Emerging Markets

Special Report

Executive Summary From Nixon-Mao To Putin-Xi The geopolitical “big picture” of Russia’s invasion of Ukraine is the deepening of the Russo-Chinese strategic partnership. While Russia’s economic and military constraints did not prohibit military action in Ukraine, they are still relevant. Most likely they will prevent a broader war with NATO or a total energy embargo of Europe. Still, volatility will persist in the near term as saber-rattling, aftershocks, and spillover incidents will occur this year.  Russo-Chinese relations are well grounded. Russia needs investment capital and resource sales, while China needs overland supply routes and supply security. Both seek to undermine the US in a new game of Great Power competition that will prevent global politics and globalization from normalizing. Tactically we remain defensive but buying opportunities are emerging. We maintain a cyclically constructive view. Favor equity markets of US allies and partners that are geopolitically secure. Trade Recommendation Inception Date Return Long Gold (Strategic) 2019-12-06 32.7% Bottom Line: Tactically investors should remain defensive but cyclically they should look favorably on cheap, geopolitically secure equity markets like those of Australia, Canada, and Mexico. Feature To understand the Russian invasion of Ukraine and the likely consequences, investors need to consider three factors: 1.  Why Russia’s constraints did not prohibit war and how constraints must always be measured against political will. 2.  Why Russia’s constraints will grow more relevant going forward, as the costs of occupation and sanctions take hold, the economy weakens, and sociopolitical pressures build. 3.  Why the struggle of the Great Powers will drive a Russo-Chinese alliance, whose competition with the US-led alliance will further destabilize global trade and investment. Russia’s Geopolitical Will Perhaps the gravest national security threat that Russia can face, according to Russian history, is a western military power based in the Ukraine. Time and again Russia has staged dramatic national efforts at great cost of blood and treasure to defeat western forces that try to encroach on this broad, flat road to Moscow. Putin has been in power for 22 years and his national strategy is well-defined: he aims to resurrect Russian primacy within the former Soviet Union, carve out a regional sphere of influence, and reduce American military threats in Russia’s periphery. He has long aimed to prevent Ukraine from becoming a western defense partner. Chart 1Russia Structured For Conflict While Moscow faced material limitations to military action in Ukraine, these were not prohibitive, as we have argued. Consider the following constraints and their mitigating factors: Costs of war: The first mistake lay in assuming that Russia was not willing to engage in war. Russia had already invaded Ukraine in 2014 and before that Georgia in 2008. The modern Russian economy is structured for conflict: it is heavily militarized (Chart 1). Military spending accounts for 4.3% of GDP, comparable to the United States, also known for waging gratuitous wars and preemptive invasions. Financial burdens: The second mistake was to think that Moscow would avoid conflict for fear of the collapse of the ruble or financial markets. Since Putin rose to power in 2000, the ruble has depreciated by 48% against the dollar and the benchmark stock index has fallen by 57% against EMs. Each new crackdown on domestic or foreign enemies has led to a new round of depreciation and yet Putin remains undeterred from his long-term strategy (Chart 2). Chart 2Putin Doesn't Eschew Conflict For Sake Of Ruble Or Stocks Economic health: Putin’s foreign policy is not constrained by the desire to make the Russian economy more open, complex, advanced, or productive. While China long practiced a foreign policy of lying low, so as to focus on generating wealth that could later be converted into strategic power (which it is doing now), Russia pursued a hawkish foreign policy for the past twenty years despite the blowback on the economy. Russia is still an undiversified petro-state and total factor productivity is approaching zero (Chart 3). Chart 3Putin Doesn't Eschew Conflict For Sake Of Productivity​​​​​​ Chart 4Putin Doesn’t Eschew Conflict For Fear Of Sanctions​​​​​​ Western sanctions: Western sanctions never provided a powerful argument against Russian intervention into Ukraine. Russia knew all along that if it invaded Ukraine, the West would impose a new round of sanctions, as it has done periodically since 2014. The 2014 oil crash had a much greater impact on Russia than the sanctions. Of course, Russia’s overall economic competitiveness is suffering, although it is capable of gaining market share in exporting raw materials, especially as it depreciates its currency (Chart 4). Chart 5Putin Doesn't Eschew Conflict For Sake Of Popular Opinion Public opinion: Surely the average Russian is not interested in Ukraine and hence Putin lacks popular support for a new war? True. But Putin has a strong record of using foreign military adventures as a means of propping up domestic support. Of course, opinion polls, which confirm this pattern, are manipulated and massaged (Chart 5). Nevertheless Russians like all people are highly likely to side with their own country in a military confrontation with foreign countries, at least in the short run. Over the long haul, the public will come to rue the war. Moscow believes that it can manage the domestic fallout when that time comes because it has done so since 2014. We doubt it but that is a question for a later time. Investors also need to consider Putin’s position if he did not stage ever-escalating confrontations with the West. Russia is an autocracy with a weak economy – it cannot win over the hearts and minds of its neighboring nations in a fair, voluntary competition with the West, the EU, and NATO. Russia’s neighbors are made up of formerly repressed Soviet ethnic minorities who now have a chance at national self-determination. But to secure their nationhood, they need economic and military support, and if they receive that support, then they inherently threaten Russia and help the US keep Russia strategically contained. Russia traditionally fights against this risk. Bottom Line: Investors and the media focused on the obstacles to Russian military intervention without analyzing whether there was sufficient political will to surmount the hurdles. Constraints Eroded None of the above suggests that Putin can do whatever he wants. Economic and military constraints are significant. However, constraints erode over time – and they may not be effective when needed. Europe did not promise to cancel all energy trade if Russia invaded: Exports make up 27% of Russian GDP, and 51% of exports go to advanced economies, especially European. Russia is less exposed to trade than the EU but more exposed than the US or even China (Chart 6). However, Russia trades in essential goods, natural resources, and the Europeans cannot afford to cut off their own energy supply. When Russia first invaded Ukraine in 2014, the Germans responded by building the Nord Stream pipeline, basically increasing energy cooperation. Russia concluded that Europeans, not bound to defend Ukraine by any treaty, would continue to import energy in the event of a conflict limited to Ukraine. Chart 6Putin Limits Conflict For Sake Of EU Energy Trade​​​​​​ Chart 7Putin Limits Conflict For Sake Of Chinese Trade​​​​​​ Russia substitutes China for Europe: As trade with the West declines, Russia is shifting toward the Far East, especially China (Chart 7). China is unlikely to reduce any trade and investment for the sake of Ukraine – it desperately needs the resources and the import-security that strong relations with Russia can provide. It cannot replace Europe – but Russia does not expect to lose the European energy trade entirely. (Over time, of course, the EU/China shift to renewables will undermine Russia’s economy and capabilities.) Ukraine is right next door: Aside from active military personnel, the US advantage over Iraq in 2002-03 was greater than the Russian advantage over Ukraine in 2022 (Chart 8). And yet the US got sucked into a quagmire and ultimately suffered political unrest at home. However, Ukraine is not Afghanistan or Iraq. Russia wagers that it can seize strategic territory, including Kiev, without paying the full price that the Soviets paid in Afghanistan and the US paid in Afghanistan and Iraq. This is a very risky gamble. But the point is that the bar to invading Ukraine was lower than that of other recent invasions – it is not on the opposite side of the world. ​​​​​​​Chart 8Putin Limits Conflict For Fear Of Military Overreach Chart 9Putin Limits Conflict For Fear Of Military Weakness NATO faces mutually assured destruction: NATO’s conventional military weight far surpasses Russia’s. For example, Russia, with its Eurasian Union, does not have enough air superiority to engage in offensive initiatives against Europe, even assuming that the United States is not involved. Even if we assume that China joins Russia in a full-fledged military alliance under the Shanghai Cooperation Organization (SCO), NATO’s military budget is more than twice as large (Chart 9). However, this military constraint is not operable in the case of Ukraine, which is not a NATO member. Indeed, Russia’s aggression toward Ukraine stems from its fear that Ukraine will become a real or de facto member of NATO. It is the fear of NATO that prompted Russia to attack rather than deterring it, precisely because Ukraine was not a member but wanted to join. Bottom Line: Russia’s constraints did not prohibit military action because several of them had eroded over time. NATO was so threatening as to provoke rather than deter military action. Going forward, Russia’s economic and military constraints will prevent it from expanding the war beyond Ukraine.  Isn’t Russia Overreaching? Yes, Russia is overreaching – the military balances highlighted in Charts 8 and 9 above should make that plain. The Ukrainian insurgency will be fierce and Russia will pay steep costs in occupation and economic sanctions. These will vitiate the economy and popular support for Putin’s regime over the long run. Chart 10The West Is Politically Divided And Vulnerable The West is also vulnerable, however, which has given rise to a fiscal and commodity cycle that helps to explain why Putin staged his risky invasion at this juncture in time: The US and West are politically divided. Western elites see themselves as surrounded by radical parties that threaten to throw them out and overturn the entire political establishment. Their tenuous grip on power is clear from the thin majorities they hold in their legislatures (Chart 10). Nowhere is this clearer than in the United States, where Democrats cannot spare a single seat in the Senate, five in the House of Representatives, in this fall’s midterm elections, yet are facing much bigger losses. Russia believes that its hawkish foreign policy can keep the democracies divided.​​​​​​​ Elites are turning to populist spending: Governments have adopted liberal fiscal policies in the wake of the global financial crisis and the pandemic. They are trying to grow their way out of populist unrest, debt, and various strategic challenges, from supply chains to cyber security to research and development (Chart 11). China is also part of this process, despite its mixed economic policies. The result is greater demand for commodities, which benefits Russia.    Elites are turning to climate change to justify public spending: Governments, particularly in Europe and China, are using fears of climate change to increase their political legitimacy and launch a new government “moonshot” that justifies more robust public investment and pump-priming. The long-term trend toward renewable energy is fundamentally threatening to Russia, although in the short term it makes Russian natural gas and metals all the more necessary. Germany especially envisions natural gas as the fossil-fuel bridge to a green future as it has turned against both nuclear power and coal (Chart 12). Russian aggression will provoke a rethink in some countries but Germany, as a manufacturing economy, is unlikely to abandon its goals for green industrial innovation. Chart 11Politically Vulnerable States Need Fiscal Stimulus​​​​​​ Chart 12The West Reluctant To Abandon Climate Goals​​​​​​ Proactive fiscal and climate policy motivate new capex and commodity cycle: The West’s attempt to revive big government and strategic spending will require vast resource inputs – resources that Russia can sell at higher prices. The new commodity cycle gives Russia maximum leverage over Europe, especially Germany, at this point in time (Chart 13). Later, as inflation and fiscal fatigue halt this cycle, Russia will lose leverage. Chart 13Commodity Cycle Gives Russia Advantage (For Now) Meanwhile Russia’s economic and hence strategic power will subside over time. Russia’s potential GDP growth has fallen since the Great Recession as productivity growth slows and the labor force shrinks (Chart 14). Chart 14Future Will Not Yield Strategic Opportunities For Russia​​​​​​ Chart 15Younger Russians Not Calling The Shots (But Will Someday) In short, the Kremlin has chosen the path of economic austerity and military aggression as a means of maintaining political legitimacy and achieving national security objectives. Western divisions, de-carbonization, the commodity cycle, and Russia’s bleak economic outlook indicated that 2022 was the opportunity to achieve a pressing national security objective, rather than some future date when Russia will be less capable relative to its opponents. In the worst-case scenario – not our base case – the invasion of Ukraine will trigger an escalation of European sanctions that will lead to Russia cutting off Europe’s energy and producing a global energy price shock. And yet that outcome would upset US and European politics in Russia’s favor, while Putin would maintain absolute control at home in a society that is already used to economic austerity and that benefits from high commodity prices. Note that Putin’s strategy will not last forever. Ukraine will mark another case of Russian strategic overreach that will generate a social and political backlash in coming years. While Putin has sufficient support among older, more Soviet-minded Russians for his Ukraine adventure, he lacks support among the younger and middle-aged cohorts who will have to live with the negative economic consequences (Chart 15). The entire former Soviet Union is vulnerable to social unrest and revolution in the coming decade and Russia is no exception. The Russo-Chinese Geopolitical Realignment Chart 16From Nixon-Mao To Putin-Xi From a broader, geopolitical point of view, Russia’s invasion of Ukraine drives another nail into the coffin of the post-Cold War system and hyper-globalization. Russia is further divorcing itself from the western economy, with even the linchpin European energy trade falling victim to renewables and diversification. The US and its allies are imposing export controls on critical technologies such as semiconductors against Russia to cripple any attempts at modernization. The US is already restricting China’s access to semiconductors and from now on is locked into a campaign to try to enforce these export controls via secondary sanctions, giving rise to proxy battles in countries that Russia and China use to circumvent the sanctions. Russia will be forced to link its austere, militarized, resource-driven economy to the Chinese economy. Hence a major new geopolitical realignment is taking place between the US, Russia, and China, on the order of previous realignments since World War II. When the Sino-Soviet communist bloc first arose it threatened to overwhelm the US in economic heft and dominate Eurasia. This communist threat drove the US to undertake vast expeditionary wars, such as in South Korea and Vietnam. These were too costly, so the US sought economic engagement with China in 1972, which isolated the Soviet Union and ultimately helped bring about its demise. Yet China’s economic boom predictably translated into a strategic rise that began to threaten US preeminence, especially since the Great Recession. Today Russia and China have no option other than to cooperate in the face of the US’s increasingly frantic attempts to preserve its global status – and China’s economic growth and technological potential makes this alliance formidable (Chart 16). In short, the last vestiges of the “Nixon-Mao” moment are fading and the “Putin-Xi” alignment is already well-established. Russia cannot accept vassalage to China but it can make many compromises for the sake of strategic security. Their economies are much more complimentary today than they were at the time of the Sino-Soviet split. And Russia’s austere economy will not collapse as long as it retains some energy trade with Europe throughout the pivot to China. In turn the US will attempt to exploit Russian and Chinese regional aggression as a basis for a revitalization of its alliances. But Europe will dampen US enthusiasm by preserving economic engagement with Russia and China. The EU is increasingly an independent geopolitical actor and a neutral one at that. This environment of multipolarity – or Great Power Struggle – will define the coming decades. It will ensure not only periodic shocks, like the Ukraine war, but also a steady undercurrent of growing government involvement in the global economy in pursuit of supply security, energy security, and national security. Competition for security is not stabilizing but destabilizing. Hyper-globalization has given way to hypo-globalization, as regional geopolitical blocs take the place of what once promised to be a highly efficient and thoroughly interconnected global economy. Investment Takeaways Tactically, Geopolitical Strategy believes it is too soon to go long emerging markets. Russia is at war, China is reverting to autocracy, and Brazil is still on the path to debt crisis. Multiples have compressed sharply but the bad news is not fully priced (Chart 17). The dollar is likely to be resilient as the Fed hikes rates and a major European war rages. Europe’s geopolitical and energy insecurity will weigh on investment appetite and corporate earnings. American equities are likely to outperform in the short run. Chart 17Investors Should Not Bet On Russian And European Equities In This Context​​​​​ Chart 18Investors Find Value, Minimize Risk In Geopolitically Secure Equity Markets​​​​​​ Cyclically, global equities outside the US, and pro-cyclical assets offer better value, as long as the war in Ukraine remains contained, a Europe-wide energy shock is averted, and China’s policy easing secures its economic recovery. While European equities will snap back, Europe still faces structural challenges and eastern European emerging markets face a permanent increase in geopolitical risk due to Russian geopolitical decline and aggression. Investors should seek markets that are both cheap and geopolitically secure – namely Australia, Canada, and Mexico (Chart 18). We are also bullish on India over the long run.    Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Special Report

Executive Summary EU-Russia Energy Trade To Persist Russia invaded Ukraine to prevent it from becoming a defense partner of the US and its allies. It is not likely to attack NATO members, which share a mutual defense treaty, so the war is limited in scope. Spillovers can occur but the US and Russia have 73 years of experience avoiding direct war. The US and EU will levy sweeping sanctions but they will not halt Russian energy exports, as that would cause a recession in Europe. European political leaders would likely fall from power in the coming years if there were a full-scale energy crisis. European nations will leverage Russian aggression to strengthen their popular support at home, while diversifying away from Russian energy over the long run. Europe will impose tough sanctions on Russia’s non-energy sectors, including finance and technology, to hobble the regime. China will consolidate power at home and strengthen ties with Russia but a war over Taiwan is a medium-to-long term risk.   Bottom Line: Investors should be cautious over the very near term but should prepare to buy the dip of a geopolitical incident that is generally limited to Ukraine and the Black Sea area. Supply responses from oil producers will remove the risk premium from oil prices and send the price of Brent crude to $85 per barrel by the end of the year. EU-Russia energy flows are the key risk to monitor. Feature Russia launched an invasion of Ukraine on February 24. The invasion was not limited to the far eastern corner of the country but involved attacks in the capital Kiev and in the far west and the coastline. Hence investors should proceed on the assumption that Russia will invade all of Ukraine even if it ends up limiting its invasion, as we expect (Map 1). Map 1Russian Invasion Of Ukraine 2022 It is critical for investors to understand the cause of the war in order to gauge its scope and adjust their risk appetite accordingly. Consider: Ukraine does not have mutual defense treaties that automatically trigger a broader war. Russia is attacking Ukraine to prevent it from becoming a defense partner of the US and its allies. Russia does not have the military capacity to attack the North Atlantic Treaty Organization (NATO) members, which have a mutual defense pact. Russia is attacking Ukraine because it does not have a mutual defense pact but was seeking one. Russia aims to neutralize Ukraine. If Moscow sacks Kiev and sets up a puppet state, then Ukraine will not seek western defense cooperation for the foreseeable future. If Russia conquers key territories to strengthen its control over Ukraine, then future Ukrainian governments will limit relations with the West for fear of Russian absorption. Russia is likely to seize coastal territory to ensure the long-term ability to blockade Ukraine. Russia will not withdraw troops until it has changed the government and seized key territories. Russia and NATO have no interest in war with each other. In the immediate fog of war, global financial markets will experience uncertainty about whether fighting will expand into a broader war between Russia and NATO. Such an expansion is unlikely because of mutually assured destruction (MAD) due to nuclear weapons. The US and Europe have already pledged that they will not send troops to fight in Ukraine. They will send troops and arms to support neighboring NATO states in central Europe, such as the Baltic states, Poland, Slovakia, Hungary, and others. This will serve as a deterrent to Russia to keep its operations limited. Spillover incidents can and will occur, such as with Malaysian Airlines Flight 17 in 2014, but the US and Russia have 73 years of experience avoiding direct war, including when Russia invaded Hungary in 1956, Czechoslovakia in 1968, and Afghanistan in 1979. The US and EU will levy sweeping sanctions but the EU will not halt Russian energy exports. When Russia first invaded Ukraine and seized territory in 2014, Germany responded by working with Russia to build the Nord Stream II pipeline so as to import energy directly from Russia and circumvent Ukraine. This historical fact over the past eight years reveals Germany’s true interests. Thus energy cooperation increased as a result of Russian aggression. Of course, Germany has suspended the certification of that pipeline in light of today’s invasion, but it was not yet operating, so energy flows are not impeded, and it still physically exists for future operation when Germany finds it politically expedient. Hungary, Italy, Finland, the Czech Republic and others will also need to keep up Russian energy flows. Chart 1EU-Russia Energy Trade To Persist Nevertheless, a cessation of energy flows is still the most important risk for investors to monitor, whether triggered by European boycott or Russian embargo. That would cause a recession in Europe. Recession would cause European political leaders to fall from power in the coming years, which explains why they will not pursue that objective in face of Russian aggression. Even the US is vulnerable to a global price shock (during a midterm election year) and hence will allow the EU to keep importing Russian energy, whatever its sanctions package may contain. True, Russia may cut off natural gas flows via Ukraine, which account for nearly 20% of Europe’s imports (Chart 1). Moreover, Europe may threaten or claim that they will sanction the energy sector. But most flows will likely continue. Europe will diversify away from Russian energy over the long run. Instead of cutting off their own vital energy supplies, European nations will leverage Russian aggression to strengthen their popular support at home, while initiating emergency state-led efforts to diversify away from Russian energy over the long run through renewables and imports from the US and its allies. This will be advantageous to European democracies that were already struggling to increase political legitimacy amid nascent populism – they will now have a crusade with which to rally their people and maintain fiscal support for their economy: energy security. Europe will sanction Russia’s non-energy sector. Europe will impose tough sanctions on Russia’s non-energy sectors, including finance and technology, to hobble the regime. Russia will eventually be cut off from the SWIFT banking communications network, since it already has a rudimentary alternative that it developed in recent years, but Germany will not agree to cut it off until the payment alternate to continue energy flows can be arranged, which is ultimately possible. China will take advantage of the moment but is probably not ready to invade Taiwan. China could seize the opportunity to consolidate power at home and it may increase pressure on Taiwan through rhetoric, sanctions, or cyber-attacks, but it is not likely to invade Taiwan. An amphibious invasion of the globally critical territory of Taiwan is far riskier for China than a land invasion of the non-critical territory of Ukraine is for Russia. Russia’s strategic calculations and timing are separate from China’s, despite their growing de facto alliance. But a war in the Taiwan Strait is at risk over the long run, as the situation is geopolitically unsustainable, for reasons similar to that of Ukraine. The situation in Ukraine is likely to get worse before it gets better, implying that investors should expect further volatility in risk assets in the near term. Structurally, the shift to a less geopolitically stable multipolar world will favor defense and cybersecurity stocks. “Great Power Struggle” is our top geopolitical investment theme over the long run and Russia’s invasion of Ukraine highlights its continuing relevance. Bottom Line: A buying opportunity for heavily discounted, pro-cyclical or high-beta assets is emerging rapidly, given our assessment, and we will monitor events over the coming weeks to identify when such a shift is prudent. A wholesale energy cutoff to Europe is the chief risk, as it would justify downgrading global equities relative to long-maturity bonds on a six-to-12 month horizon. Investment Takeaways Global Investment Strategy: With real rates coming down, owning gold remains an attractive hedge. As a fairly cheap and defensive currency, a long yen position is advisable. Assuming the conflict remains contained to Ukraine, equities and other risk assets should recover over the remainder of the year. The geopolitical premium in oil prices should also come down. Consistent with our Commodity & Energy Strategy views, our Global Investment Strategy service is closing its long Brent trade recommendation today for a gain of 24.0%. Commodities & Energy Strategy: While oil exports from Russia are not expected to diminish as a result of the invasion, it will prompt increased production from core OPEC producers – Saudi Arabia, the UAE, and Kuwait – to take the elevated risk premium out of Brent crude oil prices and allow refiners to rebuild inventories. The US and Iran may rejoin the 2015 nuclear deal, which would add about 1.0mm b/d of production to the market – Russia’s 2014 invasion of Crimea did not prevent the original nuclear deal. These production increases would take prices from the current $105 per barrel level to $85 per barrel by the second half of 2022 and keep it there throughout 2023, according to our base case view. This change marks an increase on our earlier expectation of an average $79.75 per barrel in 2023 in our previous forecast. European Investment Strategy: European equities are likely to continue to underperform in the near-term. Even if Russia and Europe avoid a full embargo of Russian energy shipments to the West, the disruption caused by a rupture of natural gas flows via Ukraine will keep European gas prices at elevated levels. Additionally, investors will continue to handicap the needed risk premia to compensate for the low but real threat of an energy crisis, which would prove particularly debilitating for Hungary, Poland, Germany, Czechia and Italy (Chart 2). Moreover, European equities sport a strong value and cyclical profile with significant overweight positions in financial and industrial equities. Industrials will suffer from higher input costs. European financials will suffer from a decline in yields as hawks in the European Central Bank are already softening their rhetoric on the need to tighten policy. However, due to the likely temporary nature of the dislocation, we do not recommend selling Europe outright and instead will stick with our current hedges, such as selling EUR/JPY and EUR/CHF. The evolution of the military situation on the ground will warrant a re-valuation of this hedging strategy next week. The euro will soon become a buy. Chart 2EU Economy Highly Vulnerable To Any Large Energy Cutoff Foreign Exchange Strategy: The Ukraine crisis will lead to a period of strength for the US dollar (DXY). Countries requiring foreign capital will be most at risk from an escalation in tensions. We still suspect the DXY will peak near 98-100, but volatility will swamp fundamental biases. Geopolitical Strategy: On a strategic basis, stick with our long trades in gold, arms manufacturers, UK equities relative to EU equities, and the Japanese yen. On a tactical basis, stick with long defensive sectors, large caps, Japanese equities relative to German, and Mexican equities relative to emerging markets. We will revisit these trades next week, after the European energy question becomes clearer, to determine whether to book profits on our bearish tactical trades.   – The BCA Research Team  

Executive Summary Copper Demand Follows GDP European copper demand will increase on the back of still-accommodative monetary policy, coupled with a loosening of COVID-19-related gathering and mobility restrictions as the virus becomes endemic. Copper demand will be supported by the EU's need to diversify natural gas supplies in favor of increased LNG import capacity over the next 10 years, which will require incremental infrastructure investment. Increasing policy stimulus in China and government measures to increase lending to metals-intensive sectors – e.g., construction and grid infrastructure – will boost global copper demand. In the US, the Biden administration is backing a $550 billion bill to fund its renewable-energy buildout, which will result in higher demand for metals and steel over the next decade. Global copper supply growth will be restrained by local politics going forward, particularly in the Americas. Bottom Line: Copper prices have been grinding higher even as China maintains its zero-tolerance COVID-19 public health policy, and markets wait out the Russia-Ukraine standoff.  We are maintaining our forecast for COMEX copper to trade to $5.00/lb this year and $6.00/lb next year.  We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to miners and traders via the XME and PICK ETFs. Feature Ever since it hit its record high in May 2021, copper prices have been range-bound, despite tight market fundamentals and record low inventories in 3Q21, which, as it happens, have not significantly rebuilt since then (Chart 1, panel 1). This can be explained by weak global macro conditions since prices peaked, which have not been especially conducive to higher copper prices, particularly in Europe and China. Activity in these two markets accounting for ~ 60% and 11% of global refined copper demand, respectively, has had a stop-start aspect that has hindered full recovery to now. Chart 1Global Copper Inventories Remain Tight Chart 2Copper Demand Follows GDP As GDP in these regions rises, demand for copper will rise, as Chart 2 shows. Per our modelling, refined copper demand in China, the EU and the world are highly cointegrated with Nominal GDP estimates provided by the IMF. The coefficient associated with nominal GDP in all three instances is positive. Further, running Granger Causality tests indicate that past and present values of nominal GDP explain present refined copper demand values for all three entities. These results indicate that economic growth and refined copper demand have a positive long-run relationship. China’s zero-COVID tolerance policy and the property-market crisis there have restricted economic growth, activity and hence demand for the metal used heavily in construction and manufacturing. In Europe, lockdowns due to the Omicron variant restricted activity causing supply chain disruptions, which contributed to inflation. Now, Europe is relying on immunity among large shares of its population to keep economies open, as COVID-19 becomes endemic. Germany is loosening restrictions at a slower rate than its neighbors, as COVID still has not reached endemicity (Chart 3). Europe’s top manufacturer reportedly is expected to ease restrictions and increase economic activity by March-end. Chart 3New EU COVID-19 Cases Collapse Natural Gas Remains Critical To Europe Apart from COVID, elevated natural gas prices have and will continue to affect economic activity in Europe. These prices will only get more volatile as fears of a Russian invasion of Ukraine increase. In the short term, we do not expect Russia to cut off all gas supplies to the EU in case of an invasion.1 However, supplies going through Ukraine likely would be cut. Coupled with the region’s precariously low natgas inventory levels, this could fuel a gas price spike (Chart 4). Higher gas prices could lead to demand destruction, if, as occurred this winter, higher power-generating costs arising from higher natgas costs makes electricity too expensive to keep industrial processes like aluminum smelters up and running. In addition, another regional bidding war could incentivize more re-routing of LNG to Europe instead of Asia. This would reduce European prices, but could force Asian markets to raise their bids. Chart 4EU's Natgas Inventories Remain Critical Assuming gas prices do not remain significantly higher for the rest of the year, Europe will start seeing economic activity improve, and as our European Investment Strategy notes, PMIs will bottom out by the second quarter of this year. High immunity levels are allowing European nations to relax restrictions as it becomes apparent that COVID in the continent – at least in Western Europe – appears to be reaching endemicity. Importantly for base metals generally, and copper in particular, lower natgas prices will allow smelters and refining units to remain in service as electricity prices stabilize or even fall in the EU. During the pandemic, households – primarily in DM economies – built up significant levels of excess savings, particularly in Europe. The IMF reported that households in Europe have amassed nearly 1 trillion euros more in savings vs. normal levels over the last two years than if the pandemic had never occurred.2 While the entirety of excess savings will not be released as spending, even a portion of it will spur economic activity, once supply-chain issues are ironed out when the global economy reopens. China's Copper Demand Will Revive China’s property sector crisis last year was a major drag on economic growth. The Chinese government’s efforts to stabilize this sector seem to be paying off. China’s National Bureau of Statistics reported that for January housing prices in China’s first-tier cities reversed a month-on-month decline from December. The number of cities that saw home prices fall in January also was lower compared to December. Continued improvements in the property sector in China will be bullish for copper. Once macro hurdles related to COVID and high gas prices dissipate, and China’s property market stabilizes, economic activity will increase and copper demand will rebound (Chart 5). However, a timeline for this is difficult to handicap, given China's insistence – at least for now – on maintaining a zero-covid public-health policy. The zero-covid policy has resulted in sharply lower infection rates than the rest of the world, but, because it has not been accompanied by wide distribution of mRNA vaccines, immunity in the population is low. As global macro factors become conducive for copper, investors’ focus will switch to tight fundamentals in the copper market (Chart 6). Unlike the first half of 2021, copper’s high prices will be more sustained, given COVID’s current trajectory towards endemicity globally, and relatively higher immunity rates. Chart 5China's Demand Will Rebound Chart 6Coppers Tight Fundamentals Will Come Into Focus Again In addition, markets will have to factor in additional demand from the US that heretofore did not exist: The Biden administration is backing a $550 billion bill to fund renewable-energy development. More such funding can be expected in coming years as the US leans into decarbonization, and competes with the likes of the EU and China for limited base metals supplies. Supply Side Difficulties Mount Local governance is becoming increasingly critical to the supply side of base metals, no moreso than in the Americas – chiefly in Chile, Peru and, of late, the US., where the Biden administration recently shut down a Minnesota mining proposal in a major win for environmental groups.3 A number of these critical commodity-producing states in the Americas have elected – or are leaning toward – left-of-center candidates, some of whom are proposing fundamental changes in the laws and regulations governing resource extraction. Gabriel Boric, Chile’s new president, takes office in March. He has largely focused his campaign on the environment, human rights, and closer ties with other Latin American countries. Boric promotes a “turquoise” foreign policy, which includes “green” policies to combat climate change, and “blue” ones to protect oceans. He is likely to commit Chile, which accounts for ~ 30% of global copper mining, to participation in the Escazú Agreement, is being positioned to span the region.4 Of greatest import to the global metals and mining markets, Boric will push for a constitutional re-write affecting taxes on copper mining, decarbonization, Chile's water crisis and the nationalization of lithium mining. Chile's new constitution is expected to be put up for a vote by the end of 2022. In Peru, which accounts for ~ 10% of global copper output, President Pedro Castillo announced at the UN General Assembly that Peru would declare a "climate emergency," and promised to reach net-zero in Peru by 2050. Civil unrest in Peru directed at mining operations is becoming more widespread, as citizens become increasingly frustrated with pollution and poverty.5 Colombia is not a major metals producer, but it is a resource-based economy leaning left. In May it will hold its general elections to Congress and Presidency. The future president will have pressure on the ratification of the Escazú Agreement, fight against illegal mining, and work on the Amazon deforestation. Presently, a left-of-center candidate, Gustavo Petro, leads the polling, according to the latest December survey by the National Consulting Center.6 Petro is promising to stop approving oil exploration contracts to restructure Colombia's economy away from hydrocarbons, and plans to accelerate the transition towards renewable energy.7 In addition, Petro is trying to gather ideological allies across Latin America and the world to fight against climate change. He hopes Chile’s president-elect Gabriel Boric will be joining this alliance.8 Caution: Downside Risks Remain Apart from the Russia-Ukraine crisis discussed above, there are more headwinds to the bullish copper view. China’s zero-covid policy will lead to reduced activity in the world’s largest producer and consumer of refined copper. This will disrupt global supply chains and, along with high energy prices, spur global inflation, prolonging slow economic growth and activity. Central bank tightening globally – led by the Federal Reserve – will increase borrowing costs, reduce manufacturing, and act as a downside risk to copper, particularly if the Fed miscalculates and lifts rates too high too soon and sparks a USD rally. Finally, while DM economies have high vaccination rates, EM states do not have the same level of immunity (Chart 7). Europe exhibits this dichotomy in immunization rates between advanced and developing countries well. While most of Western Europe appears to be nearing endemicity and reopening, Omicron is spreading quickly into Eastern Europe, where immunity is low. As long as a majority of the global population is not vaccinated, COVID-19 mutations into more virulent and transmissive variants remain a major risk. Chart 7COVID-19 Remains A Risk Investment Implications Copper prices have been grinding higher even as China maintains its zero-tolerance COVID-19 public-health policy, and markets wait out the Russia-Ukraine standoff (Chart 8). As large economies continue to emerge from COVID-19-related disruptions demand for base metals can be expected to increase, particularly for copper. We are maintaining our forecast for COMEX copper to trade to $5.00/lb this year and $6.00/lb next year. We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to miners and traders via the XME and PICK ETFs. Chart 8Copper Continues To Grid Higher   Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish The US will expand its leading position as the EU-27's and UK's top liquified natural gas (LNG) supplier this year, in our view, although Qatar will provide stiff competition (Chart 9). In January, the EIA reported half of the Europe's LNG originated in the US. For all of 2021, 26% of Europe's LNG came from the US, while 24% came from Qatar and 20% came from Russia. We expect the Russia-Ukraine military standoff, which has the potential to become a kinetic engagement, will prompt Europe to diversify its natural gas supplies away from Russia to reduce its exposure to military and geopolitical pressure on its energy supplies. This also would apply, in our estimation, to pipeline supplies of natural gas from Russia, which shipped 10.7 Bcf/d to Europe in 2021 (vs. 11.8 Bcf and 14.8 Bcf/d in 2020 and 2019, respectively. Norway supplied 10.4 Bcf/d in 2019 and 2020, rising to 11.1 Bcf/d in 2021. We also would expect additional North Sea supplies to be developed to supply Europe in the wake of the current Russia-Ukraine tensions. Base Metals: Bullish Russia’s recognition of the two breakaway states of Donetsk and Luhansk People’s Republics (DPR and LPR), elicited US sanctions targeting Russian sovereign debt and its banking sector. The possibility of sanctions on Russian nickel and aluminum exports sent both metals to multi-year highs in LME trading. Russia constitutes around 6% and 9% of global primary aluminum and nickel ore supply, respectively. Precariously low inventory levels for both nickel and aluminum are inducing high price volatility. Year-over-year, global January LME aluminum and nickel stocks are 45% and 64% lower respectively. Precious Metals: Bullish Geopolitical uncertainty due to the Russia-Ukraine crisis and Western sanctions levied on Russia has pushed gold prices to levels not seen since its last bull run last year. While gold has risen, Bitcoin – once considered to be a safe-haven asset – has fallen on this uncertainty. Over the last two years, Bitcoin has been moving more in tandem with equity markets than with other safe-haven assets, as cryptocurrency has become more popular and central banks began large asset purchase programs in response to the pandemic (Chart 10). From beginning 2018 to end-2019 the coefficient measuring daily Bitcoin prices’ correlation with the S&P 500 index was ~0.31. From beginning 2020 to present day, this value has increased to ~ 0.86. Chart 9 Chart 10     Footnotes 1     Please see our report from February 3, 2022 entitled Long-Term EU Gas Volatility Will Increase.  It is available as ces.bcaresearch.com. 2     Please see Europe’s Consumers are Sitting on 1 Trillion Euros in Pandemic Savings published by the International Monetary Fund on February 10, 2022. 3    Please see our report from on November 25, 2021 entitled Add Local Politics To Copper Supply Risks, and Biden administration kills Antofagasta's Minnesota copper project published by reuters.com on January 26, 2022. 4    Please see Chile Turns Left: The Foreign Policy Agenda of President Gabriel Boric, published by Australian Institute of Mining Affairs on January 28, 2022. 5    Please see China's MMG faces Peru whack-a-mole as mining protests splinter, published by reuters.com on February 16, 2022. 6    Please see Six Challenges Facing Colombia in 2022, published by Global Americas on January 6, 2022. 7     Please see Gustavo Petro, who leads polls in Colombia, seeks to create an anti-oil front published by Bloomberg on January 14, 2022. 8    Please see Colombia Presidential Favorite Gustavo Petro Wants to Form a Global Anti-Oil Bloc, published by Time on January 14, 2022. Investment Views and Themes Strategic Recommendations Trades Closed in 2021

Special Report

Executive Summary The Excess Return Of Corporate Bonds Is Driven By Corporate Profits Given that a sustainable business cycle acceleration in China is unlikely in the short term, onshore government bond yields will likely drop further. In the long run, odds are that Chinese government bond yields will drop below US Treasury yields. For domestic asset allocators, we continue to recommend overweighting government bonds over stocks for now. The excess return of corporate bonds is driven by the corporate profit cycle. On a volatility-adjusted basis, the total return on equities exceeds the excess return on corporate bonds during periods when economic growth is accelerating and underperforms during deceleration phases. Bottom Line: Given our view that a meaningful growth recovery in China will only be a theme for the second half of this year, onshore asset allocators should continue favoring corporate credit over stocks and government bonds over corporate bonds. The bear market in Chinese offshore corporate credit might be in its late stages but it is not yet over. Feature In this report we (1) elaborate on our outlook for Chinese government and corporate bonds and (2) offer a framework for understanding how asset allocation for fixed-income (government and corporate bonds) and multi-asset portfolios (comprised of fixed-income plus equities) should be implemented. Domestic Government Bonds Chart 1Chinese Bond Yields Have Bucked The Global Trend The risk-reward profile of Chinese domestic government bonds remains attractive. Chinese government bond yields have been declining,  bucking the global trend of surging government bond yields (Chart 1, top panel). Odds are that Chinese bond yields will drop further, both cyclically and structurally: In contrast with the Americas and Europe, China’s consumer price inflation has remained subdued. Its core, trimmed mean and headline inflation rates have remained low (Chart 2). The ongoing growth slump will cap core inflation in China at around 1%, allowing monetary authorities to lower interest rates further. Real bond yields in China remain well above those in the majority of DM (Chart 1, bottom panel). Hence, risk-free bonds in China offer value. As to the Chinese stimulus and business cycle, the recent pickup in Chinese credit numbers has been entirely due to local government bond issuance. After excluding local government bonds, credit growth and its impulse have not improved (Chart 3). While infrastructure spending will pick up in the coming months (given large special bond issuance), sentiment among consumers and private companies remains downbeat and local government budgets are severely impaired by the collapse in revenues from land sales. Hence, it will take some time before a boost in infrastructure activity lifts broader business and consumer sentiment such that a sustainable economic recovery can take hold. Chart 2Chinese Consumer Price Inflation Is Subdued Chart 3Recent Credit Improvement Is Entirely Due to Local Government Bond Issuance The special bond quota for Q1 stands at RMB 1.46 trillion and is equivalent to 28% of local government aggregate quarterly revenue. Even though the special bond issuance in Q1 is massive, it will be largely offset by the drop in local governments’ land sales revenue. The latter is shrinking and makes up more than 40% of local government aggregate revenues. In brief, strong headwinds from the property market in the form of shrinking land sales might counteract the increase from front-loaded special bond issuance in Q1 2022. As to real estate construction, funding for property developers is down dramatically from a year ago (Chart 4). In the absence of financing, real estate developers will shrink construction volumes in the months ahead. Chart 5Debt Service Burden For Chinese Enterprises And Households Is High Chart 4Property Completions Will Roll Over   Structurally, high enterprise and household debt levels in China amid slumping incomes mean that borrowing costs should drop to facilitate debt servicing. BIS estimates that debt service costs for the private sector (enterprises and households) in China are 21% of disposable income, much higher than in many other economies (Chart 5). Finally, China’s large and persistent current account surpluses mean that the nation is a major international creditor rather than a debtor. Thus, China does not need to offer high yields to attract foreign capital. Structurally speaking, foreign fixed-income inflows into Chinese domestic bonds will likely continue. Chart 6Credit Cycle And Government Bond Yields Bottom Line: Bond yields will likely drop further as a sustainable business cycle acceleration in China is unlikely in the short term. Chart 6 illustrates that the total social financing impulse leads bond yields by nine months and a cyclical bottom in yields will probably occur a few months from now. In the long run, Chinese government bonds yields will likely drop below US Treasury yields. Onshore Corporate Bonds The proper measure of corporate bond performance is excess return over similar government bonds (herein excess return). The basis for using excess return instead of total return for corporate bonds is because investors can attain government bond return by purchasing them outright. Essentially, investors prefer corporate bonds over government bonds because of credit spreads. Hence, a corporate bond performance assessment – whether in absolute terms or relative to other asset classes – should be based on excess return. In China, the excess return on onshore corporate bonds1 usually moves in tandem with the business cycle and government bond yields. In particular: The excess return of corporate bonds is positive during periods of growth acceleration and negative during slowdowns (Chart 7, top panel). The middle panel of Chart 7 illustrates that the excess return of corporate bonds correlates with analysts’ net EPS revisions for onshore listed companies. This confirms the above point that corporate bonds correlate with the profit/business cycle. Significantly, even though industrial profit growth is not yet negative (Chart 8, top panel), earnings in commodity-user industries have crashed (Chart 8, bottom panel).  This explains the negative excess return for onshore corporate bonds in the past 12 months. Chart 7The Excess Return Of Corporate Bonds Is Driven By Corporate Profits Chart 8Corporate Profit Cycle: Mind The Divergence Furthermore, the excess return of corporate bonds declines and rises with interest rate expectations (Chart 7, bottom panel). As the outlook for corporate profits remains sour, fixed-income investors should continue to favor government bonds over corporate bonds. Now, how do corporate bonds perform versus stocks? What drives their relative performance? To compare stock performance to corporate bond excess return, one should adjust for volatility. In other words, share prices are much more volatile than the excess return on corporate bonds. Hence, during risk-on periods equities always outperform corporate bonds and vice versa. Chart 9The Performance of Stocks over Corporate Bonds is Very Pro-Cyclical Chart 9 demonstrates that even on a volatility-adjusted basis, the total return on equities exceeds the excess return on corporate bonds during periods when economic growth is accelerating and underperforms during deceleration phases. In short, the performance of stocks over corporate bonds is very pro-cyclical. Bottom Line: The excess return of corporate bonds is driven by corporate revenue and profits rather than by interest rate expectations. Getting China’s business cycle right is critical to the allocation between government and corporate bonds in fixed-income portfolios and to the allocation between corporate bonds and equities in multi-asset portfolios. Given our view that a meaningful growth recovery in China will only be a theme in the second half of this year, onshore asset allocators should continue favoring corporate bonds over stocks and government bonds over corporate credit. Offshore Corporate Bonds What drives the excess return of Chinese USD corporate bonds in absolute terms as well as versus Chinese non-TMT investable stocks2 and onshore corporate bonds? Given that the offshore corporate bond universe is dominated by property developers, their excess return correlates with perceived risks to the mainland property market in general and the financial health of property developers in particular (Chart 10, top panel). Property developers are very overleveraged, their sales are shrinking and their financing has dried up. Yet, authorities are compelling them to complete construction of their pre-sold housing. Property developers will therefore continue to experience financial distress. Odds are that bond prices of corporate developers – both investment grade and high yield - will continue falling (Chart 10, middle and bottom panels). Chart 11Investable Stocks Vs. Offshore Corporate Credit: Volatility-Adjusted Performance Chart 10A Massive Bear Market In Offshore Corporate Bonds On a volatility-adjusted basis, non-TMT investable stocks outpace the excess return of offshore corporate bonds during periods of growth improvement and underperform during growth slowdowns (Chart 11, top panel). The same pattern holds true when it comes to the performance of offshore corporate bond versus the aggregate MSCI Investable equity index (including TMT stocks) (Chart 11, bottom panel). The credit cycle leads the business cycle and, thereby, it leads these financial market trends. Bottom Line: The bear market in Chinese offshore corporate credit might be in its late stages but it is not yet over. Chinese offshore corporate bonds will continue underperforming EM corporate bonds as well as Chinese onshore corporate bonds. Investment Recommendations Investors often read market signals across asset classes to gauge which market moves will persist and which ones will be short-lived.  In this regard, we have two observations for Chinese onshore markets: Chart 12Moving In Tandem The sustainability of an equity rally is higher when it is confirmed by rising excess returns of corporate bonds and rising government bond yields (Chart 12). Presently, there is no strong signal to switch from government bonds to either corporate bonds or stocks. Unfortunately, the yield curve in China does not correlate with its business cycle and, hence, cannot be used as a tool in macro analysis.  Our key investment conclusions are: For fixed-income investors, we continue to recommend receiving 10-year swap rates in China and for dedicated EM local currency bond managers to remain overweight China. The renminbi has been firm versus the US dollar despite a considerable narrowing in the interest rate differential between China and the US. In the long run, the real interest rate differential between China and the US will drive the exchange rate, and it will favor the RMB. While US real bond yields might rise relative to Chinese bond yields in the coming months, triggering a period of yuan softness, it will prove to be transitory. The basis is that the Federal Reserve is very sensitive to asset prices. As US share prices decline and corporate spreads widen, the central bank will eventually turn dovish and will lag behind the inflation curve. When a central bank falls behind the inflation curve, real rates stay low and its currency depreciates. Chart 13China’s Stock-to-Bond Ratio For domestic asset allocators, we continue to recommend favoring government bonds over stocks (Chart 13). Within fixed-income portfolios, investors should overweight government bonds over corporate bonds. Finally, corporate bonds will fare better than equities in the near term. In a few months there will be an opportunity to shift these positions.  More aggressive stimulus from authorities and aggressive property market relaxation measures will create conditions for an improvement in domestic demand. Finally, the risk-reward profile for offshore USD corporate bonds remains unattractive. Chinese offshore corporate credit will continue underperforming EM USD corporate credit as well as Chinese onshore corporate bonds.   Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1    Due to the lack of excess return data from the index provider (Bloomberg Barclays onshore bond indexes), we calculated the excess return on onshore corporate bonds as the ratio of the total return on the corporate bond index divided by the total return on the government bond index. This measure is not ideal as it does not account for duration mismatches between the corporate and government bond indexes. However, the key conclusions of this report will hold true for the duration-adjusted excess return not least because this framework is valid for financial markets in the US and Europe. 2    The reason to compare it to non-TMT (technology, media and telecommunication, i.e., Chinese tech and internet stocks) is that offshore corporate bond issuers are largely old economy industries.

Executive Summary The ultimate inflation anchor is unit labor costs. If relative price shocks cause employees to demand higher wages from their employers, and if they are granted wage increases above and beyond their productivity advances, inflation will become broad-based and persistent. US unit labor costs have been rising rapidly, which indicates that US inflation is becoming pervasive and entrenched (Chart of the week). The Fed is facing an acute dilemma that it has not encountered in the last 35 years or so: It either needs to slow growth materially to contain inflation or allow inflation to proliferate. The Fed will make a dovish pivot only after financial conditions tighten substantially, i.e., if the S&P 500 falls by 20% or more (from its peak) and credit spreads widen much more from the current levels. Rapid Rises In Unit Labor Costs Entail High Inflation Bottom Line: The Fed and equity markets are on a collision course: The Fed will not make a dovish pivot until markets sell off and markets cannot rally unless the Fed backs off. Feature In a report we published a year ago titled Riding A Tiger, we stated that “the enormous size of US stimulus and overflow of liquidity is creating a thrill akin to riding a tiger… Riding a tiger is fun. The hitch is that no one can safely get off a tiger. Similarly, US authorities are currently enjoying the exuberance from stimulus, but they will not be able to safely and smoothly dismount.” We also contended that “in any system where an explosive money/credit boom persists, the outcome will be one or a combination of the following: inflation, asset bubbles or capital misallocation… Odds are that the US will experience asset bubbles and inflation in the real economy.” Riding a tiger was indeed fun but now it is time for US policymakers to dismount. Yet, exiting the era of super easy monetary and fiscal policies will not be without costs and considerable financial market turbulence. Are the Fed and financial markets heading into a collision in the fog of inflation? Transitory Versus Persistent Inflation Chart 1US Inflation Is Broad Based, As Evidenced By Median And Trimmed-Mean CPIs US inflation has become broad-based.1 Not only is core CPI surging but also trimmed-mean, median and sticky core consumer price inflation have risen substantially (Chart 1).  Median and trimmed-mean price indexes would not be rocketing if inflation was limited to select goods or services. Particularly, the aforementioned measures exclude components with extreme price changes. What might have started as a narrow-based relative price shock has evolved into broad-based genuine inflation. The key to the transition from one-off inflation spikes to persistent genuine inflation is wages, more specifically unit labor costs. Unit labor cost are calculated as nominal wages divided by productivity (the latter is output per hour per employee). As long as unit labor costs are not rising considerably, sharp price increases in several types of goods do not entail genuine inflation and central banks should not tighten aggressively. However, when unit labor costs are escalating, odds are that higher inflation could become entrenched and persistent. The importance of wages stems from the fact that labor compensation makes up the largest share of costs for the majority of industries. Consequently, rising unit labor costs squeeze profit margins. When this transpires, businesses try to pass on rising costs to customers. Provided that robust wage growth propels consumer demand, companies often succeed in raising their prices. Chart 2US Wages Are Rising Rapidly In turn, inflation erodes the purchasing power of wages, and employees demand substantial pay raises. When revenues are strong, employers typically accommodate employees’ claims for higher compensation, and a wage-price spiral emerges. These dynamics are presently unfolding in the US. US wage growth has reached multi-decade highs of 4.5-5.5% (Chart 2). Plus, the high and climbing quit rate points to further wage acceleration (Chart 3). As US productivity cannot rise as fast as the current wage growth of 4.5-5.5% (Chart 4), the ratio of wages to productivity (unit labor costs) is escalating. Unit labor costs are rising faster than they have in the past 38-40 years. Historically, an acceleration in unit labor costs has often heralded higher inflation (Chart 5). Chart 3US Wages Will Continue Accelerating Chart 4Wage Growth Is Outpacing Productivity Gains   Chart 5Rapid Rises In Unit Labor Costs Entail High Inflation The only period when US core inflation fell despite rising unit labor costs was during the second half of the 1990s (Chart 5). During this period, EM currency devaluations from China to Mexico and then to Asia unleashed the deflation tsunami in goods prices. US imports prices from Asia collapsed allowing US inflation to drift lower despite rising unit labor costs. The current backdrop is different: US import prices from Asia, including China, are rising (Chart 6). Importantly, US wage growth is presently below headline and core CPI, i.e., real wages are contracting (Chart 7). Provided US employees have experienced a decline in their purchasing power in the past 12 months, they are keen to secure substantial pay raises in the coming months. Chart 6Unlike The Late 1990s, US Import Prices From Asia Are Rising Chart 7US Real Wages Are Shrinking   Employers facing strong demand cannot afford an employee exodus. Businesses will raise salaries and hike selling prices to preserve their profit margins, thereby giving rise to a wage-price spiral. Bottom Line: The ultimate inflation anchor is unit labor costs. This is why wages, more specifically unit labor costs, are the most important variable to monitor. If relative price shocks lead employees to demand higher wages from their employers, and if they are granted wage increases above and beyond their productivity advances, inflation will become broad-based and persistent. The Fed’s Dilemma When inflation becomes pervasive and entrenched, as it is now in the US, the only way to bring it down is to slow the economy. Unless demand decelerates meaningfully, US inflation will not go away because it has already spilled over into consumer and business expectations. Even though US headline and core CPI will likely drop in the coming months, core inflation will remain well above the Fed’s target of 2% (Chart 1 above). To maintain its credibility, the Fed should hike rates continually despite the potential rollover in headline and core CPI measures. Chart 8High Probability Of US Core Inflation Exceeding 4% In The Next 12 Months My colleague, Jonathan Laberge, Managing Editor of the Bank Credit Analyst, has quantitatively estimated that there is a almost 100% probability that in next 12 months core PCE inflation will be above 3%, and a 70% probability that it will be above 4% (Chart 8). All this means that if the Federal Reserve is serious about bringing core inflation closer to 2%, it will have to slow down the economy meaningfully. In short, the Fed cannot both achieve decent growth and bring inflation down to its 2% target in the next 1-2 years. The Fed seemed omnipotent over the past 35 years because inflation was falling or was very low. That allowed US monetary authorities during financial crises/deflationary shocks to cut rates aggressively and flood the system with liquidity. That playbook worked well in a disinflation context and the US central bank has prevented protracted debt deflation. When inflation – rather than deflation – is the problem, authorities can do little without slowing growth. In short, an inflation redux has made US policymakers’ jobs much more difficult. If the Fed tightens too much, the economy will slump. If policymakers drag their feet and do not raise interest rates rapidly and significantly, inflation will hover well above its target and inflation expectations will escalate with negative ramifications for the economy (more on this below). Bottom Line: The Fed is facing an acute dilemma. The Fed will not publicly acknowledge it, but financial markets are gradually waking up to the new reality that the era of an omnipotent Fed might be over, at least for a period of time. Why Not Allow Inflation To Proliferate? Why should authorities tighten policy and slow growth to reduce inflation? Why can’t the US operate with inflation in a range of 3.5-5%? First, there is no guarantee that core inflation will stabilize at 3.5-5% and not rise further. When higher consumer and business inflation expectations set in, they are not easily dislodged. Second, persistent inflation can damage growth itself. High price volatility increases business uncertainty as producers cannot properly plan their costs and selling prices. Higher uncertainty leads companies to abandon expansion projects and new investments. Consequently, economic growth, employment and ultimately productivity suffer. Lower productivity growth creates fertile ground for inflation to thrive. This can lead to stagflation whereby growth slows but inflation remains high. Finally, from a political perspective, inflation can be more damaging to a government’s popularity than modestly high unemployment. For example, if the unemployment rate is at 6-7%, there would be some unhappy voters, but the majority of the population would be employed and their real purchasing power would be rising. Hence, the majority of voters might be content about the incumbent government’s policies.  In an inflation scenario, however, everyone would be unhappy because inflation erodes the purchasing power of household income and wealth. The point is that moderately high unemployment affects a few families who do not have jobs while inflation affects everyone. US politicians and policymakers have forgotten the perils of inflation because rapidly rising prices have not been a problem for decades. Therefore, they have erred on the side of helicopter money assuming that deflationary pressures and higher unemployment are worse than inflation. They have forgotten that inflation is not only worse for the wider population but that it could cause growth to slump resulting in stagflation: a combination of high inflation and high unemployment. Inflation has already become a political problem in the US. With income growth lagging behind inflation, household purchasing power has declined, which has fueled dissatisfaction with the current government. Biden’s popularity has tanked in the past nine months along with the rise of inflation. If inflation is not quelled by this fall, chances are that the Democrats will lose Congress to the Republicans in the midterm elections. Further, if high inflation persists in the next two years, odds of a Republican candidate winning the 2024 presidential elections will be considerable. Recognizing this, the Biden administration will not oppose the Fed’s hawkish policy for now. While we are sympathetic to the view that the Fed will ultimately not raise rates too aggressively, they have no reason not to hike and cannot afford to appear dovish at the current juncture. Even as headline and core inflation measures start falling (which is very likely in the months ahead), the Fed has no excuse to turn dovish. The rationale is that the US core inflation rate, while dropping from 5.5-6%, will still be well above the central bank’s target of 2%. In our opinion, the Fed will make a dovish pivot only after financial conditions tighten substantially, i.e., if the S&P 500 falls by 20% or more (from its peak) and credit spreads widen much more from current levels. Bottom Line: Until panic selling occurs in the equity and credit markets or the economy is materially weaker, the Fed will hike interest rates at every meeting and will start quantitative tightening soon. Thus, US bond yields and the US dollar have more upside for the time being. Overall, the Fed and equity markets are on a collision course: the Fed will not make a dovish pivot until markets sell off and markets cannot rally unless the Fed backs off. Implications For Financial Markets Chart 9Second Half Of The 1960s: The S&P 500 And US Bond Yields Became Negatively Correlated As long as the Fed maintains its hawkish bias (which is very likely in the coming months), US bond yields will rise and/or the yield curve will flatten, the greenback will be firm, and stocks will struggle. The current environment will be more reminiscent of what occurred in the late 1960s than any other period of the past 40 years. In the second half of the 1960s, when US core CPI spiked, US share prices became negatively correlated with US bond yields (Chart 9). We discussed this topic at great length in a report from a year ago. Hawkish monetary policy amid the inflation overshoot means that the Fed appears to be credible, and this stance is positive for the US dollar. As soon as the Fed makes a dovish pivot however, the US dollar will tank. The basis is that by turning dovish earlier than warranted, odds are that inflation would remain well above its target, i.e., the Fed would fall behind the inflation curve. When a central bank is behind the inflation curve, the currency depreciates. Our US Equity Capitulation Indicator has fallen quite a bit but has not yet reached its 2018, 2016, 2011 and 2010 lows (Chart 10). We believe the macro backdrop is poor enough to justify a pullback on par with those selloffs (17-20% from the peak). In such an environment, EM stocks will outperform DM only if the US dollar weakens (Chart 11). Chart 10More Downside In The S&P 500? Chart 11EM Relative Equity Performance Moves With The US Dollar​​ Chart 12Will The Current Episode Play Out Like Q4 2018? Alternatively, we might be witnessing a replay of Q4 2018 when the S&P 500 sold off hard led by tech stocks, but having underperformed earlier that year EM outperformed (Chart 12). While such a scenario is quite possible, we need to downgrade our view on the US dollar in order to upgrade EM stocks from underweight. We are not ready to do so because we believe the Fed’s hawkish bias will for now support the greenback. On the whole, we continue to recommend underweight allocations to EM equities and credit markets within their respective global portfolios. Absolute-return investors should stay cautious on EM risk assets. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     Please note this is the view of Emerging Markets Strategy team and does not reflect the view of other BCA services.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Executive Summary Russian Invasion Scenarios And Likely Equity Impact The Ukraine crisis is escalating as predicted. We maintain our odds: 65% limited incursion, 10% full-scale invasion, 25% diplomatic de-escalation. Russia says it will take “military-technical” measures as its demands remain unmet, while the US says an invasion is imminent. Fighting has picked up in the Donbas region. Our Ukraine decision tree highlights that the key to a last-minute diplomatic resolution is a western renunciation of defense cooperation with Ukraine after a verified Russian troop withdrawal. The opposite is occurring as we go to press. Stay long gold, defensives over cyclicals, and large caps over small caps. Stay long cyber security stocks and aerospace/defense stocks relative to the broad market. Trade Recommendation Inception Date Return LONG GOLD (STRATEGIC) 2019-12-06 27.6% Bottom Line: Our 75% subjective odds of a partial Russian re-invasion of Ukraine appear to be materializing. At the same time, we are not as optimistic about an imminent solution to the US-Iran nuclear problem. A near-term energy price spike is negative for global growth so we recommend sticking with our defensive tactical trades. Feature Chart 1Ukraine: Don't Be Complacent Fears about a heightened war in Ukraine fell back briefly this week before redoubling. Russian President Vladimir Putin showed a willingness to pursue diplomacy but then western officials refuted Russian claims that it was reducing troops around Ukraine. US President Biden said Russia is highly likely to invade Ukraine in the next few days. The Russian foreign ministry sent a letter reiterating Russia’s earlier threat that it will take unspecified “military-technical” actions given that its chief demands have not been met by the United States. A worsening security outlook as we go to press will push the dollar up against the euro, the euro up against the ruble, will lead to global equities falling (with US not falling as much as ex-US), and global bond yields falling (Chart 1). To assess the situation we need to weigh the signs of escalation against those of de-escalation. What were the signs of de-escalation? First, the Russian Defense Ministry claimed it is reducing troop levels near Ukraine, although NATO and the western powers have not verified any drawdown. An unspecified number of troops were said to return to their barracks in the Western and Southern Military Regions, according to Russian Defense Ministry spokesman General Igor Konashenkov. A video showed military units and hardware pulling back from Crimea. Officials claimed all troops would leave Belarus after military drills ended on February 20.1 Second, the Kremlin signaled that diplomacy has not been exhausted. In a video released to the public, Putin met with Foreign Minister Sergei Lavrov. He asked whether there was still a chance “to reach an agreement with our partners on key issues that cause our concern?” Lavrov replied, “there is always a chance.” Putin replied, “Okay.” Then, after speaking with German Chancellor Olaf Scholz in Moscow, Putin said: "We are ready to work further together. We are ready to go down the negotiations track.”2 Third, the Ukrainians are supposedly restarting efforts to implement the 2015 Russia-imposed ceasefire, under pressure from Germany and France. Ukraine’s ruling party is expected to introduce three bills to the Rada (parliament) that would result in implementing the terms of the Russian-imposed 2015 ceasefire, the so-called Minsk II Protocols. Ukraine is supposed to change its constitution to adopt a more federal system that grants autonomy to the two Russian separatist regions in the Donbas, Donetsk and Luhansk. Ukraine is also supposed to hold elections.3 The caveats to these three points are already clear: The US said Russia actually added 7,000 troops to the buildup on the Ukrainian border. Without Russia’s reducing troops, the US and its allies cannot offer major concessions. The US cannot allow itself to be blackmailed as that would encourage future hostage-taking and blackmail. Putin’s offer of talks is apparently separate from its “military-technical” response to the West’s failure to meet its three core demands on NATO. Russia’s three core demands are no further NATO enlargement, no intermediate-range missiles within threatening range, and withdrawal of NATO forces from eastern Europe to pre-1997 status. Putin reiterated that these three demands are inseparable from any negotiation and that Russia will not engage endlessly without resolution. Yet the West has consistently rejected these demands. Then came the Foreign Ministry statement pledging Russia’s military-technical response. So talks that focus on other issues – like missile defense and military transparency – are a sideshow. Ukraine is reiterating its desire to join NATO and will struggle to implement the Minsk Protocol. The Minsk format is not popular in Ukraine as it grants influence and recognition to the breakaway ethnic Russian regions. Ostensibly President Volodymyr Zelenskiy has sufficient strength in the Rada to change the constitution, given the possibility of assistance from opposition parties that oppose war or favor Russia. But passage or implementation could fail. The Russian Duma has also advised Putin to recognize the Donetsk and Luhansk People’s Republics as independent countries, which Putin is not yet ready to do, but could do if Ukraine balks, and would nullify the Minsk format.4 Of Russia’s three core demands, investors should bear in mind the following points: Ukraine is never going to join NATO. One of the thirty NATO members will veto its membership to prevent war with Russia. Therefore Russia is either making this demand knowing it will fail to justify military action, or driving at something else, such as NATO defense cooperation with Ukraine. Even if NATO membership is practically unrealistic, the US and NATO are providing Ukraine with arms and training, making it a de facto member. The quality and quantity of western defense cooperation is not sufficient to threaten Russia’s military balance so far but it could grow over time and Russia is insisting that it stop. While there is also a broader negotiation over Europe’s entire security system, immediate progress depends on whether the US and its allies stop trying to turn Ukraine into a de facto NATO ally. NATO is not going to sacrifice all of the strategic, territorial, and military-logistical gains it has made since 1997. Especially not when Russia is attempting to achieve such a dramatic pullback by military blackmail. But NATO could reduce some of the most threatening aspects of its stance if Russia reciprocates and there is more military transparency. Similarly, the US and Russia have a track record of negotiating missile defense deals so this kind of agreement is possible over time. The problem, again, hinges on whether agreement can be found over Ukraine. The opposite looks to be the case. Based on the above points, Diagram 1 provides a “Decision Tree” that outlines the various courses of action, our subjective probabilities, and the sum of the conditional probabilities for each final scenario. Diagram 1Russia-Ukraine Decision Tree, February 9, 2022 We start with the view that there is a 55% chance that the status quo continues: the West will not rule out Ukraine’s right to join NATO and will not halt defense cooperation. If this is true, then the new round of talks will fail because Russia’s core security interests will not be met. However, we also give a 25% chance to the scenario in which Ukraine is effectively barred from NATO but not defense cooperation. This may be the emerging scenario, given Chancellor Scholz’s point that Ukrainian NATO membership is not on the agenda and the White House’s claim that it will not pressure states to join NATO. Basically, western leaders could provide informal assurances that Ukraine will never join. But then the matter of defense cooperation must be resolved in the next round of talks. Given that the US and others have increased arms transfers to Ukraine in recent months and years (with US providing lethal arms for the first time in 2018), it seems more likely (60/40) that they will continue with arms transfers. After all, if they halt arms, Russia can invade anyway, but Ukraine will have less ability to resist. We allot a 15% chance to a scenario in which the US and its allies halt defense cooperation, even if they officially maintain NATO’s “open door” policy. If the Russians withdraw troops in this scenario, then a lasting reduction of tensions will occur. Again, while allied defense cooperation has been limited so far, it is up to Russia whether it poses a long-term threat. Finally, we give a 5% chance that the US and NATO will bar Ukraine from membership and halt defense cooperation. This path would mark a total capitulation to Russia’s demands. So far the allies have done nothing like this. They have insisted on NATO’s open door policy and have continued to transfer arms. No one should be surprised that tensions are escalating. De-escalation could still conceivably occur if Russia verifiably withdraws troops, if Ukraine moves to implement the Minsk II protocol, and if the US and its allies pledge to halt defense cooperation with Ukraine. The first step is for Russia to reduce troops, since that enables the US and allies to make major concessions when they are not under duress. If the US and NATO guarantee they will halt defense cooperation, given that Ukraine is practically unlikely to join NATO, then Russia may not be as concerned with Ukraine’s implementation of Minsk. As we go to press, none of these conditions are falling into place. The security situation is deteriorating rapidly. Bottom Line: Russia is likely to stage a limited military intervention into Ukraine (75%). The odds of a diplomatic resolution at the last minute are the same (25%). A full-scale invasion of all of Ukraine remains unlikely (10%). Market Reaction To Re-Escalation Chart 2 highlights the global equity market response to the Russian invasion of Crimea in 2014, which should serve as the baseline for assessing the market reaction to any renewed attack today. Stocks fell and moved sideways relative to bonds for several months, cyclicals (except energy) underperformed defensives, small caps briefly rose then collapsed against large caps, and value stocks rose relative to growth stocks. The takeaway was to stay invested over the cyclical time frame, prefer large caps, and prefer value. The difference today is that cyclicals and small caps are already performing worse against defensives and large caps than in 2014, while value has vastly outstripped growth (Chart 3). The implication is that once war breaks out, cyclicals and small caps have less room to fall whereas value has limited near-term upside. Chart 2Market Response To Crimea Invasion, 2014​​​​​​ Chart 3Market Response 2022 Versus 2014​​​​​​ If we look closely at global equity gyrations over the past week – when the Ukraine story moved to front and center – we see that stocks are falling relative to bonds, cyclicals are flat relative to defensives, small caps are rising relative to large caps, and value is flat relative to growth but may have peaked (Chart 4). In the short term the geopolitical dynamic will move markets so we expect cyclicals, small caps, and value to underperform. Commodity prices and the energy sector are initially benefiting from tensions as expected – oil prices and energy equities spiked amid the tensions (Chart 5). But assuming war materializes, Russia will at least cut off natural gas flowing through Ukraine, cutting off about 20% of Europe’s natural gas supply and triggering a bigger price shock. Ultimately, however, this price shock will incentivize production, destroy global demand, and drive energy prices down. Chart 4Global Equities Just Woke Up To Ukraine​​​​​​ Chart 5Global Energy Sector Just Woke Up To Ukraine​​​​​ Thus we expect energy price volatility. Russia will keep shipping energy to Europe to finance its military adventures. Europe will be loath to slap sanctions on critical energy supplies, assuming Russia’s military action is limited. The Saudis may or may not increase production to prevent demand destruction – in past Russian invasions they have actually reduced production once prices started to fall. A temporary US-Iran nuclear deal could release Iranian oil to the market, though that is not what we expect in the short run (discussed below). Bottom Line: Tactically investors should favor bonds over stocks, the US dollar and US equities over global currencies and equities (especially European), defensive sectors over cyclicals, large caps over small caps, and growth over value stocks. Is Ukraine Already Priced? Not Yet. Chart 6Crisis Events And Peak-To-Trough Market Drawdown The peak-to-trough equity drawdown – in geopolitical crises that are comparable to a Russian invasion of Ukraine – range from 11%-14% going back to 1931. The following research findings are derived from a list of select events, from the Japanese invasion of China to the German invasion of Poland to lesser invasions, all the way down to Russia’s seizure of Crimea in 2014. We used the S&P 500 as it is the most representative stock index over this long period of time. The fully updated and broader list of geopolitical crises can be found in Appendix 1. Geopolitical crises tend to trigger an average 10% equity decline, smaller than economic crises or major terrorist attacks (Chart 6). The biggest geopolitical shocks to the equity market occur when an event is a truly global event, as opposed to regional shocks. Interestingly Europe-only shocks have seen some of the smallest average drawdowns at around 8% (Chart 7). An expanded Ukraine war would be limited to Europe. The average equity selloff is largest, at 14%, if both the US and its allies are directly involved in the geopolitical event. But the range is 11%-14% regardless of whether the US or its allies are involved (Chart 8). Ukraine is not an official ally, which is one reason the markets will tend to play down a larger war there. However, the market is underrating the fact that Ukraine’s neighbors are NATO members and will have a powerful interest in supporting the Ukrainian militant insurgency, which could lead to unexpected conflicts that involve NATO member-state’s citizens. Chart 7Geopolitical Crises And Markets: Where Is The Crisis?​​​​​​ Chart 8Geopolitical Crises And Markets: Who Are The Players?​​​​​​ Chart 9Russian Invasion Scenarios And Likely Equity Impact The Russians have as many as 150,000 troops on the border with Ukraine, according to President Biden’s latest speech. The Ukrainian active military numbers 215,000. This ratio is not at all favorable for a full-scale invasion. The Russians are contemplating a limited action directed at teaching Ukraine a lesson or encroaching further onto Ukrainian territory, especially coastal territory. History suggests that a limited incursion will produce a 10% total equity drawdown, whereas a full-scale invasion would produce 13% or more (Chart 9). Still, investors should view 11%-14% as the appropriate range for a geopolitically induced crisis. The S&P has fallen by 9% since its peak on January 3, 2022. But Russia has not invaded yet. If war breaks out, there is more downside, given high uncertainty. Markets could still be surprised by the initial force of any Russian military action. The US will impose sweeping sanctions immediately. The Europeans will modify their sanctions according to Russia’s actions, a key source of uncertainty. If a diplomatic resolution is confirmed – with Russia withdrawing troops and the US and its allies cutting defense cooperation with Ukraine – then the market may continue to rally. However, there are other reasons to be cautious: especially inflation and monetary policy normalization, with the Federal Reserve potentially lifting rates by 50 basis points in March. Bottom Line: Stocks can fall further given that investors do not yet know the magnitude of the Russian military action or the US and European sanctions response. However, a buying opportunity is around the corner once this significant source of global uncertainty is clarified. New Iran Deal Is Neither Guaranteed Nor Durable A short note is necessary on the situation with Iran, another major risk this year, which falls under our third 2022 key view: oil-producing states gain geopolitical leverage. The implication is that the Iran risk will not be resolved quickly or easily. The global economy could suffer a double whammy of energy supply shock from Ukraine and energy supply risk in the Middle East this year. The US-Russia showdown is connected to the US-Iran nuclear negotiation. Russia took Crimea in 2014 in part because it saw an opportunity to exact a price from the United States, which sought Russia’s assistance in negotiating the 2015 nuclear deal with Iran. Today a similar dynamic is playing out, in which Russian diplomats cooperate on Iranian talks while encroaching on Ukraine. The Russians do not have an interest in Iran achieving a deliverable nuclear weapon and thus will offer some limited cooperation to this end. Their pound of flesh is Ukraine. According to media reports, the Iranian negotiations have seen some positive developments over the past month. US interest in rejoining the 2015 deal: The Biden administration has an interest in preventing Iran from reaching “breakout” levels of uranium enrichment and triggering a conflict in the region that would drive up oil prices ahead of the midterm election. It is going to be hard for Biden to remove sanctions in the context of Russian aggression but it is likely he would do it if the Iranians recommit to complying with the 2015 restrictions on their nuclear program. Iranian interest in rejoining the 2015 deal: The Iranians have an interest in convincing President Biden to remove sanctions to improve their economy and reduce the risk of social unrest. They are demanding the removal of all sanctions, not only those levied by President Trump. They also know that rejoining the 2015 deal itself is not so bad, since it starts expiring in 2025 and does not limit their missile production or support of militant proxies in the region. However, note that the Iranian regime has suppressed domestic instability since Trump’s “maximum pressure” sanctions, and the economy is improving on oil prices, so the threat of social unrest is not forcing Iran to accept a deal today. Also note that Iran is making demands that cannot be met: Iranian Foreign Minister Hossein Amirabdollahian is asking the US to provide guarantees that the US will not renege on the deal again, for example if the Republicans return to the White House in 2025. President Biden cannot provide these guarantees. The voting margins are too thin for a “political statement,” promising that the US will not renege on a deal, to pass Congress. While House Speaker Nancy Pelosi might be willing to provide such a statement to the Iranians, Senate Majority Leader Chuck Schumer probably will not – he opposed the originally 2015 deal. Even if Congress gave Iran guarantees, the fact remains that the GOP could win the White House in 2025, so the current, hawkish Iranian leadership cannot be satisfied on this front. Furthermore, even if Biden pulls back sanctions and Iran complies with the 2015 deal for a brief reprieve, Iran’s underlying interest is to obtain a deliverable nuclear weapon to achieve regime survival in the future. Iran faces a clear distinction between Ukraine, which gave up nukes and is now being dismembered (like Libya and Iraq), and North Korea, which now has a deliverable nuclear arsenal and commands respect from the US on the national stage. Moreover if the Republicans take back power in 2025, Iran will want to have achieved or be close to achieving a deliverable nuclear weapon. The Biden administration is weak at home and facing a crisis with Russia, which may present a window of opportunity for Iran to make a dash for the nuclear deterrent. Still, we acknowledge the short-term risk to our pessimistic view: It is possible that Iran will rejoin the deal to gain sanctions relief. In this case about 1-1.2 million barrels per day of Iranian crude will hit the global market. The implication, depending on the size of the energy shock, is that Brent crude prices will fall back to the $80 per barrel average that our Commodity & Energy Strategy expects. We also agree with our Commodity & Energy Strategist that global oil production will pick up in the face of supply risks that threaten to destroy demand. Bottom Line: We doubt Iran will rejoin the 2015 nuclear deal quickly. We expect energy prices to continue spiking in the short term due to Ukraine and any setbacks in the Iran negotiations. Yet we also expect oil producers around the world to increase production, which will sow the seeds for an oil price drop. Our tactical trade recommendations rest on falling oil prices and bond yields in the short run. Investment Takeaways Stay long gold. Stay long global defensive equity sectors over cyclicals. Favor global large caps over small caps. Stay long cyber security stocks and aerospace/defense stocks relative to the broad market. Stay long Japanese industrials relative to German and long yen. Stay long British stocks relative to other developed markets excluding the US, and long GBP-CZK. Favor Latin American equities within emerging markets, namely Mexican stocks and Brazilian financials relative to Indian stocks.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      See "Russia Announces Troop Withdrawal," Russia Today, February 15, 2022, rt.com; "Ukraine crisis: Russian claim of troop withdrawal false, says US," BBC, February 17, 2022, bbc.com. 2     David M. Herszenhorn, “On stage at the Kremlin: Putin and Lavrov’s de-escalation dance,” Politico, February 14, 2022, politico.eu. 3     "Scholz says Zelensky promised to submit bills on Donbass to Contact Group," Tass, February 15, 2022, tass.com; "Scholz in Kyiv confirms Germany won’t arm Ukraine, stays mum on Nord Stream 2," February 15, 2022, euromaidanpress.com. 4     "Kiev makes no secret Minsk-2 is not on its agenda — Russian Foreign Ministry," Tass, February 17, 2022, tass.com; Felix Light, "Russian Parliament Backs Plan To Recognize Breakaway Ukrainian Regions," Moscow Times, February 15, 2022, themoscowtimes.com. Appendix 1: Geopolitical Events And Equity Market Impact Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Executive Summary Oil-Price Risk Skewed Upward The $10-$15/bbl risk premium in Brent prices will dissipate over the next month. Russia's best outcome is to follow the off-ramp offered by the US. President Biden's call to KSA's King Salman last week will result in higher oil output from the Kingdom, the UAE and Kuwait, in return for deeper US defense commitments. The Biden administration and Iran are in a hurry to get a deal done: The US wants lower oil prices, and Iran needs the revenue. Our Brent forecasts for 2022 and 2023 are revised slightly to $81.50 and $79.75/bbl, respectively, reflecting supply-demand adjustments. Price risks are tilted to the upside: A miss on any of the above assumptions will keep prices above $90/bbl, and push them higher. Bottom Line: Oil demand will remain robust this year and next.  To keep prices from surging from current levels into demand-destruction territory, additional supply is needed.  Most of this will come from KSA, the UAE and the US shale-oil producers.  We expect prices to fall from current prompt levels this year and next.  This will support sovereign budgets and oil producers' free cashflow goals.  We remain long the XOP ETF. Feature The $10-$15/bbl risk premium in Brent crude oil prices will dissipate, as the following supply-side events are ticked off: 1)   Russia gets on the off-ramp offered by the US last week to de-escalate the threat of another invasion of Ukraine by withdrawing its troops from the border;1 2)   OPEC 2.0's core producers – the Kingdom of Saudi Arabia (KSA), the United Arab Emirates (UAE), and Kuwait – increase supply in return for deeper US security commitments; 3)   Iran restores its remaining 1.0 – 1.2mm b/d of production to the market, following the restoration of its nuclear deal with Western powers; and 4)   US shale-oil producers step up production in response to higher WTI prices. Politics, Then Economics The first three assumptions above are political in nature, requiring a bargain be struck among contending interests to resolve. We do not believe Russia's endgame is to jeopardize its future oil and gas exports to the West, particularly to the EU (Chart 1). The US is warning that another invasion of Ukraine will put the use of the Nord Stream 2 pipeline to deliver gas to Germany at risk.2 It also is worthwhile noting NATO is aligned with the US on this stance. Russia derived 40-50% of its budget revenues from oil and gas production, and ~ 67% of its export revenue from oil and gas over the decade ended in 2020.3 Of course, only President Putin can determine whether oil and gas sales can be diversified enough – e.g., via higher shipments to China – to offset whatever penalties the West imposes. But, in a game-theoretic sense, the stakes are very high, and taking the US off-ramp is rational. Chart 1Russia's Critical Exports: Oil + Gas We expect the second assumption to play out in the near term, following US President Joe Biden's call to KSA's King Salman last week. The outreach stressed the US commitment to defend KSA and, presumably, its close allies in the Gulf (the UAE and Kuwait).4 KSA already has increased its production to 10.15mm b/d under the OPEC 2.0 agreement to restore 400k b/d beginning in August 2021. We estimate the coalition had fallen behind on this effort by ~ 1mm b/d, as only KSA, the UAE and Kuwait presently have the capacity to lift production and sustain it (Table 1). KSA's reference production level agreed at OPEC 2.0's July 2021 meeting will rise to 11.5mm b/d in June, up 500k b/d from its current level (Table 2). This means KSA could flex into another 850k b/d between now and the end of May; and another 500k b/d after that. The UAE's and Kuwait's reference production levels will rise 330k and 150k b/d in June to 3.5mm b/d and 3.0mm b/d, respectively. Markets will need these incremental volumes as demand continues to recover and non-core OPEC 2.0 production continues to fall (Chart 2). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Table 2Baseline Increases For Core OPEC 2.0 Our third assumption reflects our reading of the signaling by Iran over the past few weeks, which indicate growing confidence a deal with the US to restore the Joint Comprehensive Plan of Action (JCPOA) is in the offing.5 The politics here converge with the economics: the Biden Administration wants to increase oil supply ahead of mid-term elections in the US to keep gasoline prices under control; Iran needs to increase its revenues. Both sides get an immediate need satisfied. However, the risks to KSA and its Gulf allies will increase as Iran's revenues grow, because it will be able to fund proxy-war operations against the Gulf states. This is why deepening the US defense commitment to the region is critical to KSA and its allies. The last assumption reflects our view US E+P companies are being incentivized to lift production by high prompt and deferred prices. We continue to expect these companies – particularly those in the US shales, where the majority of the production increase will occur – to husband their capital resources closely, and to continue to prioritize shareholder interests. As capital availability declines – primarily due to reduced investor interest in investing in hydrocarbon production – these firms will have to focus on reducing operating costs and increasing productivity over the next decade to fund growth. Relative to 2021, we expect US oil production to increase 0.85mm b/d this year and by 0.53mm b/d in 2023 relative to this year, as producers respond to higher prices (Chart 3). Chart 2Increased Core OPEC 2.0 Production Becoming Critical Chart 3US Oil Production Will See Another Up Leg Supply-Demand Balances Are Tight Global oil demand growth this year is reduced slightly in our balances – going to 4.5mm b/d from 4.8mm b/d, mostly reflecting our assessment of slowing growth as central banks remove monetary accommodation. We lifted next year's growth estimate slightly, to 1.7mm b/d. These estimates still leave our growth expectations above the major data providers, the highest of which is OPEC's 4.2mm b/d estimate. We continue to expect DM demand to level off this year and next, and EM demand to retake its position as the global demand growth engine (Chart 4). The supply side remains tight, with average global crude oil and liquid fuels production estimated at 101.5mm b/d for 2022 and 102.8mm b/d for next year. With demand expected to average 101.5mm b/d this year and 103.2mm b/d next year, markets will remain balanced but tight (Chart 5). This means inventories will continue to be strained, leaving little in the way of a cushion to absorb unexpected supply losses (Chart 6).  Chart 4EM Demand Retakes Growth-Engine Role Chart 5Markets Remain Balanced But Tight... Chart 6...Keeping Pressure On Inventories Markets Remain Balanced But Tight Our supply-demand analysis indicates markets will remain balanced but tight, with inventories under pressure until supply increases. This will predispose markets to higher price volatility, as low inventories force prices to ration supply. This will increase the backwardation in the Brent and WTI curves, which will bolster the convenience yield in both of these markets (Chart 7).6 We expect implied volatility to remain elevated, as a result (Chart 8). Chart 7Backwardation Will Keep Convenience Yield Elevated Chart 8High Volatility Will Persist Because of these low inventory values, Brent prices for 2022 are higher than our previous estimate. By 2023, the effects of increased supply from KSA, UAE, Kuwait – albeit a marginal increase – and the US kick in to reduce prices. As supply increases, the risk premium currently embedded in Brent prices will decline, pushing them to our forecasted levels for 2022 and 2023 of $81.50/bbl and $79.75/bbl, respectively. For 1H22, we expect Brent prices to average $87.20/bbl, and in 2H22 we're forecasting a price of $75.80/bbl on the back of increased production. Next year, higher output will keep prices close to $80/bbl, with 1H23 Brent averaging $79.85 and 2H23 averaging $79.70/bbl. Word Of Caution Our analysis is predicated on strong assumptions regarding the incentives of oil producers taking a rational view of the need for stability and supply in markets. The bottom panel of Chart 9 provides an indication of how tenuous markets are if our assumptions are mistaken, and core OPEC 2.0 does not increase production, Iranian barrels are not returned to the market, or the US shale supply response is less vigorous than we expect. The highest price trajectory occurs when all of our assumptions prove wrong, which takes Brent prices above $140/bbl by the end of 2023. It goes without saying this is non-trivial. But we'll say it anyway: This is non-trivial. We can reasonably expect feedback loops in such a case – e.g., US and Canadian production kicks into high gear, and once-idled North Sea are brought back into service. However, this takes time, and will cause demand destruction on a global scale. Chart 9Scenarios For Oil Prices   Investment Implications Oil markets will remain tight and volatile until additional supplies are forthcoming. We are expecting core OPEC 2.0 to lift output by 3.2mm b/d this year, and for the US Lower 48 production to average 9.8mm b/d. The US production increase will be led by higher shale-oil output, which we expect to average 7.4mm b/d this year and 7.8mm b/d in 2023. Given the tight markets we expect, we remain long the XOP ETF, and commodity index exposure in the form of the S&P GSCI and the COMT ETF, an optimized version of the S&P GSCI.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Marketed volumes of US natural gas are expected to hit a record high of just under 107 Bcf/d next year as prices stabilize close to $4/MMBtu, in the EIA's latest estimate. This is up from just over 104 Bcf/d of marketed production this year, which itself was a 3 Bcf/d increase over 2021 levels. Almost all of this will come from the Lower 48 (97%). We expect US LNG exports to increase on the back of rising production and further investment in export terminals. Most of this will be shipped to Europe, in our estimation, as EU states seek to diversify LNG sources in the wake of the Russia-Ukraine standoff currently underway. LNG imports accounted for roughly one-fifth of all natural gas supplied to the UK and EU-27 in 2020, according to the EIA, which notes, "Growing volumes of flexible LNG supplies, primarily from the United States, contributed to the notable increases in LNG imports to Europe from 2019 to 2021." Wide price differentials can be expected to support the flow of LNG to Europe from the US (Chart 10). Base Metals: Bullish Iron ore prices took a hit after China’s National Development and Reform Commission (NDRC) stated its intentions to stabilize iron ore markets, crack down on speculation and false price disclosures after prices in 2022 rallied sharply last week.  Authorities believe price strength is coming from speculation and hoarding, which is adding to inflationary pressures.  However, fundamental factors have been, and likely will keep iron ore prices buoyed.  Based on past steel inventory levels and seasonal patterns, steel production will increase and more than double current inventory levels by end-March. Monetary policy easing, and the push by China’s steel industry to become carbon-neutral over the next five years are additional fundamental factors supporting iron ore prices. Precious Metals: Bullish The January print for US CPI jumped 7.5% year-on-year, beating estimates as headline inflation rose to a 40-year high.  Markets are expecting around five interest increases this year (Chart 11).  BCA’s US Bond Strategy expects rate hikes will be around 100 – 125 bps this year.  Gold prices initially fell on the possibility of increasing rate hikes and a hawkish Fed, but in the second half of last week settled at subsequently higher prices on each day.  Apart from increased inflation demand, this was likely due to markets’ fear of the possibility of an ultra-hawkish Fed, which could tighten US financial conditions and see a rotation out of US equity markets into safe-haven assets or into other markets ex-US, both of which will be bullish for gold. Chart 10 Chart 11         Footnotes 1     Please see Background Press Call by a Senior Administration Official on the President’s Call with Russian President Vladimir Putin, released by the US White House on February 12, 2022. 2     Please see Long-Term EU Gas Volatility Will Increase, which we published on February 3, 2022 for further discussion.  The EU is a huge market for Russia supplies Germany with 65% of its gas.  Approximately 78% of total natural gas exports (pipeline + LNG) from Russia went to the EU in 2020. 3    Please see Russia’s Unsustainable Business Model: Going All In on Oil and Gas, published on January 19, 2021 by the Hague Centre for Strategic Studies (HCSS). 4    Please see Readout of President Joseph R. Biden, Jr.’s Call with King Salman bin Abdulaziz Al-Saud of Saudi Arabia, released on February 7, 2022. The readout noted, " issues of mutual concern, including Iranian-enabled attacks by the Houthis against civilian targets in Saudi Arabia." Energy security also was discussed, which we read as code for a deal to increase production in return for a deepening of US defense commitments. This line is followed closely by Gulf media – e.g., It took Biden a year to realize Saudi Arabia’s vital regional role, published by arabnews.com on February 13, 2022, which notes: "If Putin decides to invade Ukraine, the Saudis are the only ones who could help relieve the unsteady oil markets by pumping more crude, being the largest crude exporter in the OPEC oil production group. The White House emphasized that both leaders further reiterated the commitment of the US and Saudi Arabia in ensuring the stability of global energy supplies. 5    Please see Iran 'is in a hurry' to revive nuclear deal if its interests secured -foreign minister, published by reuters.com on February 14, 2022. 6    Please see our November 4, 2021 report entitled Despite Weaker Prices Crude Oil Backwardation Will Persist for additional discussion of convenience yields and volatility.   Investment Views and Themes Strategic Recommendations Trades Closed in 2021