Brazil

Stay short Greater China assets. Stay long Japanese yen. Hold back on Brazil for now but look forward to opportunities in future.

Russia’s conflict with the West will escalate and trigger more bad news for risky assets this fall. Beyond that, stalemate looms. Latin American equities present a potential opportunity once the macro and geopolitical backdrop improve.

Executive Summary Brazil: The Economic Rebound Will Not Last Brazil: The Economic Rebound Will Not Last Brazil: The Economic Rebound Will Not Last Brazil’s goldilocks phase of economic recovery, improving fiscal accounts and falling inflation will prove to be short lived. On the contrary, the country will re-enter a period of stagflation – weak growth amid high core inflation – and the central bank will continue hiking rates. While headline inflation will continue dropping due to falling oil prices and government tax cuts on utilities, core inflation will remain above the central bank’s target due to high wage growth and high levels of indexation. The economy will weaken anew as the commodity windfall abates and continuous central bank tightening amid distressed household finances cause a drawdown in consumer spending. Public debt concerns will resurface as interest rates rise further and nominal GDP growth downshifts due to the retreat in commodity prices. Further, the imminent election of ex-President Luiz Inácio Lula da Silva will lead to higher fiscal spending and larger deficits. We expect Lula to win the election versus current President Jair Bolsonaro. While Bolsonaro might try to deny the outcome, and thereby bring a bout of market volatility, the military is unlikely to overthrow the democratic results. Bottom Line: The domestic and global macro dynamics are negative for Brazilian financial markets in absolute terms. Within EM equity and fixed-income portfolios, BCA’s Emerging Markets Strategy team recommends a neutral allocation to Brazil. For the currency, we reiterate our trade of shorting the BRL versus the MXN. Feature On the surface, the Brazilian economy seems to have recently entered a goldilocks phase: inflation has rolled over, economic activity is recovering, and the public debt-to-GDP ratio has downshifted. Financial markets have rebounded with stock prices rising by 15% in local currency terms, the BRL strengthening and 10-year domestic bond yields falling over the past two months. Financial markets have been pricing in that the Central Bank of Brazil (BCB) will turn dovish and, with it, hoping that the economy will achieve a soft landing.   Beneath the surface, however, this sanguine view of a goldilocks macro scenario shows signs of being short lived. As we see it, inflation will be sticky and will fall only gradually, the BCB will maintain a hawkish stance and will continue to hike rates, economic activity will disappoint, and fiscal accounts will worsen anew. Moreover, the likely election of former President Luiz Inácio Lula da Silva on October 2 (with a second round on October 30 if necessary) is not a solution to long-term structural problems. Inflation Will Be Sticky Chart 1Brazil: While Headline Inflation Rolls Over, Core Remains High Brazil: While Headline Inflation Rolls Over, Core Remains High Brazil: While Headline Inflation Rolls Over, Core Remains High After having one of the highest inflation prints among investable Emerging Markets, Brazil’s headline inflation has begun to roll over (Chart 1, top panel). While this shift has been celebrated by markets, odds are that going forward the decrease in inflation will be gradual and the core inflation rate, while moderating, will remain well above the central bank’s target range of 3.5% (+/-1.5%) for some time (Chart 1, top panel). First, core inflation measures – such as core, trimmed-mean CPI and non-tradable CPI − have not fully rolled over yet and remain at around 10.5%, well above the BCB’s target range (Chart 1, bottom panel). When core-type inflation measures are at around 10%, it suggests inflation is genuine and broad based and not limited to just energy and food prices. Second, the latest drop in the headline inflation rate is not due to easing inflationary pressures, but rather due to government tax cuts on gas and diesel alongside falling gasoline prices. Excluding fuel and gas, the prices for the rest of the consumer basket continued to rise materially in August. Consistently, the core inflation rate grew by 0.54% on a month-to-month basis. Third, as a sign of genuine and persistent inflationary pressures, wage growth is accelerating and unit labor costs are spiking (Chart 2, top and middle panels). As we have written repeatedly in our reports, wages, and specifically unit labor costs, are the most important drivers of genuine inflation. Chart 2Brazil: Wages Are Running Hot Brazil: Wages Are Running Hot Brazil: Wages Are Running Hot Very strong growth in nominal wages and unit labor costs poses risks to business profit margins. In an inflationary scenario, business owners will attempt to raise their selling prices to protect profitability. Thereby, they will try passing higher costs and further fuel price pressures onto consumers. When this occurs, the economy enters a wage-price spiral. In brief, unless the economy and labor market weaken substantially, core inflation will not fall within the central bank’s target range anytime soon (more on the business cycle below). Fourth, the Brazilian economy has high levels of indexation, which means that the prices of certain goods and services such as school fees, health insurance, and manual labor are linked to the past year’s inflation rate, which in 2021 stood at 10.1%. Particularly, about 40% of the Consumer Price Index is indexed, either formally or informally.1 This makes the BCB’s job of bringing inflation down to below 5% and closer to 3.5% that much harder. Another important variable indexed to inflation is the minimum wage, which rose by 10% in 2022 (Chart 2, bottom panel). The minimum wage has a particularly high impact on inflation due to the large share of workers who depend upon it. According to local consultant firm Tendências Consultoria, 38% of employed Brazilians earn the minimum wage. Bottom Line: Headline inflation is set to drop from current levels mainly due to falling energy and food prices as well as tax cuts. Nevertheless, in the coming months core inflation will remain well above the BCB’s target. Public Debt Concerns Will Resurface The latest improvement in fiscal accounts has been due to cyclical factors that are set to reverse. Thereby, public debt sustainability worries will resurface as cyclical tailwinds die down. Specifically, the amelioration of fiscal accounts and the decline in the public debt-to-GDP ratio has been due to nominal GDP growth exceeding government borrowing costs (Chart 3, top and middle panels). The public debt-to-GDP ratio has declined due to excessive inflation producing high nominal GDP growth. Rapid price increases likewise inflated government income through higher tax revenues. Nominal GDP in general and the GDP deflator in particular were lifted by the rally in commodity prices late last year and early this year (Chart 4). In particular, the GDP deflator has averaged 12% in Q1 and Q2 this year. Chart 3Brazil: Public Debt Dynamics Will Worsen Anew Brazil: Public Debt Dynamics Will Worsen Anew Brazil: Public Debt Dynamics Will Worsen Anew Chart 4As Commodity Prices Fall, So Will Brazilian Nominal Growth As Commodity Prices Fall, So Will Brazilian Nominal Growth As Commodity Prices Fall, So Will Brazilian Nominal Growth   Going forward, however, these cyclical tailwinds are set to dissipate. As commodity prices fall on the back of a global manufacturing recession, so will Brazilian nominal GDP growth (and its GDP deflator). Further, hawkish monetary policy will induce a growth slowdown in the nation’s economy and reduce inflation, albeit only modestly. All of these factors will bring down nominal GDP growth and, thereby, decrease fiscal revenues. Overall, as nominal GDP growth downshifts considerably and the central bank continues hiking rates, the interest rate on public debt will rise above the nominal GDP growth rate (Chart 3). This will lead to a rising public debt-to-GDP ratio. Further into the next year, fiscal accounts will come under more pressure as the government enacts an expansive fiscal budget. Both presidential frontrunners have explicitly stated that they will maintain cash handouts and tax cuts into the next year, at a cost of BRL 160 billion or 1.7% of GDP. President Jair Bolsonaro’s proposed budget for 2023 is already envisioning a primary deficit of 0.7% of GDP, compared to the current primary surplus of 2.5% of GDP (Chart 3, bottom panel). In fact, this budget does not even include the increase in cash handouts. Particularly, the leading candidate to win this year’s elections, former President Lula, will ease fiscal policy more than the current President Bolsonaro. In fact, Lula has stated that Congress should remove the fiscal cap and allow the government more discretion to increase spending. Lula’s key economic policies all entail higher fiscal spending and sizable deficits, which include maintaining and increasing cash handouts, a large infrastructure package, and higher spending on health. Provided Lula wins the presidency again (more on this below), odds are that fiscal policy will be very expansionary, and fiscal deficits will widen. The upshot will be rising worries about public debt sustainability. Bottom Line: Public debt sustainability concerns will resurface in the coming months as cyclical tailwinds (high nominal GDP growth) dissipate and a fiscally expansive government is elected. While Lula’s alliance with moderate politicians could see some pragmatic economic policies, his government’s fiscal policy will be expansionary. Overall, Lula’s policies in the years to come will warrant a long stocks / short currency strategy for Brazil as we argued in the report early this year. The Central Bank Cannot Afford To Go Dovish The BCB will remain hawkish and will continue hiking interest rates. While headline inflation has been ameliorating in the past months, central bank governor Roberto Campos Neto has admitted that most of the disinflation has been due to government policies (tax cuts on gas and diesel) and falling oil prices. Core inflation remains well above the central bank’s target range and has not yet rolled over decisively. Chart 5Brazil: Lending Rates Need To Rise Further Brazil: Lending Rates Need To Rise Further Brazil: Lending Rates Need To Rise Further Cyclically, booming credit growth, rising wages and fiscal stimulus all warrant monetary policy tightening. Private sector credit growth at above 20% entails that lending rates are not restrictive enough (Chart 5). Structurally, the return of President Lula only reinforces Brazil’s penchant for easy fiscal policy. The effect of Lula’s policies would be large fiscal deficits and structurally higher inflation. Both necessitate the BCB to respond with higher interest rates. Furthermore, given that Lula’s Worker’s Party disapproves of autonomy for the central bank, the BCB has a political incentive to over-tighten this year and reduce inflation early next year in order to not be caught up in a confrontation with Lula’s government over the trade-off between growth and inflation. We elaborated on the potential relationship between the BCB and the new government in our February 8 report. Finally, we believe the Fed will maintain its hawkish stance and continue raising interest rates. Consequently, the USD will continue overshooting, and Brazil’s exchange rate will weaken. This will lead the BCB to continue hiking interest rates.  All in all, we expect the BCB to continue tightening policy. The market is not pricing in any rate hikes in this cycle, but we believe the BCB will raise rates within the next three months. The central bank will maintain a hawkish stance until genuine inflationary pressures abate. The latter will require a material slowdown in economic activity. The Economic Rebound Is Both Fragile And Temporary Brazilian markets have rallied in the past two months on the back of improving economic data. However, when we look under the hood, the economic recovery is unsustainable. In fact, the nation’s business cycle is set to disappoint. Chart 6Brazil: The Economic Rebound Will Not Last Brazil: The Economic Rebound Will Not Last Brazil: The Economic Rebound Will Not Last First, the main culprit behind the recent economic recovery has been fiscal stimulus. The government and Congress enacted two measures to support demand and lower inflation in the form of cash handouts and tax cuts on utilities, each worth 0.5% and 1.2% of GDP respectively. As a result, the business cycle has defied the downbeat signal from our historically-reliable marginal propensity to spend indicator (Chart 6). Second, on the credit side, bank loans have been surging, further supporting the economy (Chart 7). Nevertheless, when looking closely at the data, a worrisome picture emerges: the credit binge has been driven by distressed households who often borrowed to pay their bills. This current scenario of a household-driven credit binge amid rising borrowing costs is not sustainable. Rising interest rates will choke off credit growth and the economy will slow: Consumers are relying heavily on credit to make ends meet. Chart 8 shows that household debt servicing is very high at 27.6% of disposable income (for comparison this ratio for US households is 9.5%), credit card usage is through the roof, and almost a third of all families have overdue bills.  Chart 7Brazil's Credit Binge Is Unsustainable Brazil's Credit Binge Is Unsustainable Brazil's Credit Binge Is Unsustainable Chart 8Household Finances Are Very Distressed Household Finances Are Very Distressed Household Finances Are Very Distressed Non-performing consumer loans are rising quickly (Chart 9). For non-financial corporations, the level of overdue loans is more subdued, but the increase is non-trivial.   As consumers and businesses start struggling to service their debt, banks will be forced to increase provisions and restrict credit (Chart 10). This will reverberate throughout the economy. Chart 9Brazil: Non-Performing Loans Are Rising Brazil: Non-Performing Loans Are Rising Brazil: Non-Performing Loans Are Rising Chart 10As Banks' Profitability Suffers, So Will Their Stock Prices As Banks' Profitability Suffers, So Will Their Stock Prices As Banks' Profitability Suffers, So Will Their Stock Prices   Finally, lower commodity prices will dampen income growth in this economy and will weigh on domestic demand. All in all, the Brazilian economy is set for a period of stagflation, i.e., weakening growth amid high core inflation. The eventual drawdown in bank credit and distressed household finances will dampen economic activity despite easy fiscal policy. Finally, the BCB will continue hiking rates amid the initial phase of the growth slowdown. The basis is that core inflation will remain very elevated and above the central bank’s upper range of 5%. Bottom Line: The current economic recovery will prove to be fleeting. Continued monetary tightening and fragile household finances will overwhelm the temporary fiscal relief, causing a growth deceleration. Elections Outlook: Lula Wins, No Military Coup Heightened political volatility around the October election poses near-term risks to Brazilian financial markets. We expect Lula to beat Bolsonaro in the elections. Bolsonaro has presided over a tumultuous four years of pandemic, inflation, and scandals, producing anti-incumbent sentiment among the electorate. His net approval rating is under water at -5.7%.  Opinion polls suggest that only 34% of Brazilians intend to vote for Bolsonaro – down from 40% in 2020. Bolsonaro never exceeded his peak of 45% approval after his election in 2018 and his approval rating has proven historically weak relative to other Brazilian presidents (Chart 11). Chart 11Bolsonaro Less Popular Than Previous Presidents Brazil 2022: Looking Under The Hood Brazil 2022: Looking Under The Hood By contrast about 44% of voters intend to vote for former President Lula. Lula’s polling has remained above 40% since early 2021 and he has maintained a nine-percentage point lead over Bolsonaro throughout 2022 (Chart 12). ​​​​​​​Chart 12Lula Maintains Large Gap Above Bolsonaro Despite Facing Competition On Left Wing Brazil 2022: Looking Under The Hood Brazil 2022: Looking Under The Hood The third-ranked candidate, Ciro Gomes, commands about 8% of voting intentions, is ideologically to the left, and thus mostly takes votes from Lula rather than Bolsonaro. Grouping voting intentions according to ideological blocs shows that the median voter leans to the left (Chart 13). If Lula does not achieve over 50% in the first round of the election, then the left-wing will consolidate around him in the second round of the election on October 30.   ​​​​​​​Chart 13Ideological Voting Blocs Suggest Median Voter Leans To The Left Brazil 2022: Looking Under The Hood Brazil 2022: Looking Under The Hood Chart 14Bolsonaro And His Liberal Party Have Not Benefited From Recovery From Pandemic Brazil 2022: Looking Under The Hood Brazil 2022: Looking Under The Hood The recovery from the Covid-19 pandemic has not helped Bolsonaro. His approval rating has been flat over the course of the crisis and its aftermath – his personal job approval has fallen 1% since January 1, 2020, while voting intentions for him and his Liberal Party have only gained 1% since then (Chart 14). Thus Bolsonaro’s support is stable but at a low level.​​​​​​​ Consumer confidence has fallen from 95, just after Bolsonaro won the election with 55% of the vote in 2018, down to 82.9 today. The “Misery Index” (unemployment plus inflation) has risen from 15.7% to 19.2% over the same period. Real wage growth has fallen from 0.7% to -2.3% today (Table 1). ​​​​​​​Table 1The Pocketbook Voter Is Not Better Off After Four Years Of Bolsonaro Brazil 2022: Looking Under The Hood Brazil 2022: Looking Under The Hood It is probable that Bolsonaro will contest or deny the results if he loses the election and mobilize his ardent supporters to protest throughout the country. This will not be enough to change the outcome of the election but it could cause a shock to business and investor confidence. This is especially true if the vote margin is extremely close and the outcome is genuinely controversial, though that is not our expectation. Note that while the US stock market rallied through America’s contested election in 2020 and subsequent rebellion, investors may not have as much confidence in Brazilian institutions.  Nevertheless the military is unlikely to overthrow the democratic results: Bolsonaro’s personal weakness: Bolsonaro has not achieved anything like exclusive personal control over the Brazilian Armed Forces or other major institutions. His lack of popularity, plus broad popular support for the post-1985 democratic system, makes it very unlikely that the military would risk its credibility for his sake. Brazil’s economic difficulties: Brazil’s structural economic weaknesses would make a military dictatorship economically unsustainable and as such the military is discouraged from seizing power. Better to retain its credibility and pin the economic woes on civilian leaders. International opposition: The military would lack foreign support for a coup d'état, particularly from the United States, where the Democratic Party supported the coup against Brazilian President João Goulart in 1964 in the context of the Cold War and ideological struggle against communism. Today the US wants to discourage Latin American governments from reaching out to authoritarian governments like Russia or China, whereas a coup would necessitate such outreach. Chart 15Lula Does Not Pose Existential Threat To Military Brazil 2022: Looking Under The Hood Brazil 2022: Looking Under The Hood Military sufficiency: The Brazilian Armed Forces have not been sidelined or aggrieved and do not stand to be disenfranchised under any Lula administration. While an extreme faction could attempt some surprise moves, the military as an institution is not at any kind of breaking point with regard to the political system (Chart 15).​​​​​​​ Investment Recommendations As to investment strategy, we have the following recommendations: Equities: BCA’s Emerging Markets Strategy (EMS) team continues to recommend a neutral allocation to Brazil within an EM equity portfolio. On the one hand, rising domestic interest rates and an ensuing domestic demand slowdown as well as the commodity relapse do not bode well for this bourse. On the other hand, Brazil’s equity valuations are attractive in both absolute and relative terms (Charts 16 and 17). Chart 16Brazilian Equities Are Cheap In Absolute Terms… Brazilian Equities Are Cheap In Absolute Terms... Brazilian Equities Are Cheap In Absolute Terms... Chart 17…But Command Neutral Valuations Compared To EM ... But Command Neutral Valuations Compared To EM ... But Command Neutral Valuations Compared To EM ​​​​​ Chart 18The BRL Is Not Cheap The BRL Is Not Cheap The BRL Is Not Cheap We will be more comfortable upgrading this bourse to overweight once financial markets fully price in fiscal risks related to Lula’s presidency as well as higher interest rates and a potential growth slowdown.  Currency: The real is now overextended and is modestly expensive according to its Real Effective Exchange Rate (Chart 18). Its failure to break above its 200-day moving average is a bearish signal. Critically, dropping commodity prices spell trouble for the BRL.   All in all, BCA’s EMS team continues to recommend that investors short the BRL versus the MXN, a position instituted on July 28 of this year. Local bonds and sovereign credit: For the reasons elaborated in this report, and given that we expect US bond yields to rise in the near term, the EMS team is closing the long Brazilian 10-year local bonds trade, which has yielded a 4.4% return since February 8th of this year.  The return of fiscal sustainability concerns, a potentially weaker BRL, and odds of political volatility lead us to maintain a neutral allocation to Brazil in EM domestic bond and sovereign credit portfolios. Juan Egaña Associate Editor juane@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Footnotes       1 Márcia De Chiara, “Indexação na economia transforma inflação de dois dígitos em 'bola de neve',” Terra, June 5, 2022, www.terra.com.br  Gabriela Cabral, “Inflação e indexação,” Brasil Escola, www.brasilescola.uol.com.br ​​​​​​​

Executive Summary Our negative view on the summer rally is coming to fruition, with equities falling back on the negative geopolitical, macro, and monetary environment. China is easing policy ahead of its full return to autocratic government this fall. Yet the Fourth Taiwan Strait Crisis has only just begun. Tensions can still deal nasty surprises to global investors. It is essential to verify that relations will thaw after the US midterm and Chinese party congress is critical. Russia continues to tighten energy supply as predicted. Ukraine’s counter-offensive is pushing back the time frame of a ceasefire deeper into next year. Putin may declare victory and quit while he is ahead – but Russia will not be forced to halt its invasion until commodity prices fall significantly. Sweden’s election will not interfere with its NATO bid; Australia’s new government will not re-engage with China; Malaysia’s election will be a positive catalyst; South Africa’s political risks are reawakening; Brazil’s risks are peaking; Turkey remains a leading candidate for a negative “black swan” event. China’s Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk Asset Initiation Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 17.4% Bottom Line: Investors should stay defensive in the short run until recession risks and geopolitical tensions abate. Feature Last week we visited clients across South Africa and discussed a broad range of global macro and geopolitical issues. In this month’s GeoRisk Update we relate some of the key points in the context of our market-based quantitative risk indicators. While we were traveling, US-Iran negotiations reached a critical phase. A deal is said to be “closer” but we remain pessimistic (we still give 40/60 odds of a deal). The important point for investors is that the supply side of global oil markets will remain tight even if a deal is somehow agreed, whereas it will get much tighter if a deal is not agreed. China’s rollout of 1 trillion yuan ($146 billion) in new fiscal stimulus and rate cuts (5 bps cut to 1-year Loan Prime Rate and 15 bps cut to 5-year LPR) is positive on the demand side and supports our key view in our 2022 annual outlook that China would ease policy ahead of the twentieth national party congress. However, it is still the case that China is not providing enough stimulus to generate a new cyclical rally. Second quarter US GDP growth was revised slightly upwards but was still negative. Russia tightened control of European energy, as expected, increasing the odds of a European recession. Europeans are getting squeezed by rising energy prices, rising interest rates, and weak external demand. China Eases Policy Ahead Of Return To Autocracy China is facing acute political risk in the short term but it is also delivering more stimulus to try to stabilize the economy ahead of the twentieth national party congress this fall (Chart 1). The People’s Bank of China cut the benchmark lending rate by (1-year LPR) by 5 basis points, while authorities unveiled fiscal spending worth 1 trillion renminbi. Chart 1China's Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk After the party congress, the regime is likely to “let 100 flowers bloom,” i.e. continue with a broad-based policy easing to secure the recovery from the Covid-19 shock. This will include loosening social restrictions and aggressive regulations against industrial sectors like the tech sector. It should also include some diplomatic improvements, especially with Europe. But it is only a short term (12-month) trend, not a long-term theme. Related Report  Geopolitical StrategyRoulette With A Five-Shooter China’s return to autocratic government under General Secretary Xi Jinping is a new, negative, structural factor and is nearly complete. Xi is highly likely to secure another decade in power and promote his faction of Communist Party stalwarts and national security hawks. The period around the party congress will be uncertain and dangerous. The exact makeup of the next Politburo could bring some surprises but there is very little chance that Xi and his faction will fail to consolidate power. The nomination of an heir-apparent is possible but of limited significance since Xi will not step down anytime soon or in a regular, predictable manner. Larger stimulus combined with power consolidation could spur greater risk appetite around the world, as it would portend a stabilization of growth and policy continuity. However, China’s underlying problems are structural. The manufacturing and property bust can be delayed but not reversed. China’s foreign policy will continue to get more aggressive due to domestic vulnerability, prompting foreign protectionism, export controls, sanctions, saber-rattling, and the potential for military conflict. Bottom Line: Investors should use any rally in Chinese assets over the coming 12 months as an opportunity to sell and reduce exposure to China’s historic confluence of political and geopolitical risk. Fourth Taiwan Strait Crisis Only Beginning The Fourth Taiwan Strait Crisis has only just begun. The previous three crises ranged from four to nine months in duration. The current crisis cannot possibly abate until November at earliest. Taiwan’s political risk will stay high and we would not buy any relief rally until there is a firm basis for believing tensions have fallen (Chart 2). Chart 2Taiwan: The Fourth Taiwan Strait Crisis Taiwan: The Fourth Taiwan Strait Crisis Taiwan: The Fourth Taiwan Strait Crisis If this year’s crisis were driven by US and Chinese domestic politics – the US midterm election and China’s party congress – then both Presidents Biden and Xi Jinping would already have achieved what they want and could proceed to de-escalate tensions by the end of the year – i.e. before somebody really gets hurt. The two leaders could hold a bilateral summit in Asia in November and agree to uphold the one China policy and status quo in the Taiwan Strait. We have given a 40% chance to this scenario, though we would still remain pessimistic about the long-term outlook for Taiwan. But if this year’s crisis is driven by a change in US and Chinese strategic thinking as a result of Russia’s invasion of Ukraine and China’s rising domestic instability, then there will not be a quick resolution on Taiwan. The crisis would grow next year, increasing the risk of aggression or miscalculation. We have given a 60% probability to this scenario, of which full-scale war comprises 20 percentage points. Bottom Line: Our geopolitical risk indicator for Taiwan spiked and Taiwanese equities rolled over relative to global equities as we expected. However, our oldest trade to capture the high long-term risk of a war in the strait – long Korea / short Taiwan – has performed badly despite the crisis. South Korea: China Stimulus A Boon But Not Geopolitics US-China rivalry – and the thawing of Asia’s once-frozen conflicts – is also manifest on the Korean peninsula, where the limited détente between the US and North Korea negotiated by President Donald Trump and Kim Jong Un has fallen apart. South Korea’s situation is not as risky as Taiwan’s but it is nevertheless less stable than it appears (Chart 3). Chart 3South Korea: Lower Geopolitical Risk Than Taiwan South Korea: Lower Geopolitical Risk Than Taiwan South Korea: Lower Geopolitical Risk Than Taiwan South Korea resumed its full-scale joint military exercise with the US, the Ulchi Freedom Shield, from August 22 to September 1. The drills involve amphibious operations and a carrier strike group. Full-scale drills were scaled down or cancelled under the Trump and Moon Jae-In administrations with the hopes of facilitating diplomacy and reducing tensions on the peninsula. North Korea was to discontinue ballistic missile tests and threats to the United States. But after the 2020 election neither Washington nor Pyongyang considered itself bound by this agreement. This year the US went forward with Ulchi Freedom even though regional tensions were sky-high because of House Speaker Nancy Pelosi’s visit to Taiwan and the De-Militarized Zone in Korea. The US is flagging its regional interests and power bases. North Korea is increasing the frequency of missile tests this year and is likely to conduct an eighth nuclear test. On August 17, it fired two cruise missiles towards the Yellow Sea. Pyongyang does not want to be ignored amid so many other geopolitical crises. It is emboldened by the fact that Russia and China will not be voting with the US for another round of sanctions at the United Nations Security Council due to the war in Ukraine and tensions over Taiwan. On August 11, South Korea responded to China’s insistence that the new government should abide by the “Three No’s,” i.e. three negatives that the Moon administration allegedly promised China: no additional deployments of the US’s Terminal High-Altitude Area Defense (THAAD) system, no Korean integration into US-led missile defense, and no trilateral military alliance with the US and Japan. Korea’s Foreign Minister Park Jin told reporters upon his return from China that the three no’s were “neither an agreement nor a promise.” South Korea’s new and conservative President Yoon Suk-yeol is unpopular and gridlocked at home but he is using the opportunity to reassert Korean national interests, including the US military alliance. Tension with the North and cold relations with China are coming at a time when the economy is slowing down. Korean GDP grew by 0.7% in Q2 2022 on a quarter-on-quarter basis, supported by household and government spending, while exports and investments shrank. Roughly a quarter of Korean exports go to China, its biggest trading partner. Korean exports to China have suffered due to China’s economic woes but cold relations could bring new economic sanctions, as China has hit South Korea before over THAAD. With the Yoon administration planning to bring the fiscal deficit back to below 3% of GDP next year, and a broader backdrop of weak Chinese and global demand, it is hard to find bright corners in the Korean economy in the near term. With Yoon’s basement level approval rating, he will resort to foreign policy to try to revive his political capital. Saber rattling and tough talk with North Korea and China will increase tensions in an already hot region – geopolitical risk is bound to stay high on the back of the Taiwan crisis. Bottom Line: On a relative basis, due to the ironclad US security guarantee, South Korea is safer than Taiwan. Investors wanting exposure to Chinese economic stimulus, electric vehicles, and semiconductors should go long South Korea. But some volatility is likely because the North’s eighth nuclear test will occur in the context of high and rising regional tensions. Australia: Stimulus Is Positive But No “Thaw” With China Australia is blessed with strong geopolitical fundamentals but it is seeing a drop in national security and economic security due to the deterioration of China relations. Domestic political turmoil is one of the consequences (Chart 4). Most recently Australia has been roiled by the revelation that former Prime Minister Scott Morrison secretly ran five ministries during the pandemic: the ministries of Home, Treasury, Finance, Resources, and Health. Chart 4Australian Geopolitical Risk Limited Australian Geopolitical Risk Limited Australian Geopolitical Risk Limited After an investigation and review by the Solicitor General Stephen Donaghue, Morrison’s action was determined to be legal, although highly inappropriate and inconsistent with the principles of responsible governance. Morrison’s appointments to these ministries were approved by the Governor General but the announcement or publication of appointments has always been the prerogative of the government of the day. One might think that this investigation is merely politically motivated but the Solicitor General is an apolitical position unlike the Attorney General, and Donaghue had been serving with Morrison, guiding him about the constitutionality of a vaccine mandate during the pandemic. The new Labor Party government of Prime Minister Anthony Albanese has vowed to be more transparent and will seek to enshrine a transparency measure into the law. Its political capital will improve, which is helpful for its ability to achieve its chief election promises. With the change of the government, it was hoped that there would be a thaw in the Australia-China relationship. China is Australia’s largest export destination and it erected boycotts against certain Australian exports in 2020 in response to Prime Minister Morrison’s inquiry into the origin of Covid-19. Hence Australia’s new defense minister, Richard Marles, met with his Chinese counterpart, General Wei Fenghe, on the sideline of the Shangri-La Dialogue in Singapore in June, which rekindled the hope that a thaw might happen. Yet a thaw is unlikely for strategic reasons, as highlighted by the Fourth Taiwan Strait Crisis, the Biden administration’s retention of former President Trump’s tariffs, and Australia’s fears of China’s rising influence in the Pacific Islands. The US and Australia are preparing for a long-term policy of containing China’s ambitions. A few days after his election, Prime Minister Albanese flew to Tokyo to attend a meeting of the Quadrilateral Security Dialogue (the Quad), sending a signal that there will be policy continuity with respect to Australian foreign policy. On May 26, Chinese fighter jets flew closely to an Australian surveillance plane on its routine operation and released aluminum chaffs that were ingested by the P8’s engines. An Australian warship, the HMAS Parramatta, was tracked by a People’s Liberation Army nuclear power submarine and multiple aircrafts on its way back from Vietnam, Korea, and Japan as part of its regional presence deployment in June. Currently Australia is hosting the Pitch-Black military exercise, with 17 countries participating. This exercise will last for three weeks – focusing on air defense and aerial refueling. It will also see the German air force with 13 military aircrafts deployed to the Indo-Pacific region for the very first time. They will be stopping in Japan after the exercise. As Australia’s policy towards China is unlikely to change, geopolitical risk will remain elevated. On the economic front, Australia’s misery index is at the highest point since 2000, with an unemployment rate at 3% and inflation at 6%. GDP growth in the first quarter was 0.8% compared to 3.6% in Q4 2021, propped up by government and household consumption while investment and exports contracted. The good news for the government is that it is inheriting this negative backdrop and can benefit from cyclical improvements in the next few years. Since the Labor government lacks a single-party majority in the Senate (where it must rely on the Greens and independents), it will be difficult for the government to raise new taxes. So far, Albanese has indicated that the budget to be tabled in October will focus on pre-election promises, which includes childcare, healthcare, and energy reforms. At worst, Australian government spending will stay flat, but it is unlikely to shrink considering Labor’s narrow control of the House of Representatives. Australian equities have not outperformed those of developed market peers despite high industrial metal prices. The stock market’s weak performance is attributable to the stumbling Chinese economy (Chart 5). Australian exports to China in June are still down 14% from June of last year. Chinese economic woes will be a headwind to Aussie growth and equity markets until next year, when Chinese stimulus efforts reach their full effect. Chart 5Australian Equities Have Yet to Benefit from Industrial Metal Prices Australian Equities Have Yet to Benefit from Industrial Metal Prices Australian Equities Have Yet to Benefit from Industrial Metal Prices On the other hand, the value of Australian natural gas and oil exports in June grew by 118% and 211% respectively (Chart 6), compared to June of last year. Chart 6Geopolitics: A Boon and Bane to Aussie Growth Geopolitics: A Boon and Bane to Aussie Growth Geopolitics: A Boon and Bane to Aussie Growth ​​​​​ Bottom Line: As China will continue stimulating the economy and global energy markets will remain tight, investors should look for opportunities in Aussie energy and materials stocks. Malaysia Closes A Chapter … And Opens A Better One? Rarely do we get to revisit our positive outlook on Malaysia – a Southeast Asian state with an ability to capitalize on the US break-up with China. On August 23, the embattled ex-prime minister of Malaysia, Najib Razak, lost his final appeal at the Federal Court in Putrajaya after being found guilty in 2020 for abuse of power, criminal breach of trust, and money laundering tied to Malaysia’s sovereign wealth fund, 1MDB. The high court instructed that he serves his 12-years prison sentence immediately, becoming the first prime minister to be imprisoned in the country’s 60-years plus of history. Political risk has weighed on the Malaysian economy for almost a decade starting with the contentious 2013 general election, which saw the collapse of non-Malay voter support for the ruling party. Then came the 2015 Wall Street Journal bombshell about 1MDB, and then the 2018 general election that resulted in Malaysia’s first change of government since independence. The pandemic also led to political crisis in 2020. Each crisis resulted in a successive weakening of animal spirits and ever lower investments, resulting in Malaysia’s loss of competitiveness (Chart 7). Malaysia’s cheap currency was unable to increase its competitiveness, due to the low investments in the economy, and reflected higher political risks in the country (Chart 8). Chart 7Political Risk Undermines Competitiveness Political Risk Undermines Competitiveness Political Risk Undermines Competitiveness ​​​​​​ Chart 8Cheap Currency Reflects Political Risk Cheap Currency Reflects Political Risk Cheap Currency Reflects Political Risk ​​​​​​ Nonetheless this entire saga has proved that Malaysia’s legal system is independent and that its political system is capable of holding policymakers accountable. The next general election will come in a matter of months and recent state elections bodes well for the institutional ruling party, the United Malay National Organization (UMNO), and its coalition, Barisan Nasional. The coalition is managing to claw back support from the Malay and non-Malay voters. The opposition had the bad luck of ruling during the pandemic and its rocky aftermath, which has helped to rehabilitate the traditional ruling party. We have long seen Malaysia as a potential opportunity. But we would advise investors to wait until the new election is held and a new government takes power before buying Malaysian equities. With the conclusion of its decade-long 1MDB saga, we would turn more bullish if the next election produces a sizeable and enduring majority, if the use of racial and sectarian rhetoric tones down, and if the governing coalition pursues pro-competitiveness policies. Bottom Line: Structurally, Malaysia is one of the largest exporters of semiconductors and will benefit from the US’s shift away from China and attempt to reconstruct supply chains so they run through the economies of allies and partners. Russia: Escalating To De-Escalate? Russia increased the number of active military personnel in a move that points to an escalation of the conflict with Ukraine and the West, even as Ukraine wages a counter-offensive against Russia in Crimea and elsewhere. The time frame for a ceasefire has been pushed further into next year. As long as the war escalates, European energy relief will be elusive. Our risk indicators will rise again (Chart 9). Chart 9Russia: Geopolitical Risk To Rise Again, Ceasefire Pushed Back Into Next Year Russia: Geopolitical Risk To Rise Again, Ceasefire Pushed Back Into Next Year Russia: Geopolitical Risk To Rise Again, Ceasefire Pushed Back Into Next Year Ukraine will not be able to drive Russians out of territory in which they are entrenched. It would need a coalition of western powers willing to go on the offense, which will not happen. Russia is also threatening to cut off the Zaporizhzhia nuclear power plant, ostensibly removing one-fifth of Ukraine’s electricity. Once the Ukrainian counter-offensive grinds to a halt, a stalemate will ensue, incentivizing ceasefire talks – but not until then. The Europeans will have to support Ukraine now but will become less and less inclined to extend the war as they get hit with recession. Russia says it is prepared for a long war but that kind of rhetoric is necessary for propaganda purposes. The truth is that Russia does not have great success with offensive wars. Russia usually suffers social instability in the aftermath. The best indicator for the duration of the war is probably the global oil price: If it collapses for any reason then Russia’s war machine will fall short of funds and the Kremlin will probably have to accept a ceasefire. This what happened in 2014-15 with the Minsk Protocols. Putin will presumably try to quit while he is ahead, i.e. complete the conquest and shift to ceasefire talks, while commodity prices are still supportive and Europe is economically weak. If commodity prices fall, Russia’s treasury dries up while Europe regains strength. So while military setbacks can delay a ceasefire, Russia should be seen as starting to move in that direction. The deal negotiated with Turkey and the United Nations to ship some grain from Odessa is not reliable in the short run but does show the potential for future negotiations. However, a high conviction on the timing is not warranted. Also, the US and Russia could enter a standoff over the US role in the war, or NATO enlargement, at any moment, especially ahead of the US midterm election. Bottom Line: Ukraine’s counteroffensive and Russia’s tightening of natural gas exports increases the risk to global stability and economic growth in the short run, even if it is a case of “escalating tensions in order to de-escalate” later when ceasefire talks begin. Italy: Election Means Pragmatism Toward Russia Italy’s election is the first large crack in the European wall as a result of Russia’s cutoff of energy. The party best positioned for the election – the right-wing, anti-establishment party called the Brothers of Italy – will have to focus on rebooting Italy’s economy once in power. This will require pragmatism toward Russian and its natural gas. Regardless of whether a right-wing coalition obtains a majority or the parliament is hung, Italian political risk will stay high in the short run (Chart 10). Chart 10Italy: Election Brings Uncertainty, Then Economic Stimulus Italy: Election Brings Uncertainty, Then Economic Stimulus Italy: Election Brings Uncertainty, Then Economic Stimulus Although the center-left Democratic Party (PD) is narrowing the gap with the Brothers of Italy in voting intentions, it is struggling to put together an effective front against the right-wing bloc. After its alliance with the centrist Azione party and +Europa party broke down, PD’s chance of winning has become even slimmer. Even if the alliance revives, the center-left bloc still falls short of the conservative parties. Together, the right-wing parties account for just 33% of voting intentions (Democrats at 23%, Greens and Left Alliance at 3%, Azione and +Europa at 7%). By contrast, the right-wing bloc has a significant lead, with 46% of the votes (Brothers of Italy at 24%, Lega at 14%, Forza Italia at 8%). They also have the advantage of anti-incumbency sentiment amid a negative economic backdrop. Unless some sudden surprises occur, a right-wing victory is expected, with Giorgia Meloni becoming the first female prime minister in Italy’s history. This has been our base case scenario for the past several months. But what does a right-wing government mean for the financial markets? In an early election manifesto published in recent weeks, the conservative alliance pledged full adhesion to EU solidarity and dropped their previous euroskepticism. This helps them get elected and is positive for investors. However, there are also clouds on the horizon: In the same manifesto, the right-wing parties pledged to lower taxes for families and firms, increase welfare, and crack down on immigration. These programs will add to Italy’s huge debt pile and eventually lead to conflicts with the ECB and other EU institutions. In the manifesto, they stated that if elected, they would seek to amend conditions of Italy’s entitlement to the EU Recovery Fund, as the Russia-Ukraine war has changed the context and priorities significantly. This could potentially put the EU’s grants and cheap loans at risk. Under the Draghi government, Italy has secured about 67 billion euros of EU funds. According to the schedule, Italy will receive a further 19 billion Euros recovery funds in the second half of 2022, if it meets previously agreed upon targets. The new government will try to accept the funds and then make any controversial policy changes. On Russia, the conservative parties claimed that Italy would not be the weak link within EU. They pledged respect for NATO commitments, including increasing defense spending. Both Meloni and her Brothers of Italy have endorsed sending weapons to support Ukraine. Still, we think that due to Italy’s historical link with Russia and the need to secure energy supplies, the new government would be more pragmatic toward Russia. On China, Meloni has stressed that Italy will look to limit China’s economic expansion if the right-wing alliance wins. She stated that “Russia is louder at present and China is quieter, but [China’s] penetration is reaching everywhere.” China will want to use diplomacy to curb this kind of thinking in Europe. Meloni also stated that she would not seek to pursue the Belt and Road Initiative pact that Italy signed with China in 2019. In short, we stand firm on our recommendation of underweighting Italian assets at least until a new government is formed. Europe Gets Its Arm Twisted Further The United Kingdom is going through a severe energy, water, and inflation crisis – on top of the long backlog at the National Health Service – as it stumbles through the aftermath of Covid-19 and Brexit. The Conservative Party’s leadership contest is a distraction – political risk will not subside after it is resolved. The new Tory leader will lack a direct popular mandate but the party will want to avoid an early election in the current economic context, creating instability. The looming attempt at a second Scottish independence referendum will also keep risks high, as the outcome this time may be too close to call (Chart 11). Chart 11UK: Tory Leaders A Sideshow, Risks Will Stay High UK: Tory Leaders A Sideshow, Risks Will Stay High UK: Tory Leaders A Sideshow, Risks Will Stay High Germany saw Russia halt natural gas flows through Nord Stream 1 as the great energy cutoff continues. As we have argued since April, Russia’s purpose is to pressure the European economies so that they are more conducive to a ceasefire in Ukraine. Germany will evolve quickly and will improve its energy security faster than many skeptics expect but it cannot do it in a single year. The ruling coalition is also fragile, even though elections are not due anytime soon (Chart 12). Chart 12Germany: Geopolitical Risk Still Rising Germany: Geopolitical Risk Still Rising Germany: Geopolitical Risk Still Rising France’s political risk will also remain high (Chart 13), as domestic politics will be reckless while President Emmanuel Macron and his allies only control 43% of the National Assembly in the aftermath of this year’s election (Chart 14). Chart 13France: Lower Geopolitical Risk Than Germany France: Lower Geopolitical Risk Than Germany France: Lower Geopolitical Risk Than Germany Chart 14Macron Will Focus On Foreign Policy Odds And Ends (A GeoRisk Update) Odds And Ends (A GeoRisk Update) Spain is likely to see its coalition destabilized and early elections, much like Italy this year (Chart 15). Chart 15Spain: Early Elections Likely Spain: Early Elections Likely Spain: Early Elections Likely Sweden, along with Finland, will be joining NATO, which became clear back in April. In this sense it is at the center of Russia’s conflict with the West over NATO enlargement, so we should take a quick look at the Swedish general election on September 11. Currently the left-wing and right-wing blocs are neck and neck in the polls. While the current Social Democrat-led government may well fall from power, Sweden’s new pursuit of NATO membership is unlikely to change. The right-wing parties in Sweden are in favor of joining NATO. The two parties that oppose NATO membership are the left-wing Green and Left Party. The Social Democrats were pro-neutrality until the invasion of Ukraine and since May have spearheaded Swedish accession to NATO. The pro-neutrality bloc currently holds 43 seats in the 349-seats Riksdag. It has a supply-and-confidence arrangement with the current government and is currently polling at 13%. If it was willing and able to derail Sweden’s NATO bid, it would already have happened. So the general election in Sweden is unlikely to stop Sweden from joining. However, Russia does not want Sweden to join and the entire pre- and post-election period is ripe for “black swan” risks and negative surprises. One thing that could change with the election is Sweden’s immigration policy. The Social Democrats are pro-immigration (albeit pro-integration), while the right-wing bloc is less so. Sweden has received a great many asylum seekers since the Syrian refugee crisis in 2015 and will be receiving more from Ukraine and Russia (Chart 16). Chart 16Asylum Seekers to Surpass 2015 Refugee Crisis Asylum Seekers to Surpass 2015 Refugee Crisis Asylum Seekers to Surpass 2015 Refugee Crisis Our Foreign Exchange Strategist Chester Ntonifor points out that the increase in asylum seekers could augment Swedish labor force and increase its potential growth in the long run, while in the short run it could increase demand in the domestic economy. But an increase in demand could also exacerbate inflation in Sweden, especially considering how much the Riksbank is behind the curve vis-à-vis the ECB. Our European Investment Strategy recommends shorting EUR/SEK as Sweden is less vulnerable to Russian energy sanctions. Sweden produces most of its energy from renewable sources. Relative to Europe, Canada faces a much more benign political and geopolitical environment (Chart 17). However, within its own context, it will continue to see more contentious domestic politics as interest rates rise on a society with high household debt and property prices. The post-Covid-19 period will undermine the Justin Trudeau government over time, though it is not facing an election anytime soon. Canada continues to benefit from North America’s geopolitical advantage, though quarrels with China will continue, including over Taiwan, and should be taken seriously. Aside from any China shocks we expect Canadian equities to continue to outperform most global bourses. Chart 17Canada: Low Geopolitical Risk But Not Happy Canada: Low Geopolitical Risk But Not Happy Canada: Low Geopolitical Risk But Not Happy South Africa: The Calm Before The Storm South Africa’s economy remains in a low growth trap, which is contributing to rising political risk (Chart 18). Electricity shortages continue to dampen economic activity. Other structural issues like 33.9% unemployment, worsening social imbalances, and a split in the ruling party threaten to cause negative policy surprises. Chart 18South Africa: Institutional Ruling Party At Risk South Africa: Institutional Ruling Party At Risk South Africa: Institutional Ruling Party At Risk The South African economy has failed to translate growth outcomes into meaningful economic development, leaving low-income households (the median voter) increasingly disenfranchised, burdened, and constrained. Last year’s civil unrest was fueled by economic hardships that persist today. Without a significant and consistent bump to growth, social and political risks will continue to rise. Low-income households remain largely state dependent. Fiscal austerity has already begun to unwind, well before the 2024 election, in a bid to shore up support and quell rising social pressures (Chart 19). Chart 19South Africa: Fiscal Easing Ahead Of 2024 Vote South Africa: Fiscal Easing Ahead Of 2024 Vote South Africa: Fiscal Easing Ahead Of 2024 Vote The fact that the social scene is relatively quiet for now should not be seen as a sign of underlying stability. For example, two of the largest trade unions led a nationwide labor strike last week – while we visited clients in the country! – but failed to “shut down” the country as advertised. Labor union constituents noted the ANC’s economic failures, demanded immediate economic reform, and advocated for a universal basic income grant. This action blew over but the election cycle is only just beginning. Looking forward to the election, President Cyril Ramaphosa’s ANC is still viewed more favorably than the faction led by ex-President Jacob Zuma, but Ramaphosa has suffered from corruption allegations recently that have detracted attention from his anti-corruption and reform agenda and highlighted the party’s shortcomings once again. The ANC’s true political rival, the far-left Economic Freedom Fighters (EFF), have so far failed to capitalize on the weak economic backdrop. The EFF is struggling with leadership battles, thus failing to attract as many soured ANC voters as otherwise possible. If the Economic Freedom Fighters refocus and install new leadership, namely a leader that better reflects the tribal composition of the country, the party will become a greater threat to the ANC. But the overall macro backdrop is a powerful headwind for the ANC’s ability to retain a parliamentary majority. Global macro tailwinds that supported local assets in the first half of the year are experiencing volatility due to China’s sluggish growth and now stimulus efforts. Cooling metals prices and slowing global growth have weighed on the rand and local equity returns. But now China is enacting more stimulus. China is South Africa’s largest trading partner, so the decision to ease policy is positive for next year, even though China’s underlying structural impediments will return in subsequent years. This makes it hard to predict whether South Africa’s economic context will be stable in the lead-up to the 2024 election. As long as China can at least stabilize in the post-pandemic environment in 2023, the ANC will not face as negative of a macro environment in 2024 as would otherwise be the case. Investors will need to watch the risk of political influence on the central bank. Recently the ANC resolved to nationalize the central bank. Nationalization is mostly about official ownership but a change in the bank’s mandate was also discussed. However, to change the bank’s mandate from an inflation target to an unemployment target, the ANC would need to change the constitution. Constitutional change requires a two-thirds vote in parliament, a margin the ANC does not hold. Constitutional change will become increasingly difficult if the ANC sheds more support in the 2024 general election, as expected. Bottom Line: Stay neutral on South Africa until global and Chinese growth stabilize. Political risk is rising ahead of the 2024 election but it is not necessarily at a tipping point. Brazil And Turkey: Election Uncertainty Prevails We conclude with two brief points on Brazil and Turkey, which both face important elections – Brazil immediately and Turkey by June 2023. Both countries have experienced different forms of instability as emerging middle classes face economic disappointment, which has led to political challenges to liberal democracy. Brazil – President Jair Bolsonaro’s popular support is rallying into the election, as expected, but it would require a large unexpected shift to knock former President Lula da Silva off course for re-election this October (Chart 20). Brazil’s first round vote will be held on October 2. If Lula falls short of the 50% majority threshold, then a second round will be held on October 30. Bolsonaro faces an uphill battle because his general popularity is weak – his support among prospective voters stands at 35% compared to Lula at 44% today and Lula at 47% when he left office in 2010. Meanwhile the macroeconomic backdrop has worsened over the course of his four-year term. Bolsonaro will contest the election if it is close so Brazil could face significant upheaval in the short run. Chart 20Brazil: Risk Will Peak Around The Election Brazil: Risk Will Peak Around The Election Brazil: Risk Will Peak Around The Election Turkey – President Recep Erdogan’s approval rating has fallen to 41%, while his disapproval has risen to 54%. It is a wonder his ratings did not collapse sooner given that the misery index is reaching 88%, with headline inflation at 78%. Having altered the constitution to take on greater presidential powers, Erdogan will do whatever it takes to stay in power, but the tide of public opinion is shifting and his Justice and Development Party is suffering from 21 years in power. Erdogan could interfere with NATO enlargement, the EU, Syria and refugees, Greece and Cyprus, North Africa and Libya, or Israel in a way that causes negative surprises for Turkish or even global investors. Turkey will be a source of “black swan” risks at least until after the general election slated for June 2023 (Chart 21). Chart 21Turkey: A Source Of 'Black Swans' Turkey: A Source Of 'Black Swans' Turkey: A Source Of 'Black Swans' We will revisit each these markets in greater detail soon. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com ​​​​​​​Yushu Ma Research Analyst yushu.ma@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Geopolitical Calendar

Executive Summary China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator A new equilibrium between NATO, which now includes Sweden and Finland, and Russia needs to be reestablished before geopolitical risks in Europe subside. Russia aims to inflict a recession on the EU which will revive dormant geopolitical risks embedded in each country. Investors should ignore the apparent drop in China’s geopolitical risk as it could rise further until Xi Jinping consolidates power at the Party Congress this fall. Stay on the sideline on Brazilian, South African, Australian, and Canadian equities despite the commodity bull market, at least until China’s growth stabilizes. Korean risk will rise, albeit by less than Taiwanese risk. The US political cycle ensures that Biden may take further actions against adversaries in Europe, Middle East, and East Asia, putting a floor under global geopolitical risk. Tactical Recommendation Inception Date Return LONG GLOBAL AEROSPACE & DEFENSE / BROAD MARKET EQUITIES 2020-11-27 9.3% Bottom Line: Geopolitical risk will rise in the near term. Stay long gold and global defensive stocks. Feature This month we update our GeoRisk Indicators and make observations about the status of political risk for each territory, and where risks are underrated or overrated by global financial markets. Russia GeoRisk Indicator Our “Original” quantitative measure of Russian political risk – the Russian “geopolitical risk premium” shown in the dotted red line below – has fallen to new lows (Chart 1). One must keep in mind that this geopolitical premium is operating under the assumption of a “free market” but the Russian market in the past few months had been anything but free. The Russian government and central bank had been manipulating the ruble and preventing capital outflows. Hence, Russian assets and any indicator derived from it does not reflect its true risk premium, merely the resolve of its government in the geopolitical struggle. Chart 1Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator While the Russia Risk Premium accurately detected the build-up in tensions before the invasion of Ukraine this year, today it gives the misleading impression that Russian geopolitical risk is low. In reality the risk level remains high due to the lack of strategic stability between Russia and the West, particularly the United States, and particularly over the question of NATO enlargement. Our “Old” Russia GeoRisk Indicator remains elevated but has slightly fallen back. This measure failed to detect the rise in risk ahead of this year’s invasion of Ukraine. We predicted the war based on non-market variables, including qualitative analysis. As a result of the failure of our indicator, we devised a “New” Russia GeoRisk Indicator after this year’s invasion, shown as the green line below. This measure provides the most accurate reading. It is pushing the upper limits, which we truncated at 4, as it did during the invasion of Georgia in 2008 and initial invasion of Ukraine in 2014. Related Report  Geopolitical StrategyThird Quarter Geopolitical Outlook: Thunder And Lightning Has Russian geopolitical risk peaked for Europe and the rest of the world? Not until a new strategic equilibrium is established between the US and Russia. That will require a ceasefire in Ukraine and a US-Russia understanding about the role of Finland and Sweden within NATO. However, Hungary is signaling that the EU should impose no further sanctions on Russia. Russia’s cutoff of natural gas exports to Europe will create economic hardship that will start driving change in European governments or policies. A full ban on Russian natural gas may not be implemented in the coming years due to lack of EU unanimity. Still, the EU cannot lift sanctions on Russia because that would enable economic recovery and hence military rehabilitation, which could enable new aggression. Also, Russia will not relinquish the territories it has taken from Ukraine even if President Putin exits the scene. No Russian leader will have the political capital to do that given the sacrifices that Russia has made. Bottom Line: Russia’s management of the ruble is distorting some of our risk indicators. Russia remains un-investable for western investors. Substantial sanction relief will not come until late in the decade, if at all. UK GeoRisk Indicator British political risk is rising, and it may surpass the peaks of the Brexit referendum period in 2016 now that Scotland is pursuing another independence referendum (Chart 2). Chart 2United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator New elections are not due until January 25, 2025 and the ruling Conservative Party has every reason to avoid an election over the whole period so that inflation can come down and the economy can recover. But an early election is possible between now and 2025. Prime Minister Boris Johnson has become a liability to his party but he is still a more compelling leader than the alternatives. If Johnson is replaced, then the change of leadership will only temporarily boost the Tories’ public approval. It will ultimately compound the party’s difficulties by dividing the party without resolving the Scottish question.  Regardless, the Tories face stiff headwinds in the coming referendum debate and election, having been in power since 2010 and having suffered a series of major shocks (Brexit, the pandemic, inflation). Bottom Line: The US dollar is not yet peaking against pound sterling, As from a global geopolitical perspective it can go further. Investors should stay cautious about the pound in the short term. But they should prefer the pound to eastern European currencies exposed to Russian instability. Germany GeoRisk Indicator German political risk spiked around the time of the 2021 election and has since subsided, including over the course of the Ukraine war (Chart 3). However, risk will rise again now that Germany has declared that it is under “economic attack” from Russia, which is cutting natural gas in retaliation to Germany’s oil embargo. Chart 3Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator This spike in strategic tensions should not be underrated. Germany is entering a new paradigm in which Russian aggression has caused a break with the past policy of Ostpolitik, or economic engagement. Germany will have to devote huge new resources to energy security and national defense and will have to guard against Russia for the foreseeable future. Domestic political risk will also rise as the economy weakens and industrial activity is rationed. Germany does not face a general election until October 26, 2025. Early elections are rare but cannot be ruled out over the next few years. The ruling coalition does not have a solid foundation. It only has a 57% majority in the Bundestag and consists of an ideological mix of parties (a “traffic light” coalition of Social Democrats, Greens, and Free Democrats). Still, Germany’s confrontation with Russia will keep the coalition in power for now. Bottom Line: From a geopolitical point of view, there is not yet a basis for the dollar to peak and roll over against the euro. That is not likely until there is a ceasefire in Ukraine and/or a new NATO-Russia understanding. France GeoRisk Indicator French political risks are lingering at fairly high levels in the wake of the general election and will only partially normalize given the likelihood of European recession and continued tensions around Russia (Chart 4). Chart 4France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator President Emmanuel Macron was re-elected, as expected, but his Renaissance party (previously En Marche) lost its majority and Macron will struggle to win over 39 deputies to gain a majority of 289 seats in the Assembly. He will, however, be able to draw from an overall right-wing ideological majority – especially the Republicans – when it comes to legislative compromises. The election produced some surprises. The right-wing, anti-establishment National Rally of Marine Le Pen, which usually performs poorly in legislative elections, won 89 seats. The left-wing alliance (NUPES) underperformed opinion polls and has not formed a unified bloc within the Assembly. Still, the left will be a powerful force as it will command 151 seats (the sum of the left-wing anti-establishment leader Jean-Luc Mélenchon’s La France Insoumise party and the Communists, Socialists, and Greens). Macron’s key reform – raising the average retirement age from 62 to 65 – will require an ad hoc majority in the Assembly. The Republicans, with 74 seats, can provide the necessary votes. But some members have already refused to side with Macron on this issue. Macron will most likely get support from the populist National Rally on immigration, including measures to make it harder to be naturalized or obtain long-term residence permits, and measures making it easier to expel migrants whose asylum applications have been refused. France will remain hawkish on immigration, but Macron will be able to rein in the populists. On energy and the environment, Macron may be able to cooperate with the Left on climate measures, but ultimately any cooperation will be constrained by the fact that Mélenchon opposes nuclear power. The Republicans and the National Rally will support Macron’s bid to shore up France’s nuclear energy sector. Popular opinion will hold up for France’s energy security in the face of Russian weaponization of natural gas. Macron and Mélenchon will clash on domestic security. Police violence has emerged as a major source of controversy since the Yellow Vest protests. Macron and the Right will protect the police establishment while the Left will favor reforms, notably the concept of “proximity police,” which would entail police officers patrolling in a small area to create stronger, more personal links between the police and the population; officers being under the control of the mayor and prefect; and ultimately most officers not carrying lethal weapons, and the ban of physically dangerous arrest techniques. Grievances over the police as well as racial inequality will likely erupt into significant social unrest in the coming years. As a second-term president without a single-party majority, Macron will increasingly focus on foreign policy. He will aim to become the premier European leader on the world stage. He will seek to revive France’s historic role as a leading diplomatic power and arbiter of Europe. He will strengthen France’s position in the EU and NATO, keep selling arms to the Middle East, and maintain a French military presence in the Sahel. Macron will favor Ukraine’s membership in the EU but also a ceasefire with Russia. He will face a difficult decision on whether to join Israeli and American military action against Iran should the latter reach nuclear breakout capacity and pursue weaponization. Bottom Line: The outperformance of French equities is stretched relative to EMU counterparts. But France will not underperform until the EU’s natural gas crisis begins to subside and a new equilibrium is established with Russia. Italy GeoRisk Indicator Italy is perhaps the weakest link in Europe both economically and strategically (Chart 5). Elections are due by June 2023 but could come earlier as the ruling coalition is showing strains. A change of government would likely compromise the EU’s attempt to maintain a unified front against Russia over the war in Ukraine. Chart 5Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Before the war Italy received 40% of its natural gas from Russia and maintained pragmatic relations with the Putin administration. Now Russia is reducing flows to Italy by 50%, forcing the country into an energy crisis at a time when expected GDP growth had already been downgraded to 2.3% this year and 1.7% in 2023. Meanwhile Italian sovereign bond spreads over German bunds have risen by 64 basis points YTD as a result of the global inflation. The national unity coalition under Prime Minister Mario Draghi came together for two purposes. First, to distribute the EU’s pandemic recovery funds across the country, which amounted to 191.5 billion euros in grants and cheap loans for Italy, 27% of the EU’s total recovery fund and 12% of Italy’s GDP. Second, to elect an establishment politician in the Italian presidency to constrain future populist governments (i.e. re-electing President Sergio Mattarella). Now about 13% of the recovery funds have been distributed in 2021, the economy is slowing, Russia is cutting off energy, and elections are looming. The coalition is no longer stable. Coalition members will jockey for better positioning and pursue their separate interests. The anti-establishment Five Star Movement has already split, with leader Luigi di Maio walking out. Five Star’s popular support has fallen to 12%. The most popular party in the country is now the right-wing, anti-establishment Brothers of Italy, who receive 23% support in polling. Matteo Salvini, leader of the League, another right-wing populist party, has seen its public support fall to 15% and will be looking for opportunities. On the whole, far-right parties command 38% of popular voting intentions, while far-left parties command 17% and centrist parties command 39%. Italy’s elections will favor anti-incumbent parties, especially if the country falls into recession. These parties will be more pragmatic toward Russia and less inclined to expand the EU’s stringent sanctions regime. Implementing a ban on Russian natural gas by 2027 will become more difficult if Italy switches. Italy will be more inclined to push for a ceasefire. A substantial move toward ceasefire will improve investor sentiment, although, again, a durable new strategic equilibrium cannot be established until the US and Russia come to an understanding regarding Finland, Sweden, and NATO enlargement. Bottom Line: Investors should steer clear of Italian government debt and equities until after the next election. Spain GeoRisk Indicator Infighting and power struggles within the People’s Party (PP) have provided temporary relief for the ruling Socialist Worker’s Party (PSOE) and Spanish Prime Minister Pedro Sanchez. However, with Alberto Nunez Feijoo elected as the new leader of PP on April 2, the People’s Party quickly recovered from its setback. It not only retook the first place in the general election polling, but also scored a landslide victory in the Andalusia regional election. Andalusia is the most populous autonomous community in Spain, contributing 17% of the seats in the lower house. The Andalusian regional election was a test run for the parties before next year’s general election. Historically, Andalusia was PSOE’s biggest stronghold, but it was ousted by the center-right People’s Party-Citizens coalition in 2018. Since then, the People’s party has consolidated their presence and popularity in Andalusia. The snap election in June, weeks after Feijoo was elected as the new national party leader, expanded PP’s seats in the regional parliament. It now has an absolute majority in the regional parliament while the Socialists suffered its worst defeat. With the sweeping victory in Andalusia, the People’s Party is well positioned for next year’s general election. In addition, the ruling Socialist Worker’s Party continues to suffer from the stagflationary economic condition. In May, Spain recorded the second highest inflation figure in more than 30 years, slightly below its March number. Furthermore, the recent deadly Melilla incident which resulted in dozens of migrants’ death, also caused some minor setbacks within Sanchez’s ruling coalition. His far-left coalition partner joined the opposition parties in condemning Sanchez for being complacent toward the Moroccan police. The pressure is on the Socialists now, and political risk will rise in the coming months, till after the election (Chart 6). Chart 6Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Bottom Line: Domestic political risk will remain elevated in this polarized country, as elections are due by December 2023 and could come sooner. Populism may return if Europe suffers a recession. Russia aims to inflict a recession on the EU which is negative for cyclical markets like Spain, but Spain benefits from Europe’s turn to liquefied natural gas and has little to fear from Russia. Investors should favor Spanish stocks relative to Italian stocks. Turkey GeoRisk Indicator Turkey faces extreme political and economic instability between now and the general election due by June 2023 (Chart 7). Chart 7Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Almost any country would see the incumbent ruling party thrown from power under Turkey’s conditions. The ruling Justice and Development Party has been in charge since 2002, the country’s economy has suffered over that period, and today inflation is running at 73% while unemployment stands at 11%. However, President Recep Tayyip Erdoğan is doing everything he can with his recently expanded presidential powers to stay in office. He is making amends with the Gulf Arab states and seeking their economic support. He is also warming relations with Israel, as Turkey seeks to diversify away from Russian gas and Israel/Egypt are potential suppliers. He is doubling down on military distractions across the Middle East and North Africa. And he waged a high-stakes negotiation with the West over Finnish and Swedish accession to NATO. Russian aggression poses a threat to Turkish national interests. Turkey ultimately agreed to Finnish and Swedish membership after a show of Erdoğan strong hands in negotiating with the West over their membership, to show his domestic audience that he is one of the big boys ahead of the election. A risk to this view is that Erdoğan stages military operations against Greek-controlled Cyprus. This would initiate a crisis within NATO and put Finnish and Swedish accession on hold for a longer period. Bottom Line: Investors should not attempt to bottom-feed Turkish lira or stocks and should sell any rallies ahead of the election. A decisive election that removes Erdoğan from power is the best case for Turkish assets, while a decisive Erdoğan victory is second best. Worse scenarios include indecisive outcomes, a contested or stolen election, a constitutional breakdown, or a military coup. China GeoRisk Indicator China’s geopolitical risk is falling and relative equity performance is picking up now that the government has begun easing monetary, fiscal, and regulatory policy to try to secure the economic recovery (Chart 8). Chart 8China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator Easing regulation on Big Tech has spurred a rebound in heavily sold Chinese tech shares, while the Politburo will likely signal a pro-growth turn in policy at its July economic meeting. The worst news of the country’s draconian “Covid Zero” policy is largely priced, while positive news regarding domestic vaccines, vaccine imports, or anti-viral drugs could surprise the market. However, none of these policy signals are reliable until Xi Jinping consolidates power at the twentieth national party congress sometime between September and November (likely October). Chinese stimulus could fail to pick up as much as the market hopes and policy signals could reverse or could continue to contradict themselves. After the party congress, we expect the Xi administration to intensify its efforts to stabilize the economy. The economic work conference in December will release a pro-growth communique. The March legislative session will provide more government support for the economy if needed. However, short-term measures to stabilize growth should not be mistaken for a major reacceleration, as China will continue to struggle with debt-deflation as households and corporations deleverage and the economic model transitions to a post-manufacturing model. Bottom Line: A Santa Claus rally in the fourth quarter, and/or a 2023 rally, is likely, both for offshore and onshore equities. But long-term investors, especially westerners, should steer clear of Chinese assets. China’s reversion to autocracy and confrontation with the United States will ultimately result in tariffs and sanctions and geopolitical crises and will keep risk premiums high. Taiwan GeoRisk Indicator Taiwan’s geopolitical risk has spiked as expected due to confrontation with China. Tensions will remain high through the Taiwanese midterm election on November 26, the Chinese party congress, and the US midterm (Chart 9). But China is not ready to stage a full-scale military conflict over Taiwan yet – that risk will grow over in the later 2020s and 2030s, depending on whether the US and China provide each other with adequate security assurances. Chart 9Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Still, Taiwan is the epicenter of global geopolitical risk. China insists that it will be unified with the mainland eventually, by force if not persuasion. China’s potential growth is weakening so it is losing the ability to absorb Taiwan through economic attraction over time. Meanwhile the Taiwanese people do not want to be absorbed – they have developed their own identity and prefer the status quo (or independence) over unification. Taiwan does not have a mutual defense treaty with the United States and yet the US and Taiwan are trying to strengthen their economic and military bonds. This situation is both threatening to China and yet not threatening enough to force China to forswear the military option. At some point China could believe it must assert control over Taiwan before the US increases its military commitment. Meanwhile China, the US, Japan, South Korea, and Europe are all adopting policies to promote semiconductor manufacturing at home, and/or outside Taiwan, so that their industries are not over-reliant on Taiwan. That means Taiwan will lose its comparative advantage over time. Bottom Line: Structurally remain underweight Taiwanese equities. Korea GeoRisk Indicator The newly elected President Yoon reaffirmed the strong military tie between Korea and the US, when he hosted President Biden in Seoul in May. Both Presidents expressed interests in expanding cooperation into new areas like semiconductors, economic security, and stability in the Indo-Pacific region. The new administration is also finding ways to improve relations with Japan, which soured in the past few years over the issue of forced labor during the Japanese occupation of Korea. A way forward is yet to be found, but a new public-private council will be launched on July 4 to seek potential solutions before the supreme court ruling in August which could further damage bilateral ties. President Yoon’s various statements throughout the NATO summit in Madrid on wanting a better relationship with Japan and to resolve historical issues showed this administration’s willingness towards a warming of the relations between the two countries, a departure from the previous administration. On the sideline of the NATO summit, Yoon also engaged with European leaders, dealing Korean defense products, semiconductors, and nuclear technologies, with a receptive European audience eager to bolster their defense, secure supply chain, and diversify energy source. North Korea ramped up its missile tests this year as it tends to do during periods of political transitions in South Korea. It is also rumored to be preparing for another nuclear test. Provocations will continue as the North is responding to the hawkish orientation of the Yoon administration. Investors should expect a rise in geopolitical risk in the peninsular, but on a relative basis, due to its strong alliance network, Korean risk will be lower compared to Taiwan (Chart 10). Korea will benefit from a rebound in China in the near term, but in the long-term, it is a secure source of semiconductors and high-tech exports, as Greater China will be mired in long-term geopolitical instability. Chart 10Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Bottom Line: Overweight South Korean equities relative to emerging markets as a play on Chinese stimulus. Overweight Korea versus Taiwan. Australia GeoRisk Indicator Australia’s Labor Party ultimately obtained a one-seat majority in the House of Representatives following the general election in May (77 seats where 76 are needed). It does not have a majority in the Senate, where it falls 13 seats short of the 39 it needs. It will rely on the Green Party (12 seats) and a few stragglers to piece together ad hoc coalitions to pass legislation. Hence Prime Minister Anthony Albanese’s domestic agenda will be heavily constrained. Pragmatic policies to boost the economy are likely but major tax hikes and energy sector overhauls are unlikely (Chart 11). Chart 11Australia: GeoRisk Indicator Australia: GeoRisk Indicator Australia: GeoRisk Indicator Fortunately for Albanese, his government is taking power in the wake of the pandemic, inflation, and Chinese slowdown, so that there is a prospect for the macroeconomic context to improve over his term in office. This could give him a tailwind. But for now he is limited. Like President Biden in the US, Albanese can attempt to reduce tensions with China after Xi Jinping consolidates power. But also like Biden, he will not have a basis for broad and durable re-engagement, since China’s regional ambitions threaten Australian national security over the long run. Global commodity supply constraints give Australia leverage over China. Bottom Line: Stay neutral on Australian currency and equities until global and Chinese growth stabilize. Brazil GeoRisk Indicator It would take a bolt of lightning to prevent former President Lula da Silva from winning re-election in Brazil’s October 2 first round election. Lula is more in line with the median voter than sitting President Jair Bolsonaro. Bolsonaro’s term has been marred with external shocks, following on a decade of recession and malaise. Polls may tighten ahead of the election but Lula is heavily favored. While ideologically to the left, Lula is a known quantity to global investors (Chart 12). However, Bolsonaro may attempt to cling to power, straining the constitutional system and various institutions. A military coup is unlikely but incidents of insubordination cannot be ruled out. Once Lula is inaugurated, a market riot may be necessary to discipline his new administration and ensure that his policies do not stray too far into left-wing populism. Chart 12Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil’s macroeconomic context is less favorable than it was when Lula first ruled. During the 2000s he rode the wave of Chinese industrialization and a global commodity boom. Today China is slipping into a balance sheet recession and the next wave of industrialization has not yet taken off. Brazil’s public debt dynamics discourage a structural overweight on Brazil within emerging markets. At least Brazil is geopolitically secure – far separated from the conflicts marring Russia, East Europe, China, and East Asia. It also has a decade of bad news behind it that is already priced. Bottom Line: Stay neutral Brazilian assets until global and Chinese growth stabilize and the crisis-prone election season is over. South Africa GeoRisk Indicator South Africa’s economy continues to face major headwinds amid persistent structural issues that have yet to be adequately addressed and resolved by policy makers. The latest bout of severe energy supply cuts by the state-run energy producer, Eskom, serve as a reminder to investors that South Africa’s economy is still dealing with a major issue of generating an uninterrupted supply of electricity. Each day that electricity supply is cut to businesses and households, the local economy stalls. Among other macroeconomic issues such as high unemployment and rising inflation, low-income households which are too the median voter, are facing increasing hardships. The political backdrop is geared toward further increases in political risk going forward (Chart 13). Chart 13South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Fiscal reform and austerity are underway but won’t last long enough to make a material difference in government finances. The 2024 election is not that far out and the ruling political party, the ANC, will look to quell growing economic pressures to shore up voter support and reinforce its voter base. Fiscal austerity will unwind. Meanwhile, the bull market in global metal prices stands to moderate on weakening global growth, which reduces a tailwind for the rand, South African equities relative to other emerging markets, and government coffers, reducing our reasons for slight optimism on South Africa until global growth stabilizes. Bottom Line: Shift to a neutral stance on South Africa until global and Chinese growth stabilize. Canada GeoRisk Indicator Canadian political risk has spiked since the pandemic (Chart 14). Populist politics can grow over time in Canada, especially if the property sector goes bust. However, the country is geopolitically secure and benefits from proximity to the US economy. Chart 14Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Global commodity supply constraints create opportunities for Canada as governments around the world pursue fiscal programs directed at energy security, national defense, and supply chain resilience. Bottom Line: Stay neutral Canadian currency and equities. While Canada benefits from the high oil price and robust US economy, rising interest rates pose a threat to its high-debt model, while US growth faces disappointments due to Europe’s and China’s troubles.     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Alice Brocheux Research Associate alice.brocheux@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar

Executive Summary Brazil: NPL Provisioning Cycles Explain Bank Share Prices Brazil: NPL Provisioning Cycles Explain Bank Share Prices Brazil: NPL Provisioning Cycles Explain Bank Share Prices Inflation is well above the central bank’s target. To assert their credibility, monetary authorities have no choice but to extend the rate hiking cycle. Drastic monetary tightening has been and will continue to occur in a context where the level of real economic activity is well below the 2013/14 level. The economy is heading into another recession in H2 this year. Such an economic contraction will weigh on banks and other domestic stocks.  Materials stocks are at risk from a relapse in industrial metal prices while Petrobras is at risk from government intervention. Brazilian equity and credit market valuations are no longer attractive relative to their EM peers. The currency is not cheap either. We find value in 10-year government local currency bonds – currently yielding 12.7% – given that the economy is heading into recession and inflation will likely peak. However, we do advise to hedge the currency risk for now. Recommendation Inception Date Return Equities: Overweight Brazil vs. Emerging Markets  2022-02-08 19.6% Sovereign Credit: Overweight Brazil vs. Emerging Markets 2022-02-08 7.2% Local Currency Government Bonds : Overweight Brazil vs. Emerging Markets 2022-02-08 18.9% Long Brazil Small Caps / Short Brazil Overall Stocks 2022-02-08 1.0% Bottom Line: We recommend that investors reduce their exposure to Brazilian risk assets by downgrading their allocation from overweight to neutral on equities, and local and sovereign fixed income within their respective EM portfolios. Feature We upgraded Brazilian financial markets to overweight versus their EM peers on February 8, and since then the nation’s stocks, local bonds as well as sovereign and corporate credit have outperformed their respective EM benchmarks (Chart 1). Presently, we recommend that EM equity and fixed-income dedicated investors scale down their exposure to Brazil to marketweight. The Central Bank Is In “Overkill” Mode Inflation in Brazil continues to surprise to the upside: headline CPI is 12%, core CPI is 9% and trimmed-mean CPI is 9.5%. All are well above the central bank’s (BCB) target band of 3.5%+/-1.5% (Chart 2, top panel). Further, consumer, business and market participants’ inflation expectations continue to inch higher and are well above the central bank’s target (Chart 2, middle and bottom panels). Chart 1Book Profits On Overweighting Brazil Versus EM Book Profits On Overweighting Brazil Versus EM Book Profits On Overweighting Brazil Versus EM Chart 2Brazil: Inflation Is Out Of Control Brazil: Inflation Is Out Of Control Brazil: Inflation Is Out Of Control Chart 3Brazil: Economic Activity Is Well Below Its 2013 Level Brazil: Economic Activity Is Well Below Its 2013 Level Brazil: Economic Activity Is Well Below Its 2013 Level In order to assert its credibility, the central bank has no choice but to extend its tightening cycle. The BCB has already hiked the policy rate by 1075 bps to 12.75%. This has been occurring in a context where the level of real economic activity is well below its 2013/14 level (Chart 3). There are also political motives that will influence the BCB’s hawkish stance in the medium term. As we wrote in the February report, the BCB has a political incentive to bring down inflation toward 5% (the upper range of its target), as it must prove that it is capable of achieving its inflation mandate in order to keep its recently granted independence. With ex-president Luiz Inácio Lula da Silva as the preferred presidential candidate in this year’s election, whose party opposes central bank autonomy and would prefer looser monetary policy, the BCB will continue tightening dramatically this year to reach target inflation. That will allow the central bank to cut rates next year when Lula assumes the presidency and, hence, avoid a major conflict with the government. To read our complete analysis on Brazilian politics and its implications for monetary policy, please access our February 8 report. In addition, fiscal policy will remain tight throughout the year, barring a new round of the cash handout program Auxílio Brasil. All in all, the fiscal thrust will be only mildly positive at 1% of GDP. This means that government spending will not offset dramatic monetary tightening. Bottom Line: Severe monetary tightening is occurring during a period in which the economy has not fully recovered. As a result, Brazil is heading into another recession. Recession Ahead Rising borrowing costs (shown inverted in Chart 4) will curtail bank lending. Further, Brazil’s business cycle has already rolled over, and chances are there will be an outright contraction in the second half of this year: The combined credit and fiscal impulse points to a major relapse in economic activity (Chart 5, top panel). Chart 4Monetary Tightening Will Curtail Bank Lending Monetary Tightening Will Curtail Bank Lending Monetary Tightening Will Curtail Bank Lending Chart 5Brazil: Prepare For A Recession In H2 2022 Brazil: Prepare For A Recession In H2 2022 Brazil: Prepare For A Recession In H2 2022   Our proxy for the marginal propensity to consume has plunged, meaning that household spending will continue to contract (Chart 5, middle panel). Consistently, the narrow money (M1) impulse will remain depressed as the BCB tightens monetary policy. This heralds a downbeat growth outlook, including shrinking manufacturing output (Chart 5, bottom panel). Another economic contraction does not bode well for Brazilian equities: Banks will become saddled with non-performing loans (NPLs). As they increase NPL provisions, their profitability will take a hit, and so will bank stocks. Chart 6 illustrates bank share prices correlate with loan provision cycles (provisions are shown inverted). Given that financials make up 25% of the Brazil MSCI index, their drawdown will weigh on the overall index. The bear market in share prices of Chinese materials points to a relapse in Brazilian materials stocks (Chart 7). Chart 6Brazil: NPL Provisioning Cycles Explain Bank Share Prices Brazil: NPL Provisioning Cycles Explain Bank Share Prices Brazil: NPL Provisioning Cycles Explain Bank Share Prices Chart 7Brazilian Materials: Heed The Message From Chinese Materials Brazilian Materials: Heed The Message From Chinese Materials Brazilian Materials: Heed The Message From Chinese Materials   Higher state interventionism in Petrobras will spook investors and damage confidence. The oil producer has a policy of raising domestic fuel prices in accordance with international markets. However, this has led and will lead to backlash from both presidential contenders, Jair Bolsonaro and Lula da Silva. Both candidates have argued for more government control of the oil producer and are not shy about placing loyalists at the head of the board and in the energy ministry in a bid to curb fuel prices and with it please the population. This is negative for Petrobras’ share price. While this sort of policy is expected from Lula, markets have been caught by surprise as the current right-wing government is trying to influence the oil producer as well. As we wrote in July of 2021, we expect Bolsonaro to increase his populist tendencies in order to appeal to poorer households and take support away from Lula’s traditional voter base. Valuations Chart 8Brazilian Equities Have A Neutral Valuation Relative To EM Brazilian Equities Have A Neutral Valuation Relative To EM Brazilian Equities Have A Neutral Valuation Relative To EM Brazilian financial markets are not undervalued anymore relative to their EM peers: Equities: The cyclically-adjusted P/E ratio for Brazil relative to Emerging Markets is now at a neutral valuation (Chart 8). Currency: The Brazilian real has been a stellar performer this year, to the point that the currency is no longer inexpensive (Chart 9). Investor positioning is presently a risk to the BRL. The aggregate position of leveraged funds and asset managers is now long as of May 10 (Chart 10). Chart 9The BRL Is No Longer Cheap The BRL Is No Longer Cheap The BRL Is No Longer Cheap Chart 10Investor Positioning On The BRL Is Net Long Investor Positioning On The BRL Is Net Long Investor Positioning On The BRL Is Net Long     Anecdotal evidence also suggests that Brazilian businesses have been using the rebound in the real to hedge their foreign currency risks. Large corporations have begun purchasing back their foreign currency bonds in anticipation of currency weakness. Further, according to Anbima, the country’s financial markets association, corporate bond sales outside of Brazil have halved compared to 1Q 2021.   We recommended a long BRL/short ZAR trade on February 8 and took a 7.4% profit on April 13. Chart 11Core Inflation Will Drop In H2 2022 Core Inflation Will Drop In H2 2022 Core Inflation Will Drop In H2 2022 Local Rates: Currency weakness risks will weigh on domestic bonds. The relative total return in USD terms of Brazilian domestic bonds versus the EM GBI index has rolled over at its previous high. That said, we find value in 10-year government domestic (local currency) bonds – currently yielding 12.7% – given that the economy is heading into recession and inflation will likely peak (Chart 11). However, we do recommend that investors hedge the currency risk for now. Sovereign and corporate credit: In terms of sovereign and corporate credit (USD bonds), Brazil has outperformed its EM benchmarks substantially in recent months. A pause in outperformance or a relapse is overdue on the back of the recession and exchange rate risks. Investment Recommendations We recommend that investors reduce their exposure to Brazilian risk assets by downgrading their allocation from overweight to neutral on equities and local and sovereign fixed income within their respective EM portfolios. We are also closing our long small caps / short the overall index trade. This trade has produced only a 1% gain since initiation on February 8 this year. Juan Egaña Associate Editor juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes