South Korea

Highlights Remain neutral on the US dollar. A breakout of the dollar would cause a shift in strategy. Russia’s conflict with the West is heating up now that Germany has delayed the certification of the Nord Stream II pipeline. As long as the focus remains on the pipeline, the crisis will dissipate sometime in the middle of next year. But there is an equal chance of a massive escalation of strategic tensions. Our GeoRisk Indicators will keep rising in Europe, negatively affecting investor risk appetite. Stick with DM Europe over EM Europe stocks. If the dollar does not break out, South Korea and Australia offer cyclical opportunities. Turkish and Brazilian equities will not be able to bounce back sustainably in the midst of chaotic election cycles and deep structural problems. Rallies are to be faded.  Feature We were struck this week by JP Morgan CEO Jamie Dimon’s claim that his business will “not swayed by geopolitical winds.”1  If he had said “political winds” we might have agreed. It is often the case that business executives need to turn up their collars against the ever-changing, noisy, and acrimonious political environment. However, we take issue with his specific formulation. Geopolitical winds cannot shrugged off so easily – or they are not truly geopolitical. Geopolitics is not primarily about individual world leaders or topical issues. It is primarily about things that are very hard and slow to change: geography, demography, economic structure, military and technological capabilities, and national interests. This is the importance of having a geopolitically informed approach to macroeconomics and financial markets: investment is about preserving and growing wealth over the long run despite the whirlwind of changes affecting politicians, parties, and local political tactics.  In this month’s GeoRisk Update we update our market-based, quantitative geopolitical risk indicators with a special focus on how financial markets are responding to the interplay of near-term and cyclical political risks with structural and tectonic pressures underlying a select group of economies and political systems. Is King Dollar Breaking Out? Chart 1King Dollar Breaking Out? Our first observation is that the US dollar is on the verge of breaking out and rallying (Chart 1). This potential rally is observable in trade-weighted terms and especially relative to the euro, which has slumped sharply since November 5th. Our view on the dollar remains neutral but we are watching this rally closely. This year was supposed to be a year in which global growth recovered from the pandemic on the back of vaccination campaigns, leading the counter-cyclical dollar to drop off. The DXY bounce early in the year peaked on April 2nd but then began anew after hitting a major resistance level at 90. The United States is still the preponderant power within the international system. The USD remains the world’s leading currency by transactions and reserves. The pandemic, social unrest, and contested election of 2020 served as a “stress test” that the American system survived, whether judging by the innovation of vaccines, the restoration of order, or the preservation of the constitutional transfer of power. Meanwhile Europe faces several new hurdles that have weighed on the euro. These include the negative ramifications of the slowdown in Asia, energy supply shortages, a new wave of COVID-19 cases, and the partial reimposition of social restrictions. Moreover the Federal Reserve is likely to hike interest rates faster and higher than the European Central Bank over the coming years. Potential growth is higher in the US than Europe and the US growth is supercharged by fiscal stimulus whereas Europe’s stimulus is more limited. Of course, the US’s orgy of monetary and fiscal stimulus and ballooning trade deficits raise risks for the dollar. Global growth is expected to rotate to other parts of the world over the coming 12 months as vaccination spreads. There is still a chance that the dollar’s bounce is a counter-trend bounce and that the dollar will relapse next year. Hence our neutral view. Yet from a geopolitical perspective, the US population and economy are larger, more dynamic, more innovative, safer, and more secure than those of the European Union. The US still exhibits an ability to avoid the reckoning that is overdue from a macroeconomic perspective.  Russia-West Conflict Resumes In our third quarter outlook we argued that European geopolitical risk had hit a bottom, after coming off the sovereign debt crisis of 2010-15, and that geopolitical risk would begin to rise over the long term for this region. Our reasoning was that the markets had fully priced the Europeans’ decision to band together in the face of risks to the EU’s and EMU’s integrity. What markets would need to price going forward would be greater risks to Europe’s stability from a chaotic external environment that Europe lacked the willingness or ability to control: conflict with Russia, immigration, terrorism, and the slowdown in Asia. In particular we argued that Russia’s secular conflict with the West would resume. US-Russia relations would not improve despite presidential summits. The Nord Stream II pipeline would become a lightning rod for conflict, as its operation was more likely to be halted than the consensus held. (German regulators paused the approval process this week, raising the potential for certification to be delayed past the expected March-May months of 2022.) Most importantly we argued that the Russian strategy of political and military aggression in its near-abroad would continue since Russia would continue to feel threatened by domestic instability at home and Western attempts to improve economic integration and security coordination with former Soviet Union countries.  Chart 2Putin Showdown With West To Escalate Further For this reason we recommended that investors eschew Russian equities despite a major rally in commodity prices. Any rally would be undercut by the slowing economy in Asia or geopolitical conflicts that frightened investors away from Russian companies, or both. Today the market is in the process of pricing the impact on Russian equities from commodity prices coming off the boil. But politics may also have something to do with the selloff in Russian equities (Chart 2). The selloff can continue given still-negative hard economic data from Asia and the escalation of tensions around Russia’s strategically sensitive borders: Ukraine, Belarus, Poland, Lithuania, Moldova, and the Black Sea. The equity risk premium will remain elevated for eastern European markets as a result of the latest materialization of country risk and geopolitical risk – the long running trend of outperformance by developed Europe has been confirmed on a technical resistance level (Chart 3). Our mistake was closing our recommendation to buy European natural gas prices too early this year. Chart 3Favor DM Europe Amid Russia Showdown In early 2021, our market-based geopolitical risk indicator for Russia slumped, implying that global investors expected a positive diplomatic “reset” between the US and Russia. We advised clients to ignore this signal and argued that Russian geopolitical risk would take back off again. We said the same thing when the indicator slumped again in the second half of the year and now it is clear the indicator will move sharply higher (Chart 4). The point is that geopolitics keeps interfering with investors’ desire to resuscitate Russian equities based on macro and fundamental factors: cheap valuations, commodity price rises, some local improvements in competitiveness, and the search for yield.   Chart 4Russian GeoRisk Indicator - Risks Not Yet Priced Russia may or may not stage a new military incursion into Ukraine – the odds are 50/50, given that Russia has invaded already and has the raw capability in place on Ukraine’s borders. The intention of an incursion would be to push Russian control across the entire southern border of Ukraine to Odessa, bringing a larger swathe of the Black Sea coast under Moscow’s control in pursuit of Russia’s historic quest for warm water ports. The limitations on Russia are obvious. It would undertake new military and fiscal burdens of occupation, push the US and EU closer together, provoke a stronger NATO defense alliance, and invite further economic sanctions. Yet similar tradeoffs did not prevent Russia from taking surprise military action in Georgia in 2008 or Ukraine in 2014. After the past 13 years the US and EU are still uncoordinated and indecisive. The US is still internally divided. With energy prices high, domestic political support low, and Russia’s long-term strategic situation bleak, Moscow may believe that the time is right to expand its buffer territory further into Ukraine. We cannot rule out such an outcome, now or over the next few years. If Russia attacks, global risk assets will suffer a meaningful pullback. It will not be a bear market unless the conflict spills out beyond Ukraine to affect major economies. We have not taken a second Ukraine invasion as our base case because Russia is focused primarily on getting the Nord Stream pipeline certified. A broader war would prevent that from happening. Military threats after Nord Stream is certified will be more worrisome.  A less belligerent but still aggressive move would be for Russia to militarize the Belarussian border amid the conflict with the EU over Belarus’s funneling of Middle Eastern migrants into the EU via Poland and Lithuania. A closer integration of Russia’s and Belarus’s economies and militaries would fit with Russia’s grand strategy, improve Russia’s military posture in eastern Europe, and escalate fears of eventual war in Poland and the Baltic states. The West would wring its hands and announce more sanctions but may not have a higher caliber response as such a move would not involve hostilities or the violation of mutual defense treaties. This outcome would be negative but also digested fairly quickly by financial markets. Our European GeoRisk Indicators (see Appendix) are likely to respond to the new Russia crisis, in keeping with our view that European geopolitical risk will rise in the 2020s: German risk has dropped off since the election but will now revive at least until Nord Stream II is certified. If Russia re-invades Ukraine it will rise, as it did in 2014.  French risk was already heating up due to the presidential election beginning April 10 (first round) but now may heat up more. Not that Russia poses a direct threat to France but more that broader regional insecurities would hurt sentiment. The election itself is not a major risk to investors, though terrorist attacks could tick up. President Macron has an incentive to be hawkish on a range of issues over the next half year. The UK is in the midst of the Russia conflict. Its defense cooperation with Ukraine and naval activity in the Black Sea, such as port calls in Georgia, have prompted Russia’s military threats – including a threat to bomb a Royal Navy vessel earlier this year. Not to mention ongoing complications around Brexit. The Russian situation is by far the most significant factor. Spain is at a further remove from Russia but its risks are rising due to domestic political polarization and the rising likelihood of a breakdown in the ruling government. Bottom Line: We still favor these countries’ equities to those of eastern Europe but our risk indicators will rise, suggesting that geopolitical incidents could cause a setback for some or all of these markets in absolute terms. A pickup in Asian growth would be beneficial for developed European assets so we are cyclically constructive. We remain neutral on the USD-EUR though a buying opportunity may present itself if and when the Nord Stream II pipeline is certified.  Korea: Nobody’s Heard From Kim In A While Chart 5Korea GeoRisk Indicator Still Elevated Geopolitical risk has risen in South Korea due to COVID-19 and its aftershocks, including supply kinks, shortages, and policy tightening by the giant to the West (Chart 5). South Korea’s geopolitical risk indicator is still very high but not because of North Korea. Our Dear Leader Kim Jong Un has not been overly provocative, although he has restarted the cycle of provocations during the Biden administration. Yet South Korean geopolitical risk has skyrocketed. The problem is that investors have lost a lot of appetite for South Korea in a global environment in which demographics are languishing, globalization is retreating, a regional cold war is developing, and debt levels are high. Domestic politics have become more redistributive without accompanying reforms to improve competitiveness or reform corporate conglomerates. The revival of the South Korean conservatives ahead of elections in 2022 suggests political risk will remain elevated. Of course, North Korea could still move the dial. A massive provocation, say something on the scale of the surprise naval attack on the Chonan in the wake of the global financial crisis in spring of 2010, could push up the risk indicator higher and increase volatility for the Korean won and equities. Kim could take such an action to insist that President Biden pay heed to him, like President Trump did, or at least not ignore him, in a context in which Biden is doing just that due to far more pressing concerns. Biden would be forced to reestablish a credible threat.  Still, North Korea is not the major factor today. Not compared to the economic and financial instability in the region. At the same time, if global growth surprises pick up and the dollar does not break out, Korea will be a beneficiary. We have taken a constructive cyclical view, although our specific long Korea trade has not worked out this year. Korean equities depreciated by 11.2% in USD terms year-to-date, compared to 0.3% for the rest of EM. Structurally, Korea cannot overcome the negative demographic and economic factors mentioned above. Geopolitically it remains a “shrimp between two whales” and will fail to reconcile its economic interests with its defense alliance with the United States.   Australia: Wait On The Dollar Chart 6Australian GeoRisk Indicator Still Elevated Australian geopolitical risk has not fallen back much from this year’s highs, according to our quant indicator (Chart 6). Global shortages and a miniature trade war were the culprits of this year’s spike. The advantage for Australia is that commodity prices and metals look to remain in high demand as the world economy fully mends. Various nations are implementing large public investment programs, especially re-gearing their energy sectors to focus more on renewables. The reassertion of the US security alliance is positive for Australia but geopolitical risk is rising on a secular basis regardless.   Cyclically we would look positively toward Australian stocks. Yet they have risen by 4.3% in common currency terms this year so far, compared to the developed market-ex-US average of 11.0%. Moreover the Aussie’s latest moves confirm that the US dollar is on the verge of breaking out which would be negative for this bourse. Structurally Australia will go through a painful economic transition but it will be motivated to do so by the new regional cold war and threats to national security. The US alliance is a geopolitical positive.   Turkey And Brazil The greenback’s rally could be sustainable not only because of the divergence of US from Asian and global growth but also because of the humiliating domestic political environment of most prominent emerging markets. Chart 7Emerging Market Bull Trap We booked gains our “short” trade of the currencies of EM “strongmen,” such as Brazil’s Jair Bolsonaro and Turkey’s Recep Erdogan, earlier this year. But we noted that we still hold a negative view on these economies and currencies. This is especially true today as contentious elections approach in both countries in 2022 and 2023 respectively (Chart 7). Turkey is trapped into an inflation spiral of its own design, which enervates the economy, as our Emerging Markets Strategy has shown. It is also trapped in a geopolitical stance in which it has repeatedly raised the stakes in simultaneous clashes with Russia, the US, Europe, Israel, the Arab states, Libya, and Iran. Russia’s maneuvers in the Black Sea are fundamentally threatening to Turkey, so while Erdogan has maintained a balance with Russia for several years, Russian aggression could upset that balance. Turkey has backed off from some recent confrontations with the West lately but there is not yet a trend of improvement. The COVID-19 crisis gave Erdogan a badly needed bump in polls, unlike other EM peers. But this simply reinforces the market’s overrating of his odds of being re-elected. In reality the odds of a contested election or an election upset are fairly high. New lows in the lira show that the market is reacting to the whole negative complex of issues around Turkey. But the full weight of the government’s mismanaging of economic policy to stay in power and stay geopolitically relevant has not yet been felt. The election is still 19 months away. A narrow outcome, for or against Erdogan and his party, would make things worse, not better. Brazil’s domestic political and geopolitical risks are more manageable than Turkey’s. But it faces a tumultuous election in which institutional flaws and failures will be on full display. Investors will try to front-run the election believing that former President Luiz Inácio Lula da Silva will restore the good old days. But we discourage that approach. We see at least two massive hurdles for the market: first, Brazil has to pass its constitutional stress test; second, the next administration needs to be forced into difficult decisions to preserve growth and debt management. These will come at the expense of either growth or the currency, according to our Emerging Markets Strategy. We still prefer Mexican stocks. Geopolitically, Turkey will struggle with Russia’s insecurity and aggression, Europe’s use of economic coercion, and Middle Eastern instability. Brazil does not have these external problems, although social stability will always be fragile. Investment Takeaways The dollar is acting as if it may break out in a major rally. Our view has been neutral but our generally reflationary perspective on the global economy is being challenged. Russia’s conflict with the West will escalate, not de-escalate, in the wake of Germany’s decision to delay the certification of the Nord Stream II pipeline. Russia has greater leverage now than usual because of energy shortages. A re-invasion of Ukraine cannot be ruled out. But the pipeline is Russia’s immediate focus. Investors have seen conflict in Ukraine so they will be desensitized quickly unless the conflict spreads into new geographies or spills out to affect major economies. The same goes for trouble on Belarus’s borders. Stick with long DM Europe / short EM Europe. Opportunities may emerge to become more bullish on the euro and European equities if and when the Nord Stream II situation looks to be resolved and Asian risks to global growth are allayed. If the dollar does not break out, South Korea and Australia are cyclical beneficiaries. Whereas “strongman” regimes will remain volatile and the source of bull traps, especially Turkey.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1  “JP Morgan chief becomes first Wall Street boss to visit during pandemic,” Financial Times, November 15, 2021, ft.com. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Open Trades & Positions Section II: Appendix: GeoRisk Indicator Russia United Kingdom Germany France Italy Canada Spain Korea Turkey Brazil Australia South Africa Section III: Geopolitical Calendar

Highlights China’s slowdown will deepen, and US bond yields will likely rise. This augurs well for the US dollar but will produce a toxic cocktail for EM. The recent weakness in the commodity complex will continue. EM markets are at risk in absolute terms and will continue to underperform their DM counterparts. From a global macro perspective, the US dollar’s appreciation will be a re-balancing act. In a world where China is exporting economic weakness/deflation and the US is experiencing genuine inflation, a strong US dollar is desirable. The latter will redistribute inflation away from the US to the rest of the world and will redirect disinflationary pressures from the rest of the world to the US. Feature Chart 1DXY Breakout, EM FX Breakdown The US dollar is breaking out and EM currencies are breaking down (Chart 1). This will set in motion a number of responses in global financial markets. These include but are not limited to selloffs in EM equities, domestic bonds and EM credit markets and a setback in the commodity complex. Hence, we reiterate our negative stance on EM stocks and fixed-income markets. We continue to recommend shorting a basket of EM currencies versus the US dollar. Please refer to the end of this report for detailed investment recommendations. Why The Greenback Is Set To Strengthen Since early in the year, our investment strategy has been based on two macro themes: China’s slowdown and rising US inflation. We concluded early on that these dynamics are positive for the US dollar. Both macro themes have played out fairly well, yet until recently the broad trade-weighted US dollar’s advance has been hesitant. Odds are that the rally in the greenback is about to accelerate. Chart 2China's Slowdown = US Dollar Rally The fundamental case for the US dollar rally remains as follows: China’s slowdown will weigh more on emerging Asia, Japan, Europe, and/or commodity producing, developing and developed economies than it will on the US. The basis is that US exports to China make up only 0.7% of its GDP. The same ratio is much higher for the rest of the world. Hence, the US economy will outperform many advanced and emerging economies. Chart 2 illustrates that, historically, whenever China has slowed down, the US dollar has rallied. The mainland’s property construction is shrinking, and traditional infrastructure investment is also extremely weak (Chart 3). Beijing is easing its regulatory and macro policies but only by degrees. For now, policy support will be insufficient to reverse the business cycle downturn. In the meantime, the US economy is overheating. Specifically, all core type inflation measures have surged to well above 2% (Chart 4). Critically, nominal wages are rising at the fastest rate seen in the past 35 years (Chart 5). Chart 3China: Infrastructure Investment Is Very Weak Chart 4US Core Inflation Is Broad-Based And High Given that the employee quit rate is very high, employers will have to grant notable wage increases to both new and current employees. Thus, wage growth will accelerate further. Recent wage gains have not been offset by productivity growth. As a result, unit labor costs are rising (Chart 6). This will push businesses to raise their selling prices. So long as household income and consumption remain robust, businesses will likely succeed in raising their prices. In short, US inflation is acute and genuine, and, hence, it will persist unless the economy slows considerably. Chart 5US Nominal Wage Growth Is At Its Fastest In 35 Years Chart 6US Unit Labor Costs Are Rising Fast The rise in US inflation will initially be bullish for the US dollar. The reason is that fixed-income markets will move to price in higher Fed funds rates and the Fed will also acknowledge the need to hike rates given that core inflation is well above its target range. At some point in future, however, high inflation will start hurting the US dollar. This will happen when the Fed eschews rate hikes and falls behind the inflation curve. We believe we are still in a window where US bond yields could rise further. Rising US interest rates will support the dollar. Finally, the US economy, but not necessarily its equity and credit markets, is better positioned to handle central bank tightening than are other DM and EM economies. American consumers have substantially deleveraged and there are shortages in US housing and cars. Even as US borrowing costs rise, interest rate sensitive sectors like housing and autos will still do well because of pent-up demand. In particular, the US housing market is sensitive to long-term (30-year) mortgage rates and not the front end of curve. On the contrary, many EM and other DM economies and their housing sectors are sensitive to domestic short-term rates. In percentage terms, the rise in US mortgage rates will likely be smaller than those in DM and EM economies. In short, the US economy will not slow sharply in the response to rates while EM and other DM economies will. This augurs well for the dollar. The key US vulnerability from higher interest rates stems from its equity and credit markets, not the real economy. US equities and credit markets are very richly priced, so the rising cost of capital could trigger a major selloff. In turn, wealth effects and tightening financial conditions will pose a risk to the real economy. However, even in this case, the US dollar will initially appreciate because it always rallies during risk-off phases. The greenback’s depreciation will resume when the Fed turns dovish again. From a big picture macro perspective, the US dollar’s appreciation will be a re-balancing act. In a world where China is exporting economic weakness/deflation and the US is experiencing genuine inflation, a strong US dollar is desirable. The latter will redistribute inflation away from the US to the rest of the world and will redirect disinflationary pressures from the rest of the world to the US. In this period of US dollar strength, EM financial markets will be hurt because foreign investors always flee EM when their currencies depreciate. Bottom Line: China’s slowdown will deepen, and US bond yields will likely rise. This will produce a toxic cocktail for EM. Watch Out Commodity Prices Chart 7Reduced Financing For Property Developers = Less Construction The downturns in China’s property construction and traditional infrastructure spending are bad for raw material prices. The following points offer an explanation as to why commodity prices will relapse in spite of the fact that they have thus far resisted China’s slowdown. Although Chinese property sales and starts have been shrinking, floor area completed (construction work) has been very strong. However, the liquidity crunch that many real estate developers are experiencing will lead them to halt or cut back on their construction work (Chart 7, top panel). The latter will weigh on raw material prices (Chart 7, bottom panel). Taiwan’s new export orders PMI for the basic materials sector has dropped below 50, indicating plunging regional demand for raw materials (Chart 8). Ongoing weakness in Chinese demand is the culprit behind this drop. Due to electricity shortages, mainland production of industrial metals has plunged (Chart 9, top panel). Yet, the prices of these metals have recently corrected (Chart 9, bottom panel). Falling prices amid shrinking supply are a sign of major demand relapse. Chart 8Greater China: Orders For Basic Materials Are Already Shrinking Chart 9Base Metal Price Falling Despite Production Shutdowns In China   The Baltic Dry index – the price of shipping bulk commodities – has rolled over decisively. It has reasonable correlation with industrial metal prices. Oil is much less exposed than base metals to China’s property and infrastructure contraction. In the case of crude, the key risks are the US and China releasing their strategic reserves and the US dollar strength. Bottom Line: The recent weakness in the commodity complex will continue. Other Considerations Chart 10China's Onshore Stock-to_Bond Ratio Is Breaking Down There are a number of other considerations and indicators that lead us to maintain a negative stance on EM financial markets: China’s onshore stock-to-bond ratio has broken below its 200-day moving average (Chart 10). This signifies a deepening growth slump in China. EM equity underperformance has been broad-based. Both the market cap-weighted and equal-weighted EM equity indexes have been underperforming their respective DM indexes. Further, not only have TMT (technology, media and telecom) stocks been underperforming their DM peers, but non-TMT stocks have also lagged their counterparts substantially (Chart 11). Last but not least, EM TMT stocks remain at risk. First, share prices of Chinese internet companies will continue derating due to structurally lower profitability going forward as the government exercises more control over them. We have discussed this in previous reports. In addition, consumer spending online has slowed sharply while smartphone sales are plunging (Chart 12). Chart 11EM Equity Underperformance Is Broad-Based Chart 12China: Online Spending Is Very Weak Second, DRAM (memory chip) prices are deflating and the value of DRAM sales is shrinking (Chart 13). This is weighing on Korean semiconductor share prices like Samsung and SK Hynix. These stocks have a large market cap in the KOSPI index. Finally, demand for semiconductors produced by Taiwanese companies has been booming but it is presently showing signs of moderation (Chart 14). Chart 13Falling DRAM Prices Are Weighing On Korean Semi Stocks Chart 14Taiwanese Semiconductor Industry: Moderating Orders Importantly, geopolitical risks around Taiwan in general and TSMC in particularly are enormous. The latter is literally at the center of the US-China confrontation. The timing of a diplomatic or even military crisis is uncertain but our Geopolitical Strategy team expects geopolitical risks over Taiwan to escalate substantially. The recent summit between Presidents Joe Biden and Xi Jinping does not change this assessment.  Investment Recommendations Chart 15EM Credit Markets: Prepare For A Broad Selloff Continue underweighting EM equities in a global equity portfolio. Within the EM space, our overweights are Korea, Singapore, China (favoring A shares over investable stocks), Vietnam, Russia, central Europe and Mexico. Concerning EM equity sectors, we reiterate the short EM banks / long DM banks and short EM banks / long EM consumer staples positions. In line with our US dollar breakout thesis, we continue to recommend a short position in a basket of the following EM currencies versus the US dollar: BRL, CLP, COP, PEN, ZAR, TRY, THB, PHP and KRW. EM exchange rate depreciation is bad for EM domestic bonds. Currency weakness could lead central banks in Latin America to hike rates further. In brief, the risk-reward of EM local currency bonds is still unattractive. In this space, we recommend the following positions: bet on yield curve flattening in Mexico and Russia (pay 1-year/receive 10-year swap rates); pay Czech 10-year swap rates; receive Chinese and Malaysian 10-year swap rates. We reiterate our underweight in EM credit (both sovereign and corporate) markets versus US corporate credit, quality adjusted. As EM exchange rates depreciate, EM credit spreads will widen (Chart 15). Chinese high-yield corporate US dollar bonds are not yet a buy because the mainland property market’s travails are far from over, as was discussed in our recent Special Report. For a complete list of our recommendations across all asset classes and country strategy within each asset class, please see below or visit our web site. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights The US Climate Prediction Center gives ~ 70% odds another La Niña will form in the August – October interval and will continue through winter 2021-22. This will be a second-year La Niña if it forms, and will raise the odds of a repeat of last winter's cold weather in the Northern Hemisphere.1 Europe's natural-gas inventory build ahead of the coming winter remains erratic, particularly as Russian flows via Ukraine to the EU have been reduced this year. Russia's Nord Stream 2 could be online by November, but inventories will still be low. China, Japan, South Korea and India  – the four top LNG consumers in Asia  – took in 155 Bcf of the fuel in June. A colder-than-normal winter would boost demand. Higher prices are likely in Europe and Asia (Chart of the Week). US storage levels will be lower going into winter, as power generation demand remains stout, and the lingering effects from Hurricane Ida reduce supplies available for inventory injections. Despite spot prices trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu – we are going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. Feature Last winter's La Niña was a doozy. It brought extreme cold to Asia, North America and Europe, which pulled natural gas storage levels sharply lower and drove prices sharply higher as the Chart of the Week shows. Natgas storage in the US and Europe will be tight going into this winter (Chart 2). Europe's La Niña lingered a while into Spring, keeping temps low and space-heating demand high, which delayed the start of re-building inventory for the coming winter.  In the US, cold temps in the Midwest hampered production, boosted demand and caused inventory to draw hard. Chart of the WeekA Return Of La Niña Could Boost Global Natgas Prices Chart 2Europe, US Gas Stocks Will Be Tight This Winter Summer in the US also produced strong natgas demand, particularly out West, as power generators eschewed coal in favor of gas to meet stronger air-conditioning demand. This is partly due to the closing of coal-fired units, leaving more of the load to be picked up by gas-fired generation (Chart 3). The EIA estimates natgas consumption in July was up ~ 4 Bcf/d to just under 76 Bcf/d. Hurricane Ida took ~ 1 bcf/d of demand out of the market, which was less than the ~ 2 Bcf/d hit to US Gulf supply resulting from the storm.  As a result, prices were pushed higher at the margin. Chart 3Generators Prefer Gas To Coal US natgas exports (pipeline and LNG) also were strong, at 18.2 Bcf/d in July (Chart 4). We expect US LNG exports, in particular, to resume growth as the world recovers from the COVID-19 pandemic (Chart 5). This strong demand and exports, coupled with slightly lower supply from the Lower 48 states – estimated at ~ 98 Bcf/d by the EIA for July (Chart 6) – pushed prices up by 18% from June to July, "the largest month-on-month percentage change for June to July since 2012, when the price increased 20.3%" according to the EIA. Chart 4US Natgas Exports Remain Strong Chart 5US LNG Exports Will Resume Growth Chart 6US Lower 48 Natgas Production Recovering Elsewhere in the Americas, Brazil has been a strong bid for US LNG – accounting for 32.3 Bcf of demand in  June – as hydroelectric generation flags due to the prolonged drought in the country. In Asia, demand for LNG remains strong, with the four top consumers – China, Japan, South Korea, and India – taking in 155 Bcf in June, according to the EIA. Gas Infrastructure Ex-US Remains Challenged A combination of extreme cold weather in Northeast Asia, and a lack of gas storage infrastructure in Asia generally, along with shipping constraints and supply issues at LNG export facilities, led to the Asian natural gas price spike in mid-January.2 Very cold weather in Northeast Asia, drove up LNG demand during the winter months. In China, LNG imports for the month of January rose by ~ 53% y-o-y (Chart 7).3 The increase in imports from Asia coincided with issues at major export plants in Australia, Norway and Qatar during that period. Chart 7China's US LNG Exports Surged Last Winter, And Remain Stout Over The Summer Substantially higher JKM (Japan-Korea Marker) prices incentivized US exporters to divert LNG cargoes from Europe to Asia last winter. The longer roundtrip times to deliver LNG from the US to Asia – instead of Europe – resulted in a reduction of shipping capacity, which ended up compounding market tightness in Europe. Europe dealt with the switch by drawing ~ 18 bcm more from their storage vs. the previous year, across the November to January period. Countries in Asia - most notably Japan – however, do not have robust natural gas storage facilities, further contributing to price volatility, especially in extreme weather events. These storage constraints remain in place going into the coming winter. In addition, there is a high probability the global weather pattern responsible for the cold spells around the globe that triggered price spikes in key markets globally – i.e., a second La Niña event – will return. A Second-Year La Niña  Event The price spikes and logistical challenges of last winter were the result of atmospheric circulation anomalies that were bolstered by a La Niña event that began in mid-2020.4 The La Niña is characterized by colder sea-surface temperatures that develops over the Pacific equator, which displaces atmospheric and wind circulation and leads to colder temperatures in the Northern Hemisphere (Map 1). Map 1La Niña Raises The Odds Of Colder Temps The IEA notes last winter started off without any exceptional deviations from an average early winter, but as the new year opened "natural gas markets experienced severe supply-demand tensions in the opening weeks of 2021, with extremely cold temperature episodes sending spot prices to record levels."5 In its most recent ENSO update, the US Climate Prediction Center raised the odds of another La Niña event for this winter to 70% this month. If similar conditions to those of the 2020-21 winter emerge, US and European inventories could be stretched even thinner than last year, as space-heating demand competes with industrial and commercial demand resulting from the economic recovery. Global Natgas Supplies Will Stay Tight JKM prices and TTF (Dutch Title Transfer Facility) prices are likely to remain elevated going into winter, as seen in the Chart of the Week. Fundamentals have kept markets tight so far. Uncertain Russian supply to Europe will raise the price of the European gas index (TTF). This, along with strong Asian demand, particularly from China, will keep JKM prices high (Chart 8). The global economic recovery is the main short-term driver of higher natgas demand, with China leading the way. For the longer-term, natural gas is considered as the ideal transition fuel to green energy, as it emits less carbon than other fossil fuels. For this reason, demand is expected to grow by 3.4% per annum until 2035, and reach peak consumption later than other fossil fuels, according to McKinsey.6 Chart 8BCAs Brent Forecast Points To Higher JKM Prices Spillovers from the European natural gas market impact Asian markets, as was demonstrated last winter. Russian supply to Europe – where inventories are at their lowest level in a decade – has dropped over the last few months. This could either be the result of Russia's attempts to support its case for finishing Nord Stream 2 and getting it running as soon as possible, or because it is physically unable to supply natural gas.7 A fire at a condensate plant in Siberia at the beginning of August supports the latter conjecture. The reduced supply from Russia, comes at a time when EU carbon permit prices have been consistently breaking records, making the cost of natural gas competitive compared to more heavy carbon emitting fossil fuels – e.g., coal and oil – despite record breaking prices. With Europe beginning the winter season with significantly lower stock levels vs. previous years, TTF prices will remain volatile. This, and strong demand from China, will support JKM prices. Investment Implications Natural gas prices are elevated, with spot NYMEX futures trading ~ $1.30/MMBtu above last winter's highs – currently ~ $4.60/MMBtu. Our analysis indicates prices are justifiably high, and could – with the slightest unexpected news – move sharply higher. Because natgas is, at the end of the day, a weather market, we favor low-cost/low-risk exposures. In the current market, we recommend going long 1Q22 NYMEX $5.00/MMBtu natgas calls vs short NYMEX $5.50/MMBtu natgas calls expecting even higher prices. This is the trade we recommended on 8 April 2021, at a lower level, which was stopped out on 12 August 2021 with a gain of 188%.   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 Earlier this week, Saudi Aramco lowered its official selling price (OSP) by more than was expected – lowering its premium to the regional benchmark to $1.30/bbl from $1.70/bbl – in what media reports based on interviews with oil traders suggest is an attempt to win back customers electing not to take volumes under long-term contracts. This is a marginal adjustment by Aramco, but still significant, as it shows the company will continue to defend its market share. Pricing to Northwest Europe and the US markets is unchanged. Aramco's majority shareholder, the Kingdom of Saudi Arabia (KSA), is the putative leader of OPEC 2.0 (aka, OPEC+) along with Russia. The producer coalition is in the process of returning 400k b/d to the market every month until it has restored the 5.8mm b/d of production it took off the market to support prices during the COVID-19 pandemic. We expect Brent crude oil prices to average $70/bbl in 2H21, $73/bbl in 2022 and $80/bbl in 2023. Base Metals: Bullish Political uncertainty in Guinea caused aluminum prices to rise to more than a 10-year high this week (Chart 9). A coup in the world’s second largest exporter of bauxite – the main ore source for aluminum – began on Sunday, rattling aluminum markets. While iron ore prices rebounded primarily on the record value of Chinese imports in August, the coup in Guinea – which has the highest level of iron ore reserves – could have also raised questions about supply certainty. This will contribute to iron-ore price volatility. However, we do not believe the coup will impact the supply of commodities as much as markets are factoring, as coup leaders in commodity-exporting countries typically want to keep their source of income intact and functioning. Precious Metals: Bullish Gold settled at a one-month high last Friday, when the US Bureau of Labor Statistics released the August jobs report. The rise in payrolls data was well below analysts’ estimates, and was the lowest gain in seven months. The yellow metal rose on this news as the weak employment data eased fears about Fed tapering, and refocused markets on COVID-19 and the delta variant. Since then, however, the yellow metal has not been able to consolidate gains. After falling to a more than one-month low on Friday, the US dollar rose on Tuesday, weighing on gold prices (Chart 10). Chart 9 Chart 10       Footnotes 1      Please see the US Climate Prediction Center's ENSO: Recent Evolution, Current Status and Predictions report published on September 6, 2021. 2     Please see Asia LNG Price Spike: Perfect Storm or Structural Failure? Published by Oxford Institute for Energy Studies. 3     Since China LNG import data were reported as a combined January and February value in 2020, we halved the combined value to get the January 2020 amount. 4     Please see The 2020/21 Extremely Cold Winter in China Influenced by the Synergistic Effect of La Niña and Warm Arctic by Zheng, F., and Coauthors (2021), published in Advances in Atmospheric Sciences. 5     Please see the IEA's Gas Market Report, Q2-2021 published in April 2021. 6     Please see Global gas outlook to 2050 | McKinsey on February 26, 2021. 7     Please see ICIS Analyst View: Gazprom’s inability to supply or unwillingness to deliver? published on August 13, 2021.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights We continue to recommend that dedicated EM equity portfolio investors overweight Korean equities. Overweighting the KOSPI within an EM equity portfolio is in line with our long-term theme of favoring global industrial stocks and is consistent with our medium-term strategy of favoring global industrials over global materials. Yet, the risk-reward for the KOSPI index in absolute terms is not yet attractive. Despite long-term positives for the semiconductor industry, near-term softness in new orders for memory chips is likely to occur. This will limit the upside in Korean tech stocks. Feature Korean share prices have been moving sideways in recent months. Is this the beginning of a major downtrend or just a consolidation before another upleg? Chart 1 illustrates that margin loans for security purchases and the number of equity transactions in Korea have been surging. In addition, retail investors continue to increase their equity holdings, i.e., they have remained net buyers (Chart 2). In short, the retail mania in Korean stocks is persisting.  Chart 1Retail Mania In Korean Stocks Persists Chart 2Korean Equities: Retail Investor Purchases Have Driven The Rally     It is impossible to determine when this retail-driven mania will subside. So long as corporate profits continue expanding, Korean share prices could correct amidst possible retail selling without necessarily collapsing. In such a scenario, odds are that domestic institutional and foreign investors will step in and buy on a meaningful dip in stock prices. Our investment strategy is as follows: in absolute terms, the risk-reward for the KOSPI index is not attractive. Significant upside in share prices from current levels is only possible if the retail-driven equity mania pushes stock valuations to very expensive levels. In relative terms, however, we continue recommending an overweight position in this bourse within an EM equity portfolio. Importantly, Korean stocks are likely to outperform the EM benchmark in any market scenario. The Semiconductor Cycle: An Inflection Point? The recent softness in DRAM (memory semiconductor) prices and the DXI (a DRAM revenue proxy) explains the correction in Korea’s semiconductor stocks that make up a large proportion of this bourse’s market cap (Chart 3). Are we witnessing a top in the semiconductor cycle? The structural and cyclical demand for semiconductors from servers, automation, and autos remains positive as we argued in our special report on semiconductors from August 20th of last year (Chart 4). Chart 3Korean Tech Stocks And DRAM Revenue Proxy Chart 4There Is Pent-Up Demand For Semiconductors   However, near-term downside risks cannot be ruled out: Rising bitcoin prices encourage mining and promote demand for memory chips (Chart 5). The plunge in bitcoin prices and a crackdown on bitcoin mining and transactions in China and in some other countries could lead to a decline in bitcoin mining investments. The latter will herald a moderation in demand for memory chips worldwide. Another reason for a potential slump in DRAM demand is contracting smartphone sales in China (Chart 6). These account for 26% of global smartphone sales. Chart 5Does Bitcoin Drive DRAM Prices? Chart 6Smartphone Sales Have Been Dismal In China Chart 7China Has Been Accumulating Semiconductor Inventories In addition, China has been aggressively building semiconductor inventories since early 2019 amid the escalating US-China confrontation which is especially intense pertaining to the semiconductor industry (Chart 7). Given that such stockpiling is driven by non-economic aims, it is impossible to know how long this restocking process will last. That said, however, it is reasonable to expect some moderation in the pace of semiconductor stockpiling in China. Global personal computer (PC) shipments have skyrocketed in the past 12 months due to the work-from-home phenomenon (Chart 8). As the US and European economies reopen and employees make a partial return to offices, it is reasonable to expect a decline in PC sales and ultimately demand for memory chips. Finally, there has recently been some softness in the Taiwanese semiconductor industry data as shown in Chart 9. Chart 8Personal Computer Shipments Have Benefited From Work From Home Chart 9A Soft Spot In The Taiwanese Semiconductor Industry?   Bottom Line: Despite long-term positives for the semiconductor industry, the occurrence of near-term softness in new memory chip orders is likely. This will cap the upside in Korean tech stocks that make up 40% of the KOSPI index. The KOSPI As An Industrial Play Within The EM Benchmark One of our major long-term themes is to be bullish on global industrial stocks. Global industrial companies’ share prices will appreciate and outperform the global equity benchmark in the coming years. This bull market will be driven by: benefits from strong infrastructure investments in the US and decarbonization initiatives globally; cost reductions and wider profit margins due to the widespread deployment of robotics; the role of industrials serving as inflation protection for investment portfolios.1 However, the market cap of industrial companies in the MSCI EM equity benchmark is small at just 5%. Plus, these industrial companies have performed substantially worse than their DM peers over the past ten years. The reasons behind such disappointing performance are partially related to corporate governance in EM industrial companies. So, how then does one play the bullish industrials theme within the EM benchmark? The KOSPI represents a good proxy for industrials within the EM benchmark. Even though the market cap of industrial companies in the MSCI Korea index is only 5%, large weights in Samsung and automakers render the Korean bourse a good proxy play on a global industrial boom. Chart 10The KOSPI As An Industrial Play Within The EM Benchmark Notably, Korea’s relative equity performance against the EM benchmark correlates well with trends in global industrials relative to global non-TMT stocks (Chart 10). We continue recommending the long global industrial/short global materials as a cyclical strategy for global equity portfolios. The mirror image of this strategy in the EM equity universe would be long KOSPI/short EM index. The basis for favoring global industrials against global materials is a bet on the industrial boom in the US/DM and on a slowdown in China’s construction and infrastructure sectors. The latter two are vital to bulk commodity prices, and thereby, to global material stocks. Bottom Line: Overweighting the KOSPI within an EM equity portfolio is in line with our long-term theme of favoring global industrial stocks and is akin to our medium-term strategy of favoring global industrials over global materials. Korea’s Exposure To China Chart 11Korea's Export Destinations As the largest importer of Korean exports, China’s impending slowdown poses a risk to Korean exports and the absolute performance of the KOSPI. However, the bourse will likely outperform the EM equity benchmark on the basis that Korean exports are also meaningfully exposed to the US and the EU. The US and the EU combined account for 25% of Korean exports while China accounts for 26% (Chart 11). While Korean exports to China are large, the equity market cap of those export sectors most exposed to the mainland only make up a small share of the Korean stock market. Namely, the materials and industrials sectors, make up only 15% of the MSCI Korea equity index. What’s more, Chinese imports of consumer goods from Korea are far less vulnerable than Chinese imports of commodities and capital goods. The latter are more sensitive to China’s credit cycle than consumer goods. Hence, the Korean bourse and the currency are less vulnerable than those economies that ship raw materials and industrial goods to China. Investment Recommendations Chart 12Analysts Have Been Downgrading Korean Tech EPS But Not Overall EM EPS Estimates We continue to recommend that dedicated EM equity portfolio investors overweight Korean equities. Equity analysts have commenced downgrading their corporate earnings estimates for Korean technology companies but there has been little downgrade in their overall EM EPS profits projections (Chart 12). From a contrarian perspective, these EPS projections warrant overweighing the Korean index with its very large weight in technology. Korea’s exchange rate will be driven by trends in the broad trade-weighted US dollar. In the coming months, we expect the greenback to rebound. Thus, tactically, the won will likely correct. In the long run, risks to the US dollar are to the downside, and, hence, the Korean won will appreciate against the greenback. Local currency government bond yields move in tandem with US Treasurys yields. The next large move will be higher US and Korean government bond yields. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Vanessa Wong Ee Shan Research Associate vanessaw@bcaresearch.com   Footnotes 1 We will elaborate on these reasons in much more detail in a forthcoming report.