. With little valuation cushion, real estate prices could become very vulnerable to higher yields. Nevertheless, real estate is also a real asset that produces an inflation hedge. Moreover, rental income follows global household income, and stronger aggregate demand will likely lift median household income especially in an environment in which globalization has reached its apex and populism remains a constant threat. Bottom Line: Global investor positioning has become stretched; therefore, a near-term pullback in yield is very likely, especially as central bank expectations have become aggressive. Nonetheless, a bond rally is unlikely to be durable in an environment in which bonds are expensive and in which growth and inflation will remain more robust than they were last decade. A greater long-term risk stems from expensive global real estate markets. However, real estate is sensitive to global economic activity and inflation, which should allow this asset class ultimately to weather higher yields. Investment Conclusions An environment in which yields rise will inflict additional damage on global bond portfolios. This is especially true in inflation-adjusted terms, since real yields stand at a paltry -0.76% in the US and -2.5% in Germany. Hence, we continue to recommend investors maintain a structural below-benchmark duration bias in their portfolios. Nonetheless, investors with enough flexibility in their investment mandate should take advantage of the expected near-term pullback in yields. Those without this flexibility should use the pullback as an opportunity to shorten their portfolio duration. Higher yields will also prevent strong multiple expansion from taking place; hence, the broad stock market will also offer paltry long-term real returns. Another implication of rising yields, especially if they reflect stronger growth and rising neutral interest rates, is to underweight growth stocks relative to value stocks (Chart 12). Growth stocks are expensive and very vulnerable to the pull on discount rates that follows rising risk-free rates. Meanwhile, stronger economic activity driven by infrastructure spending and capex will help the bottom line of industrial and material firms. Financials will also benefit. Higher yields help this sector and robust capex also boosts loan growth, which will generate a significant tailwind for banking revenues. Hence, rising yields will boost the attractiveness of banks, especially after they have become significantly cheaper because of the Ukrainian war (Chart 13). Chart 12Favor Value Over Growth Chart 13Bank Remain Attractive Related Report  European Investment StrategyFallout From Ukraine Finally, four weeks ago, we highlighted that defense stocks were particularly appealing in today’s context. The re-armament of Europe in response to secular tensions with Russia is an obvious tailwind for this sector. However, it is not the only one. A long-term theme of BCA’s Geopolitical Strategy service is the expanding multipolarity of the world.  The end of an era dominated by a single hegemon (the US) causes a rise in geopolitical instability and tensions. The resulting increase in conflict will invite a pickup in global military spending. Chart 14Defense Will Outshine The Rest European defense and aerospace stocks are expensive, with a forward P/E ratio approaching the top-end of their range relative to the broad market and other industrials. However, their relative earnings are also depressed following the collapse in airplane sales caused by the pandemic. Our bet on the sector is that its earnings will outperform the broad market as well as other industrials because of the global trend toward military buildup. As relative earnings recover their pandemic-induced swoon, so will relative equity prices (Chart 14). Bottom Line: Higher yields warrant a structural below-benchmark duration in European fixed-income portfolios, even if a near-term yield pullback is likely. As a corollary, value stocks will outperform growth stocks while industrials, materials, and financials will also beat a broad market whose long-term real returns will be poor. Within the industrial complex, aerospace and defense equities are particularly appealing because a global military buildup will boost their earnings prospects durably.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Executive Summary Biden’s Low Approval On Foreign Policy   The energy shock stemming from President Biden’s foreign policy challenges could get worse, especially if US-Iran talks fail. The energy and inflation shocks condemn the Democrats to a dismal midterm election showing, even if Biden handles the Ukraine crisis reasonably well and his approval rating stabilizes. Biden’s foreign policy is still somewhat defensive, focusing on refurbishing US alliances, and as such should not force the EU to boycott Russian energy outright. Biden’s foreign policy doctrine will likely be set in stone with his imminent decision on whether to rejoin the 2015 nuclear deal with Iran. We doubt it will happen but if it does the market impact will be fleeting due to lack of implementation. Biden’s foreign policy toward China will likely grow more aggressive over time. Recommendation (Cyclical) Inception Level Initiation Date Return Long ISE Cyber-Security Index  647.53  Dec 8, 2021 -4.6% Bottom Line: President Biden foreign policy challenges are creating persistent downside risks for equity markets. Feature External risk is one of our key views for US politics in 2022. This risk includes but is not limited to the war in Ukraine. The Biden administration’s urgent foreign policy challenges are creating persistent downside risks for the global economy and financial markets in the short run – embodied in rising energy costs (Chart 1). Related Report  US Political Strategy2022 Key Views: Gridlock Begins Before The Midterms Chart 1Oil Prices And Prices At The Pump Ukraine Can Still Hurt US Stocks The Ukraine war is not on the verge of resolution – more bad news is likely to hit US equity markets. The Russian military is bombarding the port city of Mauripol, which will fall in the coming days or weeks (Map 1). Given that Mauripol is refusing to surrender, it is highly unlikely that the central government in Kiev will surrender anytime soon. Map 1Russian Invasion Of Ukraine 2022 The military situation is approaching stalemate and yet ceasefire talks are not promising. The Ukrainians do not accept Russian control of Donbas and Crimea and will need to hold a referendum on the terms of any peace agreement. Lack of progress will drive the Russians to escalate the conflict, whether by means of bombardment, troop reinforcements, or bringing the Belarussian military into the fight. The United States and its allies are increasing defense support for Ukraine while warning that Russia could use chemical, biological, or even tactical nuclear weapons. In our sister Geopolitical Strategy service we argue that the war to get worse before it gets better, with Russia determined to replace the government in Kiev. US investors should expect continued equity market volatility. US and global growth expectations are yet to be fully downgraded as a result of the global energy shortage – the Fed now expects GDP growth of 2.8% while the Atlanta Fed shows GDP clocking in at 1.3%, well below consensus expectations (Chart 2). Corporate earnings will suffer downgrades as a result of higher energy costs. The Federal Reserve just started hiking interest rates and it is not discouraged by foreign affairs. Real rates will rise. Chairman Jerome Powell sounded a hawkish tone by saying that he is willing to hike by 50 basis points at a time if required. The threat of a wage-price spiral is real. The 2-year/10-year Treasury slope is on the verge of inverting. The Fed’s new interest rate projections suggest that the interest rate will rise above the neutral rate in 2023-24. Chart 2Growth Will Take A Hit Ukraine’s Impact On The Midterm Elections A negative foreign policy and macroeconomic background will compound the Democratic Party’s woes in the midterm elections. Biden’s approval rating is languishing at Donald Trump levels, yet without Trump’s high marks on the economy (Chart 3). Biden will not be able to turn the economy around because even if inflation starts to abate, voters will react to the one-year and two-year increase in inflation rather than any month-on-month improvement. Republicans have pulled ahead of Democrats in generic congressional ballot opinion polling (Chart 4). Even if Biden’s ratings stabilize ahead of the midterms (even if he handles Ukraine well), Democrats face a shellacking. The market is rightly priced for Republicans to take over all of Congress, though the GOP’s odds of taking the Senate are lower than consensus holds (Chart 5). A Republican victory is not negative for US corporate earnings but uncertainty over the general direction of US policy will continue to weigh on the equity market this year. Chart 3Biden’s Approval Ratings Chart 4Republicans Take The Lead Biden’s foreign policy can and will get a lot more aggressive if the Democratic Party views its election odds as so dismal that foreign tensions come to be seen as a source of badly needed popular support. That is not yet the case but developments with Russia and Iran could force the administration to adopt a more offensive foreign policy, which would be negative for financial markets. Hence investors will have to worry about rising policy uncertainty over the 2022-24 political cycle. Chart 5Midterm Election Odds Biden’s Policy Toward Russia And Europe It is too soon to say precisely what is the “Biden Doctrine” of foreign policy. The withdrawal from Afghanistan and the war in Ukraine were thrust upon Biden. What will define his foreign policy is how he handles Russia, Iran, and China going forward. By the end of the year, Biden will have forged his foreign policy doctrine, for better or worse. Biden began with a defensive foreign policy. His administration’s primary intention is to refurbish US alliances in Europe and Asia to counter Russia and China. Consider: In 2021, Biden condoned Germany’s deepening economic and energy integration with Russia (i.e. the Nord Stream II pipeline). Russia’s invasion forced Germany to change its mind and join the US and other democracies in imposing harsh sanctions on Russia. Even so, the US is calibrating its actions to what the European allies can stomach. Biden is attempting to negotiate new trade deals with allies, by contrast with President Trump’s tendency to slap tariffs on allies as well as rivals.1 Biden is likely to try to revive the Transatlantic Trade and Investment Partnership (TTIP) with Europe, he is scheduled to restart talks with the UK about a post-Brexit trade deal, and he will probably attempt to rejoin the Trans-Pacific Partnership (CPTPP) in future. Now that Russia has invaded Ukraine, Biden’s foreign policy is becoming more aggressive, albeit still within certain limitations: The US is not willing to send troops to defend Ukraine or impose a no-fly zone, which would trigger direct conflict with Russia. But the US is continuing to provide Ukraine with lethal weapons, which helped precipitate the war. Congress recently voted to increase Ukraine aid by $13.6 billion, including $6.5 billion in defense support, including drones, Stinger anti-aircraft missiles, and Javelin anti-tank missiles. These are supposed to start arriving in Ukraine in a few days. The US is reportedly looking into providing Ukraine with Soviet-era SA-8 air defense, though not the S-300s missile defense.2 The US is bulking up its military presence across Europe to deter Russia from broadening its attacks beyond Ukraine. Biden has declared a red line in that he will defend “every inch” of NATO territory. This means that a single Russian attack that spills over into Poland or another NATO country will precipitate a new and bigger crisis (and financial market selloff). The risk going forward is that American policy could grow increasingly aggressive to the point that tensions with Russia escalate. Unlike Russia and Europe, the US does not have vital national interests at stake in Ukraine. American national security is not directly threatened by the war there. Hence the US can afford to take actions that its European allies would prefer not to take. As long as Biden prioritizes solidarity with the Europeans, geopolitical risks may be manageable for the markets. But if Biden attempts to lead an even bolder charge against Russia (or China), then risks will become unmanageable. So far Biden is allowing Europe to impose sanctions at its own pace and intensity. The Europeans must tread more carefully than the US, lest sanctions cause a broad energy cutoff that plunges their economy into recession along with Russia’s. This would destabilize the whole Eurasian continent and increase the chances of strategic miscalculation and a broader military conflict. Europe has opted for a medium-term strategy of energy diversification while avoiding the US’s outright boycott of Russian energy. The EU depends on Russia for 26% of its oil and 16% of its natural gas imports (Chart 6). The dependency is higher for certain countries. Germany, Italy, Hungary, and others oppose an outright boycott – and a single EU member can veto any new sanctions. Theoretically the Europeans could ban oil while still accepting natural gas. Natural gas trade routes are fixed due to physical pipelines, whereas oil is more easily rerouted, leaving Russia with alternatives if Europe stops importing oil. But Russia exports 63% of its oil to developed markets and 65% of its natural gas, with the bulk of that going to the European Union at 48% and 15% respectively (Chart 7). Russia’s economy would suffer from an oil ban and it would assume that a natural gas ban would soon follow, which could unhinge expectations that war tensions can be contained. Chart 6EU Mulls Boycott Of Russian Oil Chart 7Russian Regime Depends On O&G Given the damaged state of the Russian economy and high costs of war, Moscow will probably keep accepting energy revenues as long as Europe is buying. But if it believes Europe will cut off the flow, then it has an incentive to act first. This is a risk, not our base case. Still, as Russia targets the capital Kiev with intense shelling and civilian casualties increase, US pressure for an expansion of sanctions will increase. This is the risk that investors need to monitor. If the US brings the EU around to adopting sanctions on Russian energy then equity markets will plunge anew. And since Europe is diversifying over time anyway, Russia will have to escalate the war now to try to achieve its aims before its source of funds dries up. Biden’s Policy Toward China Biden’s foreign policy also started out defensively with regard to China. Biden intended to stabilize relations, i.e. engage in some areas like climate policy and avoid expanding President Trump’s trade war. Both the Democratic Party and the Communist Party face important political events in 2022 and their inclination is to prevent global instability from interfering. But the Ukraine war has made this goal harder. As with Europe the immediate question is whether Biden will try to force China to cooperate on Russia sanctions. But in China’s case Biden is more likely to use punitive measures – at least eventually. After a two-hour bilateral phone call on March 18, Biden “described the implications and consequences if China provides material support to Russia as it conducts brutal attacks against Ukrainian cities and civilians.”3 Biden’s threat of sanctions is a negative for Chinese exporters and banks (Chart 8). Chinese stock markets were already suffering from China’s historic confluence of internal and external political and economic risks. The Ukraine war has increased the fear of western investors that investing in China will result in stranded capital when strategic tensions rise explode, as with Russia. Chart 8Biden Threatens China With Sanctions Economically, China is much more dependent on the West than Russia. While Germany and Russia take a comparable share of Chinese exports, at 3.4%and 2.0% respectively, the EU takes up more than three times as many Chinese exports as the Commonwealth of Independent States, at 15.4% versus 3.2% (Chart 9A Chart 9B). China was never eager to commit to an exclusive economic relationship with Russia at the expense of its western markets. Strategically, however, China cannot afford to reject Russia. Chart 9AEU Wary Of Targeting China Chart 9BEU Wary Of Targeting China   Russia has now severed ties with the West and has no choice but to offer favorable deals to China on the whole range of relations. China’s greatest strategic threat is US sea power; Russia offers a strategically vital overland source of natural resources. Russia also offers intelligence and security assistance in critical regions like Central Asia and the Middle East that China needs to access. Like Russia, China fears US containment policy and views US defense relations with its immediate neighbors as a fundamental national security threat. President Biden reassured China that US policy toward the Taiwan Strait has not changed but also said that the US opposes any unilateral attempt to change the status quo. The implication is that China will segregate its EU and Russia networks of trade and finance to minimize the impact of any US secondary sanctions. China will offer Russia some assistance while making diplomatic gestures to maintain economic relations with Europe. The Europeans will lobby the Americans not to expand sanctions on China. The Biden administration will be reluctant to increase sanctions on China immediately, since it wants to maintain global stability in general, control the pace of rising global tensions, and maintain maneuverability for immediate problems with Russia and Iran. Biden’s priority is to rebuild US alliances and Europe will be averse to expanding the sanction regime to China. Therefore any sanctions on China will come only slowly and with ample warning to global investors. But sanctions are possible over the course of the year. If the Biden administration concludes that it has utterly lost domestic support, that the midterm elections are a foregone conclusion, then it can afford to get tougher in the international arena in hopes that it can improve its standing with voters. Biden’s Policy Toward Iran While Afghanistan and Ukraine were thrust upon Biden, the major foreign policy challenge in which he retains the initiative is whether to rejoin the 2015 nuclear deal with Iran. Thus it may be policy toward Iran and the Middle East that defines the Biden doctrine. The Ukraine war has not stopped the Biden administration from seeking to rejoin the 2015 Joint Comprehensive Plan of Action, which was a strategic US-Iran détente that sought to freeze Iran’s nuclear program in exchange for its economic development. The original nuclear deal occurred with Russia’s blessing after the US and EU overlooked Russia’s invasion of Crimea. Now negotiations toward rejoining that deal are reaching the critical hour. The US has supposedly offered Russia guarantees to retain Russian support. The reason for Biden to rejoin the 2015 deal is to open Iran’s oil and natural gas reserves to the global and European economy and thus mitigate the global energy shock ahead of the midterm elections. Iran could return one million barrels per day to global markets. There is also a strategic logic for normalizing relations with Iran: to maintain a balance of power in the Middle East, reduce US military commitment there, provide Europe with greater security, and free up resources to counter Russia and China. Whether the deal will fulfill these ends is debatable but the Biden administration apparently believes it will. Biden is capable of rejoining the deal because the critical concessions do not require congressional approval. Through executive action alone, Biden could meet Iran’s demands: sanctions relief, delisting the Iranian Revolutionary Guard Corps as a terrorist organization, and ensuring that Russo-Iranian trade (especially nuclear cooperation) is not exempted from the new Russia sanctions. There will be domestic political blowback for each of these concessions but not as much as there will be if gasoline prices continue to rise due to greater global instability stemming from the Middle East. The Iranians are also capable of rejoining the deal. Supreme Leader Ali Khamenei, in his Persian New Year speech, gave a green light for President Ebrahim Raisi’s administration to pursue policies that would remove US sanctions. Khamanei implied that Iran should let the West lift sanctions while continuing to fortify its economy to future US sanctions.4 While the US and Iran are clearly capable of a stop-gap deal, it will not be a durable agreement – and hence any benefits for global energy supply will be called into question. The reason is that the underlying strategic logic is suffering: Biden will appear incoherent if he alienates Saudi Arabia and the UAE while appealing to them to increase oil production – and they are more capable than Iran on this front (Chart 10). Biden will appear incoherent if he agrees to secure Russo-Iranian trade at the same time as he seeks to cut Russia off from all other trade. Biden may not achieve a reduction in regional tensions through an Iran deal, since Israel insists that it is not bound to the nuclear deal. If Iran does not comply with the nuclear freeze, Israel will ramp up military threats. The Iranians cannot trust American guarantees that the next president, in 2025, will not tear up the nuclear deal and re-impose sanctions on Iran. The Iranians need Russian and Chinese assistance so they cannot afford to embark on a special new relationship with the West. Ultimately the Iranians are highly likely to pursue deliverable nuclear weapons for the sake of regime survival, as our Geopolitical Strategy has argued. Chart 10US-Iran Deal Will Not Be Durable   Thus Biden may choose a deal with Iran but we would not bet on it. Moreover any stop-gap deal will be undermined in practice, so that the investment repercussions will be ephemeral. If Biden fails to clinch his Iran deal as expected, then the world faces an even larger energy shock due to rising tensions in the Middle East. Investment Takeaways The Biden administration’s foreign policy challenges will compound its macroeconomic challenges and weigh on the Democratic Party in the midterm elections. The war in Ukraine will hurt Biden and the Democrats primarily because of the energy shock. The energy shock will get worse if Biden fails to agree to a stop-gap deal with Iran. But we expect either the US or Iran to back out for strategic reasons. With Republicans likely to reclaim Congress this fall, US political polarization will remain at historically high levels over the course of the 2022-24 election cycle. However, Russia’s belligerence underscores our view that rising geopolitical threats will cause the US to unify and reduce polarization over the long run. The war reinforces our US Political Strategy themes of “Peak Polarization” and “Limited Big Government,” as a new bipartisan consensus is forming around the view that the federal government should take a larger role in the economy to address national challenges both at home and abroad. One of our cyclical investment ideas stemming from these themes is to buy cyber-security stocks. President Biden warned US government and corporations on March 21 that Russia could stage cyber attacks against the United States and that private businesses must be prepared. Cyber stocks have suffered amid the general rout in tech stocks but they are starting to recover. Year to date, they are outperforming the S&P 500, and the tech sector, and look to be starting to outperform defensive sectors (Chart 11). Chart 11Biden Warns Of Cyber Attacks   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     See Yuka Hayashi, “U.S., U.K. Strike Trade Deal to End Tariffs on British Steel and American Whiskey”, Wall Street Journal, March 22, wsj.com 2     See Nancy Youssef and Michael Gordon, “U.S. Sending Soviet Air Defense Systems It Secretly Acquired to Ukraine”, Wall Street Journal, March 21, wsj.com. 3    White House, “Readout of President Joseph R. Biden Jr. Call with President Xi Jinping of the People’s Republic of China,” March 18, 2022, whitehouse.gov. 4    Ayatollah Ali Khamenei implied at his Persian New Year speech that a deal with the Americans could go forward. He emphasized the need to improve the economy and implied that some of the economic burdens will go away starting this year. He pointed to a way forward with US sanctions intact, while also saying that he did not discourage attempts to remove sanctions. “We should not tie the economy to sanctions... It is possible to make economic advances despite U.S. sanctions. It is possible to expand foreign trade, as we did, enter regional agreements and have achievements in oil and other areas … I never say to not go after sanctions relief, but I am asking you to govern the country in a way in which sanctions do not hurt us.” See “Iran's Khamenei Says Economy Should Not Be Tied to U.S. Sanctions,” Reuters, March 21, 2022, usnews.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Today, we are downgrading the S&P restaurants index from overweight to neutral. Currently, the industry faces a trifecta of challenges: Rising input prices, a stronger dollar, and a shift in consumer spending away from discretionary goods and services towards necessities. Chart 1 Rising Input Costs: Soaring food prices and rising wages for the lowest-paid cohort of the US workers is pressuring US restaurants’ bottom line. Restaurants are trying to offset wage pressures by hiking prices with food away from home CPI climbing 2.2 standard deviations away from its five-year average (Chart 1). A mean reversion move is likely coming, meaning that going forward restaurants will have to absorb some of the cost increases, which will damage their bottom line.  Stronger USD: The index is dominated by two multinational players, Starbucks (SBUX) and MacDonald’s (MCD), that command a 40% and 30% weight of the industry, respectively.  When averaged together, those two companies derive over 45% of sales from abroad compared to 40% for the S&P 500.  Stronger dollar dents companies’ profits by making American goods and services more expensive, and because of the accounting translation effect (Chart 2).  Making things worse, US restaurants’ withdrawal from Russia to protest the invasion of Ukraine will have an adverse effect on their sales. McDonald’s announced that closing its extensive network of restaurants in Russia will cost it $50 million a day, or 9% of its revenue. Consumer spending is shifting towards necessities: High inflation in general, and rising prices of food and gasoline weigh on consumer spending, forcing many consumers to allocate a higher share of their spending towards necessities (Chart 3). As the US consumer tightens its belt, restaurants and other discretionary spending categories are likely to come under pressure. Chart 2 Chart 3 Bottom Line:  We are downgrading the S&P restaurants index from overweight to neutral, booking a loss of 13.5%.

Executive Summary Table 1Equity Capitulation Scorecard We have put together a framework to capture the extent to which recent economic and political developments have been priced in by the equity market.  It has seven criteria: Rate stabilization has not materialized yet, monetary conditions will continue to tighten Economic growth expectations do not yet reflect the deteriorating economic backdrop.  US GDP forecasts will be downgraded which will be a drag on equity performance Earnings growth expectations need to come down to reflect supply disruptions, raging input prices, and the stronger dollar Oil prices have stabilized which provides support for US equities Valuations have retraced, signaling that the market is reasonably priced Technicals signal that the market is oversold “Black swans”: The effects of the war in Ukraine will be a drag on US equities and are not yet fully priced in.  However, China’s pledge to be more investor-friendly is a positive. On balance, risks for US equities slightly outweigh the upside opportunity. Bottom Line: Although many ingredients for a sustainable rally are already in place, our analysis concludes that US equities have not hit rock bottom yet, and time is needed to resolve remaining headwinds. Feature The S&P 500 and NASDAQ are in correction territory, having pulled back 13% and 22%, respectively from their peak. Over the past few months, investors had to process a witches’ brew of staggering inflation, impending monetary tightening, and a war in the heart of Europe. Too much! Related Report  US Equity StrategyAre We There Yet? However, over the past couple of days, US equities have staged an aggressive rally: The S&P rebounded 5.5% and the NASDAQ 8%. While we are long-term investors and don’t focus on short-term market moves, we find a recent market turn a good excuse to take a close look at US equities and gauge whether this recent rally is a “dead-cat bounce” or the market has truly bottomed and is in the early stages of a recovery rally. To do so, we have put together a framework to capture the extent to which recent economic and political developments have been priced in by the equity market. “Equity Capitulation” Framework Historically, equities bottomed when bad news had been reflected in expectations, valuations had come down to reflect the new economic reality, and investors had capitulated. Here are our criteria for an equity rebound this economic cycle: Monetary tightening has been priced in and rates have stabilized Economic growth expectations have been downgraded Energy prices have normalized Earnings growth expectations have come down and earnings are unlikely to surprise on the downside Investors have capitulated and sentiment is rock-bottom Valuations have lost their “good times” froth and are attractive There are resolutions of the geopolitical factors that have contributed to market turmoil In this report, we will go through each of the criteria and do our best to gauge whether “we are there yet.” Pricing In Tighter Monetary Policy – Rate Stabilization Is Still Elusive The recent correction of US equities reflects a repricing due to tighter monetary policy. The million-dollar question is how much monetary tightening is priced in and when will rates stabilize? To our minds, this is one of the key conditions for a sustainable bull market. Last week, the Fed raised rates for the first time since 2018. This first rate hike is 0.25 - 0.50, which did not come as a surprise and was broadcast well in advance. The latest dot plot also signals that the Fed expects the target rate to reach 1.75% by the end of 2022, i.e., six more hikes are expected this year. However, a day after the announcement, the market is pricing eight to nine rate hikes (Chart 1), with the Fed rate ending the year at 2.25-2.5%. Thus, the market expects aggressive Fed action and is likely to be positively surprised when the Fed takes a more measured approach than anticipated. This is certainly positive for equities.   Chart 1The Market Is Pricing More Hikes In 2022 Then The Fed Chart 2Monetary Conditions Will Continue To Tighten However, despite the market coming to terms with an aggressive hiking schedule, monetary conditions are still easy (Chart 2), and real rates are negative. With the Fed’s emphasis on combating inflation, it is reasonable to expect that monetary conditions will continue to tighten, and real rates will rise. Also, nominal rates don’t yet show any signs of stabilization either (Chart 3). What does this mean for equities? Empirical analysis demonstrates that it takes around three months after the first hike for equities to adjust to a new monetary regime and deliver positive returns (Chart 4). Chart 3Rates Have Not Stabilized Yet Chart 4Adjusting to A Tighter Monetary Regime Takes Time Monetary conditions are likely to tighten further. Rate stabilization, which we are looking for, has not materialized just yet. On a positive note, we don’t expect any negative surprises from the Fed. Forecasts Need To Reflect Slowing Economic Growth According to the Bloomberg consensus, economic growth expectations for 2022 are still robust and have not been substantially downgraded (Chart 5). The market still expects the US economy to grow at 3.55%, compared to 3.8% in January, despite monetary tightening, falling ISM PMI readings (Chart 6), and soaring energy costs. The Fed is more realistic about the effects of its policy on economic growth, changing expectations from 4% to 2.8%. The logical conclusion is that more GDP growth downgrades are on the way. The latest reading of the Atlanta Fed stands at only 1.3%. Chart 5Economic Forecasts Do Not Yet Reflect Deteriorating Macro Backdrop Chart 6Surveys Signal Growth A Slow Down It is also important to note that both the direct and indirect effects of the war in Ukraine are yet to be reflected in US growth forecasts: Since the beginning of the war, the GSCI Commodities index has increased by 11%. One might argue that soaring commodity prices are a temporary phenomenon and forward curves signal eventual reversion to long-term averages. However, this may take months and even years, and by then, most of the stockpiles and hedges are likely to run out. Growth expectations are likely to fall, or worse yet, economic growth may surprise on the downside. Earnings Expectations Need To Come Down Similar to economic growth forecasts, bottom-up earnings growth expectations have barely budged (Chart 7): The market is still expecting about 9% earnings growth over the next 12 months. However, global supply disruptions and raging input prices are bound to cut into corporate profitability and slow earnings growth. Chart 7Earnings Expectations Have Not Budged To make things worse, the US dollar has appreciated by nearly 10% since the beginning of 2021 (Chart 8). Since companies in the S&P 500 derive 40% from abroad, the strong greenback is bound to translate into softer overseas profits, cutting into the profitability of US multinationals. The effect of a stronger currency will be further exacerbated by the withdrawal of US companies from Russia to protest the war in Ukraine. While most US companies have limited exposure to Russia, there are some that will take a hit: For example, Philip Morris derives 8% of sales from that market. McDonald’s announced that closing its restaurants in Russia will cost $50 million a month or 9% of annual sales. While it is hard to accurately gauge the effect of the war and self-sanctions on US corporate profits, on the margin it is definitely a negative. Chart 8Dollar Has Strengthened Significantly Earnings growth expectations have barely budged, and do not reflect a surge in commodity prices, a war, and slowing economic growth. We posit that downgrades are highly likely, and will be a drag on US equity performance. Oil Prices Have Stabilized The key channel for the war in Ukraine to affect the rest of the world is through the supply of energy. High energy prices present an economic danger because they touch every facet of the economy. Goldman Sachs estimates that spiraling electricity prices have already taken down 900,000 tonnes of aluminum capacity and 700,000 tonnes of zinc capacity in Europe. Certainly, in the past, a jump in the oil price has often been associated with recessions and negative equity returns (Chart 9). Therefore, we consider it a major shot in the arm that the WTI has come down from $130 to $105 on the back of lockdowns in China. This hiatus gives policymakers and oil producers time to negotiate deals and restart production – the onus is on US shale producers and Gulf nations. However, the long-term resolution is yet to be seen. Chart 9Oil Price Increases Have Been Associated With Negative Equity Returns Oil price stabilization provides solid support for US equity performance. Valuations – No Longer An Excuse Not To Buy The correction in US equity markets has taken the froth off valuations: The S&P 500 forward multiple has come down from roughly 23x to 19x earnings (Chart 10), with all of the change attributable to multiple contraction. The BCA S&P 500 Valuation Indicator shows that the index is no longer “overvalued” (Chart 11). Outright cheap? No. But valuations can no longer be an excuse not to buy. Also, there are multiple corners of the market that are outright cheap – lots of bottom fishing is already taking place. Chart 10Valuations Have Moderated Chart 11The S&P 500 Is No Longer Overvalued...   Valuations have moderated and the market is reasonably priced. Technicals – The Market Is Oversold While valuation multiples may contract further, most technical and sentiment indicators are flashing capitulation. The AAII Investor Bull/Bear Sentiment Indicator is below its March 2020 reading while the BCA Technical Indicator has shifted towards the oversold zone (Chart 12). It is important to note that this indicator is driven primarily by momentum components – its reading is oblivious to the top-heavy index composition and reflects prospects for large caps. A useful way to look under the index’s hood is to consider the number of stocks that retraced from their highs, currently over 95% of NASDAQ stocks have retraced  (Chart 13). This high a reading flashes that the market is oversold, and there are lots of bargains to be had. Chart 12...Or Overbought Chart 13Majority Of Stocks Are Oversold   Technicals indicate an oversold market. Black Swans Have Landed The war in Ukraine: Optimism about a potential peace deal between Russia and Ukraine seems premature – the conflict is just getting started and neither side will be backing off until it has to surrender unconditionally. However, while the war is contained in Ukraine, and Russian gas is flowing to Europe, any crisis in the equity market would be averted. The war in Ukraine will remain a headwind to global equities for a while. And while the US equity market is insulated from the direct consequences of the crisis, indirect effects will continue to reverberate through its economy for now. The direct and indirect effects of the war in Ukraine will be a drag on US equities and are not yet fully priced in. China pledged to keep capital markets stable and vowed to support overseas stock listings, indicating that regulation of Big Tech will end soon. In addition, it promised to offer support for property developers to minimize their risks. And China’s pledge to be more investor-friendly is believable as in its current stage of economy and with the onset of COVID, the government is in dire need of propping up both the economy and the stock market. Of course, China still presents great uncertainty associated with lockdowns. This is a positive for the US market as there are a number of Chinese companies listed on the US stock exchanges. Putting It All Together Our Equity Capitulation scorecard has seven different criteria, as discussed above. According to our assessment of the economic and market environments, there are two factors that signal near-term equity rebound: Investor capitulation or Technicals, and Energy prices. However, there are still headwinds: Monetary conditions will continue to tighten, economic and earnings growth expectations will be downgraded, and the war in Ukraine is unlikely to end soon. On balance, risks for US equities slightly outweigh the opportunity. The final score is -1, which indicates a mildly negative stance on US equities (Table 1). However, most of the outstanding negatives are likely to be resolved soon (i.e., downward revisions of expectations). Table 1Equity Capitulation Scorecard Investment Implications Our equity capitulation indicator signals that cautious investors should continue to be underweight equities on the back of monetary tightening, slowing growth, and upcoming downward revision cycles. While Technicals and valuations make equities tempting, volatility in equities is likely to continue, and rallies will probably be short-lived. As always, long-term investors have more latitude in investment decision-making, and we believe that the long-term outlook for equities is positive. Bottom Line Our analysis concludes that US equities have not hit rock bottom yet, although many ingredients are already in place: Valuations are attractive, and equities are outright oversold. While buying equities at these levels is tempting, we recommend patience: Economic growth expectations are still elevated, and bottom-up earnings growth forecasts need to come down to reflect slowing growth and the direct and indirect effects of the war in Ukraine.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   Recommended Allocation

Executive Summary Ebbing Stagflation Fear Will Prompt Rerating European inflation will rise further before peaking this summer. Core CPI will reach between 2.8% and 3.2% by year-end before receding. The combination of stabilizing growth and the eventual peak in inflation will cause stagflation fears to recede. European assets have greater upside. Cyclicals, small-caps, and financials will be major beneficiaries of declining stagflation fears. The underperformance of UK small-cap stocks is nearing its end. UK large-cap equities are a tactical sell against Eurozone and Swedish shares. TACTICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Buy European & Swedish Equities / Sell UK Large Caps Stocks 03/21/2022     Bottom Line: Stagflation fears are near an apex as commodity inflation recedes. A peak in these fears will allow European asset prices to perform strongly over the coming quarters.     Despite a glimmer of hope that Ukraine and Russia may find a diplomatic end to the war, the reality on the ground is that the conflict has intensified. Although the hostilities are worsening and the European Central Bank (ECB) surprised the markets with its hawkish tone, European assets have begun to catch a bid. The crucial question for investors is whether this rebound constitutes a new trend or a counter-trend move? Our view about Europe is optimistic right now. The path is not a direct line upward. The recent optimism about the outcome of the Russia-Ukraine talks is premature; however, we are getting to the point when markets are becoming desensitized to the war and energy prices are losing steam. Moreover, the increasing number of statements by Chinese economic authorities pointing toward greater stimulus and support to alleviate the pain created by China’s stringent zero-COVID policy are another positive omen. Higher Inflation For Some Time European headline inflation is set to exceed 7% this summer and core CPI will increase between 2.8% and 3.2% by the end of 2022. Related Report  European Investment StrategySpring Stagflation The main force that will push inflation higher in Europe remains commodity prices. Energy inflation is extremely strong at already 32% per annum (Chart 1). It will increase further because of both the recent jump in Brent prices to EUR122/bbl on March 8 and the upsurge in natural gas prices, which were as high as EUR212/MWh on the same day before settling to EUR106/MWh last Friday. The impact of energy prices will not be limited to headline inflation and will filter through to core CPI (Chart 1, bottom panel). The average monthly percentage change in the Eurozone core CPI inflation stands at 0.25% for the past six months (compared to an average of 0.09% over the past ten years), or the period when energy-prices inflation has been the strongest. Assuming monthly inflation remains at such an elevated level, annual core CPI will hit 3.3% in the Eurozone by the end of 2022 (Chart 2). Chart 2Core CPI to Rise Further Chart 1Energy Inflation: Alive And Well The picture is not entirely bleak. Many forces suggest that these inflationary forces will recede before year-end in Europe. Energy prices are peaking, which is consistent with a diminishing inflationary impulse from that space. We showed two weeks ago that the massive backwardation of oil curves, the heavy bullish sentiment, and the high level of risk-reversals were consistent with a severe but transitory adjustment in the energy market. Oil markets will experience further volatility, as uncertainty around peace/ceasefire negotiations continues to evolve in Ukraine. Nonetheless, the peak in energy prices has most likely been reached. BCA’s energy strategists expect Brent to average $93/bbl in 2022 and in 2023. The potential for a decline in headline CPI after the summer is not limited to energy prices. Dramatic moves in the commodity market, from metals to agricultural resources, have made headlines. Yet, the rate of change of commodity prices is decelerating, hence, the commodity impulse to inflation is slowing sharply. As Chart 3 shows, this is a harbinger of a slowdown in European headline CPI. Related Report  European Investment StrategyFallout From Ukraine Looking beyond commodity markets, the recent deceleration in European economic activity also suggests weaker inflation in the latter half of 2022. Germany will likely suffer a recession because it already registered a negative GDP growth in Q4 2021. Q1 2022 growth will be even worse because of the country’s high exposure to both China and fossil fuel prices. More broadly, the recent deceleration in the rate of change of both the manufacturing and services PMIs is consistent with an imminent peak in the second derivative of goods and services CPI (Chart 4). Chart 3Commodity Impulse Is Peaking Chart 4Inflation's Maximum Momentum Is Now Underlying drivers of inflation also remain tame in Europe. European negotiated wages are only expanding at a 1.5% annual rate, which translates into unit labor costs growth of 1% (Chart 5). This contrast with the US, where wages are expanding at a 4.3% annual rate. A peak in inflation, however, does not mean that CPI readings will fall below the ECB’s 2% threshold anytime soon. The European economy continues to face supply shortages that the Ukrainian conflict exacerbates (Chart 6). Moreover, the recent wave of COVID-19 in China increases the risk of disruptions in supply chains, as highlighted by the closure of Foxconn factories in Shenzhen. Finally, inflation has yet to peak; mathematically, it will take a long time before it falls back below levels targeted by Frankfurt. Chart 5The European Labor Market Is Not Inflationary Chart 6Not Blemish-Free Bottom Line: European headline inflation will peak this summer, probably above 7%. Additionally, core CPI is likely to reach between 2.8% and 3.2% in the second half of 2022. As a result of a decline in the commodity impulse, inflation will decelerate afterward, but it will remain above the ECB’s 2% target for most of 2023. Hopes For Growth Two weeks ago, we wrote that Europe was facing a stagflation episode in the coming one to two quarters, but that, ultimately, economic activity will recover well. Recent evidence confirms that assessment. Chart 7A Coming Chinese Tailwind? The tone of Chinese policymakers is becoming more aggressive, in favor of supporting the economy. On March 16, Vice-Premier Liu He highlighted that Beijing was readying to support property and tech shares and that it will do more to stimulate the economy. True, this response was made in part to address the need to close cities affected by the sudden spike of Omicron cases around China. Nonetheless, the global experience with Omicron demonstrates that, as spectacular and violent the surge in cases may be, it is short-lived. Meanwhile, the impact of stimulus filters through the economy over many months. As a result, Europe will experience the impact of China’s Omicron-induced slowdown, while it also suffers from the growth-sapping effects of the Ukrainian conflict; however, it will also enjoy the positive effect on growth of a rising credit impulse over several subsequent quarters (Chart 7). Beyond China, the other themes we have discussed in recent weeks remain valid. First, European fiscal policy will become looser, as governments prepare to fight the slowdown caused by the war, while also increasing infrastructure spending to wean Europe off Russian energy. Moreover, European military spending is well below NATO’s 2% objective. This will not remain the case, as military expenditure may leap from less than EUR100bn per year to nearly EUR400bn per year over the coming decade. Second, European spending on consumer durable goods still lags well behind the trajectory of the US. With the energy drag at its apex today, consumer spending on durable goods will be able to catch up in the latter half of the year, especially with the household savings rate standing at 15% or 2.5 percentage points above its pre-COVID level. Bottom Line: European growth will be very low in the coming quarters. Germany is likely to face a technical recession as Q1 2022 data filters in. Nonetheless, Chinese stimulus, European fiscal support, pent-up demand, and a declining energy drag will allow growth to recover in the latter half of the year. As a result, we agree with the European Commission estimates that European growth will slow markedly this year. Market Implications In the context of a transitory shock to European economic activity and a coming peak in inflation, European stock prices have likely bottomed. Chart 8Depressed Sentiment To Help Beta Sentiment has reached levels normally linked with a durable market floor. The NAAIM Exposure Index has fallen to a point from which global markets often recover. Europe’s high beta nature increases the odds that European equities will greatly benefit in that context (Chart 8). Valuations confirm that sentiment toward European assets has reached a capitulation stage. The annual rate of change of the earnings yields in the earnings yields has hit 73%, which is consistent with a market bottom (Chart 9). More importantly, the change in European forward P/E tracks closely our European Stagflation Sentiment Proxy (ESSP), based on the difference between the Growth and Inflation Expectations’ components of the ZEW survey (Chart 10). For now, our ESSP indicates that stagflation fears in Europe have never been so widespread, but these fears will likely dissipate as energy inflation declines. This process will lift European earnings multiples. Chart 9Bad News Discounted? Chart 10Ebbing Stagflation Fear Will Prompt Rerating Earnings revisions will likely bottom soon as well. The ESSP is currently consistent with a dramatic decline in European net earnings revisions (Chart 10, bottom panel). It will take a few more weeks for lower earnings revisions to be fully reflected. However, they follow market moves and, as such, the 17% decline in the MSCI Europe Index that took place earlier this year already anticipates their fall. Consequently, as stagflation fears recede, earnings revisions will rise in tandem with equity prices. Chart 11Maximum Pressure On Corporate Spreads A decline in stagflation fears is also consistent with a decrease in European credit spreads in the coming months (Chart 11). This observation corroborates the analysis from the Special Report we published jointly with BCA’s Global Fixed-Income Strategy team last week.  In terms of sectoral implications, a decline in stagflation fears is often associated with a rebound in the performance of small-cap equities relative to large-cap ones (Chart 12, top panel). This reflects the greater sensitivity of small-cap equities to domestic economic conditions compared to large-cap stocks. Moreover, small-cap equities had been oversold relative to their large-cap counterparts but now, momentum is improving (Chart 12). As a result, it is time to buy these equities. Similarly, financials have suffered greatly from the recent events associated with the Ukrainian conflict. European financial institutions have not only been penalized for their modest exposure to Russia, they have also historically declined when stagflation fears are prevalent (Chart 13). This relationship reflects poor lending activity when the economy weakens, and the risk of a policy-induced recession caused by high inflation. Financials will continue their sharp rebound as stagflation fears dissipate. Chart 13Financials Have Suffered Enough Chart 12Small-Caps Time To Shine The dynamics in inflation alone are very important. As Table 1 highlights, in periods of elevated inflation over the past 20 years, financials underperform the broad market by 11.3% on average. It is also a period of pain for small-cap equities and cyclicals. Logically, exiting the current environment will offer opportunities in European cyclical equities and for financials in particular. Table 1Who Suffers From High Inflation? Chart 14Long Industrials & Materials / Short Energy Finally, a pair trade buying industrials and materials at the expense of energy makes sense today. Materials and industrials suffer relative to energy equities when stagflation rises, especially in periods when these fears reflect rising energy pressures (Chart 14). A reversal in relative earnings revisions in favor of materials and industrials will propel this position higher. Bottom Line: Sentiment toward European assets reached a selling climax in recent weeks. Stagflation fears in Europe have reached an apex, and their reversal will lift both multiples and earnings revisions in the subsequent quarters. Diminishing stagflation fears will also boost the appeal of European corporate credit, contributing to an easing in financial conditions. Small-cap stocks, cyclicals, and financials will reap the greatest benefits from this adjustment. Going long materials and industrials at the expense of energy stocks is an attractive pair trade. Key Risk: A Policy Mistake The view above is not without risks. The number one threat to European growth and assets is a policy mistake from the ECB. On March 10, 2022, the ECB’s policy statement and President Christine Lagarde’s press conference showed that the Governing Council (GC) will decrease asset purchases faster than anticipated. Chart 15Will The ECB Repeat It Past Mistakes? It is important to keep in mind the dynamics of 2011. Back then, the ECB opted to increase interest rates as European headline CPI was drifting toward 2.6% on the back of rising energy prices. According to our ESSP, the April 2011 interest rates hike took place at the greatest level of stagflation fears recorded until the current moment (Chart 15). Lured by rising inflation, the ECB ignored underlying weaknesses in European economic activity, which wreaked havoc on European financial markets and growth. If the ECB were to increase rates as growth remains soft, a similar outcome would take place. For now, the ECB’s communications continue to de-emphasize the need for rate hikes in the near term, which suggests that the GC is cognizant of the risk created by weak growth over the coming months. Waiting until next year, when activity will be stronger and the output gap will be closed, will offer the ECB a better avenue to lift rates durably. This risk warrants close monitoring of the ECB’s communication over the coming months. If headline inflation does not peak by the summer, the ECB is likely to repeat its past error, which will substantially hurt European assets. Our optimism is tempered by this threat. UK Outperformance Long In The Tooth? Last week, the Bank of England (BoE) increased the Bank Rate by 25bps to 0.75%, in a move that was widely expected. Yet, the pound fell 0.7% against the euro and gilt yields fell 6 bps. This market reaction reflected the BoE’s choice to temper its forward guidance. The central bank is now expected to increase interest rates to 2.2% next year, before they decline in 2024. The dovish projection of the BoE shows the MPC’s concerns over the impact of higher energy costs and rising National Insurance contributions on household spending. In the BoE’s opinion, the economy is very inflationary right now, but it will slow, which will mitigate the inflationary impact down the road. We share the BoE’s worries about the UK’s near-term economic outlook. The combination of higher taxes, higher interest rates, and rising energy costs will have an impact on growth. However, the rapid decline in small-cap stocks, which have massively underperformed their large cap-counterparts, already discounts considerable bad news (Chart 16). Additionally, small-cap equities relative to EPS have begun to stabilize, while relative P/E and price-to-book ratios have also corrected their overvaluations. In this context, UK small-cap equities are becoming attractive. Chart 17UK vs Eurozone: A Stagflation Bet Chart 16UK Small-Cap Stocks Have Purged Their Excesses In contrast to small-cap stocks, UK large-cap equities have greatly benefited from the global stagflation scare. The UK large-cap benchmark had the right sector mix for the current environment, overweighting defensive names as well as energy and resources. It is likely that when stagflation fears recede, UK equities will undo their outperformance (Chart 17). Technically, UK equities are massively overbought against Euro Area and Swedish stocks, both of which have been greatly impacted by stagflation fears and their pro-cyclical biases (Chart 18 & 19). An attractive tactical bet will be to sell UK large-cap stocks while buying Eurozone and Swedish equities, as energy inflation declines and as China’s stimulus boosts global industrial activity in the latter half of 2022 Bottom Line: Move to overweight UK small-cap stocks within UK equity portfolios. Go long Euro Area and Swedish equities relative to UK large-cap stocks as a tactical bet. Chart 18UK Overbought Relative To Euro Area... Chart 19… And Sweden   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Special Report

Executive Summary Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries​​​​ Tectonic geopolitical trends are taking shape in Emerging Markets (EMs) today that will leave an indelible imprint on the next decade. First, EMs have gone on a relatively unnoticed public debt binge at a time when the economic prospects of the median EM citizen have deteriorated. This raises the spectre of sudden fiscal populism, aggressive foreign policy or social unrest in EMs. China, Brazil and Saudi Arabia appear most vulnerable to these risks. Second, the defense bill of major EMs could be comparable to that of the top developed countries of the world in a decade from now. Investors must brace for EMs to play a central role in the defense market and in wars, in the coming years. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. To extract most from the theme of EM militarization, we suggest a Long on European Aerospace & Defense relative to European Tech stocks.   Trade Recommendation Inception Date Return LONG EUROPEAN AEROSPACE & DEFENSE / EUROPEAN TECH EQUITIES (STRATEGIC) 2022-03-18   Bottom Line: Even as EMs are set to emerge as protagonists on the world stage, investors must prepare for these countries to exhibit sudden fiscal expansions, bouts of social unrest or a newfound propensity to initiate wars. The only way to dodge these volatility-inducing events is to leverage geopolitics to foresee these shocks. Feature Only a few weeks before Russia’s war with Ukraine broke out, a client told us that he was having trouble seeing the importance of geopolitics in investing. “It seems like geopolitics was a lot more relevant a few years back, with the European debt crisis, Brexit, and Trump. Now it does not seem to drive markets at all”, said the client. To this we gave our frequent explanation which is, “Our strategic themes of Great Power Struggle, Hypo-Globalization, and Nationalism/Populism are now embedded in the international system and responsible for an observable rise in geopolitical risk that is reshaping markets”. In particular we highlighted our pessimistic view on both Russia and Iran, which have incidentally crystallized most clearly since we had this client conversation. Related Report  Geopolitical StrategyBrazil: The Road To Elections Won't Be Paved With Good Intentions Globally key geopolitical changes are afoot with Russia at war. In the coming weeks and months, we will write extensively about the dramatic changes we see taking shape in the realm of geopolitics and investing. We underscored the dramatic geopolitical realignment taking place as Russia severs ties with the West and throws itself into China’s arms in a report titled “From Nixon-Mao To Putin-Xi”. In this Special Report we highlight two key geopolitical themes that will affect emerging markets (EMs) over the coming decade. The aim is to help investors spot these trends early, so that they can profit from these tectonic changes that are sure to spawn a new generation of winners and losers in financial markets. (For BCA Research’s in-depth views on EMs, do refer to the Emerging Markets Strategy (EMS) webpage). Trend #1: Beware The Wrath Of EMs On A Debt Binge Chart 1The Pace Of Debt Accumulation Has Accelerated In Major EMs Investors are generally aware of the debt build-up that has taken place in the developed world since Covid-19. The gross public debt held by the six most developed countries of the world (spanning US, Japan, Germany, UK, France and Italy) now stands at an eye-watering $60 trillion or about 140% of GDP. This debt pile is enormous in both absolute and relative terms. But at the same time, the debt simultaneously being taken on by EMs has largely gone unnoticed. The cumulative public debt held by eight major EMs today (spanning China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey) stands at $20tn i.e., about 70% of GDP. Whilst the absolute value of EM debt appears manageable, what is worrying is the pace of debt accumulation. The average public debt to GDP ratio of these EMs fell over the early 2000s but their public debt ratios have now doubled over the last decade (Chart 1). EMs have been accumulating public debt at such a rapid clip that the pace of debt expansion in EMs is substantially higher than that of the top six developed countries (Chart 1). These six DMs have a larger combined GDP than the eight EMs with which they are compared. Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em (For in-depth views on China’s debt, do refer to China Investment Strategy (CIS) report here). Now developed countries taking on more debt makes logical sense for two reasons. Firstly, most developed countries are ageing, and their populations have stopped growing. So one way to prop up falling demand is to get governments to spend more using debt. Secondly, this practice seems manageable because developed country central banks have deep pockets (in the form of reserves) and their central banks are issuers of some of the safest currencies of the world. But EMs using the same formula and getting addicted to debt at an earlier stage of development is risky and could prove to be lethal in some cases. Also distinct from reasons of macroeconomics, the debt binge in EMs this time is problematic for geopolitical reasons. This Time Is Different EMs getting reliant on debt is problematic this time because their median citizen’s economic prospects have deteriorated. Growth is slowing, inflation is high, and job creation is stalling; thereby creating a problematic socio-political backdrop to the EM debt build-up. Growth Is Slowing: In the 2000s EMs could hope to grow out of their social or economic problems. The cumulative nominal GDP of eight major EMs more than quadrupled over the early 2000s but a decade later, these EMs haven not been able to grow their nominal GDP even at half the rate (Chart 2). Inflation Remains High: Despite poorer growth prospects, inflation is accelerating. Inflation was high in most major EMs in 2021 (Chart 3) i.e., even before the surge seen in 2022. Chart 2Major EM’s Growth Engine Is No Longer Humming Like A Well-Tuned Machine​​​​​ Chart 3Despite Slower Growth, Inflation In Major EMs Remains High​​​​​ Rising Unemployment: Employment levels have improved globally from the precipice they had fallen into in 2020. But unemployment today is a far bigger problem for major EMs as compared to developed markets (Chart 4). If the economic miseries of the median EM citizen are not addressed, then they can produce disruptive sociopolitical effects that will fan market volatility. This problem of rising economic misery alongside a rapid debt build-up, can also be seen for the next tier of EMs i.e. Mexico, Indonesia, Iran, Poland, Thailand, Nigeria, Argentina, Egypt, South Africa and Vietnam. While the average public debt to GDP ratios of these EMs fell over the early 2000s, the pace of debt accumulation has almost doubled over the last decade (Chart 5). Furthermore, the growth engine in these smaller EMs is no longer humming like a well-tuned machine and inflation remains at large (Chart 5). Chart 4Unemployment - A Bigger Problem In Major EMs Today​​​​​ Chart 5Smaller EMs Must Also Deal With Rising Debt, Alongside Slowing Growth​​​​​ Chart 6The Debt Surge In EMs This Time, Poses Unique Challenges History suggests that periods of economic tumult are frequently followed by social unrest. The eruption of the so-called Arab Spring after the Great Recession illustrated the power of this dynamic. Then following the outbreak of Covid-19 in 2020 we had highlighted that Turkey, Brazil, and South Africa are at the greatest risk of significant social unrest. We also showed that even EMs that looked stable on paper faced unrest in the post-Covid world, including China and Russia. In this report we take a decadal perspective which reveals that growth is slowing, and debt is growing in EMs. Given that EMs suffer from rising economic miseries alongside growing debt and lower political freedoms (Chart 6), it appears that some of these markets could be socio-political tinderboxes in the making. Policy Implications Of The EM Debt Surge “As it turns out, we don't 'all' have to pay our debts. Only some of us do.” – David Graeber, Debt: The First 5,000 Years (Melville House Publishing, 2011) The trifecta of fast-growing debt, slowing growth and/or low political freedoms in EMs can add to the volatility engendered by EMs as an asset class. Given the growing economic misery in EMs today, politicians will be wary of outbreaks of social unrest. To quell this unrest, they may resort broadly to fiscal expansion and/or aggressive foreign policy. Both of these policy choices can dampen market returns in EMs. Chart 7India's Performance Had Flatlined Post Mild Populist Tilt Policy Choice #1: More Fiscal Spending Despite High Debt Policymakers in some EMs may respond by de-prioritizing contentious structural reforms and prioritizing fiscal expansion. The Indian government’s decision to repeal progressive changes to farm laws in late 2021, launch a $7 billion home-building program in early 2022 and withholding hikes in retail prices of fuel, illustrates how policymakers are resorting to populism despite high public debt levels. As a result, it is no surprise that MSCI India had been underperforming MSCI EM even before the war in Ukraine broke out (Chart 7). Brazil is another EM which falls into this category, while China’s attempts to run tighter budgets have failed in the face of slowing growth. Policy Choice #2: Foreign Policy Aggression EMs may also adopt an aggressive foreign policy stance. Russia’s decision to invade Ukraine, Turkey’s interventions in several countries, and China’s increasing assertiveness in its neighboring seas and the Taiwan Strait provide examples. Wars by EMs are known to dampen returns as the experience of the Russian stock market shows. Russian stocks fell by 14% during its invasion of Georgia in 2008 and are down 40% from 24 February 2022 until March 9, 2022, i.e. when MSCI halted trading. If politicians fail to pursue either of these policies, then they run the risk of social unrest erupting due to tight fiscal policy or domestic political disputes. In fact, early signs of social discontent are already evident from large protests seen in major EMs over the last year (see Table 1). Table 1Social Unrest In Major EMs Is Already Ascendant Bottom Line: The last decade has seen major EMs go on a relatively unnoticed public debt binge. This is problematic because this debt surge has come at a time when economic prospects of the median EM citizen have deteriorated. Politicians will be keen to quell the resultant discontent. This raises the specter of excessive fiscal expansion, aggressive foreign policy, and/or social unrest. All three outcomes are negative from an EM volatility perspective. Trend #2: The Rise And Rise Of EM Defense Spends Great Power Rivalry is an outgrowth of the multipolar structure of international relations. This theme will drive higher defense spending globally. In this report we highlight that even after accounting for a historic rearmament in developed countries following Russia’s invasion of Ukraine, a decade from now EMs will play a key role in driving global military spends. The defense bill of the six richest developed countries of the world (the US, Japan, Germany, UK, France and Italy) will increasingly be rivaled by that of the top eight EMs (China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey). While key developed markets like Japan and Germany in specific (and Europe more broadly) are now embarking on increasing defense spends, the unstable global backdrop will force EMs to increase their military budgets as well. The combination of these forces could mean that the top eight EM’s defense spends could be comparable to that of the top six developed markets in a decade from now i.e., by 2032 (Chart 8). This is true even though the six DMs have a larger GDP. The assumptions made while arriving at the 2032 defense spend projections include: Substantially Higher Pace Of Defense Spends For Developed Countries: To reflect the fact that Russia’s invasion of Ukraine will trigger a historical wave of armament in developed markets we assume that: (a) NATO members France, Germany and Italy (who spent about 1.5% of GDP on an average on defense spends in 2019) will ramp up defense spending to 2% of GDP by 2032, (b) US and UK i.e. NATO members who already spend substantially more than 2% of GDP on defense spends will still ‘increase’ defense spends by another 0.4% of GDP each by 2032 and finally (c) Japan which spends less than 1% of GDP on defense spends today, in a structural break from the past will increase its spending which will rise to 1.5% of GDP by 2032. China And Hence Taiwan As Well As India Will Boost Spends: To capture China’s increasingly aggressive foreign policy stance and the fact that India as well as Taiwan will be forced to respond to the Chinese threat; we assume that China increases its stated defense spends from 1.7% of GDP in 2019 to 3% by 2032. Taiwan follows in lockstep and increases its defense spends from 1.8% of GDP in 2019 to 3% by 2032. India which is experiencing a pincer movement from China to its east and Pakistan to its west will have no choice but to respond to the high and rising geopolitical risks in South Asia. The coming decade is in fact likely to see India’s focus on its naval firepower increase meaningfully as it feels the need to fend off threats in the Indo-Pacific. India currently maintains high defense spends at 2.5% of GDP and will boost this by at least 100bps to 3.5% of GDP by 2032. Defense Spending Trends For Five EMs: For the rest of the EMs (namely Russia, Saudi Arabia, South Korea and Brazil), the pace of growth in defense spending seen over 2009-19 is extrapolated to 2032. For Turkey, we assume that defense spends as a share of GDP increases to 3% of GDP by 2032. Extrapolation Of Past GDP Growth For All Countries: For all 14 countries, we extrapolate the nominal GDP growth calculated by the IMF for 2022-26 as per its last full data update, to 2032. This tectonic change in defense spending patterns has important historical roots. Back in 1900, UK and Japan i.e., the two seafaring powers were top defense spenders (Chart 9). Developed countries of the world continued to lead defense spending league tables through the twentieth century as they fought expensive world wars. Chart 8Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries​​​​​​ Chart 9Back In 1900, Developed Countries Like UK And Japan Were Top Military Spenders​​​​​​ Chart 10By 2000, EMs Had Begun Spending Generously On Armament But things began changing after WWII. Jaded by the world wars, developed countries began lowering their defense spending. By the early 2000s EMs had now begun spending generously on armament (Chart 10). The turn of the century saw growth in developed markets fade while EMs like China and India’s geopolitical power began rising (Chart 11). Then a commodities boom ensued, resulting in petro-states like Saudi Arabia establishing their position as a high military spender. The confluence of these factors meant that by 2020 EMs had becomes major defense spenders in both relative and absolute terms too (Chart 12). Going forward, we expect the coming renaissance in DM defense spending in the face of Russian aggression, alongside rising geopolitical aspirations of China, to exacerbate this trend of rising EM militarization. Chart 11The 21st Century Saw Developed Countries’ Geopolitical Power Ebb Chart 12EMs Today Are Top Military Spenders, Even In Absolute Terms Why Does EM Weaponizing Matter? History suggests that wars are often preceded by an increase in defense spends: Well before WWI, a perceptible increase in defense spending could be seen in Austria-Hungary, Germany, and Italy (Chart 13). These three countries would go on to be known as the Triple Alliance in WWI. Correspondingly France, Britain and Russia (i.e., countries that would constitute the Triple Entente) also ramped up military spending before WWI (Chart 14). Chart 13Well Before WWI; Austria-Hungary, Germany, And Italy Had Begun Ramping Up Defense Spends​​​​​​ Chart 14The ‘Triple Entente’ Too Had Increased Defense Spends In The Run Up To WWI​​​​​​ History tragically repeated itself a few decades later. Besides Japan (which invaded China in 1937); Germany and Italy too ramped up defense spending well before WWII broke out (Chart 15). These three countries would come to be known as the Axis Powers and initiated WWII. Notably, Britain and Russia (who would go on to counter the Axis Powers) had also been weaponizing since the mid-1930s (Chart 16). Chart 15Axis Powers Had Been Increasing Defense Spends Well Before WWII​​​​​ Chart 16Allied Powers Too Had Been Increasing Defense Spends In The Run Up To WWII​​​​​ Chart 17Militarily Active States Have Been Ramping Up Defense Spends Russia, Ukraine, Turkey and Gulf Arab states like Iraq have been involved in wars in the recent past and noticeably increased their defense budgets in the lead-up to military activity (Chart 17). Given that a rise in military spending is often a leading indicator of war and given that EMs are set to spend more on defense, it appears that significant wars are becoming more rather than less likely, which Russia’s invasion of Ukraine obviously implies. A large number of “Black Swan Risks” are clustered in the spheres of influence of Russia, China, and Iran, which are the key powers attempting to revise the US-led global order today (Map 1). Map 1Black Swan Risks Are Clustered Around China, Russia & Iran Distinct from major EMs, eight small countries pose meaningful risks of being involved in wars over the next. These countries are small (in terms of their nominal GDPs) but spend large sums on defense both in absolute terms (>$4 billion) and in relative terms (>4% of GDP). Incidentally all these countries are located around the Eurasian rimland and include Israel, Pakistan, Algeria, Iran, Kuwait, Oman, Ukraine and Morocco (Map 2). In fact, the combined sum of spending undertaken by these countries is so meaningful that it exceeds the defense budgets of countries like Russia and UK (Chart 18). Map 2Eight Small Countries That Spend Generously On Defense Chart 188 Countries Located Near The Eurasian Rimland, Spend Large Sums On Defense​​​​ Bottom Line: As EM geopolitical power and aspirations rise, the defense bill of top developed countries will be challenged by the defense spending undertaken by major EMs. On one hand this change will mean that certain EMs may be at the epicenter of wars and concomitant market volatility. On the other hand, this change could spawn a new generation of winners amongst defense suppliers. Investment Conclusions In this section we highlight strategic trades that can be launched to play the two trends highlighted above. Trend #1: Beware The Wrath Of EMs On A Debt Binge Investors must prepare for EMs to witness sudden fiscal expansions, unusually aggressive foreign policy stances, and/or bouts of social unrest over the next few years. The only way to dodge these volatility-inducing events in EMs is to leverage geopolitics to foresee socio-political shocks. Using a simple method called the “Tinderbox Framework” (Table 2), we highlight that: Table 2Tinderbox Framework: Identifying Countries Most Exposed To Socio-Political Risks Within the eight major EMs; China, Brazil, Russia and Saudi Arabia face elevated socio-political risks. Amongst the smaller ten EMs, these risks appear most elevated for Egypt, South Africa and Argentina. It is worth noting that Brazil, South Africa and Turkey appeared most vulnerable as per our Covid-19 Social Unrest Index that we launched in 2020. We used the tinderbox framework in the current context to fade out effects of Covid-19 and to add weight to the debt problem that is brewing in EMs. Client portfolios that are overweight on most countries that fare poorly on our “Tinderbox Framework” should consider actively hedging for volatility at the stock-specific level. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. China’s public debt ratio is high and social pressures may be building with limited valves in place to release these pressures (Table 2). The renminbi has performed well amid the Russian war, which has weighed down the euro, but China faces a confluence of domestic and international risks that will ultimately drag on the currency, while the euro will benefit from the European Union’s awakening as a geopolitical entity in the face of the Russian military threat. Trend #2: EM’s Will Drive Wars In The 21st Century Wars are detrimental to market returns.1 Furthermore, as the history of world wars proves, even the aftermath of a war often yields poor investment outcomes as wars can be followed by recessions. It is in this context that investors must prepare for the rise of EMs as protagonists in the defense market, by leveraging geopolitics to identify EMs that are most likely to be engaged in wars. While we are not arguing that WWIII will erupt, investors must brace for proxy wars as an added source of volatility that could affect EMs as an asset class. To profit from these structural changes underway we highlight two strategic trades namely: 1.  Long Global Aerospace & Defense / Broad Market Thanks to the higher spending on defense being undertaken by major EMs, global defense spends will grow at a faster rate over the next decade as compared to the last. We hence reiterate our Buy on Global Aerospace & Defense relative to the broader market. 2.  Long European Aerospace & Defense / European Tech Up until Russia invaded Ukraine and was hit with economic sanctions, Russia was the second largest exporter of arms globally accounting for 20% global arms exports. With Russia’s ability to sell goods in the global market now impaired, the two other major suppliers of defense goods that appear best placed to tap into EM’s demand for defense goods are the US (37% share in the global defense exports market) and Europe (+25% share in the global defense exports market). Chart 19American Defense Stocks Have Outperformed, European Defense Stocks Have Underperformed​​​​​​ Chart 20Defense Market: Russia’s Loss Could Be Europe’s Gain​​​​​ But given that (a) American aerospace & defense stocks have rallied (Chart 19) and given that (b) France, Germany, and Italy are major suppliers of defense equipment to countries that Russia used to supply defense goods to (Chart 20), we suggest a Buy on European Aerospace & Defense relative to European Tech stocks to extract more from this theme. In fact, this trade also stands to benefit from the pursuance of rearmament by major European democracies which so far have maintained lower defense spends as compared to America and UK. This view from a geopolitical perspective is echoed by our European Investment Strategy (EIS) team too who also recommend a Long on European defense stocks and a short on European tech stocks. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      Please see: Andrew Leigh et al, “What do financial markets think of war in Iraq?”, NBER Working Paper No. 9587, March 2003, nber.org.  David Le Bris, “Wars, Inflation and Stock Market Returns in France, 1870-1945”, Financial History Review 19.3 pp. 337-361, December 2012, ssrn.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Global Oil Price Pushes Up Inflation Expectations The US cut off of Russian energy exports has limited immediate impact because EU trade with Russia continues. Russia is unlikely to embargo the EU as it needs revenues to wage war. However, the EU will diversify away from Russia over time, which means that Russia will intensify its efforts to replace the government in Ukraine. The Biden administration began with an adversarial posture toward the energy sector, both US producers and Gulf Arab petro-states. Now it is adjusting its stance as prices surge. The OPEC states do not favor Biden but have an interest in calibrating production to avoid global recession and prolong their profit windfall. Even if the US restores the 2015 nuclear deal with Iran, which we doubt, investors should fade the oil price implications and stay focused on OPEC. Recommendation (Tactical) Inception Level Inception Date Return Long DXY (Dollar Index) 96.19 Feb 23, 2022 2.9% Bottom Line: Stagflation is the likeliest economic outcome of today’s global supply constraints. Feature Biden’s Oil Policy: Implications Will the Ukraine crisis lead to a US recession? The probability of a recession is 7.7% today, according to the bond market, but the oil price shock suggests that the probability will only increase from here. Stagflation, at least, is now highly likely. Short-term interest rates are rising faster than long-term rates, causing the 2-year/10-year Treasury slope to slide toward inversion, though it is not there yet. That would be a telltale sign of a looming recession (Chart 1). The 3-mo/10-year Treasury yield slope is nowhere near inverting and has a better record of predicting recessions than the 2-year/10-year. The Federal Reserve’s interest rate hikes are expected to cause the 10-year yield to rise and the yield curve to steepen. But exogenous shocks may push short rates even higher. When the oil price doubles, a recession often ensues. Out of the past seven recessions, five of them witnessed an oil spike beforehand. True, not every spike causes a recession. But the causality is clear. Today’s spike is large enough to be recessionary (Chart 2). The critical question is where will the price settle? If it settles above $90-$100 per barrel then it will erode global demand. Chart 1An End-Of-Cycle Crisis? Chart 2Oil Price Often Doubles Before Recessions Most likely the price will settle at around $85 per barrel by the end of 2022, and average $85 in 2023, according to our Commodity & Energy Strategy. High prices will discourage consumption and incentivize new production, leading to a price drop and new equilibrium. The OPEC cartel will increase production because they want to prolong the business cycle. Non-OPEC producers like US shale oil companies will also increase production. It is not likely that the US will significantly lift sanctions on Iran and Venezuela, though that would free up 1.3 million barrels per day and 700,000 barrels per day respectively. More on this below. Even so, this year’s energy spike will feed into a larger bout of inflation that is eroding real incomes. Headline consumer price inflation is running at 7.9% as of February, the highest in four decades. Core inflation is running at 6.4%. The Ukraine war did not prevent the European Central Bank from delivering a hawkish surprise in its fight against inflation on March 10, so it is even less likely to prevent the Fed from delivering a hawkish surprise on March 16. The Fed has a history of hiking rates even during geopolitical crises (as during the Arab oil embargo of 1973), which implies that the war in Ukraine will not prevent the Fed from hiking rates four times or more this year. There is a close relationship between the global oil price and the financial market’s long-term inflation expectations (Chart 3). When the costs of production and transportation go up, investors start to expect higher prices. Expectations are already rising because of the global pandemic, stimulus, supply constraints, wage pressure, and tardy policy normalization. Gasoline prices at the pump will shape consumer expectations (Chart 4). Chart 3Global Oil Price Pushes Up Inflation Expectations Chart 4Geopolitics Compound Inflation Yet high commodity prices are not coinciding with strong global growth and a weak dollar, as one might suspect. Global growth is falling and the dollar is strengthening. The energy shock from Russia will rattle importing countries like Europe, China, and India and thus enhance the dollar’s rise (Chart 5). Investor sentiment will suffer as the war in Ukraine reinforces the secular rise in geopolitical risk. Global policy uncertainty is also rising sharply, which will reinforce the dollar, weighing on global economic activity. Chart 5Dollar Strengthens on Weak Global Growth Bottom Line: A stagflationary dynamic is taking shape. Moreover the risk of recession is underrated by the bond market’s measure of recession probability. Investors should maintain tactically bearish trades and cut losses on cyclically bullish trades that suffer from higher rates and persistent inflation. US Boycotts Russia And Begs OPEC The Biden administration’s decision to ban Russian oil exports – and to encourage private sector boycotts of the Russian energy trade – raises the potential for the Russian conflict to escalate beyond Ukraine’s borders. While a total boycott of Russian oil exports is unlikely, it would be one of the larger oil shocks in modern history (Chart 6). Unlike the Iranian attack on the Saudi oil refinery in 2019, the Russian shock would come amid an existing energy shortage. Chart 6Worst Case Oil Risk in Historical Context There are two critical questions about US policy at this stage: Will the US foist its energy boycott on Europe, triggering a Russian retaliation? This could plunge Europe into recession and further upset the global economy. Will the US convince the OPEC cartel to increase oil production? A production boost would reduce prices and help to rebalance the economy, salvaging the business cycle. The next two sections discuss these options. US Boycotts Russia The first question is how Russia will respond to the US boycott and whether the Biden administration will try to force Europe to adopt the boycott. The US is comfortable boycotting Russian energy because oil and gas imports only account for 0.6% of GDP and those from Russia only 0.04%. Europe cannot make the same decision. While O&G imports are only 2.21% of GDP, and Russian O&G imports at 0.4%, these numbers will spike to near 2008 levels as a result of the price shock (Charts 7A & 7B). Major European countries, notably Germany, have already rejected the US boycott, and any EU direct sanctions require unanimity. The EU is instead outlining a plan to diversify away from Russia more gradually. This is a medium-term threat to Russia and hence a major concern for global stability but it is not an instant cutoff, which would cause an immediate recession in Europe. Chart 7AThe US Is Energy Independent... Chart 7B...The EU Is Not The EU’s plan would theoretically reduce its dependency on Russian energy by 66% by the end of the year. But that is easier said than done. Also, Europe cannot simply swap the US for Russia. American exports to the rest of the world could be redirected to Europe, but the switch requires an overhaul of supply chains. A total switch of US exports to Europe is impracticable in the short run and would leave other US allies dependent on Russian exports (Charts 8A & 8B). Chart 8AUS Will Not Replace Russian Energy Anytime Soon Chart 8BUS Will Not Replace Russian Energy Anytime Soon US shale producers are only starting to increase production. With WTI crude oil at $100, and Henry Hub natural gas spot price at $4.6 per million BTU, American production will speed up. But US companies are more focused on profitability and returns to shareholders than they were at the beginning of the shale boom, which has restrained oil production (Charts 9A & (9B). Chart 9AUS Production And Exports Increase After Pandemic Lull Chart 9BUS Production And Exports Increase After Pandemic Lull   The Biden administration has not yet fully adopted the tactics necessary: promoting the domestic fossil fuel industry and coordinating it for purposes of national strategy. American oil executives complain that while the Biden administration courts foreign energy producers and contemplates arbitrarily lifting sanctions on Iran and Venezuela, it has not approached domestic producers about facilitating production.1 Meanwhile there is a risk that Russia will retaliate against western sanctions by cutting off natural gas to the EU, for instance via the Nord Stream I pipeline. This is a risk, rather than a base case, because Moscow would prefer to sell energy as long as Europe is buying – and even increase the amount it produces at today’s high prices. Russian energy exports to the EU account for 5% of Russian GDP and thus provide an important lifeline at a time when the country is suffering heavily under banking, technology, and trade sanctions (Chart 10). Russian natural resource exports on average provide 43% of government revenue, which is essential for Moscow to carry on its war effort (Chart 11). Chart 10Russia Will Not Punish EU For US Boycott Chart 11Russia Needs EU Energy Imports And yet Russians are now slapping an embargo on agricultural exports, constricting global food supply and pushing up food prices. The implication is that a reduction in energy exports to the EU is not out of the question, especially an incremental reduction aimed at increasing Russian diplomatic pressure on Europe. If the Russians cut off Europe, it will fall into a severe recession and the energy shock will risk a global recession. While US direct trade exposure to Europe is limited, at about 3.8% of GDP (Chart 12A), nevertheless the US would suffer from price pressures. The US is already seeing import prices rise toward 2008 levels (Chart 12B). Chart 12AUS Exposure To The EU Is Limited... Chart 12B...But Its Import Prices Will Rise Bottom Line: The US is boycotting Russian oil but not forcing the EU to join the boycott. Europe is pursuing gradual diversification but Russia is unlikely to cut off Europe’s supply. However, this dynamic is showing signs of faltering, which means investors are justified in taking further risk off the table. US Begs OPEC The Biden administration started off on the wrong foot with the Gulf Arab states by criticizing them for autocratic government and human rights abuses, threatening to withhold arms sales, and trying to restore the 2015 nuclear deal and détente with Iran. Now, with a global energy shock unfolding, Biden is going back to Saudi Arabia and the UAE and imploring them to increase oil production and ease the supply pressure. The Arab states are reportedly giving him the cold shoulder, ignoring his phone calls while answering Russian President Vladimir Putin’s calls.2 These states never have an interest in producing oil at any US president’s beck and call. The US and Iran have also reached a critical stage in nuclear negotiations. So it is only fitting that the Arab states play hard to get. While the UAE ambassador to the US suggested that his country supporting increasing production on March 9, the country’s energy minister said the opposite. However, the core OPEC states are even less likely to do Russia’s bidding. Moscow propped up the Syrian regime, arms and subsidizes Iran, and aspires to gain ever greater control over Middle East exports to Europe. The Gulf states also know that the Russians will produce as much energy as they can since they need the revenues to sustain their war (Chart 13). Chart 13Core OPEC Countries Have An Interest In Increasing Oil Supply The Gulf states rely on the US military for national security, they fear that US-Iran détente will lead to US abandonment and Iranian regional ascendancy, and they seek to sustain their centrality to the global oil market. They want to prolong their export revenues in the context of a growing global economy for the sake of their own delicate internal stability and reforms. They do not aim to incentivize non-OPEC oil production and renewable energy transition with excessive prices, or to trigger a global recession (Chart 14). Hence the Saudi and UAE strategy will be to lower the oil price closer to their fiscal breakeven rate of $82.3 and $62.8 (oil price consistent with a balanced budget) and prolong the business cycle (Chart 15). Chart 14Core OPEC Does Not Want To Threaten Their Fiscal Future Chart 15Current Oil Price Comfortably Supports Fiscal Spending In OPEC The critical factor in the negotiation with the Biden administration will be Iran, their chief rival. Biden is trying to rejoin the 2015 nuclear deal, which would require removing sanctions in exchange for Iran’s halting its nuclear progress. A deal would bring 1.3 million barrels per day online, at least for the next two years or so. It could also prompt the Saudis or others to increase production to prevent Iran from stealing market share, as occurred in 2014 (Chart 16). Any deal would reduce the risk of military conflict in the short term and as such would remove some risk premium from oil prices. If Biden agrees to walk away from the Iran deal, then perhaps the Saudis and UAE will oblige him with a larger and quicker production boost. They know the Democratic Party is doomed in this year’s midterm elections anyway. Sanctions are not preventing the Iranians from exporting oil today and there is very little chance that they will truly abandon their quest for nuclear weapons (Chart 17). Chart 16Production Ramped Up Ahead Of The Iran Deal In 2015 Chart 17Production May Ramp Up Again As Iran Managed To Evade Sanction Either way the core OPEC members need to adjust the oil supply to maintain market share and prolong the business cycle. Taking it all together, investors should expect oil prices to remain volatile and for oil supply risks to remain elevated, meaning that oil prices will likely resume their rise after the expected OPEC intervention. Biden is also tinkering with the idea of easing sanctions on Venezuela. This would take a long time and require regime change to come to fruition. Venezuela produces about 700,000 barrels per day at present, down from about 2 million bpd in 2017.Given the lack of capital, investment, and engineering expertise, the Venezuelans probably cannot increase production beyond 1 million bpd over the next year or so. Of that, maybe 600,000 barrels could be sent to export markets, according to our Commodity & Energy Strategist Bob Ryan. The US cannot remove all sanctions from Venezuela as it does not recognize the legitimacy of President Nicolas Maduro’s regime. The Department of Justice indicted Maduro in 2020. Accommodating Maduro will create even more bad blood between the Democrats and the Cuban-American voters in electorally critical Florida. US companies will be reluctant to get involved in oil production in Venezuela on such a flimsy basis, as they will fear future sanctions if Republicans win in 2024. So investment in Venezuela, and hence oil production, will remain limited even if Biden waives some sanctions. Bottom Line: Biden’s attempts to ease sanctions on Iran and Venezuela are unlikely to have a lasting impact on oil prices. But it is possible that he will convince the OPEC states to increase production, as their own interests support such a move. Investment Takeaways Comparing Russia’s 2022 invasion of Ukraine to the original invasion in 2014, the major trends are parallel: stocks are falling relative to bonds, cyclical sectors are underperforming defensives, and small caps are outperforming large caps (Chart 18A). Chart 18AMarket Response 2022 Versus 2014 Chart 18BMarket Response 2022 Versus 2014 If Russia imposes an energy embargo or OPEC refuses to increase production, then there will be an even larger global energy shock and a European recession that will weigh on global growth. The dollar will stay well bid in the near term. Value stocks are far outpacing growth stocks in the 2022 crisis, in keeping with high inflation and rising bond yields (Chart 18B). While we favor value over growth on a structural basis, we took the opposite stance as a tactical trade at the beginning of this year in expectation of falling bond yields, which has backfired. We are closing this trade for a loss of 7.7%.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     See Shannon Pettypiece, “White House, oil industry spar anew over drilling as gas prices surge”, NBC News, March 12, nbcnews.com. 2     See Holman Jenkins, “The Putin Endgame,” The Wall Street Journal, March 1, 2022, wsj.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Executive Summary Winners And Losers Combining Russia and Ukraine: Taken together, Russia and Ukraine account for a small fraction of global trade. However, Russia is a key player in the global energy and metals markets, providing rare materials like palladium. Ukraine is a sizable agricultural producer, as well as an exporter of specialized products such as neon. Effects on global trade: Shortages of metals and agricultural goods will reverberate across the global economy, exacerbating shortages and supply disruptions. Manufacturer anxiety about the availability of raw input materials catalyzed an explosive rally in the commodity universe.  Effect on the US companies: Most US equity sectors have limited direct sales exposure to Russia. However, self-sanctioning will have an adverse immediate effect on many multinationals, while indirect effects of the war will be even more impactful. Winners and losers: At the margin, the escalation in Ukraine is a net positive for Energy, Big Tech, and Metals & Mining, while Travel, Consumer Staples, Semiconductors Manufacturers, and Automakers will be hit by shortages and surging input costs. Bottom Line:The war in Ukraine has wreaked havoc in the US equity market, even though US trade with Russia and Ukraine is insignificant and is mostly limited to energy, palladium, and other rare metals. However, US companies are affected by the scarcity of selected metals and materials, soaring prices, and supply chain disruptions. Feature Introduction The war in Ukraine has become the proverbial black swan that has blindsided even the most cautious investors. The world simply did not expect Russia to wage such a bloody, and all-out war. As such, tragically, small Ukraine has come out of obscurity, and became a focal point of the world’s attention, mostly for humanitarian reasons. While our heart goes out to the people living under fire, it is our job as investment strategists to conduct a detailed economic analysis of the effect of the war in Ukraine and sanctions on Russia’s goods and services on US equities. To do so, we will first investigate trade links between Ukraine, Russia, and the US. And then look at the indirect effects of the war on US equity sectors. Russia And Ukraine Effect On Global Trade Taken together, Russia and Ukraine account for about 3.5% of global GDP in PPP terms and only 1.9% in dollar terms. Even a deep recession in each of these economies is unlikely to cause a dent in global growth, at least not directly. Unfortunately, the indirect effects of this war are substantial. What Is Russia Producing? In 2019, Russia exported $407B in goods, which made it the 13th largest exporter in the world. It is the second-largest commodities exporter (after the US) and the second-largest oil producer, accounting for 12% of annual global output. Energy: Russia’s crude oil exports account for 8.4% of global crude consumption, while natural gas exports account for 5.9% of global consumption, and 3.4% for coal (Table 1). These energy products constitute roughly 60% of Russia’s exports. Its exports of natural gas represent close to half of all European gas imports. Table 1Russia’s Global Share In Various Commodities Nickel: Russia is also one of the top metal producers. It is the third largest producer of nickel, accounting for 4.4.% of global output. The recent surge in nickel prices reflects manufacturers’ anxiety about the potential shortages of this metal.1 Elon Musk has said that a shortage of nickel is the “biggest challenge” in “producing high-volume, long-range batteries”. Palladium: In addition, to nickel, Russia accounts for 35.6% of global palladium output. Palladium is widely used in catalytic converters, electrodes, and other types of electronics.2 Palladium prices are up 46% since the start of the year. Chart 1War Wreaked Havoc In Commodities Market Fertilizers: Together, Russia and Belarus account for about 40% of global potash production, a key ingredient in potassium-based fertilizers. Russia also produces two-thirds of all ammonium nitrate, the main source of nitrogen-rich fertilizers. Wheat and lumber: Russia produces 10% of the global supply of wheat and lumber. While Russia’s trading network is wide, the most common destinations for its exports are China (14%), Netherlands (10%), Belarus (5%), and Germany (4.6%), making its direct effect on global trade limited. What Is Ukraine Producing? Ukraine’s effect on global trade is less significant: In 2019 it exported only $49.5B, with exports dominated by agricultural products and metals (Chart 2). Food: Ukraine’s production is dominated by foodstuffs such as corn, wheat, and seed oils. Russia and Ukraine together account for 25% of global wheat exports, much of which is going to the developing nations of Africa and Asia (Chart 3). Russia and Ukraine are also significant producers of potatoes, sunflowers, and sugar beets. Chart 2Ukraine Exports Metals And Food Chart 3Wheat Is Exported To North Africa And Asia With war and sanctions, most of this output will be lost or kept for domestic consumption, accelerating food inflation, which is already rampant. Of course, the rest of the world could try to compensate for lost agricultural output, but there is a major snag: Russia, Ukraine, and Belarus are significant producers of fertilizer. Metals: Ukraine produces significant amounts of steel. ArcelorMittal and Metinvest suspended production at their Ukrainian plants last week. Auto Components: In addition, Ukraine is a major producer of automotive wire harnesses. Volkswagen, BMW, and Porsche have all had to curtail auto production due to war-related shortages. Neon: Then there are the more esoteric commodities. The bulk of semiconductor-grade neon, used in high-precision lasers, comes from Ukraine. A dearth of this critical gas could exacerbate the semiconductor shortage. While Ukraine trades predominately with its European neighbors, such as Russia, Germany, Poland, and Italy, shortages of agricultural products, semiconductors, and automotive components are likely to reverberate across the globe. The US Is An Island… Almost According to the OEC,3 in 2019 the US was the number two economy in terms of total exports ($1.51T), and the number one economy in total imports ($2.38T). Russia barely registers as the US trading partner, with only $14.B or 0.61% of total imports coming from Russia. Ukraine is even less significant for the US: Its exports constitute only $1.23B. US exports to Ukraine and Russia constitute less than 1% of its total exports. However, to uncover the potential effects of the possible halting of Russian trade on the US economy, let’s look at what goods the US is buying. The reality on the ground may be complex. Petrochemicals Refined and crude petroleum constitute about half of all Russian imports to the US and account for roughly $7 billion (Chart 4). The US sanctioning of Russian oil is unlikely to have a significant effect on the US economy: It constitutes only about 5.7% of all the US oil imports, both crude and refined, which in 2019 were about $123B. As a result, the recent US embargo of Russian oil is unlikely to have much impact. Platinum, Titanium, And Other Rare and Precious Metals US imports roughly $7B worth of platinum, over one-fifth of which is sourced from Russia. Russia also provides about 21.5% of all titanium and 23% of radioactive chemicals that the US imports. Chart 4US Imports Fuels And Rare Metals From Russia Palladium The situation with palladium is even more strained: Russia produces 42% of the palladium imported by the US while South Africa supplies another 30%. All other exports of palladium are fragmented, and producers are unlikely to be able to ramp up production fast enough. Nickel US imports only $1.4B worth of nickel per year, 11% of which is coming from Russia. Australia and Canada are the only other large producers of this metal, and it is not clear if they will be able to step in and fill in the void left by Russia. How Much Production From Russia Will Be Curtailed? The West’s official sanctions affect Russian exports of certain commodities but there is also a reluctance on the part of private companies to buy or ship Russian exports. This latter factor makes it nearly impossible to gauge just how much supply of each individual commodity will be curtailed. In addition, Putin has announced his decision to suspend some commodity exports at least until 2023. Assuming in the near term that a considerable share of Russia’s commodity exports will be blocked from global markets, the largest impact will be on oil, palladium, copper, nickel, fertilizer, and grains. The Stock Market Is Not The Economy US Companies Most Exposed To Russian Trade Most US multinational companies have limited direct sales exposure to Russia. Among those that do have some exposure (Table 2), Philip Morris comes on top of the list at 8% of sales, PepsiCo 4.3%, Mondelez 3.1%, and McDonald’s 4.5%. Apple has generated only 1.3% of its sales in Russia. Overall, the Consumer Staples sector has the highest exposure to Russia. Exodus The majority of US multinationals have announced their exit from the Russian market in protest at the war. The exodus affects wide swaths of the Russian economy, including joint ventures in energy, auto manufacturing, finance, retail, entertainment, and fast food (See Appendix for the list). The war affects US sectors in many different way, and there are winners and losers (Chart 5). Table 2US Multinationals With The Highest Exposure To Russia Chart 5Winners And Losers Investment Implications Energy Sector – Positive The US embargo of Russian oil does not have a pronounced immediate and direct effect on the US energy sector as US imports from Russia are minor. Exxon’s exit from Russia is not going to have any noticeable short-term effect on the US energy sector. On the contrary, elevated oil and gas prices create an impetus for the US shale producers to ramp up output. Oil Equipment and Services companies will be the key beneficiaries of the new energy Capex cycle. While we closed our overweight in E&P companies with a view that OPEC will open oil spigots and cure high prices, locking in a gain of 60%, we remain overweight E&S Energy industry. Consumer Staples – Negative Companies such as Mondelez, Philip Morris, and PepsiCo are most exposed to the Russian market. All three have announced that they are discontinuing or curtailing Russian operations, taking a direct hit on earnings. However, disruptions in agricultural exports from Russia and Ukraine, and accompanying soaring food prices (Chart 6), are likely to have a broad negative effect on the sector, increasing input prices while sector margins are already razor-thin. So far, the sector had been able to pass on costs to customers, but its pricing power may be limited going forward (Chart 7). Chart 6Food Price Surge Is Parabolic Chart 7Consumer Staples Have Been Able To Pass Costs On To Customers We are overweight Consumer Staples thanks to its defensive attributes in the face of overall market volatility. However, we will be monitoring this position closely. Semiconductors - Neutral Disruptions in supplies of neon, palladium, and nickel, which are essential components of the manufacturing of semiconductors, will exacerbate global chip shortages, and hit profits of semiconductor manufacturers, mostly in Asia. However, the majority of the large US semiconductor companies are chip designers and are unlikely to be affected. The only exception is Intel, which is an integrated semiconductor company. Intel has also announced that it is exiting Russia, which may have an adverse effect on its profitability. Auto Manufacturers - Negative Overall, US car manufacturers have limited direct exposure to Russia. Ford has recently closed its joint venture with a Russian car manufacturer. GM does not have a significant presence in Russia, selling only 3,000 cars a year there, of the six million it sells worldwide. Tesla’s presence in Russia is also insignificant – there are only 700 Teslas registered there. However, there are supply problems. Shortages of metals, such as palladium and nickel, widely used in catalytic converters and electrodes, will compound shortages in tight auto component markets. Travel Complex: Hotels, Restaurants, and Airlines Hilton, Marriott, and Hyatt have announced that they are halting development and new investments in Russia. While these actions on the margin will have a long-lasting negative effect on their business, a more immediate concern is that a war in Europe will suppress travel, which only recently started rebounding after COVID-19 country closures. US airlines will suffer from a double whammy of rising fuel costs, and consumer reluctance for international travel in the light of hostilities in the heart of Europe. International and business travel are the most lucrative segments of their business, the rebound of which is needed for these companies to restore profitability. We were positive on airlines in light of the reopening of international travel as the Omicron wave was receding, but now have to reconsider our optimistic stance if oil prices don’t normalize soon. Fast-food restaurant closures in Russia (Burger King, McDonald’s, Starbucks, etc.) will result in a significant hit to their bottom line. To put these actions in perspective, McDonald’s announced that temporary closures of its 750 restaurants in Russia and 180 in Ukraine will make it lose $50 million a month, resulting in a 9% hit to its revenue. In addition, these businesses are already reeling from rising food prices and consumers shifting their goods and services away from discretionary spending to necessities because of negative wage growth. We are overweight the Travel complex but are likely to downgrade it in the coming days. Big Tech – Positive According to a recent report by the IDC, the global impact of a steep decline in Information and Communications Technology (ICT) spending in Russia and Ukraine will be somewhat limited. Combined, the two countries only account for 5.5% of all ICT spending in Europe and 1% worldwide.4 Meanwhile, tech spending among Western European countries may increase in part due to expanded defense and security allocations. We believe that dislocation also creates an opportunity for US technology companies, especially in the software and cybersecurity space. Exiting the Russian market is likely to have a limited negative effect on US technology companies’ revenue, as most of them derive only a very small proportion of it from Russia. We are overweight the Software and Cybersecurity industries. Metals and Mining - Positive Disruption of the supply of metals from Russia and Ukraine creates an opportunity for US metals and mining companies, with soaring pricing promising a profits windfall. Unlike with oil and gas, an increase of supply in metals not only takes substantial investment but also takes years to bring to production. As a result, there is no respite in sight. As such, we will consider adding to our existing position, bringing allocation to an overweight. Stay tuned. Bottom Line The war in Ukraine has wreaked havoc in the US equity market, even though US trade with Russia and Ukraine is insignificant and is mostly limited to energy, palladium, and other rare metals. However, the US economy is affected by the scarcity of selected metals and materials, soaring prices, and supply chain disruptions. As is often the case, there are winners and losers: Energy, and Metals & Mining are mostly immune to the crisis and are likely to benefit by picking up slack in supply. The Technology sector, especially Software and Cybersecurity, will benefit from the disruption of the war. Consumer Staples, Travel, Auto Manufacturers, and Semiconductor Manufacturers are likely to take a hit because of shortages and soaring input prices.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Appendix: Companies’ Self-Sanctions In Russia5 Airlines American Airlines, Delta, and United cut ticket sales partnerships with Russian airlines. All three have stopped flying over Russia. Banks Goldman Sachs became the first American bank to announce that it is exiting Russia. Citigroup also indicated that it is curtailing operations in Russia. Technology Accenture is discontinuing its operations in Russia. Airbnb (ABNB) announced that the company is suspending all operations in Russia and Belarus. Amazon (AMZN)’s cloud division, Amazon Web Services (AWS), said it would halt new sign-ups for the service in Russia and Belarus. AWS indicated that it has no data centers in Russia and, as a matter of policy, it does not do business with the Russian government. It stated that while it had Russian customers, they are all headquartered outside of Russia. Apple (AAPL) has stopped selling its products in Russia, and limited access to digital services, such as Apple Pay, inside Russia. Google confirmed that it is no longer accepting new Google Cloud customers in Russia. It has also halted its advertisement operations in the country. IBM (IBM) has suspended all business in Russia. Intel (INTC) has stopped all shipments to Russia and Belarus, the company announced. Microsoft (MSFT) is suspending all new sales of its products and services in Russia. Microsoft (MSFT) also said it will continue aiding in Ukrainian cybersecurity. Netflix (NFLX) said it will be suspending its streaming service in Russia. Spotify (SPOT) said it has closed its office in Russia “indefinitely” and restricted shows “owned and operated by Russian state-affiliated media.” Adobe stopped all new sales in Russia Uber is divesting from internet company Yandex Paypal suspended all services in Russia Big Four Accounting Firms Ernst & Young, Deloitte, KPMG, and PwC are pulling out of the country. Energy Exxon pledged to leave its last remaining oil and gas project in Russia and not to invest in new developments in the country. Credit Card Providers All three American credit card giants, Mastercard (MA), Visa (V), and American Express (Amex), have suspended all their network operations in Russia. Credit cards issued by Russian banks will not work in other countries, and cards issued elsewhere will not work for purchases in Russia. Hotels Hyatt (H), Hilton (HLT), and Marriott (MAR) are halting development and new investments in Russia. Hilton and Marriott are closing their corporate offices. Hilton is keeping its existing 26 hotels open (a fraction of the company’s 6,800 properties worldwide). Marriott hotels are franchised and the company is evaluating the ability to keep these hotels open. Industrials 3 has halted operations in Russia. Dow (DOW) has suspended all purchases of feedstocks and energy from Russia. It has also stopped all investments in the region and is supplying only limited essential goods in Russia. General Electric (GE) suspended most of its operations in Russia, with the exception of “providing essential medical equipment and supporting existing power services.” John Deere (DE) has halted shipments of its products to Russia. Caterpillar (CAT) is suspending operations at its Russian manufacturing facilities. Boeing (BA) said it would suspend support for Russian airlines. Automakers Ford (F) announced it was suspending its operations in Russia. The American automaker has a 50% stake in Ford (F) Sollers, a joint venture that employs at least 4,000 workers. GM does not have much of a presence in Russia. Entertainment Disney (DIS) is also suspending the release of its theatrical films in Russia, citing “the unprovoked invasion of Ukraine.” WarnerMedia said on February 28 that it would pause the release of “The Batman” in Russia. The company is also pausing all new business in Russia, ceasing broadcast of its channels, halting all new content licensing with Russian entities, and pausing planned theatrical and games releases. Retail Estée Lauder Companies will suspend all commercial activity in Russia, including closing every store and brand site and halting shipments to any of our retailers in Russia. The company had also already suspended business investments and initiatives in Russia. TJX has promised to divest its equity ownership in Familia, an off-price retailer with more than 400 stores in Russia. Consumer Staples Mondelez (MDLZ) said it would scale back all non-essential activities in Russia “while helping maintain continuity of the food supply.” The company said it would focus on “basic offerings,” and discontinue all new capital investments and suspend advertising spending in the country. Procter & Gamble (PG) has discontinued all new capital investments in Russia and is suspending all media, advertising, and promotional activity. The company will continue to provide basic health, hygiene, and personal care items. Philip Morris suspended planned investments and will reduce manufacturing in Russia. PepsiCo will stop selling soda in Russia but will continue to produce dairy and baby food. Restaurants Yum Brands (YUM) is closing 70 company-owned KFC restaurants and 50 Pizza Hut franchises in Russia. It will also suspend all investment and restaurant development in the country. McDonald’s (MCD) is closing some 750 restaurants in Russia. Russia’s restaurants along with another 108 in Ukraine, accounted for 9% of the company’s revenue in 2021. The company said that halting Russian operations will cost it $50 million a month. Restaurant Brands International (owner of Burger King) will end corporate support for 800 locations in Russia and will not approve any additional investment or expansion. Starbucks is closing all of its locations in Russia. Transportation UPS, DHL, and FedEx have suspended operations in Russia and Belarus.       Footnotes 1     The nickel price increase was compounded by a margin call on a major Chinese nickel producer that had accumulated a large short position through forward contracts in order to lock in a price for future delivery. 2     Palladium - Wikipedia 3    United States (USA) Exports, Imports, and Trade Partners | OEC - The Observatory of Economic Complexity 4    A New Report from IDC Looks at the Initial Impact of the Russia-Ukraine War on Global ICT Markets. 5    Which Companies Have Pulled Out of Russia? Here’s a List. - The New York Times (nytimes.com) and https://www.cnn.com/2022/03/02/business/companies-pulling-back-russia-ukraine-war-intl-hnk/index.html Recommended Allocation