Cyclicals vs Defensives

Dear Client, Next week, there will not be a written European Investment Strategy report; instead we will host a Webcast on April 26 with Chester Ntonifor, BCA’s Foreign Exchange Strategist. Regards, Mathieu Savary Executive Summary Cyclicals Are Not Cheap Enough Cyclicals Are Not Cheap Enough Cyclicals Are Not Cheap Enough Global growth remains fragile as China’s economy becomes increasingly affected by COVID containment measures. The US economy is likely to slow down significantly in the coming months, while Europe flirts with a recession. This time around, monetary policy is unlikely to provide a relief valve. While European equities may inch higher in the coming months, cyclical stocks do not offer the necessary valuation discount relative to defensive equities to compensate investors against these risks.  Heed the rotational patterns to guide near-term country and sector allocation. The French election remains an important source of risk, even though President Emmanuel Macron is still the favorite.   Bottom Line: Maintain a modest positive bias toward equities, but overweight defensive stocks at the expense of cyclicals. Focus on short-term capital protection by favoring small-cap over momentum stocks, materials over energy, and UK equities over French ones.     Chart 1So Far, Defensives Win Plenty Of Risks For Cyclical Stocks Plenty Of Risks For Cyclical Stocks European equities have experienced a very volatile first quarter, with a maximum drawdown of nearly 23%. Since their March 7th low, they have rebounded 18% but remain 13% below the January 5th high. Apart from the energy sector, defensives have been running the show so far this year (Chart 1). We wrote four weeks ago that the European market is likely to have made its low for the year,  but that the volatility of the first quarter of 2022 is likely to continue. We still hold this view. For now, we recommend investors stay long European equities, but defensive sector and country stances are appropriate. Cyclical stocks have corrected, but front-loaded global economic risks create additional downside. Economic Risks Abound The global economic environment remains fragile as headwinds continue to build. Cyclical equities do not seem to have fully discounted this threat. China’s economic outlook constitutes the first hindrance to global growth. COVID cases in Shanghai are surging and many Chinese cities are also witnessing an acceleration in new cases (Chart 2). The Communist Party is still adamant about its zero-tolerance policy, which suggests that these severe lockdowns will become the norm around the country. This situation creates significant downside for Chinese domestic demand, which will prompt a growth slowdown. The service sector is already feeling the pain from the lockdowns. The March import numbers also highlight an abrupt slowdown in the goods sector (Chart 3). In CNY terms, imports contracted 1.7% annually. This is a nominal number. Both global goods and commodity inflation are elevated, and thus, import volumes are weakening sharply. Furthermore, a recent Reuters article indicated that Chinese crude oil imports have already contracted 14% annually. Chart 2China's COVID Problem China's COVID Problem China's COVID Problem Chart 3Slowing Chinese Domestic Demand Slowing Chinese Domestic Demand Slowing Chinese Domestic Demand Chart 4Declining Shipping Costs, But For How Long? Declining Shipping Costs, But For How Long? Declining Shipping Costs, But For How Long? China’s COVID policy also risks adding new supply chain bottlenecks. Freight within the country is grinding to a halt and ships are queuing up outside the port of Shanghai. As lockdowns multiply around China, risks to global supply chains will increase, hence, the recent decline in shipping rates out of China may soon be undone (Chart 4). This represents a major risk for the global economy, as it would tighten constraints to global economic activity. It also threatens European profitability, as PPI inflation would outpace CPI inflation for longer than anticipated (Chart 4, bottom panel). The US also shows signs of weakness. While a US recession is unlikely, a meaningful deceleration is probable. US consumers are feeling the pinch from surging food and energy prices. Consequently, real wages are contracting 1.8% annually and consumer confidence has plunged (Chart 5). Thankfully, US households have accumulated $185 billion in excess savings since the pandemic began and their net worth has increased by $33 trillion, which should prevent a complete meltdown. Nevertheless, a further deterioration in retail sales is still very likely. Businesses are also increasingly worried. The March NFIB survey shows that Small Business Optimism is falling quickly and that few companies believe it is a good time to expand (Chart 5, bottom panel). Adding to these stresses, the most cyclical sector of the US economy is weakening rapidly. The recent rise in US mortgage rates to 5% is causing a collapse in mortgage applications for house purchases and is behind the 30% tumble suffered by homebuilder stocks (Chart 6). Chart 5US Confidence Is Falling US Confidence Is Falling US Confidence Is Falling Chart 6Tarnished US Housing Outlook Tarnished US Housing Outlook Tarnished US Housing Outlook Europe is in a situation worse than the US and is at risk of a recession in the first half of 2022, or, at least, a very severe growth slowdown. As we highlighted six weeks ago, the energy shock in Europe is larger than it is in the US; moreover, Europe does not enjoy the counterweight of a large commodity sector. Recent data confirm that a slowdown is imminent. The ZEW Expectations survey, the German Ifo, and the European Commission’s Consumer Confidence data are all collapsing, which is consistent with a severe shock (Chart 7). To add insult to injury, bond yields continue to rise; therefore, the only relief valve for the region is a weak currency. Global monetary policy is unlikely to come to the rescue of investors anytime soon. The Fed began lifting rates in March and, if the actions of the Bank of Canada and the Reserve Bank of New Zealand are any indication, the FOMC will increase rates by 50bps in May. The OIS curve expects a Fed Funds rate at 2.2% by year-end, which seems appropriate. With a backdrop of weakening growth, a flat yield curve and an additional increase in real rates will feed risk aversion, especially against the cyclical sectors of the market (Chart 8). Chart 7Severe Slowdown In Europe... Or Worse Severe Slowdown In Europe... Or Worse Severe Slowdown In Europe... Or Worse Chart 8Slowing Growth Meets Higher Real Rates Slowing Growth Meets Higher Real Rates Slowing Growth Meets Higher Real Rates The liquidity tightening is not a phenomenon unique to the US. 63% of global central banks have removed monetary accommodation over the past three months (Chart 9). Moreover, our BCA Monetary Index continues to deteriorate. While we cannot characterize global monetary policy as being anywhere close to tight right now, cyclical equities remain vulnerable to the liquidity slowdown. Bottom Line: The global economy is likely to deteriorate in the coming months. The impact of COVID-19 on Chinese growth will only increase, while Europe flirts with a recession in the first half of the year. Meanwhile, US growth faces swelling headwinds. Expect a meaningful deterioration in global economic surprises (Chart 10). In this context, tighter policy will feed risk aversion, which will create a particularly strong headwind for cyclical stocks. Chart 9A Global Tightening A Global Tightening A Global Tightening Chart 10Economic Surprises Will Fall Economic Surprises Will Fall Economic Surprises Will Fall European Cyclicals Remain Vulnerable This backdrop is not equity-friendly and points to meagre returns over the next three to six months. Nonetheless, European stocks will not generate negative returns over this time frame because European benchmarks already discount a significant portion of the negative news, as illustrated by the surge in their earnings yield (Chart 11). Importantly, inflation in Europe should peak over the summer as the commodity impulse is decelerating (Chart 11, bottom panel). Therefore, fears of stagflation will recede, which will help aggregate European shares (Chart 12). Chart 11European Stocks Already Discount A Lot European Stocks Already Discount A Lot European Stocks Already Discount A Lot Chart 12Ebbing Stagflation Fears Will Help European Equities Ebbing Stagflation Fears Will Help European Equities Ebbing Stagflation Fears Will Help European Equities The consequence of the additional slowdown in global growth is likely to be reflected in the relative performance of European cyclical sectors. Already, Swedish economic growth and asset prices have deteriorated (Chart 13). This poor performance does not bode well for cyclical assets, considering the heightened sensitivity of Swedish assets to the global industrial cycle. More signals point to downside for the cyclical/defensive split. While the short-term momentum of the performance of cyclicals relative to defensives is becoming oversold, its 40-week rate of change has yet to reach a paroxysm (Chart 14). Additionally, cyclicals have not experienced the kind of valuation discount associated with a full discounting of the economic and monetary headwinds described in the previous section (Chart 14, bottom panel). Chart 13Heed Sweden's Message Heed Sweden's Message Heed Sweden's Message Chart 14Cyclicals Are Not Cheap Enough Cyclicals Are Not Cheap Enough Cyclicals Are Not Cheap Enough Cyclicals Are Not Cheap Enough Cyclicals Are Not Cheap Enough The commodity sector is also at risk of a pullback. China’s economic slowdown is likely to hurt commodity demand. While this will not end the secular commodity bull market underpinned by a lack of supply capacity, it could easily cause a significant correction in commodity prices. If, as we anticipate, inflation slows this summer, the inflation-hedging demand for commodities will also pause. These dynamics would hurt mining stocks, which have avoided a serious pullback, as well as the energy sector. Thus, a correction in commodities would cause additional weaknesses for the cyclicals-to-defensives ratio (Chart 15). Yields create a supplemental risk. Historically, rising US yields and inflation expectations correlate with an outperformance of cyclical shares. However, in 2022, cyclicals have bifurcated from yields and CPI swaps (Chart 16), because higher yields currently do not signal reflation but stagflation. If yields rise further, it will hurt growth prospects and damage cyclicals. If they fall, it will likely reflect increasing growth fears, which is also negative for cyclicals. Moreover, falling yields will hurt the profit margins of financials, which are a large component of cyclicals. Therefore, cyclicals seem stuck in a lose-lose situation with respect to yields. Chart 15The Commodity Link The Commodity Link The Commodity Link Chart 16Yields and Cyclicals: A Lose-Lose Proposition Yields and Cyclicals: A Lose-Lose Proposition Yields and Cyclicals: A Lose-Lose Proposition The strength in the dollar creates the last major hurdle for cyclicals. A strong dollar both tightens global financials conditions and indicates weak growth ahead. Consequently, it often heralds a period of softness in the cyclicals-to-defensives ratio (Chart 17). How should investors position themselves? We have a long-held preference for telecommunication services stocks over consumer discretionary equities and for healthcare relative to tech shares. These trades have respectively generated hefty gains of 32% and 13% since June 2021, but they are becoming long in the tooth (Chart 18). Chart 17A Strong Dollar Hurts Cyclicals A Strong Dollar Hurts Cyclicals A Strong Dollar Hurts Cyclicals Chart 18Hedges Have Performed Strongly Hedges Have Performed Strongly Hedges Have Performed Strongly Related Report  European Investment StrategyThe Great Rotation As an alternative, we recommend investors stay nimble and use our Excess Returns Rotation Approach expanded in a Special Report two months ago. Below, you will find the new trades suggested by this process. Bottom Line: Cyclicals remain vulnerable. They have not reached the kind of valuation discount necessary to compensate investors for weaker growth and tighter monetary policy. To hedge against these risks, we recommended selling consumer discretionary relative to telecom stocks and tech shares relative to healthcare. However, investors should not add to those trades to mitigate against further weaknesses in cyclical stocks. Instead, investors should focus on relative rotational patterns (see next section).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Excess Returns Rotation Maps: An Update1 European Investment Styles The most noteworthy move comes from small-cap stocks, going from the “Lagging” quadrant to the “Leading” one rapidly (Chart 19). This is consistent with our view that European small-cap equities’ outperformance has further to run. The attractiveness of value stocks is thinning relative to growth stocks (Table 1). Chart 19Relative Rotation Graph: European Investment Styles Plenty Of Risks For Cyclical Stocks Plenty Of Risks For Cyclical Stocks Table 1European Investment Styles Positioning Plenty Of Risks For Cyclical Stocks Plenty Of Risks For Cyclical Stocks   Trade Recommendations (12-Month Horizon): Volatility stocks relative to momentum (unchanged) Small-cap stocks relative to momentum (new) European Sectors Chart 20 illustrates the wild ride in European equity markets in the wake of the Ukraine/Russia conflict. Most sectors experienced violent swings, moving rapidly across several quadrants. Only consumer discretionary, tech, and utilities stocks have remained in the same quadrant, the former two in “Lagging” and the latter in “Leading.” Interestingly, the European energy sector has moved into the “Weakening” quadrant (Table 2). We are taking profit on our Long Energy / Short Financials recommendation. It delivered 14% returns since mid-February and is getting long in the tooth. Chart 20Relative Rotation Graph: European Sectors Plenty Of Risks For Cyclical Stocks Plenty Of Risks For Cyclical Stocks Table 2European Sectors Positioning Plenty Of Risks For Cyclical Stocks Plenty Of Risks For Cyclical Stocks   Trade Recommendations (12-Month Horizon): Materials over energy (unchanged) Energy over financials (unchanged) Tech over communication services (unchanged) Utilities over healthcare (new) Communication services over healthcare (new) Consumer discretionary over healthcare (new) European National Markets Sectoral biases dictate the rotational patterns exhibited by European national bourses (Chart 21). The cyclicality of the German, French, and Italian markets caused them to lag behind their European counterparts. Meanwhile, the Dutch market remains solidly in the Lagging quadrant, mirroring tech equities. Only Spain and Sweden have shown signs of improvement over the past twelve weeks and should outperform the European benchmark over the short term (Table 3). Chart 21Relative Rotation Graph: European National Markets Plenty Of Risks For Cyclical Stocks Plenty Of Risks For Cyclical Stocks Table 3European National Markets Positioning Plenty Of Risks For Cyclical Stocks Plenty Of Risks For Cyclical Stocks   Trade Recommendations (12-Month Horizon): UK stocks over Dutch ones (new) UK stocks over French ones (new) Italian stocks over Swedish ones (new) UK stocks over Swedish ones (new) French Elections: Preparing For The Second Round The first round of the French presidential elections did not surprise. As in 2017, incumbent President Emmanuel Macron will face Marine Le Pen in the second round. Beyond this expected outcome, two important takeaways will be crucial in the second round: The collapse of traditional right-wing (Les Républicains) and left-wing (Parti Socialiste) parties. Far-left candidate Jean-Luc Mélenchon surprised to the upside with 22% of votes, right behind Marine Le Pen. The key implication is that the vote transfer has become more favorable to Macron (Diagram 1). In 2017, Marine Le Pen created the surprise and bested center-right candidate François Fillon by the narrowest of margins. As a result, Le Pen’s attempt to appeal to Fillon’s voters was a real threat. Today, the third largest pool of voters belongs to far-left candidate Mélenchon, who has already called upon his voters “not to give a single vote to Marine Le Pen.” Diagram 1Extrapolating France’s First-Round Election To The Second Round Plenty Of Risks For Cyclical Stocks Plenty Of Risks For Cyclical Stocks How does it translate into voting intentions for the second round? Assuming a full transfer of votes from the defeated candidates based on the support they made public, Macron will crush Marine Le Pen as he did in 2017. However, this is unlikely, since many voters feel stuck between a rock and a hard place, and may decide not to vote. Related Report  European Investment StrategyFrance: Macron And Macro Assuming Macron obtains only half of the voting intentions from other parties, while Marine Le Pen retains the full support from other far-right candidates’ voters, acquires half of the center-right votes, and secures a quarter of Mélenchon’s votes, the outcome will be much narrower at 53.4% vs. 46.6% in favor of Macron. This is in line with national polls. Two weeks ago, we presented the investment implications of a second Macron mandate.  Since then, we have received many questions about the market consequences should Marine Le Pen enjoy a surprise victory. While this is not our base-case, we cannot rule out the possibility of a negative shock to the markets. Chart 22A Le Pen Surprise Victory Would Hurt The Euro A Le Pen Surprise Victory Would Hurt The Euro A Le Pen Surprise Victory Would Hurt The Euro The only certainty within this very uncertain outcome is that Marine Le Pen would be constrained by a strong opposition in the Assemblée Nationale. Although she has changed her stance on “Frexit,” her presidency would undoubtfully carry an increased geopolitical risk within the European Union (EU) and hurt European unity and integration efforts. Thus, the resulting French isolationism would be synonymous with a weaker euro (Chart 22). French assets would be de-rated because her presidency would reverse previous reform efforts, which would hurt trend GDP growth, productivity, and the role of France within the EU. These trends are not only negative for stocks, but they would also put long-term upward pressure on OATs yields as French public finances would deteriorate meaningfully under a populist Le Pen presidency. In this context, underweighting both French equities and government bonds would be warranted.   Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com   Footnotes Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary The Ukraine war reinforces our key view that commodity producers will use their geopolitical leverage this year. The market is growing complacent again about Russian risks. Iran is part of the same dynamic. If US-Iran talks fail, as we expect, the Middle East will destabilize and add another energy supply risk on top of the Russian risk. The Ukraine war also interacts with our other two key views for 2022: China’s reversion to autocracy and the US’s policy insularity. Both add policy uncertainty and weigh on risk sentiment. The war also reinforces our strategic themes for the 2020s: Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism. Stagflation Cometh Stagflation Cometh Stagflation Cometh Trade Recommendation Inception Date Return Cyclically Long Global Defensives Versus Cyclicals 2022-01-20 10.8% Bottom Line: Tactically stay long global defensives and large caps. Cyclically stay long gold, US equities, aerospace/defense, and cyber security. Feature In our annual outlook, “The Gathering Storm,” we argued that the post-pandemic world economy would destabilize due to intensifying rivalry among the leading nations. We argued that China’s reversion to autocracy, US domestic divisions, and Russia’s commodity leverage would produce a toxic brew for global investors in 2022. By January 27 it was clear to us that Russia would invade Ukraine, so the storm was arriving sooner than we thought, and we doubled down on our defensive and risk-averse market positioning. We derived these three key views from new cyclical trends and the way they interact with our underlying strategic themes – Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism (Table 1). These themes are mutually reinforcing, rooted in solid evidence over many years, and will not change easily. Table 1Three Geopolitical Strategic Themes Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Related Report  Geopolitical Strategy2022 Key Views: The Gathering Storm The Ukraine war reinforces them: Russia took military action to increase its security relative to the US and NATO; the West imposed sanctions that reduce globalization with Russia and potentially other states; Russian aggression stemmed from nationalism and caused a spike in global prices that will spur more nationalism and populism going forward. In this report we examine how these trends will develop in the second quarter and beyond. We see stagflation taking shape and recommend investors prepare for it by continuing to favor defensive sectors, commodities, and value plays. Checking Up On Our Russia View For 2022 Our third key view for 2022 – that oil producers like Russia and Iran possessed immense geopolitical leverage and would most likely use it – is clearly the dominant geopolitical trend of the year, as manifested in the Russian invasion of Ukraine.1 Russia first invaded Ukraine in 2014 and curtailed operations after commodity prices crashed. It launched a new and larger invasion in 2022 when a new commodity cycle began (Chart 1). Facing tactical setbacks, Russia has begun withdrawing forces from around the Ukrainian capital Kyiv. But it will redouble its efforts to conquer the eastern Donbas region and the southern coastline. The coast is the most strategic territory at stake (Map 1). Chart 1Russia's Commodity-Enabled Aggression Russia's Commodity-Enabled Aggression Russia's Commodity-Enabled Aggression Map 1Russian Invasion Of Ukraine, 2022 Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours The most decisive limitation on Russia’s military effort would come from a collapse of commodity exports or prices, which has not happened yet. Europe continues to buy Russian oil and natural gas, although it is debating a ban on the $4.4 billion worth of coal that it imports. With high energy prices making up for a drop in export volumes, Russian armed forces can still attempt a summer and fall campaign (Chart 2). The aim would be to conquer remaining portions of Donetsk and Luhansk, the “land bridge” to Crimea, and potentially the stretch of land between the Dnieper river and eastern Moldova, where Russian troops are already stationed. Chart 2Russia’s War Financing Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Ukraine’s military neutrality is the core Russian objective. Ukraine is offering neutrality in exchange for security guarantees in the current ceasefire talks. Hence a durable ceasefire is possible if the details of neutrality are agreed – Ukraine forswears joining NATO and hosting foreign military infrastructure while accepting limitations on military exercises and defense systems. The security guarantees that Ukraine demands are mostly symbolic, as the western powers that would be credible guarantors are already unwilling to use military force against Russia (e.g. the US, UK, NATO members). However, Russia’s withdrawal from Kyiv will embolden the Ukrainians, so we do not expect a durable ceasefire in the second quarter. Global investors will be mistaken if they ignore Ukraine in the second quarter, at least until core problems are resolved. What matters most is whether the war expands beyond Ukraine: The likelihood of a broader war is low but not negligible. So far the Russian regime is behaving somewhat rationally: Moscow attacked a non-NATO member to prevent it from joining NATO; it limited the size of the military commitment; and it is now accepting reality and withdrawing from Kyiv while negotiating on Ukrainian neutrality. But a major problem emerges if Russia’s military fails in the Donbas while Ukraine reneges on offers of neutrality. Any ceasefire could fall apart and the war could re-escalate. Russia could redouble its attacks on the country or conduct a limited attack outside of Ukraine to trigger a crisis in the western alliance. Moreover, if sanctions keep rising until Russia’s economy collapses, Moscow could become less rational. Finland and Sweden have seen a shift of public opinion in favor of joining NATO. Any intention to do so would trigger a belligerent reaction from Russia. These governments are well aware of the precarious balance that must be maintained to prevent war, so war is unlikely. But if their stance changes then Russia will threaten to attack. Russia would threaten to bomb these states since it cannot now credibly threaten invasion by land (Charts 3A & 3B). Chart 3ANordic States Joining NATO Would Trigger Larger War Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours ​​​​​ Chart 3BNordic States Joining NATO Would Trigger Larger War Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours ​​​​​​ The Black Sea is vulnerable to “Black Swan” events or military spillovers. Russia is re-concentrating its military efforts in the Donbas and land bridge to Crimea. Russia could expand its offensive to Odessa and the Moldovan border. Or Russia could attempt to create a new norm of naval dominance in the Black Sea. Or ships from third countries could hit mines or become casualties of war. For these and other reasons, investors should not take on additional risk in their portfolios on the basis that a durable ceasefire will be concluded quickly. Russia’s position is far too vulnerable to encourage risk-taking. Moscow could escalate tensions to try to save face. It is also critical to ensure that Russia and Europe maintain their energy trade: Neither side has an interest in total energy cutoff. Russia needs the revenue to finance its war and needs to discourage Europe from fulfilling its pledges to transition rapidly to other sources and substitutes. Europe needs the energy to avoid recession, maintain some tie with Russia, and enable its energy diversification strategy. So far natural gas flows are continuing (Chart 4). Chart 4Natural Gas Flows Continuing (So Far) Natural Gas Flows Continuing (So Far) Natural Gas Flows Continuing (So Far) ​​​​​​ Chart 5Global Oil Supply/Demand Balance Global Oil Supply/Demand Balance Global Oil Supply/Demand Balance ​​​​​​ However, risks to energy trade are rising. Russia is threatening to cut off energy exports if not paid in rubles, while the EU is beginning to entertain sanctions on energy. Russia can reduce oil or gas flows incrementally to keep prices high and prevent Europe from rebuilding stockpiles for fall and winter. Partial energy cutoff is possible. Europe’s diversification makes Russia’s predicament dire. Substantial sanction relief is highly unlikely, as western powers will want to prevent Russia from rebuilding its economy and military. Russia could try to impose significant pain on Europe to try to force a more favorable diplomatic solution. A third factor that matters is whether the US will expand its sanction enforcement to demand strict compliance from other nations, at pain of secondary sanctions: Secondary sanctions are likely in the case of China and other nations that stand at odds with the US and help Russia circumvent sanctions. In China’s case, the US is already interested in imposing sanctions on the financial or technology sector as part of its long-term containment strategy. While the Biden administration’s preference is to control the pace of escalation with China, and thus not to slap sanctions immediately, nevertheless substantial sanctions cannot be ruled out in the second quarter. Secondary sanctions will be limited in the case of US allies and partners, such as EU members, Turkey, and India. Countries that do business with Russia but are critical to US strategy will be given waivers or special treatment. Russia is not the only commodity producer that enjoys outsized geopolitical leverage amid a global commodity squeeze. Iran is the next most critical producer. Iran is also critical for the stability of the Middle East. In particular, the consequential US-Iran talks over whether to rejoin the 2015 nuclear deal are likely to come to a decision in the second quarter. Chart 6Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply Failure Of US-Iran Talks Jeopardizes Middle East Oil Supply If the US and Iran agree to a strategic détente, then regional tensions will briefly subside, reducing global oil disruption risks and supply pressures. Iran could bring 1.3 million barrels per day of oil back online, adding to President Biden’s 1 million per day release of strategic petroleum reserves. The combination would amount to 2.3% of global demand and more than cover the projected quarterly average supply deficit, which ranges from 400k to 900k barrels per day for the rest of 2022 (Chart 5). If the US and Iran fail to agree, then the Middle East will suffer another round of instability, adding a Middle Eastern energy shock on top of the Russian shock. Not only would Iran’s 1.3 million barrels per day be jeopardized but so would Iraq’s 4.4 million, Saudi Arabia’s 10.3 million, the UAE’s 3.0 million, or the Strait of Hormuz’s combined 24 million per day (Chart 6). This gives Iran leverage to pursue nuclear weaponization prior to any change in US government that would strengthen Israel’s ability to stop Iran. We would not bet on an agreement – but we cannot rule it out. The Biden administration can reduce sanctions via executive action to prevent a greater oil shock, while the Iranians can accept sanction relief in exchange for easily reversible moves toward compliance with the 2015 nuclear deal. But this would be a short-term, stop-gap measure, not a long-term strategic détente. Conflict between Iran and its neighbors will revive sooner than expected after the deal is agreed, as Iran’s nuclear ambitions will persist. OPEC states are already producing more oil rapidly, suggesting no quick fix if the US-Iran deal falls apart. While core OPEC states have 3.5 million barrels per day in spare capacity to bring to bear, a serious escalation of tensions with Iran would jeopardize this solution. Finally, if commodity producers have geopolitical leverage, then commodity consumers are lacking in leverage. This is clear from Europe’s inability to prevent Russia’s attack or ban Russian energy. It is clear from the US’s apparent unwillingness to give up on a short-term deal with Iran. It is clear from China’s inability to provide sufficient monetary and fiscal stimulus as it struggles with Covid-19. Turkey, Egypt, and Pakistan are geopolitically significant importers of Russian and Ukrainian grain that are likely to face food insecurity and social unrest. We will address this issue below under our Populism/Nationalism theme. Bottom Line: Investors should not be complacent. Russia’s military standing in Ukraine is weak, but its ability to finance the war has not yet collapsed, which means that it will escalate the conflict to save face. What About Our Other Key Views For 2022? Our other two key views for 2022 are even more relevant in the wake of the Ukraine re-invasion. China’s reversion to autocracy is a factor in China’s domestic and foreign policy: Domestically China needs economic and social stability in the advance of the twentieth national party congress, when President Xi Jinping hopes to clinch 10 more years in power. In pursuit of this goal China is easing monetary and fiscal policy. However, with depressed animal spirits, a weakening property sector, and high debt levels, monetary policy is proving insufficient. Fiscal policy will have to step up. But even here, inflation is likely to impose a limitation on how much stimulus the authorities can utilize (Chart 7). Chart 7China Stimulus Impaired By Inflation China Stimulus Impaired By Inflation China Stimulus Impaired By Inflation ​​​​​​ Chart 8Chinese Supply Kinks To Persist Due To Covid-19 Chinese Supply Kinks To Persist Due To Covid-19 Chinese Supply Kinks To Persist Due To Covid-19 China is also trying but failing to maintain a “Covid Zero” policy. The more contagious Omicron variant of the virus is breaking out and slipping beyond the authorities’ ability to suppress cases of the virus to zero. Shanghai is on lockdown and other cities will follow suit. China will attempt to redouble its containment efforts before it will accept the reality that the virus cannot be contained. Chinese production and shipping will become delayed and obstructed as a result, putting another round of upward pressure on global prices (Chart 8). Stringent pandemic restrictions could trigger social unrest. China is ripe for social unrest, which is why it launched the “Common Prosperity” program last year to convince citizens that quality of life will improve. But this program is a long-term program that will not bring immediate relief. On the contrary, the economy is still suffering and the virus will spread more widely, as well as draconian social restrictions. The result is that the lead up to the national party congress will not be as smooth as the Xi administration had hoped. Global investors will remain pessimistic toward Chinese stocks. In foreign affairs, China’s reversion to autocracy is reinforced by Russia’s clash with the West and the need to coordinate more closely. Xi hosted Putin in Beijing on February 4, prior to the invasion, and the two declared that their strategic partnership ushers in a “new era” of “multipolarity” and that their cooperation has “no limits,” which really means that military cooperation is not forbidden. China agreed to purchase an additional 10 billion cubic meters of Russian natural gas over 30-years. While this amount would only replace 3% of Russian natural gas exports to Europe, it would mark a 26% increase in Russian exports to China. More importantly it acts as a symbol of Chinese willingness to substitute for Europe over time. There is a long way to go for China to replace Europe as a customer (Chart 9). But China knows it needs to convert its US dollar foreign exchange reserves, vulnerable to US sanctions, into hard investments in supply security within the Eurasian continent. Chart 9Long Way To Go For China NatGas Imports To Replace EU Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours China is helping Russia circumvent sanctions. China’s chief interest is to minimize the shock to its domestic economy. This means keeping Russian energy and commodities flowing. China could also offer military equipment for Russia. The US has expressly warned China against taking such an action. China could mitigate the blowback by stipulating that the assistance cannot be used in Ukraine. This would be unenforceable but would provide diplomatic cover. While China is uncomfortable with the disturbance of the Ukraine war – it does not want foreign affairs to cause even larger supply shocks. At the same time, China does not want Russia to lose the war or Putin’s regime to fall from power. If Russia loses, Taiwan and its western allies would be emboldened, while Russia could pursue a détente with the West, leaving China isolated. Since China faces US containment policy regardless of what happens in Russia, it is better for China to have Putin making an example out of Ukraine and keeping the Americans and Europeans preoccupied. Chart 10China Strives To Preserve EU Trade Ties China Strives To Preserve EU Trade Ties China Strives To Preserve EU Trade Ties China must also preserve ties with Europe. Diplomacy will likely succeed in the short run since Europe has no interest or desire to expand sanctions to China. The Biden administration will defer to Europe on the pace of sanctions – it is not willing or able to force Europe to break with China suddenly. Eventually Europe and China may sever relations but not yet – China has a powerful incentive to preserve them (Chart 10). China will also court India and other powers in an attempt to hedge its bets on Russia while weakening any American containment. Beyond the party congress, China will be focused on securing the economic recovery and implementing the common prosperity agenda. The first step is to maintain easy monetary and fiscal policy. The second step is to “let 100 flowers bloom,” i.e. relaxing social and regulatory controls to try to revive entrepreneurship and animal spirits, which are heavily depressed. Xi will have the ability to do this after re-consolidating power. The third step will be to try to stabilize economic relations with Europe and others (conceivably even the US temporarily, though no serious détente is likely). The remaining key view for 2022 is that the Biden administration’s domestic focus will be defensive and will invite foreign policy challenges. The Ukraine war vindicates this view but the question now is whether Biden has or will change tack: The Biden administration is focused on the midterm elections and the huge risk to the Democratic Party’s standing. Biden has not received a boost in opinion polls from the war. He is polling even worse when it comes to handling of the economy (Chart 11). While he should be able to repackage his budget reconciliation bill as an energy security bill, his thin majorities in both houses make passage difficult. Chart 11Biden And Democrats Face Shellacking In Midterm Election Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Biden’s weak standing – with or without a midterm shellacking – raises the prospect that Republicans could take back the White House in 2024, which discourages foreign nations from making any significant concessions to the United States in their negotiations. They must assume that partisanship will continue to contaminate foreign policy and lead to abrupt policy reversals. In foreign policy, the US remains reactive in the face of Russian aggression. If Russia signs a ceasefire, the US will not sabotage it to prolong Russian difficulties. Moreover Biden continues to exempt Europe and other allies and partners from enforcing the US’s most severe sanctions for fear of a larger energy shock. Europe’s avoidance of an energy ban is critical and any change in US policy to try to force the EU to cut off Russian energy is unlikely. China will not agree to structural reform or deep concessions in its trade negotiations, knowing that former President Trump could come back. The Biden administration’s own trade policy toward China is limited in scope, as the US Trade Representative Katherine Tai admitted when she said that the US could no longer aim to change China’s behavior via trade talks. Biden’s only proactive foreign policy initiative, Iran, will not bring him public kudos if it is achieved. But American inconstancy is one of the reasons that Iran may walk away from the 2015 nuclear deal. Why should Iran’s hawkish leaders be expected to constrain their nuclear program and expose their economy to future US sanctions if they can circumvent US sanctions anyway, and Republicans have a fair chance of coming back into power as early as January 2025? Biden’s unprecedented release of strategic petroleum reserves will not be able to prevent gasoline prices from staying high given the underlying supply pressures at home and abroad. This is especially true if the Iran talks fail as we expect. Even if inflation abates before the election, it is unlikely to abate enough to save his party from a shellacking. That in turn will weaken the global impression of his administration’s staying power. Hence Biden will focus on maintaining US alliances, which means allowing Europe, India, and others to proceed at a more pragmatic and dovish pace in their relations with Russia and China. Bottom Line: China’s reversion to autocracy and America’s policy insularity suggest that global investors face considerable policy uncertainty this year even aside from the war in Europe. Checking Up On Our Strategic Themes For The 2020s Russia’s invasion strongly confirmed our three strategic themes of Great Power Rivalry, Hypo-Globalization, and Populism/Nationalism. These themes are mutually reinforcing: insecurity among the leading nation-states encourages regionalization rather than globalization, while populism and nationalism encourage nations to pursue economic and security interests at the expense of their neighbors. First, the Ukraine war confirms and exacerbates Great Power Rivalry: Chart 12China And Russia Both Need To Balance Against US Preponderance Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Russia’s action vindicates the “realist” school of international relations (in which we count ourselves) by forcing the world to wake up to the fact that nations still care primarily about national security defined in material ways, such as armies, resources, and territories. The paradox of realism is that if at least one of the great nations pursues its national self-interest and engages in competition for security, then all other nations will be forced to do the same. If a nation neglects its national security interests in pursuit of global economic engagement and cooperation, then it will suffer, since other nations will take advantage of it to enhance their security. Hence, as a result of Ukraine, nations will give a higher weight to national security relative to economic efficiency. The result will be an acceleration of decisions to use fiscal funds and guide the private economy in pursuit of national interests – i.e. the Return of Big Government. Since actions to increase deterrence will provoke counteractions for the same reason, overall insecurity will rise. For example, the US and China will take extra precautions in case of future sanctions and war. But these precautions will reduce trust and cooperation and increase the probability of war over the long run. For the same reason, China cannot reject Russia’s strategic overture – it cannot afford to alienate and isolate Russia. China and Russia have a shared interest in countering the United States because it is the only nation that could conceivably impose a global empire over all nations (Chart 12). The US could deprive Beijing and Moscow of the regional spheres of influence that they each need to improve their national security. This is true not only in Ukraine and Taiwan but in other peripheral areas such as Belarus, the Caucasus, Central Asia, and Southeast Asia. China has much to gain from Russia. Russia is offering China privileged overland access to Russian, Central Asian, and Middle Eastern resources and markets. This resource base is vital to China’s strategic needs, given its import dependency and vulnerability to US maritime power (Chart 13). Chart 13China’s Maritime Vulnerability Forces Eurasian Strategy, Russian Alliance Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours Investors should understand Great Power Rivalry in a multipolar rather than bipolar sense. As Russia breaks from the West, investors are quick to move rapidly to the bipolar Cold War analogy because that is what they are familiar with. But the world today has multiple poles of political power, as it did for centuries prior to the twentieth. While the US is the preponderant power, it is not hegemonic. It faces not one but two revisionist challengers – Russia and China. Meanwhile Europe and India are independent poles of power that are not exclusively aligned with the US or China. For example, China and the EU need to maintain economic ties with each other for the sake of stability, and neither the US nor Russia can prevent them from doing so. The same goes for India and Russia. China will embrace Russia and Europe at the same time, while hardening its economy against US punitive measures. India will preserve ties with Russia and China, while avoiding conflict with the US and its allies (the maritime powers), whom it needs for its long-term strategic security in the Indian Ocean basin. Ultimately bipolarity may be the end-game – e.g. if China takes aggressive action to revise the global order like Russia has done – but the persistence of Sino-European ties and Russo-Indian ties suggest we are not there yet. Second, the Ukraine war reinforces Hypo-Globalization: Since the pandemic we have argued that trade would revive on the global economic snapback but that globalization – the deepening of trade integration – would ultimately fall short of its pre-2020 and pre-2008 trajectory. Instead we would inhabit a new world of “hypo-globalization,” in which trade flows fell short of potential. So far the data support this view (Chart 14). Chart 14Globalization Falling Short Of Potential Second Quarter Outlook 2022: When It Rains, It Pours Second Quarter Outlook 2022: When It Rains, It Pours The Ukraine war has strengthened this thesis not only by concretely reducing Russia’s trajectory of trade with the West – reversing decades of integration since the fall of the Soviet Union – but also by increasing the need for nations to guard against a future Chinese confrontation with the Western world. Trust between China and the West will further erode. China will need to guard against any future sanctions, and thus diversify away from the US dollar and assets, while the US will need to do a better job of deterring China against aggression in Asia, and will thus have to diversify away from Chinese manufacturing and critical resources like rare earths. While China and Europe need each other now, the US and China are firmly set on a long-term path of security competition in East Asia. Eventually either the US or China will take a more aggressive stance and Europe will be forced to react. Since Europe will still need US support against a decaying and aggressive Russia, it will likely be dragged into assisting the US against China. Third, the Ukraine war reflects and amplifies Populism/Nationalism: Populism and nationalism are not the same thing but they both stem from the slowing trend of global income growth, the rise of inequality, the corruption of the elite political establishments, and now the rise in inflation. Nations have to devote more resources to pacifying an angry populace, or distracting that populace through foreign adventures, or both. The Ukraine war reflects the rise in nationalism. First, the collapse of the Soviet Union ushered in a period in which Moscow lost control of its periphery, while the diverse peoples could pursue national self-determination and statehood. The independence and success of the Baltic states depended on economic and military cooperation with the West, which eroded Russian national security and provoked a nationalist backlash in the form of President Putin’s regime. Ukraine became the epicenter of this conflict. Ukraine’s successful military resistance is likely to provoke a dangerous backlash from Moscow until either policy changes or the regime changes. American nationalism has flared repeatedly since the fall of the Soviet Union, namely in the Iraq war. The American state has suffered economically and politically for that imperial overreach. But American nationalism is still a potent force and could trigger a more aggressive shift in US foreign policy in 2024 or beyond. European states have kept nationalism in check and tried to subsume their various nationalist sentiments into a liberal and internationalist project, the European Union. The wave of nationalist forces in the wake of the European debt crisis has subsided, with the exception of the United Kingdom, where it flowered in Brexit. The French election in the second quarter will likely continue this trend with the re-election of President Emmanuel Macron, but even if he should suffer a surprise upset to nationalist Marine Le Pen, Europe’s centripetal forces will prevent her from taking France out of the EU or euro or NATO (Chart 15). Over the coming decade, nationalist forces will revive and will present a new challenge to Europe’s ruling elites – but global great power competition strongly supports the EU’s continued evolution into a single geopolitical entity, since the independent states are extremely vulnerable to Russia, China, and even the US unless they unite and strengthen their superstructure. Chart 15Macron Favored, Le Pen Would Be Ineffective Macron Favored, Le Pen Would Be Ineffective Macron Favored, Le Pen Would Be Ineffective In fact the true base of global nationalism is migrating to Asia. Chinese and Indian nationalism are very potent forces under President Xi Jinping and Prime Minister Narendra Modi. Xi is on the verge of clinching another ten years in power while Modi is still favored for re-election in 2024, so there is no reason to anticipate a change anytime soon. The effects are various but what is most important for investors is to recognize that as China’s potential GDP has fallen over the past decade, the Communist Party has begun to utilize nationalism as a new source of legitimacy, and this is expressed through a more assertive foreign policy. President Xi is the emblem of this shift and it will not change, even if China pursues a lower profile over certain periods to avoid provoking the US and its allies into a more effective coalition to contain China. Chart 16Food Insecurity Will Promote Global Unrest, Populism Food Insecurity Will Promote Global Unrest, Populism Food Insecurity Will Promote Global Unrest, Populism The surge in global prices will destabilize regimes that lack food security and contribute to new bouts of populism and nationalism. Turkey is the most vulnerable due to a confluence of political, economic, and military risks that will unsettle the state. But Egypt is vulnerable to an Arab Spring 2.0 that would have negative security implications for Israel and add powder to the Middle Eastern powder keg. Pakistan is already witnessing political turmoil. Investors may overlook any Indonesian unrest due to its attractiveness in a world where Russia and China are scaring away western investment (Chart 16). All three of these strategic themes are mutually reinforcing – and they tend to be inflationary over the long run. Great powers that redouble the pursuit of national interest – through defense spending and energy security investments – while simultaneously being forced to expand their social safety nets to appease popular discontent, will drive up budget deficits, consume a lot of natural resources, and purchase a lot of capital equipment. They will also more frequently engage in economic or military conflicts that constrain supply (Chart 17). Chart 17War And Preparation For War Are Inflationary War And Preparation For War Are Inflationary War And Preparation For War Are Inflationary Bottom Line: The Ukraine war is a powerful confirmation of our three strategic themes. It is also a confirmation that these themes have inflationary macroeconomic implications. Investment Takeaways Chart 18Global Investors Still Flee To US For Safety Global Investors Still Flee To US For Safety Global Investors Still Flee To US For Safety Now that great power rivalry is intensifying immediately and rapidly, and yet China’s and Europe’s economies are encountering greater difficulties, we expect stagflation to arrive sooner rather than later. High headline and core inflation, the Ukraine war, tacit Chinese support for Russia, persistent Chinese supply kinks, US and EU sanctions, US midterm elections, and a potential US-Iran diplomatic breakdown will all weigh on risk sentiment in the second quarter. In Ukraine, Russia’s position is too weak to give comfort for investors, who should continue to favor defensive over cyclical equities and US stocks over global stocks. Russia’s break with the West, and the West’s use of sanctions to prevent Russia from accessing its foreign exchange reserves, has raised new questions about the global currency reserve system and the dollar’s status within that system. Over the coming years China will redouble the efforts it began in the wake of the Great Recession to reduce its dependency on US dollar assets within its reserve basket, while also recycling new current account surpluses into non-dollar assets. However, the evidence does not suggest that King Dollar will suffer a structural breakdown. First, the world lacks alternative safe-haven assets to US Treasuries – and net foreign purchases of US bonds rose in the face of the Ukraine war (Chart 18). Second, the return of war to Europe will weaken the perceived long-term security of European currency and government bonds relative to US counterparts. Even if the Ukraine war is contained in the short run, as we expect, Russia is in structural decline and will remain a disruptive player for some time. We are not at all bearish on the euro or European bonds but we do not see the Ukraine war as increasing their value proposition, to put it lightly. The same logic extends to Japanese bonds, since China, like Russia, is an autocratic and revisionist state that threatens to shake up the security order in its neighborhood. Japan is relatively secure as a nation and we are bullish on the yen, but China’s de facto alliance with Russia weakens Japan’s security outlook over the very long run, especially relative to the United States. Thus, on a cyclical basis the dollar can depreciate, but on a structural basis the US dollar will remain the dominant reserve currency. The US is not only the wealthiest and most secure country in the world but also the largest oil producer. Meanwhile Chinese potential growth, domestic political stability, and foreign relations are all worsening. The US-Iran talks are the most critical geopolitical dynamic in the second quarter aside from Russia’s clash with the West. The fate of the 2015 nuclear deal will be decided soon and will determine whether an even bigger energy shock begins to emanate from the Middle East. We would not bet on a new US-Iran deal but we cannot rule it out. Any deal would be a short-term, stop-gap deal but would prevent an immediate destabilization of the Middle East this year. As such it would reduce the risk of stagflation. Since we expect the deal to fail, we expect a new energy shock to emerge. We see stagflation as more likely than the BCA House View. It will be difficult to lift productivity in an environment of geopolitical and political uncertainty combined with slowing global growth, rising interest rates, and a worsening commodity shock (Chart 19). We will gladly revise this stance if Biden clinches an Iran deal, China relaxes its Covid Zero policy and stabilizes domestic demand, Russia and Europe maintain energy trade, and commodity prices fall to more sustainable levels for global demand. Chart 19Stagflation Cometh Stagflation Cometh Stagflation Cometh Strategically we remain long gold, overweight US equities, overweight UK equities, long British pound and Japanese yen, long aerospace/defense stocks and cyber security stocks. We remain short Chinese renminbi and Taiwanese dollar and short emerging European assets. Our short Chinese renminbi trade and our short Taiwanese versus Korean equity trade are our worst-performing recommendations. However, the above analysis should highlight – and the Ukraine war should underscore – that these two economies face a fundamentally negative geopolitical dynamic. Both Chinese and Taiwanese stocks have been underperforming global peers since 2021 and our short TWD-USD trade is in the money. While we do not expect war to break out in Taiwan this year, we do expect various crisis events to occur, particularly in the lead up to the crucial Taiwanese and American 2022 midterms and 2024 presidential election. We also expect China to depreciate the renminbi when inflation peaks and commodity prices subside. Cyclically we remain long North American and Latin American oil producers and short Middle Eastern producers, based on our pessimistic read of the Iran situation. The Americas are fundamentally better protected from geopolitical risks than other regions, although they continue to suffer from domestic political risks on a country-by-country basis. Cyclically we continue to take a defensive positioning, overweighting defensive sectors and large cap equities.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      That the Russian threat fell under our third key view for 2022 implies that we did not get our priorities straight. However, consider the timing: shortly after publishing our annual outlook on December 15, the Russians issued an ultimatum to the western powers demanding that NATO stop expanding toward Russia. Diplomats from Russia and the West met on January 12-13 but Russia’s demands were not met. We upgraded the odds that Russia would invade Ukraine from 50% to 75% on January 27. Shuttle diplomacy ensued but failed. Russia invaded on February 24. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar

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

Executive Summary Wars Don’t Usually Affect Markets For Long Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested We expect the war in Ukraine to stay within its borders, and therefore to have little impact on global growth. Markets will be volatile, but we recommend allocators stay invested – with some moderate hedges in place. The Fed won’t tighten as fast as markets expect, and US long rates will not rise much further this year. So, within fixed-income, we raise government bonds to neutral. Flat rates remove a positive for the Financials equity sector, which we lower to neutral. The oil price will fall back to $85 by the second half, as Saudi and others increase supply. We reduce our recommendation for Canadian equities and the CAD. Recommendation Changes Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested Bottom Line: Stay invested in risk assets, but have some hedges. We shift from Financials to the defensive-growth IT sector, raise our weight in UK equities, and suggest long positions in cash, CHF and JPY.   Recommended Allocation Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested The war in Ukraine is likely to have only a limited impact on markets beyond the short term. As disturbing as the human tragedy is, Russia’s aims are limited to regime change in Kyiv. The European Union and US face restraints on how draconian sanctions against Russia can be, balking (so far at least) at blocking imports of Russian energy to the EU, given how much this would hurt the economy. The risk of the conflict spreading beyond Ukraine’s borders is low, limited perhaps to cyberattacks on Western targets. A Russian attack on a NATO member, such as Poland or one of the Baltic states, is extraordinarily unlikely – though Moldova and Georgia (not NATO members) might be more vulnerable at some point in the future. For more detailed analysis, please read the two reports on the Ukraine situation by our Geopolitical Service that we have made available to all BCA Research subscribers.1 Asset allocators need to look at these events dispassionately. Markets are likely to remain volatile over the coming months, as events in Ukraine unfold. But the lesson of most major conflicts is that they typically do not have a long-lasting impact on asset performance (Chart 1). There is little chance that the Ukraine war will significantly dent global growth. The only exception would be if the oil price were to rise much further to, say, $120 a barrel as some are forecasting. Certainly, in the past, a jump in the oil price has often been associated with recessions – even though the causality is unclear (Chart 2). But BCA’s Energy strategists expect to see an increase in oil supply by Saudi Arabia and Gulf states which will bring Brent crude back to $85 by the second half (from $98 now). Chart 1Wars Don't Usually Affect Markets For Long Wars Don't Usually Affect Markets For Long Wars Don't Usually Affect Markets For Long Chart 2But A Jump In Oil Prices Would But A Jump In Oil Prices Would But A Jump In Oil Prices Would Meanwhile, global growth remains robust, with all major economies expected to continue to grow well above trend this year, supported by robust consumption and capex (Chart 3). And sentiment towards equities has turned very pessimistic since the start of the year, with indicators such the US Association of Individual Investors’ weekly survey at its most bearish level since 2008 (Chart 4). These sort of sentiment levels have typically pointed to a rebound in risk assets. Chart 4Sentiment Is At Rock-Bottom Sentiment Is At Rock-Bottom Sentiment Is At Rock-Bottom Chart 3Economic Growth Still Above Trend Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested         Our advice now would be to stay invested, but with some moderate safe-haven hedges in place – largely as we have recommended since late last year. We continue to recommend an overweight in cash, but will look to allocate this to risk assets when it becomes clearer how the situation in Ukraine will pan out. The trajectory of markets over the rest of this year still largely comes down to what the Fed and other central banks will do. The hawkish turn by the Fed in December has been the driver of markets in the past two months, with the result that none of the major asset classes have produced positive returns year to-date – only inflation hedges such as commodities and gold (Chart 5). Chart 5Most Asset Classes Are Down Year-To-Date Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested The futures market is pricing the Fed to raise rates seven times over the next 12 months, the fastest rate of predicted tightening since the early 2000s (Chart 6). We think that is a little excessive. Inflation, as we have argued previously, is likely to fade over the coming quarters, as the supply response to strong consumer demand for manufactured goods brings down the price of cars, semiconductors, shipping and other major items. The Fed may well start in March with the intention of raising rates by 25bps every meeting, but the slowing of inflation we expect, and the tightening of financial conditions already under way (Chart 7), make it unlikely that it will continue at that pace. And remember that Fed policy will need to be even more hawkish than the market is currently pricing in for it to have an incrementally negative impact on risk assets. Chart 6Market Believes Fed Will Hike Fast Market Believes Fed Will Hike Fast Market Believes Fed Will Hike Fast Chart 7Financial Conditions Have Already Tightened Financial Conditions Have Already Tightened Financial Conditions Have Already Tightened There are certainly risks to this scenario. The forward yield curve is pointing to inversion one year ahead, something which normally presages recession over the following 1-3 years (Chart 8). Higher prices are starting to hurt consumer confidence, though there is a big disparity between the two main US indicators (Chart 9). Chart 8Will Yield Curve Invert Within A Year? Will Yield Curve Invert Within A Year? Will Yield Curve Invert Within A Year? Chart 9Inflation May Be Hurting Consumer Confidence Inflation May Be Hurting Consumer Confidence Inflation May Be Hurting Consumer Confidence What all this boils down to is how high a level of interest rates the economy is able to withstand. The futures markets imply that, in most countries, central banks will raise rates aggressively this year, but then be forced to stop or even cut rates after that because their actions cause an economic slowdown (Table 1). Our view is that the terminal rate is much higher than what is priced by markets and projected by central banks: In the US perhaps 3-4% in nominal terms.2 Even with seven Fed hikes over the next year, the policy rate would therefore remain well below neutral – an environment in which historically equities have outperformed bonds (Chart 10). Table 1Central Banks Will Hike Aggressively – But Then Stop Soon Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested Chart 10Even In A Year, Rates Will Be Well Below Neutral Even In A Year, Rates Will Be Well Below Neutral Even In A Year, Rates Will Be Well Below Neutral One final comment: On long-term returns. As a result of the recent moderate equity correction, strong earnings growth, and higher long-term rates, the outlook is somewhat rosier than when we published our most recent report on Return Assumptions in May 2021 – though admittedly forward long-term returns are still likely to be lower than over the past 20 years (Table 2). This is not, then, a time to turn defensive. Table 2Long-Term Return Outlook No Longer Looks So Gloomy Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested Fixed Income: In the short-term, government bonds look oversold (Chart 11). With inflation set to peak and the Fed likely to be less hawkish than the market has priced in, we do not see the 10-year US Treasury yield rising more than another 25 basis points or so above its current level this year. Accordingly, we are changing our duration call from underweight to neutral, and raise our recommendation for government bonds within the (still underweight) fixed-income bucket to neutral. For more cautious investors, a slight increase in government bond holdings might be warranted. Within credit, investment-grade bonds still offer little pickup, despite the moderate rise in spreads this year (from 92 to 121 in the US, for example), and so we lower this asset class to underweight. We continue to prefer high-yield bonds, which in the US now imply a jump in the default rate from 1.2% over the past 12 months to 4.5% over the coming year (Chart 12). As long as the economy grows in line with our expectations, that is very unlikely. Chart 11Government Bonds Look Oversold Government Bonds Look Oversold Government Bonds Look Oversold Chart 12Will Defaults Really Jump This Much? Will Defaults Really Jump This Much? Will Defaults Really Jump This Much?   Equities: With the economy continuing to grow above-trend, global earnings should remain robust. This will not be a classic year for equity returns, but we expect them to do better than bonds. We continue to prefer US over European equities. As was seen in the aftermath of the invasion of Ukraine, US stocks are more defensive, and European growth will continue to be under threat from higher energy prices (Chart 13). We also move our recommended portfolio a little in the defensive direction by going overweight UK equities (which have a particularly high weight in defensive growth sectors, such as a 13 point overweight in Consumer Staples); we fund this by lowering Canadian equities to underweight, given their close linkage with oil (Chart 14), and the vulnerability of the Canadian housing market to rising rates. We remain underweight EM, but Chinese stocks (which were very oversold in late 2021) have been a relative safe haven as China started to stimulate, and so we continue with our neutral position for now. Chart 13Higher Energy Prices Threaten Europe Higher Energy Prices Threaten Europe Higher Energy Prices Threaten Europe Chart 14Canadian Stocks Move With The Oil Price Canadian Stocks Move With The Oil Price Canadian Stocks Move With The Oil Price Chart 15Financials Not So Attractive If Rates Don't Rise Financials Not So Attractive If Rates Don't Rise Financials Not So Attractive If Rates Don't Rise Our view that long-term rates have limited upside this year makes us more cautious on Financials stocks, which are closely correlated with rates, and so we cut this sector to neutral (Chart 15). A period of slowing growth points towards a preference for defensive growth, and so we raise our recommended weight in the IT sector to overweight from neutral. It is tempting to think of this sector as being composed of ridiculously overvalued speculative internet names, but it is in fact dominated by established hardware and software titans with deep competitive moats (Table 3). While the sector is not exactly cheap, its risk premium over bonds is quite reasonable by historical standards (Chart 16).   Table 3Tech Sector Is Not Made Up Of Speculative Stocks Monthly Portfolio Update: Keep Calm And Stay Invested Monthly Portfolio Update: Keep Calm And Stay Invested Chart 16Tech Is Not Unreasonably Priced Tech Is Not Unreasonably Priced Tech Is Not Unreasonably Priced Chart 17Relative Rates Suggest Some Upward Pressure On USD Relative Rates Suggest Some Upward Pressure On USD Relative Rates Suggest Some Upward Pressure On USD Currencies: A neutral position on the US dollar still makes sense. Short-term rates are likely to rise somewhat faster in the US, relative to expectations, than in Europe or Japan (Chart 17). Nevertheless, the USD is expensive, and long-dollar is a consensus trade – reasons why the dollar has risen by less than 1% year-to-date on a trade-weighted basis, despite all the higher rate expectations and geopolitical shocks. Investors looking for hedges against downside risk might look to the Japanese yen, which is particularly cheap, and the Swiss franc. By contrast, the Canadian dollar, like Canadian equities, is closely linked to the oil price and a fallback in the Brent price would be negative; we move underweight. We also raise the CNY to neutral, since it may become a safe haven currency in the current geopolitical situation, though the Chinese authorities won’t let it rise too much since that would slow the economy. Commodities: China’s stimulus remains somewhat halfhearted (Chart 18). Although the credit and fiscal impulse has bottomed, we expect to see it rebound only moderately, with just minor cuts in interest rates and the reserve ratio. This will stabilize Chinese growth, but not cause a boom as in 2020, 2016 or 2013. The rise in industrial commodities prices, therefore, is likely to be limited from here. For oil, as mentioned above, we expect to see Brent crude return to around $85 by the second half, as new supply comes onto the market. Gold has done well, as expected, in the face of a major geopolitical event. But it is expensive by historical standards, vulnerable to a rise in real (as opposed to nominal rates) as inflation eases (Chart 19), and faces cryptocurrencies as a rival. We keep our neutral, as a hedge against the tail-risk of much higher inflation, but would not chase the price at this level. Chart 18China's Stimulus Isn't Enough To Help Metals Prices China's Stimulus Isn't Enough To Help Metals Prices China's Stimulus Isn't Enough To Help Metals Prices Chart 19Rising Real Rates Are Negative For Gold Rising Real Rates Are Negative For Gold Rising Real Rates Are Negative For Gold Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   Footnotes 1     Please see Geopolitical Strategy Special Reports, “Russia Takes Ukraine: What Next?” dated February 24, 2022, and "From Nixon-Mao To Putin-Xi," dated February 25, 2022. 2     Please see Global Investment Strategy, “The New Neutral” dated January 14, 2022.   Recommended Asset Allocation Model Portfolio (USD Terms)

Executive Summary Hopes of an imminent peace deal between Russia and Ukraine will be dashed. The conflict will worsen over the coming days. As was the case during the original Cold War, both sides will eventually forge an understanding that allows the pursuit of mutually beneficial arrangements. A stabilization in geopolitical relations, coupled with fading pandemic headwinds, should keep global growth above trend this year, helping to support corporate earnings. The era of hyperglobalization is over. While central banks will temper their plans to raise rates in the near term, increased spending on defense and energy independence will lead to higher interest rates down the road. How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis Bottom Line: The near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected.   Dear Client, Given the rapidly evolving situation in Ukraine, we are sending you our thoughts earlier than normal this week. We will continue to update you as events warrant it. Best regards, Peter Berezin Chief Global Strategist   False Dawn In the lead-up to the invasion, Vladimir Putin assumed that Ukrainian forces would fold just as quickly as US-backed Afghan forces did last summer. He also presumed that the rest of the world would reluctantly accept Russia’s takeover of Ukraine. Both assumptions appear to have been proven wrong. Even if Putin succeeds in installing a puppet government in Kyiv, a protracted insurgency is sure to follow. In the initial days of the invasion, Russian troops generally tried to avoid harming civilians, partly in the hope that Ukrainians would see the Russian military as liberators. Now that this hope has been dashed, a more brutal offensive could unfold. This would trigger even more sanctions, leading to a wider gulf between Russia and the West. It is highly doubtful that sanctions will dissuade Putin from trying to subdue Ukraine. Putin made a name for himself by staging a successful invasion of Chechnya in 1999, just three years after the Yeltsin government had suffered a major defeat there. To withdraw from Ukraine now, without having fomented a regime change in Kyiv, would be a humiliating outcome for him. In this light, BCA’s geopolitical team, led by Matt Gertken, has argued that ongoing peace talks taking place on the border of Ukraine and Belarus are unlikely to amount to much. The situation will get worse before it gets better. Market Implications It always feels a bit crass writing about finance during times like this, but as investment strategists, it is our job to do so. With that in mind, we would make the following observations: Global equities are likely to suffer another leg down in the near term as hopes of an imminent peace deal fizzle. Consequently, we are downgrading our view on global stocks from overweight to neutral on a 3-month horizon. Nimble investors with a low risk tolerance should consider going underweight equities. We are shifting our stance on US stocks from underweight to neutral on a 3-month horizon. Europe could face significant pressures from near-term disruptions to Russian gas supplies. It does not make much sense for Russia to export gas if it is effectively barred from accessing the proceeds of its sales. Central and Eastern Europe will be particularly hard hit (Chart 1). Chart 1Central and Eastern Europe Would Suffer The Most From A Russian Energy Blockade A New Cold War A New Cold War For now, we are maintaining an overweight to stocks on a 12-month horizon. While it will take a month or two, both sides will ultimately forge an understanding whereby Russia and the West continue to publicly bad-mouth each other while still pursuing mutually beneficial arrangements. Remember that during the Cold War, the Soviet Union continued to sell oil to the West. Even the Cuban Missile Crisis had only a fleeting impact on equities (Chart 2). Chart 2How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis Chart 3European Fiscal Policy Will Remain Structurally Looser Over The Coming Years A New Cold War A New Cold War Assuming that any reduction in Russian energy exports is temporary, oil prices will eventually recede. BCA’s commodities team, led by Bob Ryan, expects Brent to settle to $88/bbl by the end of 2022 (down from the current spot price of $101/bbl and close to the forward price of $87/bbl). Like oil, gold prices have upside in the near term but should edge lower once the dust settles.    Global growth should remain solidly above trend in 2022 as pandemic-related headwinds fade and fiscal policy turns more expansionary. Even before the Ukraine invasion, the structural primary budget deficit in Europe was set to swing from a small surplus to a deficit (Chart 3). The emerging new world order will lead to sizable additional military spending, as well as increased outlays towards achieving energy independence (new LNG terminals, more investment in renewables, and perhaps even some steps towards restarting nuclear power programs). China will also step up credit easing and fiscal stimulus. This will not only benefit the Chinese economy, but it will also provide some much-needed support to European exporters (Chart 4). While credit spreads are apt to widen further in the near term, corporate bonds should benefit from stronger growth later this year. US high-yield bonds are pricing in a jump in the default rate from 1.3% over the past 12 months to 4.2% over the coming year, which seems somewhat excessive (Chart 5).  Chart 4Chinese Policy Will Be A Tailwind For Growth Chinese Policy Will Be A Tailwind For Growth Chinese Policy Will Be A Tailwind For Growth Chart 5Credit Markets Are Pricing In An Excessive Default Rate Credit Markets Are Pricing In An Excessive Default Rate Credit Markets Are Pricing In An Excessive Default Rate Central banks will temper their plans to raise rates in the near term. Investors and speculators are net short duration at the moment, which could amplify any downward move in bond yields (Chart 6). However, over a multi-year horizon, recent events will lead to both higher inflation and interest rates. Larger budget deficits will sap global savings. The retreat from globalization will also put upward pressure on wages and prices. As defensive currencies, the US dollar and the Japanese yen will strengthen in the near term as the conflict in Ukraine escalates. Looking beyond the next few months, the dollar will weaken. On a purchasing power parity basis, the dollar is amongst the most expensive currencies (Chart 7). For example, relative to the euro, the dollar is 22% overvalued (Chart 8). The US trade deficit has doubled since the start of the pandemic, even as equity inflows have dipped (Chart 9). Speculators are long the greenback, which raises the risk of an eventual reversal in dollar sentiment. Chart 6Short Duration Is A Crowded Trade Short Duration Is A Crowded Trade Short Duration Is A Crowded Trade Chart 7The US Dollar Is Overvalued… A New Cold War A New Cold War   Chart 8...Especially Against The Euro A New Cold War A New Cold War The freezing of Russia’s foreign exchange reserves will encourage China to diversify away from US dollars towards hard assets such as land and infrastructure in economies where they are less likely to be seized. It will also encourage the Chinese authorities to bolster domestic demand and permit a further modest appreciation of the RMB since these two steps will reduce the current account surpluses that make foreign exchange accumulation necessary. EM currencies will benefit from this trend. Chart 9The Trade Deficit Is A Headwind For The Dollar The Trade Deficit Is A Headwind For The Dollar The Trade Deficit Is A Headwind For The Dollar In summary, the near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected. Trade Update: We closed our long Brent oil trade for a gain of 24% last week. Earlier today, we were stopped out of the trade we initiated on September 16, 2021 going long the Russian ruble and the Brazilian real. The BRL leg was up 6.2% at the time of termination while the RUB leg was down 23.1% (based on the Bloomberg RUB/USD Carry Return Index as of 4pm EST today). Peter Berezin Chief Global Strategist peterb@bcaresearch.com View Matrix A New Cold War A New Cold War Special Trade Recommendations A New Cold War A New Cold War Current MacroQuant Model Scores A New Cold War A New Cold War

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

Highlights We reformatted and added three sections to our existing trade tables: strategic themes, cyclical asset allocations and tactical investment recommendations. An extensive audit of our current trade book shows that our country and sector allocation recommendations have been successful. Of the eight open trades in our book, six have so far generated positive returns. We now recommend closing three out of the eight positions, based on a review of the original basis and subsequent performance of our trades. We have also added one cyclical and two tactical trades. We will look for opportunities to propose new trades to our book in the coming months. Feature In this week's report, we introduce our newly formatted trade tables (on Page 15), which include the following: Strategic themes (structural views beyond 18 months) Cyclical asset allocations within Chinese financial markets (in the next 6 to 18 months) Tactical trades (investment recommendations for the next 0 to 6 months) We revisited the original basis and subsequent performance of our open trades as part of an audit of our trade book. We maintain five of the eight trades and will add one cyclical and two tactical trades. Our new features and the rationale for retaining or closing each trade are presented below. Strategic Themes The new Strategic Themes section now includes the following market relevant structural forces: President Xi Jinping’s “common prosperity” policy initiative, which is intended to narrow the nation’s wealth gap; a demographic shift of a shrinking population by 2025; and secular disputes between the US and China (Table 1). Table 1 Introducing New Trade Tables Introducing New Trade Tables These structural aspects will have a macro impact on China’s policy landscape, economy and financial markets. Investors should consider whether the themes point toward a reflationary policy bias; whether they will have a medium- to long-term effect on corporate earnings; and whether these themes will, on a structural basis, warrant higher/lower risk premiums for owning Chinese stocks. Cyclical Equity Index Allocation Recommendations (Relative To MSCI All Country World) Table 2 is a summary of our cyclical recommendations for Greater China equity indexes. We recommend the following equity index allocations within a global equity portfolio, for the next 6 to 18 months: Table 2 Introducing New Trade Tables Introducing New Trade Tables Underweight MSCI China (Chinese investable stocks). Underweight MSCI China A Onshore (Chinese onshore or A-share stocks). Neutral stance on MSCI Hong Kong Index. Overweight MSCI Taiwan Index. Chart 1Chinese Stocks Substantially Underperformed Global Equities Chinese Stocks Substantially Underperformed Global Equities Chinese Stocks Substantially Underperformed Global Equities Our recommendation to underweight MSCI China Index and MSCI China A Onshore Index were extremely successful in 2021 (Chart 1). We will continue to maintain an underweight stance for the time being, based on our concern that the current policy easing measures will be insufficient to revive China’s slowing economy. We expect policy stimulus to step up in the coming months and economic growth to start improving by mid-2022. However, corporate profits are set to disappoint in the first half of the year. This implies that Chinese share prices will remain volatile with substantial downside risks. Chinese investable stocks are in oversold territory and will likely rebound in the near term in both absolute and relative terms (discussed in the Tactical Recommendations section on Page 14) (Chart 2). Nonetheless, on a cyclical basis, they face challenges both from the impact of a slowing economy on earnings growth and ongoing regulatory and geopolitical risks. Our model suggests high odds (70%) of a considerable earnings contraction in Chinese investable stocks in the next 6 to 12 months. We recommend investors upgrade their allocation to the MSCI Hong Kong Index from underweight to neutral within a global equity portfolio. The MSCI Hong Kong equity index appears to be very cheap compared with global equities (Chart 3). Chart 2Chinese Investable Stocks Are Oversold Chinese Investable Stocks Are Oversold Chinese Investable Stocks Are Oversold Chart 3MSCI HK Equities Are Cheap MSCI HK Equities Are Cheap MSCI HK Equities Are Cheap The MSCI Hong Kong equity index includes Hong Kong-domiciled companies and not mainland issuers listed in Hong Kong. Rising US Treasury yields will be a headwind to Hong Kong-domiciled company stock performance because the HKD is pegged to the USD and therefore Hong Kong bond yields tend to follow the direction of bond yields in the US. Chart 4MSCI HK Index Is Defensive In Nature MSCI HK Index Is Defensive In Nature MSCI HK Index Is Defensive In Nature However, an offsetting factor is that due to composition changes over time, the MSCI Hong Kong equity index has become much more defensive and tends to perform better than the emerging Asian and EM equity benchmarks during turbulent times (Chart 4). The weight of insurance companies and diversified financials account for over 40% of the MSCI Hong Kong Index, compared with property stocks, which take up 20% of the equity market cap. The insurance and diversified financials subsectors are less vulnerable to escalating short-term interest rates compared with property stocks. During risk-off phases, the defensive nature in the MSCI Hong Kong Index will support its performance relative to the some of the more industrial- and tech-heavy EM and global equity indexes. We maintain an overweight stance on the MSCI Taiwan Index relative to global equities. The trade (see discussion in the Cyclical Equity And Sector Trades section) has brought an impressive 40% rate of return since its inception in 2019. Cyclical Recommended Asset Allocation (Within Chinese Onshore Assets) Image We recommend an underweight position in equities in China’s onshore multi-asset portfolios (Table 3). Chinese onshore stocks are not cheap and will likely underperform onshore government bonds as the economy struggles to regain its footing. Chart 5Total Returns In Chinese Onshore Stocks Have Barely Kept Up With Onshore GB Total Returns In Chinese Onshore Stocks Have Barely Kept Up With Onshore GB Total Returns In Chinese Onshore Stocks Have Barely Kept Up With Onshore GB Chart 5 shows that in the past decade total returns in Chinese onshore stocks have barely kept up with that in onshore long-duration government bonds. During policy easing cycles Chinese onshore stocks generated positive excess returns over government bonds, however, the outperformance has been extremely volatile and very brief. Given that we do not expect Beijing to allow a significant overshoot in stimulus this year, there is a good chance that the returns in Chinese onshore stocks will underperform onshore government bonds. Cyclical Equity And Sector Trades Our rationale for retaining or closing each trade is described below. Chart 6Chinese Onshore Stocks Outperformance Has Been Passive Chinese Onshore Stocks Outperformance Has Been Passive Chinese Onshore Stocks Outperformance Has Been Passive Long China A-Shares/Short Chinese Investable Stocks (Maintain) We initiated this trade in March 2021. The recommendation has been our most successful trade, generating a 40+% return since then (Chart 6). China’s internet platform giants have a large weight in the MSCI Investable index and they remain vulnerable (Chart 7). Although China’s antitrust regulations may have passed the peak of intensity, they will not be rolled back and multiple compression in these stocks will likely continue in 2022. In contrast, the A-share index is heavily weighted in value stocks. The trade is in line with our view that the global investment backdrop has shifted in favor of global value versus growth stocks due to an above-trend US expansion and climbing US bond yields in the next 6 to 12 months. The relative ratio between China A-shares and investable stocks is overbought and will likely pull back in the near term (Chart 8). However, the cyclical and structural outlook continues to favor onshore stocks versus the investable universe. Chart 7Sizable Underperformance In Investable Consumer Discretionary Stocks Sizable Underperformance In Investable Consumer Discretionary Stocks Sizable Underperformance In Investable Consumer Discretionary Stocks Chart 8A Near-Term Pullback In Relative Ratio Is Likely A Near-Term Pullback In Relative Ratio Is Likely A Near-Term Pullback In Relative Ratio Is Likely Long CSI500/Short Broad A-Share Market (Maintain) The CSI500 index, which comprises 500 SMID-cap companies, has outperformed the broad A-share market by 32% since mid-February (Chart 9). We think the outperformance in SMID stocks has not fully run its course. Historically, SMID-caps tend to outperform large caps in the late phase of an economic recovery and the valuation premia in small cap stocks remains near decade lows (Chart 10). In addition, the government’s increasing efforts to support small- and medium-sized corporates will help to shore up confidence in those companies. Therefore, SMID will probably continue to outperform large cap stocks this year. Chart 9A Low Valuation Premia And More Policy Support Will Help Lift Prices Of SMID-Caps A Low Valuation Premia And More Policy Support Will Help Lift Prices Of SMID-Caps A Low Valuation Premia And More Policy Support Will Help Lift Prices Of SMID-Caps Chart 10SMID-Caps Tend To Outperform Large-Caps In Late Business Cycle SMID-Caps Tend To Outperform Large-Caps In Late Business Cycle SMID-Caps Tend To Outperform Large-Caps In Late Business Cycle Long MSCI Taiwan Index/Short MSCI All Country World (Maintain) The MSCI Taiwan equity index has consistently outperformed global equities since mid-2019, mostly driven by the rally in Taiwanese semiconductor stocks. Global chip supply shortages since the COVID pandemic have further boosted the sector’s outperformance (Chart 11). Furthermore, Chart 12 highlights improvements in the cyclical case for Taiwanese stocks as an aggregate. Panels 1 & 2 show an uptick in the new export orders component of Taiwanese manufacturing PMI. The new export orders component has historically coincided with both Taiwanese exports to China and the relative Taiwanese manufacturing PMI on a cyclical basis. As such, the economic fundamentals also support a continued outperformance in Taiwanese stocks. Chart 11A Great Run In MSCI Taiwan Equity Index And Semis A Great Run In MSCI Taiwan Equity Index And Semis A Great Run In MSCI Taiwan Equity Index And Semis Chart 12Exports To China, 12-Month Forward EPS, And Relative Stock Prices: All Likely To Improve Exports To China, 12-Month Forward EPS, And Relative Stock Prices: All Likely To Improve Exports To China, 12-Month Forward EPS, And Relative Stock Prices: All Likely To Improve Long Chinese Onshore Industrial Stocks/Short MSCI China A Index (Maintain) This trade, initiated in September last year, has brought a slightly positive return as of today. Our view was based on improving manufacturing investment and policy support for the sector, even though China’s business cycle had already peaked. Chart 13China Onshore Industrials Closely Track Economic Fundamentals China Onshore Industrials Closely Track Economic Fundamentals China Onshore Industrials Closely Track Economic Fundamentals While we maintain the trade for now, we will monitor credit growth in Q1 to assess whether to close the trade. The sector’s performance is highly correlated with our BCA China Activity Index and the Li Keqiang Leading Indicator (Chart 13). A bottoming in both indicators in mid-2022 would suggest that investors should maintain the trade. The caveat, however, is that the sector’s valuations have already become extreme, indicating that the bar may be higher for the sector to outperform even when economic fundamentals improve in 2H22. We will watch for signs of an overshoot in stimulus in the coming three to six months. Conversely, credit growth in Q1 that is at or below expectations will warrant closing this trade. Long Domestic Semiconductor Sector/Short Global Semiconductor Benchmark (Close) Replace with: Long Domestic Semiconductor Sector/Short MSCI China A Onshore The trade has been our biggest loser since its inception in August 2020. Although Chinese onshore semiconductor stocks outperformed the broad A-share market by a large margin, they have underperformed their global peers (Chart 14). Thus, we are closing the trade and replacing it with long Chinese onshore semis relative to the broad A-share market. We remain bullish on Chinese semi stocks, on both a structural and cyclical basis. Secular pressures from the US and the West to curb the advancement of Chinese technology will encourage China’s authorities to double down on supporting state-led technology programs. Moreover, prices of Chinese onshore semis have plummeted since November last year, bringing their lofty valuations closer to long-term trend and providing a better cyclical risk-reward profiles for these stocks (Chart 15). Chart 14Chinese Onshore Semis Underperformed Global... Chinese Onshore Semis Underperformed Global... Chinese Onshore Semis Underperformed Global... Chart 15...But Outperformed Domestic Broad Market ...But Outperformed Domestic Broad Market ...But Outperformed Domestic Broad Market Long Domestic Consumer Discretionary/Short Broad A-Share Market (Close) Chart 16A Trend Reversal In Chinese Onshore Consumer Discretionary Stocks Performance A Trend Reversal In Chinese Onshore Consumer Discretionary Stocks Performance A Trend Reversal In Chinese Onshore Consumer Discretionary Stocks Performance We placed the trade in May 2020 when China’s economy and household discretionary consumption showed a strong rebound from the deep slump in Q1 2020. As strength waned in the country’s domestic demand for housing, housing-related durable goods and automobiles, the sector’s relative performance also started to dwindle from its peak in the fall of last year (Chart 16). Going forward, even though China’s economy will start to improve on a cyclical basis, domestic consumer discretionary sector will face non-trivial headwinds. The performance of its subsectors, such as hotels, restaurants, and services, will remain subdued due to China’s zero tolerance COVID policy that leads to frequent lockdowns and travel restrictions (Chart 17). Moreover, the internet and direct-marketing retail subsectors are facing tighter regulations, which lowers the sector’s profitability and valuations (Chart 18). Chart 17Domestic COVID Flareups Pose Significant Threat To Chinese Consumer Services Sector Performance Domestic COVID Flareups Pose Significant Threat To Chinese Consumer Services Sector Performance Domestic COVID Flareups Pose Significant Threat To Chinese Consumer Services Sector Performance Chart 18Online Retailing Also Faces Regylatory Pressures Online Retailing Also Faces Regylatory Pressures Online Retailing Also Faces Regylatory Pressures Short Hong Kong 10-Year Government Bond/Long US 10-Year Treasury (Maintain) In the past decade, Hong Kong's 10-year government bond yield has been consistently below that of the US, even though Hong Kong has an exchange rate pegged to the US dollar and its monetary policy is directly tied to that of the US. Chart 19The US-HK Yield Gap Should Widen In The Coming Months The US-HK Yield Gap Should Widen In The Coming Months The US-HK Yield Gap Should Widen In The Coming Months The US-Hong Kong 10-year yield spread has substantially narrowed since early 2020 when the US Fed aggressively cut its policy rate. In the coming 6-12 months, however, the spread will likely widen given that the Fed will start to normalize rates (Chart 19, top panel). Chart 19 (bottom panel) highlights that the relative total return profile of the trade (in unhedged terms) trends higher over time due to the carry advantage. Although cyclically the relative total return will likely reverse to its trend line and argues for a short stance on US Treasury, we think it is too early to close the trade. The USD will likely remain strong in the near term, and we have yet to turn positive on Chinese and Hong Kong assets over a 6 to 18-mont time horizon. Therefore, we maintain this trade until the USD starts to weaken, and foreign investment flows into China and Hong Kong shows sustainable momentum. Long USD-CNH (Close) We are closing this trade, which we initiated in May 2020 when tensions between the US and China were rising. The trade has lost more than 10% since its inception because the RMB exchange rate was boosted in 2021 by China’s record current account surplus, wide interest rate differentials and speculation that tension between the US and China would abate. Chart 20A Weaker USD Will Prevent Sizable RMB Depreciation A Weaker USD Will Prevent Sizable RMB Depreciation A Weaker USD Will Prevent Sizable RMB Depreciation We expect all three favorable conditions supporting the RMB to start reversing in 1H22, suggesting downward pressure on the RMB. However, over a longer period of 6 to 18 months the US dollar also has the potential to trend lower, preventing the RMB from any sizable depreciation (Chart 20). The dollar strength in the past year has been the result of both speculative flows into the US dollar based on rising interest rate expectations and portfolio inflows into the US equity markets.  In the next 6 to 18 months, however, our Foreign Exchange Strategist Chester Ntonifor predicts that the dollar could begin a paradigm shift, whereby any actions by the Fed could eventually lead to a weakening of the US dollar. Higher rates than the market expects will initially boost the US dollar, but will also undermine the US equity market leadership, reversing the substantial portfolio inflows from recent years. On the flip side, fewer rate hikes will severely unwind higher rate expectations in the US relative to other developed markets. Chester further predicts that the DXY could touch 98 in the near term but will break below 90 in the next 12-18 months. Tactical Recommendations (0-6 months) We are initiating two tactical trades to go long on the MSCI China Index and MSCI Hong Kong Index relative to global equities. Relative to global stocks, Chinese investable equities are very oversold and offer value. In addition, while US tech stocks are entering a rollercoaster phase due to higher bond yields in the US, Chinese tech stocks will also fall but by a lesser degree because China’s monetary policy cycle is less affected by the Fed’s policy decisions. In other words, Chinese investable stocks may passively outperform global equities. Nonetheless, as noted in our previous reports, Chinese investable stocks face both cyclical and structural challenges. Hence the overweight stance on these stocks is strictly a tactical play rather than a cyclical one. We favor the MSCI Hong Kong Index versus global equities for similar reasons as Chinese investable stocks. The Hong Kong equity index is also technically oversold. Since the composition of the index has become more defensive, it will likely outperform in risk-off phases. In addition, if the US dollar rallies in the near term, share prices of Hong Kong-domiciled companies will materially outperform.   Jing Sima China Strategist jings@bcaresearch.com Strategic View Cyclical Recommendations Tactical Recommendations

Highlights The markets are already looking past Omicron. Now they have new worries – the Fed battling inflation. In the past, the Fed moved because of confidence that strong economic growth can withstand rates normalization. This time around, the Fed’s hand is forced by inflation, which is no longer deemed “transitory”.  So far, fear of an inflation-induced tightening cycle manifests in expectations of a steeper trajectory for rates, and violent and indiscriminate rotation out of the tech names. Companies have set aside record amounts of cash for wage increases. This is sure to cut into corporate profitability and validates our thesis that peak margins are in the rear-view window. Supply bottlenecks are easing, so is the ISM activity index, which we interpret as a normalization. When it comes to our style recommendations, we continue preferring small caps over large caps on the back of attractive valuations and favorable economic backdrop. Today, we also upgrade Value / Growth from neutral to OW - rising rates are a tailwind for Value. Recommended Allocation US Equity Chart Pack US Equity Chart Pack Feature December was a good month for equities (Chart 1). While the beginning of the month was marred by turbulence, induced by the arrival of Omicron, and the Fed shifting to a more hawkish stance, Santa Claus did deliver a rally to close the month, with the S&P 500 rising by 6% and lifting its 2021 gains to an impressive 27%. But 2021 was a wild year for active investors, as only 15% of funds and strategies outperformed the S&P 500. Hence, many investors had to watch the S&P 500 gains from the sidelines: The year was characterized by rotation across sectors and styles. December brought about a sell-off in the most speculative names in the equity market (EEM, IWM, ARKK, BTC, IPO), which has continued unabated into January: The Fed’s imminent monetary tightening is a culprit. Capital has also rotated away from Cyclicals and towards Defensives (the MSCI Cyclicals / Defensive ratio was down 7% in December). However, Cyclicals are starting to rebound from the Omicron slump. Chart 1 Overarching Macroeconomic Themes Omicron or “Omicold”? Either Way, The US Market Is Looking Past It… Little was known about the Omicron variant when it took us all by surprise at the end of November. Fortunately, an expectation that this variant is more contagious but less virulent has come to pass: While the number of cases has surged (nearly, every family I know in the tri-state area has had it by now), the number of hospitalizations has remained contained (Chart 2). The economic damage, at least in the US, has been minor, and mostly due to people being away from work sick or quarantined. It also appears that this COVID wave is close to a peak, which explains the recent outperformance of Cyclicals (Chart 3): The markets are already looking past Omicron. Now they have new worries – the Fed battling inflation. Chart 2Omicron Wave Is Close To A Peak... Omicron Wave Is Close To A Peak... Omicron Wave Is Close To A Peak... Chart 3...And Cyclicals Are Rebounding ...And Cyclicals Are Rebounding ...And Cyclicals Are Rebounding Inflation Is Forcing The Fed’s Hand Into An Aggressive Tightening Cycle Fed rate hikes are now all but certain: The market is pricing in four rate hikes in 2022 with a probability of nearly 90% (Chart 4), a noticeable increase from the three rate hikes expected in December 2021. The Fed’s December meeting minutes indicate that the first rate hike may come as soon as March. What is different this time is the inflation backdrop: In the past, the Fed moved because of confidence that strong economic growth can withstand rates normalization. This time around, the Fed’s hand is forced by inflation, which is no longer deemed “transitory”. The Fed is raising rates to squish growth to tame inflation, giving rate rises a different context: The Fed is behind the curve, and while in the past the stock market took rate hikes in its stride (after a short-lived slump in performance), now market reaction may be much more negative. So far, fear of an inflation-induced tightening cycle manifests in expectations of a steeper trajectory for rates (Chart 5), and violent and indiscriminate rotation out of the tech names. Chart 4Market Is Expecting Four Hikes In 2022 Market Is Expecting Four Hikes In 2022 Market Is Expecting Four Hikes In 2022 Chart 5Rates Made A Vertical Move Rates Made A Vertical Move Rates Made A Vertical Move More Wage Raises Are On The Way – A Headwind To Corporate Profitability According to the NIPA, wages constitute about 50% of sales of US companies. Over the past year, nominal wages increased by 5.8% but still could not keep up with rising prices – real wage growth is running at -2.3% (Chart 6). Considering that in 2021 only a minor share of workers got raises – those rejoining the workforce, starting a new job, or members of a few labor unions, the majority of Americans have had no change in income and have been bewildered by prices in the supermarkets. As the new calendar year rolls on, many of these workers will negotiate their salaries to get inflation adjustments (Chart 7). In fact, according to the WSJ, companies have set aside record amounts of cash for wage increases. This is sure to cut into corporate profitability and validates our thesis that peak margins are in the rearview window. Chart 6Wages Are Not Keeping Up With Inflation Wages Are Not Keeping Up With Inflation Wages Are Not Keeping Up With Inflation Chart 7Wage-Price Spiral? Wage-Price Spiral? Wage-Price Spiral? Another concern is a wage-price spiral, leading to rampant inflation, making the Fed’s job harder, and calling for more aggressive monetary tightening, striking a blow to the stock market. Supply Bottlenecks Are Easing, So Is The ISM Activity Index The ISM Manufacturing index has turned from 64.7 to 58.7 (Chart 8A). Part of the decline in the top-line numbers is due to the resolution of supply-chain bottlenecks: The ISM Supplier Index has fallen from 78.6 to 64.9 (Chart 8B), indicating a reduction in delivery times. On the other hand, the New Orders index has also declined from 68 to 60.4, suggesting that bottlenecks are clearing thanks to the reduction in business activity, which we interpret as a normalization. Of course, zero-tolerance to COVID policy in China and other countries may lead to new production and shipping delays, and another leg up for the inflation readings. Chart 8AISM PMI Has Turned... ISM PMI Has Turned... ISM PMI Has Turned... Chart 8BAnd Not Only Because Of Shorter Delivery Times And Not Only Because Of Shorter Delivery Times And Not Only Because Of Shorter Delivery Times Styles Comments Small Vs. Large Cap: Sticking To Our Overweight In Small Valuations: Small caps are cheap and unloved, trading at 16x forward earnings with a 25% discount to Large. The BCA Valuation Indicator for Small vs. Large is standing more than two standard deviations below its long-term average. Profitability: Since 2019, Small has delivered 47% annualized profit growth compared to 14% from Large. The small companies have demonstrated resilience and successfully navigated the economic landscape, plagued with supply bottlenecks, labor shortages, and surging prices (Chart 9A). Small-cap margins have exceeded the historical average and have likely peaked, just like the margins of their larger brethren. According to the NFIB Small Business Survey, a core concern is inflation, but 54% of small companies intend to raise prices, passing on costs to customers. Like all other American companies, they experience labor shortages and are planning to raise wages too. On balance, we believe that small caps will remain profitable and their earnings will continue to grow, albeit at a slower pace, i.e., at 15% (Chart 9B), which is significantly less than 88% in 2021, but more than the 10% growth expected of larger companies. Chart 9ASmall Businesses Are Worried About Inflation And Are Raising Prices Small Businesses Are Worried About Inflation And Are Raising Prices Small Businesses Are Worried About Inflation And Are Raising Prices Chart 9BEarnings Growth Expectations Have Normalized Earnings Growth Expectations Have Normalized Earnings Growth Expectations Have Normalized Macroeconomic Backdrop: Historically, small caps have outperformed large caps in the environment of rising rates (Chart 10), because of higher allocations to Cyclicals, such as Financials and Industrials. Also, while rising rates take the froth off the high-flying growth stocks, smaller companies are cheap and have moderate growth expectations. Overweight Small vs. Large: Attractive valuations and fundamentals, and a high likelihood to perform well when rates are rising, make overweighting Small vs Large an attractive proposition. Chart 10 Risks: While we stay with the call, there are a few caveats: Small caps’ margins are narrow, and continued cost pressures, especially surging labor costs, have the potential to dent their profitability. Further, while empirical analysis indicates that Small outperforms during the rate-hiking cycle, we are concerned that surging inflation may render this analysis less useful – can this time really be different? Growth Vs. Value: Shifting Towards Value Valuations: Over the course of 2021, Growth outperformed Value by 23% (trough to peak), and by 5% over just the last 26 weeks. As a result of such a strong run, Growth has become very expensive, trading at 29x forward multiples, which is which is a 70% premium to Value (which is trading at 17x). The Growth/Value BCA Valuation Indicator corrected below the 2 standard deviation mark and is mean reverting. Profitability: Despite significant valuation discrepancy between Growth and Value, both asset classes are set to deliver roughly the same earnings growth over the next year, suggesting that the premium for Quality and Growth may be excessive (Chart 11A). Macroeconomic Backdrop: Since the beginning of the pandemic, performance of Value vs. Growth has been strongly linked to the direction of change in yields (Chart 11B). Growth is overweight long-duration Technology stocks, while Value is highly exposed to Financials, which appear to thrive in the environment of rising rates. Chart 11AGrowth Expectation Are Similar, But Value Is Cheaper Growth Expectation Are Similar, But Value Is Cheaper Growth Expectation Are Similar, But Value Is Cheaper Chart 11BRising Rates Are A Tailwind For Value Rising Rates Are A Tailwind For Value Rising Rates Are A Tailwind For Value Overweight Value: As we stated in our 2022 Outlook, “Our neutral position [in Growth vs. Value] will be a great launching pad towards overweighting value stocks at the first whiff of rising long rates.” Now, with rate hikes drawing nearer and Omicron peaking, we are changing our neutral allocation to a cyclical overweight in Value, and underweight in Growth. Valuations and the macroeconomic backdrop are at the core of the call. Risks: We may be early with our presumption that Omicron is just an uber-contagious “Omicold” – hospitalizations may still surge, while global lockdowns may cause much economic damage. In that case, rates may remain range-bound, while the Fed may delay rate hikes. Then Growth would be bound to outperform Value.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com   S&P 500 Chart 12Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 13Profitability Profitability Profitability Chart 14Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 15Uses Of Cash Uses Of Cash Uses Of Cash Cyclicals Vs Defensives Chart 16Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 17Profitability Profitability Profitability Chart 18Valuation And Technicals Valuation And Technicals Valuation And Technicals Chart 19Uses Of Cash Uses Of Cash Uses Of Cash Growth Vs Value Chart 20Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 21Profitability Profitability Profitability Chart 22Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 23Uses Of Cash Uses Of Cash Uses Of Cash Small Vs Large Chart 24Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 25Profitability Profitability Profitability Chart 26Valuations and Technicals Valuations and Technicals Valuations and Technicals Chart 27Uses Of Cash Uses Of Cash Uses Of Cash Image Image Recommended Allocation Footnotes  .   

Highlights In this week’s report we update our Chart Pack, updating familiar charts that underscore our strategic themes and cyclical/tactical views. Social unrest in Kazakhstan points to two of our strategic themes: great power struggle and populism/nationalism. A sneak preview of our Black Swan risks for the year: Iran crisis, Russian aggression, and a massive cyber attack. Recent market moves reinforce the BCA House View that investors will rotate out of US growth stocks and into global cyclicals and value plays.  We are sticking with our current tactical and cyclical views and trades. Feature Since releasing our key views for 2022, bond yields have surged, tech shares have sold off, and social unrest has erupted in Central Asia. These developments have both structural and cyclical drivers and are broadly supportive of our investment strategy. First, a brief word about Kazakhstan. The surge in unrest this week is a new and urgent example of one of our strategic themes: populism and nationalism. Long-accumulating Kazakh nationalism is blowing up and forcing the autocratic regime to complete an unfinished political leadership transition that began three years ago. Russia is now forced to intervene militarily to maintain stability in this important satellite state. If instability is prolonged, Russia will be weakened in its high-stakes standoff against the United States and the West over Ukraine. China’s interest in Kazakhstan is also threatened by the change in political orientation there. We will provide a full report on this topic soon but for now the investment implication is to stay short Russian equities. In the rest of this report we offer our newly revised chart book for investors to consider as they gird for a year that promises to be anything but dull. The purpose of the chart book is to update a succinct series of charts that underpin our key themes and views. Many of these charts will be familiar to regular readers but here they are updated with some notable points highlighted in the text. A Waning Pandemic And Global Growth Falling To Trend The Omicron variant of COVID-19 is causing a surge of new cases and hospitalizations around the world, which will weigh on economic activity in the first quarter. However, this variant does not appear to be a game changer. While it is highly contagious, not as many people who go to the hospital end up in the intensive care unit (Chart 1). Chart 1 China is in a difficult predicament that will continue to constrict the global supply side of the economy. Chinese authorities maintain a “zero COVID” policy that emphasizes draconian social restrictions to suppress COVID cases and deaths to minimal levels (Chart 2A). Chart 2 ​​​​​ Chart 2 But Chinese-made vaccines are not as effective as western alternatives, particularly against Omicron, as discussed in our flagship Bank Credit Analyst. Hence China cannot open its economy without risking a disastrous wave of infections. When China shuts down activity, as at the Yantian port last spring, the rest of the world suffers higher costs for goods (Chart 2B). Chart 3Global Growth Will Fall Back To Trend Global Growth Will Fall Back To Trend Global Growth Will Fall Back To Trend Global economic growth is decelerating from the peaks of the extreme rebound (Chart 3). The historic fiscal stimulus of 2020 (Chart 4A) is giving way to negative fiscal thrust, or a decline in budget deficits, that will take away from growth (Chart 4B). Chart 4 Chart 4 Chart 5Inflation Will Moderate But Remain A Long-Term Risk Inflation Will Moderate But Remain A Long-Term Risk Inflation Will Moderate But Remain A Long-Term Risk Yet a recession is not the likeliest scenario since growth is expected to stabilize given the resumption of activity across the world due to an improved ability to live with the virus. The Federal Reserve is considering hiking interest rates faster than the market had expected given that the unemployment rate is collapsing and core inflation is surging. The persistence of the pandemic’s supply disruptions adds to concerns. At the same time, a wage-price spiral is not yet taking shape, as our bond strategist Ryan Swift shows. Productivity is growing faster than real wages and long-term inflation expectations remain within reasonable ranges, at least for now (Chart 5). Three Strategic Themes In our annual outlook (“2022 Key Views: The Gathering Storm”)  we revised our long-term mega themes: 1. Great Power Struggle The US’s relative decline as a share of global geopolitical power, despite a brief respite last year, is indicated in Charts 6-8. Chart 6 Chart 7 ​​​​​ Chart 7 ​​​​​ Chart 8America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) 2. Hypo-Globalization An ongoing globalization process, yet one that falls short of potential, is shown in Charts 9-10. A tentative improvement in our multi-century globalization chart is misleading – it is due to lack of data reporting by several countries, which artificially suppresses the denominator.  Chart 9Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Chart 10AFrom 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization While trade sharply rebounded from the pandemic, the global policy setting is now averse to ever-deeper dependency on international trade. Chart 10BFrom 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization ​​​​​ 3. Populism and Nationalism The post-pandemic cycle will see these structural trends reaffirmed. Charts 11-12 shows a rising Misery Index, or sum of unemployment and inflation, a source of political turmoil that will both reflect and feed these trends. Chart 11Misery Indexes Signal More Unrest, Populism, And Nationalism Misery Indexes Signal More Unrest, Populism, And Nationalism Misery Indexes Signal More Unrest, Populism, And Nationalism ​​​​​​ Chart 12EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 ​​​​​ Chart 12 highlights major markets that have local or nationwide elections in 2022-23, where policy fluctuations are already occurring with various investment implications. We are tactically bullish on South Korea and Brazil, strategically but not tactically bullish on India, and bearish on Turkey. Russia’s domestic sociopolitical problems are not all that different from Kazakhstan’s and its response may be outwardly aggressive, so we are bearish. Three Key Views For 2022 Our annual outlook also outlined three key views for this year: 1. China’s Reversion To Autocracy The government will ease policy to secure the economic recovery so that President Xi Jinping can clinch his personal rule for at a critical Communist Party personnel reshuffle this fall (Chart 13). Chart 13China Will Easy Policy Ahead Of Political Reversion To Autocracy China Will Easy Policy Ahead Of Political Reversion To Autocracy China Will Easy Policy Ahead Of Political Reversion To Autocracy A stabilization of Chinese demand in 2022 will be positive for commodities, cyclical equity sectors, and emerging markets. Chart 14 ​​​​​​ Chart 14 Policy easing will not lead to a sustainable rally in Chinese equities, as internal and external political risks remain high (Charts 14A & 14B). A “fourth Taiwan Strait Crisis”  is likely in the short run while a military conflict is not unlikely over the long run. ​​​​​​​​​​​​​​2. America’s Policy Insularity The Biden administration is focused on domestic legislation and the midterm elections, due November 8, 2022. Biden’s approval rating has deteriorated further, putting the Democrats in line for a loss of around 40 seats in the House and four seats in the Senate, judging by historic patterns (Chart 15). But our sense is that the Senate is still in play – Democrats probably will not lose four Senate seats – but they are likely to lose control of both chambers as things stand. Chart 15 However, the Democrats still have a subjective 65% chance of passing a partisan budget reconciliation bill, which would be a badly needed victory. The “Build Back Better” plan would include a minimum corporate tax and various social programs. Another round of fiscal reflation would reinforce the Federal Reserve’s less dovish pivot. Chart 16US Still At Peak Polarization US Still At Peak Polarization US Still At Peak Polarization Polarization will remain at historic peaks leading up to the election, as the Democrats will need “wedge issues” to drive enthusiasm among their popular base in the face of Republican enthusiasm. For decades polarization has correlated with falling Treasury yields and US tech sector equity outperformance (Chart 16). Midterm election years tend to see flat equity performance and falling yields, albeit with yields higher when a single party controls government, as is the case this year. 3. Petro-State Leverage Globally, commodity markets continue to tighten on the supply side. Our Commodity & Energy Strategist Bob Ryan outlines the situation admirably: The supply side is tightening in oil markets, where OPEC 2.0 producers have been unable to restore output under their agreement to return 400,000 barrels per day each month since August 2021. It is true in base metals, where the energy crisis in Europe and Asia are constricting supplies, particularly in copper. And it is true in agricultural commodities, where high natural gas prices are driving fertilizer prices higher, which will push food prices up this year. Demand for these commodities will increase as Omicron becomes the dominant COVID-19 strain, keeping consumption above production, particularly in oil. These are long-term trends. Oil and natural gas markets will probably remain tight throughout the decade, as will base metal markets. This is going to put enormous stress on the global energy transition to renewable energy over the next 10 years. The ascendance of left-of-center political parties in critical base-metal exporting states, and rising ESG initiatives, will increase costs for energy and metals producers; and global climate activism in boardrooms and courtrooms will push costs higher as well. Higher prices will be necessary to recover these cost increases. In this context, energy producers gain geopolitical leverage. Their treasuries become flush with cash and they see an opportunity to pursue foreign policy objectives. Conflicts involving oil producers are more likely when oil prices are swinging up (Chart 17). Chart 17 This trend is on display in Russia’s dispute with the West, where Europe is struggling with a surge in natural gas prices due to Russian supply constraints that weaken its resolve in the showdown over Ukraine (Chart 18, top panel). Chart 18Energy Prices: Biden's And Europe's Problem Energy Prices: Biden's And Europe's Problem Energy Prices: Biden's And Europe's Problem ​​​​​ Yet even in the energy-independent US, the Biden administration is wary of pursuing policies against Russia or Iran that would ignite a bigger spike in prices at the pump during an election year (Chart 18, bottom panel). Biden will have to attend to foreign policy this year but will be defensive. Petro-states are not immune to domestic problems, including social unrest. Many of them are poor, unequal, misgoverned, and suffering from inflation. Iran is a prime example. Yet Iran has not collapsed under sanctions so far, the world is recovering, and Tehran has the advantage in its negotiations with the US because it can stage attacks across the Middle East, including the Persian Gulf and Strait of Hormuz. Military incidents could drive oil prices into politically punitive territory. Three Black Swans For 2022 This brings us to three “Black Swans” or low-probability, high-impact events for 2022. We will publish our regular annual report on this year’s black swans soon. For now we offer a sneak preview: 1. Iran Crisis In Middle East The fear of being abandoned by the US has kept Israel from acting unilaterally so far (Chart 19A). Chart 19 ​​​​​​ Chart 19 ​​​​ But an attack is not impossible if Iran reaches “breakout” levels of highly enriched uranium – and the global impact of an attack could be catastrophic (Chart 19B). The news media have been conspicuously quiet about Iran. Taken together, this scenario is pretty much the definition of a black swan. 2. Russian Aggression Abroad There is a 50% chance that Russia will stage a limited re-invasion of Ukraine to secure its control of territory in the east or along the Black Sea coast. Chart 20Black Swan #2: Russian Aggression Abroad Black Swan #2: Russian Aggression Abroad Black Swan #2: Russian Aggression Abroad Within this risk, there is a small chance (less than 5%) that Russia would invade all of Ukraine. We do not expect this and neither do other analysts. The total conquest of Ukraine is unlikely when Russia’s domestic conditions are weak and it faces so much unrest in other parts of its sphere of influence (including Belarus and Kazakhstan). As we go to press, Russia is staging a military intervention in Kazakhstan, which could expand. Kazakhstan could create a way for Russia to avoid its self-induced pressure to take military action against Ukraine. But most likely Russia and Kazakhstan will quell the unrest, enabling Russia to sustain the threat of a partial re-invasion of Ukraine. Putin’s low approval rating often triggers new foreign adventures and financial markets are pricing higher risks (Chart 20). 3. Massive Cyber Attack Amid the pandemic and inflation surge, investors have forgotten about the huge risks facing businesses and individuals from their extreme dependency on remote work and digital services. A cyber war is also raging behind the scenes. So far it has not spilled into the physical realm. Yet Russia-based ransomware attacks in 2021 showed that vital US infrastructure is vulnerable. Cyber stocks have topped out amid the recent tech selloff (Chart 21A). But the global average cost of data breaches is skyrocketing. Governments are devoting more resources to network security and cyber-security (Chart 21B), which should be positive for earnings. Chart 21ABlack Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack ​​​​​ Chart 21BBlack Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack ​​​​​ Investment Takeaways The revised Geopolitical Risk Index does not show as pronounced of an uptrend as the version published last year but it is still higher than in the late 1990s (Chart 22). Our reading of all available evidence points to rising geopolitical risk – at least until the current challenge to US global supremacy leads to a new equilibrium. Chart 22 Global policy uncertainty is also rising on a secular basis and maintaining its correlation with the trade-weighted dollar, which has rebounded despite the global growth recovery and rise in inflation (Chart 23). We remain neutral on the dollar. Chart 23A Secular Rise In Global Uncertainty A Secular Rise In Global Uncertainty A Secular Rise In Global Uncertainty Gold has fallen from its peaks during the onset of the pandemic and real rates suggest it will fall further. But we hold it as a hedge against geopolitical risk as well as inflation (Chart 24). Chart 24Stay Long Gold As Hedge Against Geopolitical Crisis As Well As Inflation Stay Long Gold As Hedge Against Geopolitical Crisis As Well As Inflation Stay Long Gold As Hedge Against Geopolitical Crisis As Well As Inflation The evidence is inconclusive about whether global investors will rotate away from US assets this year. The US share of global equity capitalization is stretched. Long-dated Treasuries will eventually reflect higher inflation expectations (Chart 25). Chart 25No Substitute For The USA Yet No Substitute For The USA Yet No Substitute For The USA Yet ​​​​​ Chart 26Waiting For Rotation Waiting For Rotation Waiting For Rotation ​​​​​ US equity outperformance continues unabated and emerging market equities are still underperforming their developed peers (Chart 26). Cyclically investors should take the opposite side of these trends but not tactically. The renminbi is tentatively peaking against both the dollar and euro. As expected, China’s policymakers are shifting toward preserving economic stability (Chart 27). Stabilization may require a weaker renminbi, though producer price inflation is also a factor for the People’s Bank to consider. Chart 27Strategically Short Renminbi And Taiwanese Dollar Strategically Short Renminbi And Taiwanese Dollar Strategically Short Renminbi And Taiwanese Dollar Taiwanese stocks continue to outperform Korean stocks (to our chagrin) but they have not broken above previous peaks relative to global equities. Nor has the Taiwanese dollar broken above previous peaks versus the greenback (Chart 28). So far Taiwan has avoided the fate of semiconductor stocks, which have sold off. This situation presents a buying opportunity for semi stocks but we remain short Taiwan as a bourse because it is central to US-China strategic conflict. Chart 28Strategically Short Taiwan Strategically Short Taiwan Strategically Short Taiwan ​​​​​​ Chart 29Strategically Short Russia And EM Europe Strategically Short Russia And EM Europe Strategically Short Russia And EM Europe ​​​​​​ Chart 30Safe Havens Look Attractive Safe Havens Look Attractive Safe Havens Look Attractive Russia and eastern European assets continue to underperform developed market peers as geopolitical risks mount across the former Soviet Union (Chart 29). Russia’s negotiations with the US, NATO, and the EU in January will help us to gauge whether tensions will break out to new highs. Assuming Russia succeeds in quashing Kazakh unrest, it will be necessary for the US to offer concessions to Russia to prevent the Ukraine showdown from worsening Europe’s energy crisis. Safe havens caught a bid in early 2021 and have not yet broken down. Our geopolitical views support building up safe-haven positions (Chart 30). Presumably one should favor global cyclical equities as the pandemic wanes and global growth stabilizes. But cyclicals are struggling to outperform defensives (Chart 31A). Chart 31AFavor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization ​​​​​ Chart 31BFavor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization ​​​​​ ​​​​​​​China’s policy easing is positive in this regard, although the new wave of fiscal-and-credit support is only just beginning and financial markets will remain skeptical until the dovish policy pivot is borne out in hard data (Chart 31B). Global value stocks have ticked up again versus growth stocks, suggesting that the choppy process of bottom formation continues (Charts 32A & 32B). Chart 32AValue’s Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks ​​​​​​ Chart 32BValue’s Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks ​​​​​     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights Global equities are poised to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Non-US markets are likely to outperform. We examine the four pillars that have historically underpinned stock market performance. Pillar 1: Technically, the outlook for equities is modestly bullish, as investor sentiment is nowhere near as optimistic as it usually gets near market tops. Pillar 2: The outlook for economic growth and corporate earnings is modestly bullish as well. While global growth is slowing, it will remain solidly above trend in 2022. Pillar 3: Monetary and financial conditions are neutral. The Fed and a number of other central banks are set to raise rates and begin unwinding asset purchases this year. However, monetary policy will remain highly accommodative well into 2023. Pillar 4: Valuations are bearish in the US and neutral elsewhere. Investors should avoid tech stocks in 2022, focusing instead on banks and deep cyclicals, which are more attractively priced. The Bedrock For Equities In assessing the outlook for the stock market, our research has focused on four pillars: 1) Sentiment and other technical factors, which are most pertinent for stocks over short-term horizons of about three months; 2) cyclical fluctuations in economic growth and corporate earnings, which tend to dictate the path for stocks over medium-term horizons of about 12 months; 3) monetary and financial conditions, which are also most relevant over medium-term horizons; and finally 4) valuations, which tend to drive stocks over the long run. In this report, we examine all four pillars, concluding that global equities are likely to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Pillar 1: Sentiment And Other Technical Factors (Modestly Bullish)   Chart 1US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern Scaling The Wall Of Worry Stocks started the year on a high note, before tumbling on Wednesday following the release of the Fed minutes. Market breadth going into the year was quite poor. Even as the S&P 500 hit a record high on Tuesday, only 57% of NYSE stocks and 38% of NASDAQ stocks were trading above their 200-day moving averages compared to over 90% at the start of 2021 (Chart 1). The US stock market had become increasingly supported by a handful of mega-cap tech stocks, a potentially dangerous situation in an environment where bond yields are rising and stay-at-home restrictions are apt to ease (more on this later). That said, market tops often occur when sentiment reaches euphoric levels. That was not the case going into 2022 and it is certainly not the case after this week's sell-off. The number of bears exceeded the number of bulls in the AAII survey this week and in six of the past seven weeks (Chart 2). The share of financial advisors registering a bullish bias declined by 25 percentage points over the course of 2021 in the Investors Intelligence poll. Option pricing is far from complacent. The VIX stands at 19.6, above its post-GFC median of 16.7.  According to the Minneapolis Fed’s market-based probabilities model, the market was discounting a slightly negative 12-month return for the S&P 500 as of end-2021, with a 3.6 percentage-point larger chance of a 20% decline in the index than a 20% increase (Chart 3). Chart 3Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Chart 2Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Equities do best when sentiment is bearish but improving (Chart 4). With bulls in short supply, stocks can continue to climb the proverbial wall of worry.   Whither The January Effect? Historically, stocks have fared better between October and April than between May and September (Chart 5). One caveat is that the January effect, which often saw stocks rally at the start of the year, has disappeared. In fact, the S&P 500 has fallen in January by an average annualized rate of 5.2% since 2000 (Table 1). Other less well-known calendar effects – such as the tendency for stocks to underperform on Mondays but outperform on the first trading day of each month – have persisted, however. Chart 4 Chart 5 Table 1Calendar Effects The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Bottom Line: January trading may be choppy, but stocks should rise over the next few months as more bears join the bullish camp. Last year’s losers are likely to outperform last year’s winners. Pillar 2: Economic Growth And Corporate Earnings (Modestly Bullish)   Economic Growth And Earnings: Joined At The Hip The business cycle is the most important driver of stocks over medium-term horizons of about 12 months. The reason is evident in Chart 6: Corporate earnings tend to track key business cycle indicators such as the ISM manufacturing index, industrial production, business sales, and global trade. Chart 6The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons Chart 7PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth Global growth peaked in 2021 but should stay solidly above trend in 2022. Both the service and manufacturing PMIs remain in expansionary territory (Chart 7). The forward-looking new orders component of the ISM exceeded 60 for the second straight month in December. The Bloomberg consensus is for real GDP to rise by 3.9% in the G7 in 2022, well above the OECD’s estimate of trend G7 growth of 1.4% (Chart 8). Global earnings are expected to increase by 7.1%, rising 7.5% in the US and 6.7% abroad (Chart 9). Our sense is that both economic growth and earnings will surprise to the upside in 2022. Chart 9Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Chart 8 Plenty Of Pent-Up Demand For Both Consumer And Capital Goods US households are sitting on $2.3 trillion in excess savings (Chart 10). Around half of these savings will be spent over the next few years, helping to drive demand. Households in the other major advanced economies have also buttressed their balance sheets. Chart 10Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand After two decades of subdued corporate investment, capital goods orders have soared. This bodes well for capex in 2022. Inventories remain at rock-bottom levels, which implies that output will need to exceed spending for the foreseeable future (Chart 11). On the residential housing side, both the US homeowner vacancy rate and the inventory of homes for sale are near multi-decade lows. Building permits are 11% above pre-pandemic levels (Chart 12). Chart 11Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Chart 12Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Chart 13China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed Chinese Growth To Rebound, Europe To Benefit From Lower Natural Gas Prices Chinese credit growth decelerated last year. However, the 6-month credit impulse has bottomed, and the 12-month impulse is sure to follow (Chart 13). Chinese coal prices have collapsed following the government’s decision to instruct 170 mines to expand capacity (Chart 14). China generates 63% of its electricity from coal. Lower energy prices and increased stimulus should support Chinese industrial activity in 2022. Like China, Europe will benefit from lower energy costs. Natural gas prices have fallen by nearly 50% from their peak on December 21st. A shrinking energy bill will support the euro (Chart 15). Chart 14Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Chart 15A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro Chart 16 Omicron Or Omicold? While the Omicron wave has led to an unprecedented spike in new cases across many countries, the economic fallout will be limited. The new variant is more contagious but significantly less lethal than previous ones. In South Africa, it blew through the population without triggering a major increase in mortality (Chart 16). Preliminary data suggest that exposure to Omicron confers at least partial immunity against Delta. The general tendency is for viral strains to become less lethal over time. After all, a virus that kills its host also kills itself. Given that Omicron is crowding out more dangerous strains such as Delta, any future variant is likely to emanate from Omicron; and odds are this new variant will be even milder than Omicron. Meanwhile, new antiviral drugs are starting to hit the market. Pfizer claims that its new drug, Paxlovid, cuts the risk of hospitalization by almost 90% if taken within five days from the onset of symptoms. Bottom Line: While global growth has peaked and the pandemic remains a risk, growth should stay well above trend in the major economies in 2022, fueling further gains in corporate earnings and equity prices.   Pillar 3: Monetary And Financial Factors (Neutral)   Chart 17The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months Tighter But Not Tight Monetary and financial factors help govern the direction of equity prices both because they influence economic growth and also because they affect the earnings multiple at which stocks trade. There is little doubt that a number of central banks, including the Federal Reserve, are looking to dial back monetary stimulus. However, there is a big difference between tighter monetary policy and tight policy. Even if the FOMC were to raise rates three times in 2022, as the market is currently discounting, the fed funds rate would still be half of what it was on the eve of the pandemic (Chart 17). Likewise, even if the Fed were to allow maturing assets to run off in the middle of this year, as the minutes of the December FOMC meeting suggest is likely, the size of the Fed’s balance sheet will probably not return to pre-pandemic levels until the second half of this decade.   A Higher Neutral Rate We have argued in the past that the neutral rate of interest in the US is higher than widely believed. This implies that the overall stance of monetary policy remains exceptionally stimulative. Historically, stocks have shrugged off rising bond yields, as long as yields did not increase to prohibitively high levels (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market If the neutral rate ends up being higher than the Fed supposes, the danger is that monetary policy will stay too loose for too long. The question is one of timing. The good news is that inflation should recede in the US in 2022, as supply-chain bottlenecks ease and spending shifts back from goods to services. The bad news is that the respite from inflation will not last. As discussed in Section II of our recently-published 2022 Strategy Outlook, inflation will resume its upward trajectory in mid-2023 on the back of a tightening labor market and a budding price-wage spiral. This second inflationary wave could force the Fed to turn much more aggressive, spelling the end of the equity bull market. Bottom Line: While the Fed is gearing up to raise rates and trim the size of its balance sheet, monetary policy in the US and in other major economies will remain highly accommodative in 2022. US policy could turn more restrictive in 2023 as a second wave of inflation forces a more aggressive response from the Fed.   Pillar 4: Valuations (Bearish In The US; Neutral Elsewhere)   US Stocks Are Looking Pricey… While valuations are a poor timing tool in the short run, they are an excellent forecaster of stock prices in the long run. Chart 18 shows that the Shiller PE ratio has reliably predicted the 10-year return on equities. Today, the Shiller PE is consistent with total real returns of close to zero over the next decade. Chart 18 Investors’ allocation to stocks has also predicted the direction of equity prices (Chart 19). According to the Federal Reserve, US households held a record high 41% of their financial assets in equities as of the third quarter of 2021. If history is any guide, this would also correspond to near-zero long-term returns on stocks. Chart 19Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II)   … But There Is More Value Abroad Valuations outside the US are more reasonable. Whereas US stocks trade at a Shiller PE ratio of 37, non-US stocks trade at 20-times their 10-year average earnings. Other valuation measures such as price-to-book, price-to-sales, and dividend yield tell a similar story (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) Cyclicals And Banks Overrepresented Abroad Our preferred sector skew for 2022 favors non-US equities. Increased capital spending in developed economies and incremental Chinese stimulus should boost industrial stocks and other deep cyclicals, which are overrepresented outside the US (Table 3). Banks are also heavily weighted in overseas markets; they should also do well in response to faster-than-expected growth and rising bond yields (Chart 21). Table 3Deep Cyclicals And Financials Are Overrepresented Outside The US The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Chart 21Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Bottom Line: Valuations are more appealing outside the US, and with deep cyclicals and banks set to outperform tech over the coming months, overseas markets are the place to be in 2022. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image