Diplomacy/Foreign Relations

In Section I, we note that the Fed’s new interest rate projections show that US monetary policy is set to rise soon into restrictive territory even relative to what we consider to be the neutral rate of interest, and to a level that has been consistent with the onset of recession since the 1960s. Imminent supply-side and pandemic-related disinflation is crucial for the US to avoid a recession over the coming year. Stay neutral stocks versus bonds for now, but the next shift in our recommended asset allocation stance is more likely to be a downgrade to underweight rather than an upgrade to overweight. In Section II, a guest piece from our European Investment Strategy service discusses the outlook for European assets.

Executive Summary Turkey is staring into an abyss: economic crisis that will morph into political crisis in the June 2023 election cycle. President Erdoğan will pursue populist economic policies and foreign policy adventurism to try to stay in power, leading to negative surprises and “black swan” risks over the coming 9-12 months. While Erdoğan and the ruling party are likely to be defeated in elections, which is good news, investors should not try to front-run the election given high uncertainty. Neither Turkey’s economy and domestic politics nor the global economy and geopolitics warrant a bullish view on Turkish assets. GEOPOLITICAL STRATEGY  Recommendation (TACTICAL) Initiation Date Return LONG JPY/TRY 2022-09-23     Erdoğan’s Net Negative Job Approval Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Bottom Line: The Lira will depreciate further versus the dollar. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Feature Turkey – now technically Türkiye – is teetering on the verge of a national meltdown. The inflation rate is the fastest in G20 countries, both because of a domestic wage-price spiral and soaring global food and fuel prices. President Recep Tayyip Erdoğan and his Justice and Development Party (AKP) have been in power since 2002, making them highly vulnerable to demands for change in the general election slated for June 18, 2023. Yet Erdoğan is a strongman who won a popular vote to revise the constitution in 2017 and increase his personal power over institutions. His populist Islamist movement is starkly at odds with the country’s traditional elite, including the secular military establishment. Given the poor state of the economy, Erdoğan will likely lose the 2023 election but he could refuse to leave office … or he could win the election and be ousted in a coup d'état, as happened in Turkey in 1960, 1971, and 1980.1 Meanwhile Turkey is beset by foreign dangers – including war in Ukraine and instability in the Middle East. Erdoğan will try to use foreign policy to bolster his popular standing. Turkey has inserted itself in various regional conflicts and could instigate conflicts of its own. While global investors are eager to buy steeply discounted Turkish financial assets ahead of what could be a monumental change in national policy in 2023, the country is extremely unstable. It is a source of “black swan” risks. The best bet is to remain underweight Turkish assets unless and until a pro-market election outcome shakes off the two-decade trend toward economic ruin. Turkish Grand Strategy Turkey is permanently at a crossroads. The land-bridge between Europe and Asia, it is secular and cosmopolitan but also Islamist and traditional. Its past consists of the greatness of empires – Byzantine, Ottoman – while its present consists of a frustrating search for new opportunities in a chaotic regional context. The core of the country consists of the disjointed coastal plains around the Bosporus and Dardanelles straits and the Sea of Marmara, where Istanbul is located. The Byzantine and Ottoman empires were seated on this strategic location at the juncture of the world’s east-west trade. To secure this area, the Turks needed to control the larger Anatolian peninsula – Asia Minor – to prevent roving Eurasian powers from invading, just as they themselves had originally invaded from Central Asia. During times of greatness the Turks could also expand their empire to control the Balkan peninsula and Danube river valley up to Vienna, Crimea and the Black Sea coasts, and the eastern Mediterranean island approaches. During the Ottoman empire’s golden days Turkish power extended all the way into North Africa, Mesopotamia, the Nile river valley, and Mecca and Medina. The empire – and the Islamic Ottoman Caliphate – collapsed in 1924 after centuries of erosion and the catastrophes of World War I. Subsequently Turkey emerged as a secular republic. It adapted to the post-WWII world order by allying with the United States and NATO, in conflict with the Soviet Union which encircled the Turks on all sides. The Russians are longstanding rivals of Turkey, notably in the Black Sea and Crimea, and Stalin wanted to get his hands on the Dardanelles and Bosporus straits. Hence alliance with the US and NATO fulfilled one of the primary demands of Turkish grand strategy: a navy that could defend the straits and Turkish interests in the Black Sea and eastern Mediterranean. The collapse of the Soviet Union seemed to usher in an era of opportunity for Turkey. Turkey benefited from democratization, globalization, and foreign capital inflows. But then America’s wars and crises, Russia’s resurgence, and Middle Eastern instability created a shatter-belt surrounding Turkey, impinging on its national security. In this context of limited foreign policy options, Turkey’s domestic politics coalesced around Erdoğan, the AKP, political Islam, and investment-driven economic growth. Erdoğan and the AKP represent the Anatolian, religious, and Middle Eastern interests in Turkey, as opposed to the maritime, secular, and Euro-centric interests rooted in Istanbul. This point can be illustrated by observing that the poorer interior regions have grown faster than the national average over the period of AKP rule, whereas the more developed coastal regions have tended to lag (Map 1). Voting patterns from the 2018 general election overlap with these economic outcomes. The AKP has steered investment capital into the interior to fund infrastructure and property construction while currency depreciation, rather than productivity enhancement, has merely maintained the status quo with the manufacturing export sector in the coastal regions (Chart 1). Map 1Turkey’s Anatolian Model And The Struggle With The Coasts Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Chart 1Turkey's Export Competitiveness Turkey's Export Competitiveness Turkey's Export Competitiveness Today Turkey faces three distinct obstacles to its geopolitical expansion: Russian aggression: Russia’s resurgence, especially with the seizure of Crimea in 2014 and broader invasion of Ukraine in 2022, threatens Turkey’s interests in the Black Sea and eastern Mediterranean. Turkey must always deal with Russia carefully but over the past 14 years Russia has become belligerent, forcing Turkey to come to terms with Putin while maintaining the NATO alliance. Today Erdoğan tries to mediate the conflict as it does not want to encourage Russian aggression but also does not want NATO to provoke Russia. For instance, Turkey is willing to condone Finland and Sweden joining NATO but only if the West grants substantial benefits to Turkey itself. Ultimately Turkish ties with Russia are overrated. For both economic reasons and grand strategic reasons outlined above, Turkey will cleave to the West (Chart 2). Chart 2Turkey Still Linked To The West Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan ​​​​​ Chart 3Turkish Energy Ties With Russia Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Western liberal hegemony: The EU and NATO foreclosed any Turkish ambitions in Europe. The EU has consolidated with each new crisis while rejecting Turkish membership. This puts limits on Turkish access to European markets and influence in the Balkans. Turkey has guarded its independence jealously against the West. After the Cold War the US expected Turkey to serve American interests in the Middle East and Eurasia. The EU expected it to serve European interests as an energy transit state and a blockade against Middle Eastern refugees. But Turkish interests were often sidelined while its domestic politics did not allow blind loyalty to the West. This led Turkey to push back against the West and cultivate other options, such as deeper economic ties with Russia and China. Turkish dependency on Russian energy is substantial and Turkey has tried to play a mediating role in Russia’s conflict with NATO (Chart 3). Recently Turkey offered to join the Shanghai Cooperation Organization (SCO), a military alliance of Asian powers. However, as with trade, Turkish defense and security ties with the Russo-Chinese bloc are ultimately overrated (Chart 4).  There is room for some cooperation but Turkey is not eager to abandon American military backing in a period in which Russia is threatening to control the Black Sea rim, cut off grain exports arbitrarily, and use tactical nuclear weapons. Chart 4Turkey’s Defense Alliance With The West Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan Middle Eastern instability: The Middle East is a potential area for Turkey to increase influence, especially given the AKP’s embrace of political Islam. Turkey benefits from regional economic development and maintains relations with all players. But the region’s development is halting and Turkey is blocked by competitors. The US toppled Iraq in 2003, which strengthened Iran’s regional clout over the subsequent decades. But Iran is not stable and the US has not prevented Iran from achieving nuclear breakout capacity. Turkey cannot abide a nuclear-armed Iran. At the same time, the US continues to support Israel and the Gulf Arab monarchies, which oppose Turkey’s combination of Islam and democratic populism. Russia propped up Syria’s regime in league with Iran, which threatens Turkey’s border integrity. Developments in Syria, Iraq, and Iran have all complicated Turkey’s management of Kurdish militancy and separatism. Kurds make up nearly 20% of Turkey’s population and play a central role in the country’s political divisions. Erdoğan’s Anatolian power base is antagonistic toward the Kurds and regional Kurdish aspirations. China’s strategic rise brings both risks and rewards for Turkey but China is too distant to become the focus of Turkish strategy: China’s dream of reviving the Silk Road across Eurasia harkens back to the glory days of Ottoman power. The Belt and Road Initiative and other investments help to develop Central Asia and the Middle East, enabling Turkey to benefit once again as the middleman in east-west trade (Chart 5). Chart 5Turkey Benefits From East-West Trade Turkey Benefits From East-West Trade Turkey Benefits From East-West Trade But insofar as China’s Eurasian strategy is successful, it could someday impinge on Turkish ambitions, particularly by buttressing Russian and Iranian power. In recent years Erdoğan has experimented with projecting Turkish power in the Middle East (Syria), North Africa (Libya), the Caucasus (Armenia), and the eastern Mediterranean (Cyprus). He cannot project power effectively because of the obstacles outlined above. But he can manipulate domestic and foreign security issues to try to prolong his hold on power. Bottom Line: Boxed in by Russian aggression, western liberal hegemony, and Middle Eastern instability, Turkey cannot achieve its geopolitical ambitions and has concentrated on internal development over the past two decades. However, the country retains some imperial ambitions and these periodically flare up in unpredictable ways as the modern Turkish state attempts to fend off the chaotic forces that loom in the Black Sea, Middle East, North Africa, and Caucasus. The Erdoğan regime is focused on consolidating Anatolian control of Turkey and projecting military power abroad so that the military does not become a political problem for his faction at home. Erdoğan’s Domestic Predicament President Erdoğan has stayed in power for 20 years under the conditions outlined above but he faces a critical election by June 18, 2023 that could see him thrown from power. The result will be extreme political turbulence over the coming nine months until the leadership of the country is settled by hook or by crook. Erdoğan has pursued a strongman or authoritarian leadership style, especially since domestic opposition emerged in the wake of the Great Recession. By firing three central bankers, he has pressured the central bank into running an ultra-dovish monetary policy, producing a 12% inflation rate prior to the Covid-19 pandemic and an 80% inflation rate today. He has also embraced populist fiscal handouts and foreign policy adventurism. Taken together his policies have eroded the country’s political as well as economic stability. From the last general election in 2018 to the latest data in 2022: Real household disposable income  growth has fallen from -7.4% to -18.7% (Chart 6). Chart 6Real Incomes Falling Real Incomes Falling Real Incomes Falling ​​​​​​ Chart 7Turkish Activity Slows Ahead Of Election Turkish Activity Slows Ahead Of Election Turkish Activity Slows Ahead Of Election ​​​​​ The manufacturing PMI has fallen from 49.0 to 47.4 (Chart 7). Consumer confidence has fallen from 92.1 to 72.2 (Chart 8). Chart 8Consumer Confidence: Not Better Off Than At Last Election Consumer Confidence: Not Better Off Than At Last Election Consumer Confidence: Not Better Off Than At Last Election ​​​​​​ Chart 9Erdoğan’s Net Negative Job Approval Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan ​​​​​​ Bad economic news is finally altering public opinion, with polls now shifting against the president and incumbent party: Since the pandemic erupted, Erdoğan’s approval rating has fallen from a peak of 57% to 40% today. Disapproval has Erdoğan’s risen to 54%, leaving him a net negative job approval (Chart 9). Bear in mind that Erdoğan won the election with 52.6% of the vote in 2018, only slightly better than the 51.8% he received in 2014 and well below the 80% that his AKP predecessor received in 2007. Meanwhile the AKP, which never performs as well as Erdoğan himself, has fallen from a 45% support rate to 30% today in parliamentary polls, dead even with the main opposition Republican People’s Party (Chart 10). The AKP won 42.6% of the vote in 2018, down from 49.5% in the second election of 2015, 49.8% in 2011, and 46.6% in 2007. Chart 10Justice And Development Party Neck And Neck With Republican Opposition Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan The gap between Erdoğan and his Republican rivals has narrowed sharply since the global food and fuel price spike began to bite in late 2021 (Chart 11). Chart 11Erdoğan Faces Tough Re-Election Race Turkey: Before And After Erdoğan Turkey: Before And After Erdoğan However, the 2023 election is not straightforward. There are several caveats to the clear anti-incumbent tendency of economic and political data: Soft Economic Landing? The election takes place in nine months, enough time for surprises to salvage Erdoğan’s presidential campaign, given his and his party’s heavily entrenched rule. For example, it is possible – not probable – that Russia will resume energy exports, enabling Europe to recover, and that central banks will achieve a “soft landing” for the global economy. Turkey’s economy would bounce just in time to help the incumbent party. This is not what we expect (see below) but it could happen. Foreign Policy Victories? Erdoğan could achieve some foreign policy victories. He has negotiated a tenuous deal with Russia and Ukraine, along with the UN, to enable grain exports out of Odessa. He could build on this process to negotiate a broader ceasefire in Ukraine. He could also win major concessions from the US and NATO to secure Finnish and Swedish membership in that bloc. If he did he would come off looking like a grand statesman and might just buy another term in office. Unfortunately what is more likely is that Erdoğan will pursue an aggressive foreign policy in an attempt to distract voters from their bread-and-butter woes, only to destabilize Turkey and the region further. Stolen Election? Erdoğan revised the constitution in 2017 – winning 51.4% of the votes in a popular referendum – to give the presidency substantial new powers across the political system. Using these powers he could manipulate the election to produce a favorable outcome or even cling to power despite unfavorable election results. He does not face nearly as powerful and motivated of a liberal establishment as President Trump faced in 2020 or as Brazilian President Jair Bolsonaro faces in 2022. As noted Erdoğan has a contentious relationship with the Turkish military, so while investors cannot rule out a stolen election, they also cannot rule out a military coup in reaction to an attempted stolen election. Thus the election could produce roughly four outcomes, which we rank below from best to worst in terms of their favorability for global investors: 1.  Best Case: Decisive Opposition Victory – 25% Odds – A resounding electoral defeat for the AKP would reverse its unorthodox economic policies in the short term and serve as a lasting warning to future politicians that populism and economic mismanagement lead to political ruin. This outcome would also provide the political capital and parliamentary strength necessary to impose tough reforms and restore a semblance of macroeconomic stability. 2.  Good Case: Narrow AKP Defeat – 50% Odds – A narrow or contested election would produce a weak new government that would at least put a stop to the most inflationary AKP policies. It would improve global investor sentiment around Turkey’s eventual ability to stabilize its economy. The new government would lack the ability to push through structural reforms but it could at least straighten out the affairs of the central bank so as to ensure a cycle of monetary policy tightening, which would stabilize the currency. 3.  Bad Case: Narrow AKP Victory – 15% Odds – A narrow victory would force the AKP to compromise with opposition parties in parliament and pacify social unrest. Foreign adventurism would continue but harmful domestic policies would face obstructionism. 4.  Worst Case: Decisive AKP Victory – 10% Odds – A resounding victory for the ruling party would vindicate Erdoğan and his policies despite their negative economic results, driving Turkey further down the path of authoritarianism, populism, money printing, currency depreciation, and hyper-inflation. He could also be emboldened in his foreign adventurism. Bottom Line: We expect Erdoğan and the AKP to be defeated and replaced. However, Turkey is in the midst of an economic and political crisis and the next 12 months will bring extreme uncertainty. The election could be indecisive, contested, stolen, or overthrown. The aftermath could be chaotic as well as the lead-up. If the AKP stays in power then investors will abandon Turkey and its economy will suffer a historic shock. Therefore investors should underweight Turkey – at least until the next phase in the economic downturn confirms our forecast that the AKP will fall from power. Macro Outlook: Fade The Equity Rally Chart 12Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM Turkish Stock Rally Will Fade Soon; Stay Underweight This Market Versus EM The Turkish economy is beset by hyper-inflation. Headline consumer prices are rising at upwards of 80% and core inflation is 65%. Yet Turkish government 10-year bond yields are low and falling: they are down to 11% currently, from a high of 24% at the beginning of the year. Turkish stocks have also outperformed their Emerging Markets counterparts this year in common currency terms even though the lira has been the worst performing EM currency (Chart 12). So, what’s going on in this market? The answer is hidden in the slew of unorthodox policies adopted by the authorities. These measures caused massive distortions in both the economy and the markets. Specifically, late last year, despite very high inflation, the central bank began to cut policy rates encouraging massive loan expansion. As a result, both local currency loans and money supply surged. Which, in turn, completely unhinged inflation (Chart 13). As inflation rose, so did government bond yields. In a bid to keep government borrowing costs low, policymakers changed several bank regulations to force commercial banks to buy government bonds.2  The upshot was that the bond yields stopped tracking inflation and instead began to fall even as inflation skyrocketed. The rampant inflation meant Turkish non-financial firms’ nominal sales skyrocketed. Indeed, sales of all MSCI Turkey non-financials companies have risen by 40% in US dollar terms and 200% in local currency (Chart 14). Chart 13Massive Bank Credit And Money Growth Completely Unhinged The Inflation Massive Bank Credit And Money Growth Completely Unhinged The Inflation Massive Bank Credit And Money Growth Completely Unhinged The Inflation This was at a time when policy rates were being cut. The policy rate has fallen to 12% today from 19% a year earlier. Firms’ local currency real borrowing costs have fallen deeply into negative territory (Chart 15). It helped reduce firms’ costs significantly. Chart 14Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits Surging Sales Amid Deeply Negative Real Borrowing Costs Boosted Firms' Profits ​​​​​ Chart 15Policy Rates Are Being Cut Even As The Inflation Reigns Havoc Policy Rates Are Being Cut Even As The Inflation Reigns Havoc Policy Rates Are Being Cut Even As The Inflation Reigns Havoc ​​​​​ Chart 16Wage Costs Have Risen Too, But Not As Much As Inflation Wage Costs Have Risen Too, But Not As Much As Inflation Wage Costs Have Risen Too, But Not As Much As Inflation ​​​​​ Meanwhile, even though wage growth accelerated, it still fell short of inflation, and therefore of nominal sales of the firms (Chart 16). Firms’ wage costs did not rise as much as their prices. All this boosted non-financial firms’ margins. Total profits have risen by 35% in US dollar terms from a year earlier (200% in lira terms). ​​​​​​​ Chart 17The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket The Deluge Of Money Has Led All Kinds Of Asset Prices To Skyrocket ​​​​​​​ On their part, listed financials’ profits have surged by 50% in USD terms and 220% in local currency terms. They benefited both from surging interest income due to rapid loan growth and from massive capital gains on their holding of government securities (see Chart 14 above). All this is reflected in Turkish companies’ earnings per share as well. The spike in EPS has propped up Turkish stocks for past few months. Over the past year, not only have corporate profits and share prices surged, but also house prices have skyrocketed by 170% in local currency terms and 30% in USD terms (Chart 17). In sum, the abnormally low nominal and deeply negative real borrowing costs have produced a money/credit deluge, which has generated a massive inflationary outbreak and has inflated revenues/profits as well as various asset prices. The Lira To Depreciate Further This macro setting is a recipe for a major currency sell-off.  First, Europe – the destination of 90% of Turkish exports – will likely slide into recession over the coming year (Chart 18).  Chart 18A Slowing Europe Will Materially Dent Turkish Growth Too A Slowing Europe Will Materially Dent Turkish Growth Too A Slowing Europe Will Materially Dent Turkish Growth Too A fall in exports will widen Turkey’s current account deficit. Notably, imports will not fall much since the authorities are pursuing easy money policy. Second, the lack of credible macro policies as well as political crisis will assure that foreign capital escapes Turkey. Turkey will find the current account deficit nearly impossible to finance. Third, the country’s net foreign reserves, after adjusting for the central bank’s foreign currency borrowings and commercial banks’ deposits with the central bank, stand at minus 30 billion dollars. In other words, the central bank now has large net US dollar liabilities. As such, it has little wherewithal to defend the currency. There are very high odds that the lira depreciation will accelerate in the months ahead. Fourth, the slew of unorthodox measures taken by the Turkish authorities will encourage banks to buy more government local currency bonds to suppress the government’s borrowing costs. When commercial banks buy government securities from non-banks, they create money “out of thin air.” Hence, the ongoing money supply deluge will continue. This is bearish for the currency. Notably, the economy will likely enter into recession next year – and yet core inflation will stay very high (30% and above). Recent unorthodox bank regulations are meant to encourage a certain kind of lending – loans to farmers, exporters, and small and medium-sized businesses – while discouraging other kinds. Consequently, the overall loan growth will likely slow in nominal terms. There are already signs that credit is decelerating on the margin (Chart 19). Given the very high inflation, slower credit growth will likely lead to a liquidity crunch for many businesses – forcing them to curtail their activity.  Chart 19Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations Bank Credit Will Decelerate Due To Many Unorthodox Bank Regulations ​​​​​​ Chart 20Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP Bank Loans Are Already Contracting in Real Terms: Not a Good Omen For Real GDP ​​​​​​ Indeed, in real terms (deflated by core CPI), local currency loan growth has already slipped into negative territory. This is a bad omen for the overall economy: contracting real loan growth is a harbinger of recession (Chart 20). In short, Turkey is looking into an abyss: a recession amid high inflation (i.e., stagflation) as well as a brewing political crisis (with Erdoğan likely doubling down on unorthodox and populist policies). All this point to another period of a large currency depreciation. While the country will likely change direction to avoid the abyss, investors should wait to allocate capital until after the change in direction is confirmed.    Investment Takeaways The Turkish lira will fall much more vis-à-vis the US dollar in the year ahead. Both Turkish stocks and local currency bonds merit an underweight stance in an EM basket. EM sovereign credit investors, however, should be neutral on Turkish sovereign credit relative to the EM sovereign credit benchmark. Turkey is involved in an economic crisis that will devolve into a political crisis over the election cycle. While Erdoğan and the AKP are likely to fall from power as things stand today, they are heavily entrenched and will be difficult to remove, creating large risks of an indecisive or contested election in 2023 that will increase rather than decrease policy uncertainty and the political risk premium in Turkish assets. As a strongman leader Erdoğan has consolidated political power in his own hands, so there is no one to take the blame for the country’s economic mismanagement – other than foreigners. Hence there is a distinct risk that his foreign policy adventurism will escalate between now and next year, resulting in significant military conflicts or saber-rattling. These will shake out western investors who try to speculate on the likelihood that the election or the military will oust Erdoğan and produce sounder national and economic policies. That outcome is indeed likely but Erdoğan is not going without a fight. Our Geopolitical Strategy also recommends tactically shorting the lira versus the Japanese yen in light of global slowdown, extreme geopolitical risk, and the Bank of Japan’s desire to prevent the yen from falling too far.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com Andrija Vesic Consulting Editor Footnotes 1      Sinan Ekim and Kemal Kirişci, “The Turkish constitutional referendum, explained,” Brookings Institution, April 13, 2017, brookings.edu. 2     The central bank replaced an existing 20% reserve requirement ratios for credits with a higher 30% treasury bond collateral requirement. Lenders will have to cut interest rates on commercial loans (except for loans to farmers, exporters, and SMEs). Otherwise, banks will have to maintain additional securities. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary The US inflation surprise increases the odds of both congressional gridlock and recession, which increases uncertainty over US leadership past 2024 and reduces the US’s ability to lower tensions with China and Iran.   Despite the mainstream media narrative, the Xi-Putin summit reinforces our view that China cannot reject Russia’s strategic partnership. The potential for conflict in Taiwan forces China to accept Russia’s overture. For the same reason the US and China cannot re-engage their economies sustainably, even if Biden and Xi somehow manage to reduce tensions after the midterm elections and twentieth national party congress. Russia could reduce oil exports as well as natural gas, intensifying the global energy shock. Ukraine’s counter-offensive and Europe’s energy diversification increase the risk of Russian military and economic failure. The Middle East will destabilize anew and create a new source of global energy supply disruptions. US-Iran talks are faltering as expected. Russian Oil Embargo Could Deliver Global Shock Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Asset Initiation Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 19.1% Bottom Line: Stay long US stocks, defensive sectors, and large caps. Avoid China, Taiwan, eastern Europe, and the Middle East. Feature Several notable geopolitical developments occurred over the past week while we met with clients at the annual BCA Research Investment Conference in New York. In this report we analyze these developments using our geopolitical method, which emphasizes constraints over preferences, capabilities over intentions, reality over narrative. We also draw freely from the many valuable insights gleaned from our guest speakers at the conference.  China Cannot Reject Russia: The Xi-Putin Summit In Uzbekistan Presidents Xi Jinping and Vladimir Putin are meeting in Uzbekistan as we go to press and Putin has acknowledged China’s “questions and concern” about the war in Ukraine.1 They last met on February 4 when Xi gave Putin his blessing for the Ukraine invasion, promising to buy more Russian natural gas and to pursue a “no limits” strategic partnership (meaning one that includes extensive military cooperation). The meeting’s importance is clear from both leaders’ efforts to make it happen. Putin is leaving Russia despite rising domestic criticism over his handling of the Ukraine war and European energy war. Ukraine is making surprising gains in the battlefield, particularly around Kharkiv, threatening Russia’s ability to complete the conquest of Donetsk and the Donbas region. Meanwhile Xi is leaving China for the first time since the Covid-19 outbreak, despite the fact that he is only one month away from the most important political event of his life: the October 16 twentieth national party congress, where he hopes to clinch another five, ten, or fifteen years in power, expand his faction’s grip over the political system, and take over Mao Zedong’s unique title as chairman of the Communist Party. We do not yet know the full outcome of the Uzbek summit but we do not see it as a turning point in which China turns on Russia. Instead the summit reinforces our key point to investors all year: China cannot reject Russia. Russia broke energy ties with Europe and is fighting a proxy war with NATO. The Putin regime has lashed Russia to China’s side for the foreseeable future. China may not have wanted to move so quickly toward an exclusive relationship but it is not in a position to reject Russia’s diplomatic overture and leave Putin out to dry. The reason is that China is constrained by the US-led world order and like Russia is attempting to change that order and carve a sphere of influence to improve its national security. Beijing’s immediate goal is to consolidate power across the critical buffer territories susceptible to foreign interests. It has already consolidated Tibet, Xinjiang, Hong Kong, and to some extent the South China Sea, the critical approach to Taiwan. Taiwan is the outstanding buffer space that needs to be subjugated. Xi Jinping has taken it upon himself to unify China and Taiwan within his extended rule. But Taiwanese public opinion has decisively shifted in favor of either an indefinite status quo or independence. Hence China and Taiwan are on a collision course. Regardless of one’s view on the likelihood of war, it is a high enough chance that China, Taiwan, the US, and others will be preparing for it in the coming years. Chart 1US Arms Sales To Taiwan Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions The US is attempting to increase its ability to deter China from attacking Taiwan. It believes it failed to deter Russia from invading Ukraine – and Taiwan is far more important to US economy and security than Ukraine. The US is already entering discussions with Taiwan and other allies about a package of severe economic sanctions in the event that China attacks – sanctions comparable to those imposed on Russia. The US Congress is also moving forward with the Taiwan Policy Act of 2022, which will solidify US support for the island as well as increase arms sales (Chart 1).2  Aside from China's military preparation – which needs to be carefully reviewed in light of Russia’s troubles in Ukraine and the much greater difficulty of invading Taiwan – China must prepare to deal with the following three factors in the event of war: 1. Energy: China is overly exposed to sea lines of communication that can be disrupted by the United States Navy. Beijing will have to partner with Russia to import Russian and Central Asian resources and attempt to forge an overland path to the Middle East (Chart 2). Unlike Russia, China cannot supply its own energy during a war and its warfighting capacity will suffer if shortages occur or prices spike. 2. Computer Chips: China has committed at least $200 billion on a crash course to build its own semiconductors since 2013 due to the need to modernize its military and economy and compete with the US on the global stage. But China is still dependent on imports, especially for the most advanced chips, and its dependency is rising not falling despite domestic investments (Chart 3). The US is imposing export controls on advanced microchips and starting to enforce these controls on third parties. The US and its allies have cut off Russia’s access to computer chips, leading to Russian shortages that are impeding their war effort.  Chart 2China’s Commodity Import Vulnerability Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Chart 3China's Imports Of Semiconductors China's Imports Of Semiconductors China's Imports Of Semiconductors     3. US Dollar Reserves: China is still heavily exposed to US dollar assets but its access will be cut off in the event of war, just as the US has frozen Russian, Iranian, Venezuelan, and Cuban assets over the years. China is already diversifying away from the dollar but will have to move more quickly given that Russia had dramatically reduced its exposure and still suffered severely when its access to dollar reserves was frozen this year (Chart 4). Where will China reallocate its reserves? To developing and importing natural resources from Russia, Central Asia, and other overland routes. Chart 4China's US Dollar Exposure China's US Dollar Exposure China's US Dollar Exposure Russia may be the junior partner in a new Russo-Chinese alliance but it will not be a vassal. Russia has resources, military power, and regional control in Central Asia that China needs. Of course, China will maintain a certain diplomatic distance from Russia because it needs to maintain economic relations with Europe and other democracies as it breaks up with the United States. Europe is far more important to Chinese exports than Russia. China will play both sides and its companies will develop parallel supply chains. China will also make gestures to countries that feel threatened by Russia, including the Central Asian members of the Shanghai Cooperation Organization (SCO). But the crucial point is that China cannot reject Russia. If the Putin regime fails, China will be diplomatically isolated, it will lose an ally in any Taiwan war, and the US will have a much greater advantage in attempting to contain China in the coming years and decades. Russo-Chinese Alliance And The US Dollar Many investors speculate that China’s diversification away from the US dollar will mark a severe downturn for the currency. This is of course possible, given that Russia and China will form a substantial anti-dollar bloc. Certainly there can be a cyclical downturn in the greenback, especially after the looming recession troughs. But it is harder to see a structural collapse of the dollar as the leading global reserve currency. The past 14 years have shown how global investors react to US dysfunction, Russian aggression, and Chinese slowdown: they buy the dollar! The implication is that a US wage-price spiral, a Russian détente with Europe, and a Chinese economic recovery would be negative for the dollar – but those stars have not yet aligned. Related Report  Geopolitical StrategyThe Geopolitical Consequences Of The Ukraine War The reason China needs to diversify is because it fears US sanctions when it invades Taiwan. Hence reducing its holdings of US treasuries and the dollar signals that it expects war in future. But will other countries rush into the yuan and yuan-denominated bonds if Xi is following in Putin’s footsteps and launching a war of choice, with damaging consequences for the economy? A war over Taiwan would be a global catastrophe and would send other countries plunging into the safe-haven assets, including US assets.   Nevertheless China will diversify and other countries will probably increase their yuan trade over time, just as Russia has done. This will be a cyclical headwind for the dollar at some point. But it will not knock the US off the premier position. That would require a historic downgrade in the US’s economic and strategic capability, as was the case with the United Kingdom after the world wars. China will continue to stimulate the economy after the party congress. A successful Chinese and global economic rebound next year – and a decision to pursue “jaw jaw” with the US and Taiwan rather than “war war” – would be negative for the dollar. Hence we may downgrade our bullish dollar view to neutral on a cyclical basis before long … but not yet and not on a structural basis.  Bottom Line: Favor the US dollar and the euro over the Chinese renminbi and Taiwanese dollar. Underweight Chinese and Taiwanese assets on a structural basis. Ukraine’s Counter-Offensive And A Russian Oil Embargo Ukraine launched a counter-offensive against Russia in September and achieved significant early victories. Russians fell back away from Kharkiv, putting Izyum in Ukrainian hands and jeopardizing Russia’s ability to achieve its war aim of conquering the remaining half of Donetsk province and thus controlling the Donbas region of eastern Ukraine. Russian positions also crumbled west of the Dnieper river, which was always an important limit on Russian capabilities (Map 1). Map 1Status Of Russia-Ukraine War: The Ukrainian Counter-Offensive (September 15, 2022) Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Some commentators, such as Francis Fukuyama in the Washington Post, have taken the Ukrainian counter-offensive as a sign that the Ukrainians will reconquer lost territory and Russia will suffer an outright defeat in this war.3 If Russia cannot conquer the Donbas, its control of the “land bridge” to Crimea will be unsustainable, and it may have to admit defeat. But we are very skeptical. It will be extremely difficult for Ukrainians to drive the Russians out of all of their entrenched positions. US military officials applauded Ukraine’s counter-offensive but sounded a cautious note. The chief problem is that neither President Putin nor the Russian military can afford such a defeat. They will have to double down on the Donbas and land bridge. The war will be prolonged. Ultimately we expect stalemate, which will be a prelude to ceasefire negotiations. But first the fighting will intensify and the repercussions for global economy and markets will get worse. Russia’s war effort is also flagging because Europe is making headway in finding alternatives for Russian natural gas. Russia has cut off flows through the Nord Stream pipeline to Germany, the Yamal pipeline to Poland, and partially to the Ukraine pipeline system, leaving only Turkstream operating normally. Yet EU gas storage is in the middle of its normal range and trending higher (Chart 5).   Chart 5Europe Handling Natural Gas Crisis Well … So Far Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Of course, Europe’s energy supply is still not secure. Cold weather could require more heating than expected. Russia has an incentive to tighten the gas flow further. Flows from Algeria or Azerbaijan could be sabotaged or disrupted (Chart 6). Chart 6Europe’s NatGas Supply Still Not Secure Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions Chart 7Europe Tipping Into Recession Anyway Europe Tipping Into Recession Anyway Europe Tipping Into Recession Anyway Russia’s intention is to inflict a recession on Europe so that it begins to rethink its willingness to maintain a long-term proxy war. Recession will force European households to pay the full cost of the energy breakup with Russia all at once. Popular support for war will moderate and politicians will adopt more pragmatic diplomacy. After all they do not have an interest in prolonging the war to the point that it spirals out of control. Clearly the economic pain is being felt, as manufacturing expectations and consumer confidence weaken (Chart 7). Europe’s resolve will not collapse overnight. But the energy crisis can get worse from here. The deeper the recession, the more likely European capitals will try to convince Ukraine to negotiate a ceasefire.   However, given Ukraine’s successes in the field and Europe’s successes in diversification, it is entirely possible that Russia faces further humiliating setbacks. While this outcome may be good for liberal democracies, it is not good for global financial markets, at least not in the short run. If Russia is backed into a corner on both the military and economic fronts, then Putin’s personal security and regime security will be threatened. Russia could attempt to turn the tables or lash out even more aggressively. Already Moscow has declared a new “red line” if the US provides longer-range missiles to Ukraine. A US-Russia showdown, complete with nuclear threats, is not out of the realm of possibility. Russia could also start halting oil exports, as it has threatened to do, to inflict a major oil shock on the European economy. Investors will need to be prepared for that outcome.  Bottom Line: Petro-states have geopolitical leverage as long as global commodity supplies remain tight. Investors should be prepared for the European embargo of Russian oil to provoke a Russian reaction. A larger than expected oil shock is possible given the risk of defeat that Russia faces (Chart 8). Chart 8Russian Oil Embargo Could Deliver Global Shock Xi-Putin Summit, Ukraine Offensive, Iran Tensions Xi-Putin Summit, Ukraine Offensive, Iran Tensions US-Iran Talks Falter Again This trend of petro-state geopolitical leverage was one of our three key views for 2022 and it also extends to the US-Iran nuclear negotiations, which are faltering as expected. Tit-for-tat military action between Iran and its enemies in the Persian Gulf will pick up immediately – i.e. a new source of oil disruption will emerge. If global demand is collapsing then this trend may only create additional volatility for oil markets at first, but it further constrains the supply side for the foreseeable future. It is not yet certain that the talks are dead but a deal before the US midterm looks unlikely. Biden could continue working on a deal in 2023-24. The Democratic Party is likely to lose at least the House of Representatives, leaving him unable to pass legislation and more likely to pursue foreign policy objectives. The Biden administration wants the Iran deal to tamp down inflation and avoid a third foreign policy crisis at a time when it is already juggling Russia and China. The overriding constraints in this situation are that Iran needs a nuclear weapon for regime survival, while Israel will attack Iran as a last resort before it obtains a nuclear weapon. Yes, the US is reluctant to initiate another war in the Middle East. But public war-weariness is probably overrated today (unlike in 2008 or even 2016) and the US has drawn a hard red line against nuclear weaponization. Iran will retaliate to any US-Israeli aggression ferociously. But conflict and oil disruptions will emerge even before the US or Israel decide to launch air strikes, as Iran will face sabotage and cyber-attacks and will need to deter the US and Israel by signaling that it can trigger a region-wide war. Chart 9If US-Iran Talks Fail, Iraq Will Destabilize Further If US-Iran Talks Fail, Iraq Will Destabilize Further If US-Iran Talks Fail, Iraq Will Destabilize Further Recent social unrest in Iraq, where the nationalist coalition of Muqtada al-Sadr is pushing back against Iranian influence, is only an inkling of what can occur if the US-Iran talks are truly dead, Iran pushes forward with its nuclear program, and Israel and the US begin openly entertaining military options. The potential oil disruption from Iraq presents a much larger supply constraint than the failure to remove sanctions on Iran (Chart 9). A new wave of Middle Eastern instability would push up oil prices and strengthen Russia’s hand, distracting the US and imposing further pain on Europe. It would not strengthen China’s hand, but the risk itself would reinforce China’s Eurasian strategy, as Beijing would need to prepare for oil cutoffs in the Persian Gulf. Iran’s attempts to join the Shanghai Cooperation Organization should be seen in this context. Ultimately the only factor that could still possibly convince Iran not to make a dash for the bomb – the military might of the US and its allies – is the same factor that forces China and Russia to strengthen their strategic bond. The emerging Russo-Chinese behemoth, in turn, acts as a hard constraint on any substantial reengagement of the US and Chinese economies. The US cannot afford to feed another decade of Chinese economic growth and modernization if China is allied with Russia and Central Asia. Of course, we cannot rule out the possibility that the Xi and Biden administrations will try to prevent a total collapse of US-China relations in 2023. If China is not yet ready to invade Taiwan then there is a brief space for diplomacy to try to work. But there is no room for long-lasting reengagement – because the US cannot simply cede Taiwan to China, and hence China cannot reject Russia, and Russia no longer has any options. Bottom Line: Expect further oil volatility and price shocks. Sell Middle Eastern equities. Favor North American, Latin American, and Australian energy producers. Investment Takeaways Recession Risks Rising: The inflation surprise in the US in August necessitates more aggressive Fed rate hikes in the near term, which increases the odds of rising unemployment and recession. US Policy Uncertainty Rising: A recession will greatly increase the odds of US political instability over the 2022-24 cycle and reduce the incentive for foreign powers like Iran or China to make concessions or agreements with the US. European Policy Uncertainty Rising: We already expected a European recession. Russia’s setbacks make it more likely that it will adopt more aggressive military tactics and economic warfare. Chinese Policy Uncertainty Rising: China will continue stimulating next year but its economy will suffer from energy shocks and its stimulus is less effective than in the past. It will likely increase economic and military pressure on Taiwan, while the US will increase punitive measures against China. It is not clear that it will launch a full scale invasion of Taiwan – that is not our base case – but it is possible so investors need to be prepared. Long US and Defensives: Stay long US stocks over global stocks, defensive sectors over cyclicals, and large caps over small caps. Buy safe-havens like the oversold Japanese yen. Long Arms Manufacturers: Buy defense stocks and cyber-security firms. Short China and Taiwan: Favor the USD and EUR over the CNY. Favor US semiconductor stocks over Taiwanese equities. Favor Korean over Taiwanese equities. Favor Indian tech over Chinese tech. Favor Singaporean over Hong Kong stocks. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1     Tessa Wong and Simon Fraser, “Putin-Xi talks: Russian leader reveals China's 'concern' over Ukraine,” BBC, September 15, 2022, bbc.com. 2     US Senate Foreign Relations Committee, “The Taiwan Policy Act of 2022,” foreign.senate.gov. 3    Greg Sargent, “Is Putin facing defeat? The ‘End of History’ author remains confident,” Washington Post, September 12, 2022, washingtonpost.com.                                                                                         Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary US Military Constraint: Strait Of Hormuz Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? A US-Iran deal would make for a notable improvement in the geopolitical backdrop during an otherwise gloomy year. It would remove the risk of a major new oil shock. We maintain our 40% subjective odds of a deal, which is well below consensus. The risk of failure is underrated. Our conviction level is only moderate because President Biden can make concessions to clinch a deal – and Supreme Leader Khamenei may want to earn some money and time. Yet we have high conviction in our view that the US will ultimately fail to provide Iran with sufficient security guarantees while Iran will pursue a nuclear deterrent. Hence the Middle East will present a long-term energy supply constraint. In the short term, global growth and recession risk will drive oil prices, not any Iran deal. Asset Initiation Date Return LONG GLOBAL AEROSPACE & DEFENSE / BROAD MARKET EQUITIES 2020-11-27 9.3% Bottom Line: Any US-Iran deal will be marginally positive for risky assets. However, the failure of a deal would sharply increase the odds of oil supply disruptions in the short run. Feature Negotiations over Iran’s nuclear program remain in a critical phase. Rumors suggest Iran has agreed to rejoin the 2015 Joint Comprehensive Plan of Action (JCPA) with the United States. But these rumors are unconfirmed, while the International Atomic Energy Agency (IAEA) just announced that Iran has started operating more advanced centrifuges at its Natanz nuclear site.1 In this report we provide a tactical update on the topic. A US-Iran nuclear deal is one item on our checklist for global macro and geopolitical stability (Table 1). We are pessimistic about a deal but it would be a positive outcome for markets. Table 1Not A Lot Of Positive Catalysts In H2 2022 Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? A decision could come at any moment so investors should bear in mind our key conclusions about a deal: Chart 1Oil Volatility: The Only Certainty Of Iran Saga Oil Volatility: The Only Certainty Of Iran Saga Oil Volatility: The Only Certainty Of Iran Saga 1.  Any deal will be a short-term, stop-gap measure to delay a crisis until 2024 or beyond. This is not a small point because a crisis could lead to a large military conflict. 2.  The short-run implication of any deal is oil volatility, not a drop in oil prices (Chart 1). Global demand is wobbly and OPEC could cut oil production in reaction to a deal. 3.  Over the long run, global supply and demand balances will remain tight even if a deal is agreed. 4.  If there is no deal, then a major new source of global supply constraint will emerge immediately due to a new spiral of conflict in the Middle East. Iran’s nuclear program will continue which will prompt threats from Israel and the Gulf Arab states and Iranian counter-threats. We are sticking with our subjective 40/60 odds that a deal will occur – i.e. our conviction level is medium, not high. The Biden administration wants a deal and has the executive authority to conclude a deal. Iran wants sanctions lifted and can buy time with a short-term deal. Our pessimism stems from the fact that neither side can trust the other, the US can no longer give credible security guarantees, and Iran has a strategic interest in obtaining nuclear weapons. A deal can happen but its durability depends on the 2024 US election. Status Of Negotiations Table 2Iran’s Three Demands Of US For Rejoining 2015 Nuclear Deal Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? Ostensibly there were three outstanding Iranian demands over the month of August that needed to be met to secure a deal (Table 2). Iran reportedly dropped the first demand: that the US remove the Iranian Revolutionary Guard Corps from the US State Department’s list of Designated Foreign Terrorist Organizations. This concession prompted the news media to become more optimistic about a deal. This leaves two outstanding demands. Iran wants the IAEA conclude a “safeguards” investigation into unexplained uranium traces found at unauthorized sites in Iran, indicating nuclear activity that has not been accounted for. The IAEA will be very reluctant to halt such a probe on a political, not technical, basis. But it could happen under US pressure. Related Report  Geopolitical StrategyRoulette With A Five-Shooter Iran also wants the US to provide a “guarantee” that future presidents will not renege on the nuclear deal and reimpose sanctions like President Trump did in 2019. President Biden cannot give any credible guarantee because the JCPA is an executive action, not a formal treaty, so a different president could reverse it. (The deal always lacked sufficient support in the Senate, even from top Democrats.) Iran is demanding certain diplomatic concessions and/or an economic indemnity in the event of another American reversal. Aside from attempting to incarcerate former President Trump, Biden can only offer empty promises on this front. In what follows we review the critical constraints facing the US and Iran. The US’s Constraints The first constraint on the US is the stagflationary economy. High inflation and oil prices pose a threat to President Biden and the Democrats not only in this year’s midterm elections but also in the 2024 presidential election. A recession is not at all unlikely by that time, given the inverted yield curve (Chart 2). If the US can help maintain stability in the Middle East, then the odds of another major oil supply shock (on top of Russia) will be reduced. Lifting sanctions on Iran will free up around 1 million barrels of oil to feed global demand. With Europe and the US imposing an oil and oil shipping embargo on Russia, the world is likely to lose around two million barrels of crude per day that the Gulf Arab states can only partially make up for, according to our Chief Commodity Strategist Bob Ryan (Table 3). This is a notable material constraint – and the main reason that Bob is more optimistic about an Iran deal than we are. Chart 2US Economic Constraint: Stagflation US Economic Constraint: Stagflation US Economic Constraint: Stagflation ​​​​​ Table 3The Oil Math Behind Any Iran Deal Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? However, Saudi Arabia would be alienated by a US-Iran détente. The American view is that Iranian production would threaten Saudi market share and force the Saudis to produce more. But the Saudis are seeing weakening global demand and have signaled that they will cut production. There is still an economic basis for an Iran deal but it is not clear that it will lower prices, especially in the short run. Over the long run the Saudis are a more reliable oil producer than Iran for both economic and geopolitical reasons. The second constraint is political. The US public is primarily concerned about the economy. Stagflation or recession could ultimately bring down the Biden administration. However, in the short run, American voters are much more concerned about domestic social issues (such as abortion access) than they are about foreign policy. In the long run, American voters are likely to maintain their long-held negative view of Iran (Chart 3). So the Biden administration has an incentive to prevent geopolitical events from hurting the economy but not to join arms with Iran in a major diplomatic agreement. The third constraint is military. Americans are not as war-weary today as they were in 2008 or 2016 but they are still averse to any new military conflicts in the Middle East. An Iranian nuclear bomb could change that view – but until a bomb is tested it will persist. Chart 3US Political Constraint: Americans Ignore Foreign Policy, Dislike Iran Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? ​​​​​​ Chart 4US Military Constraint: Strait Of Hormuz Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? If Iran freezes its nuclear program then it will reduce the odds of a Middle Eastern war and large-scale oil supply disruptions. If Iran does not freeze its nuclear program, then Israel will have to demonstrate a credible military threat against nuclear weaponization, and then Iran will have to demonstrate its region-wide militant capabilities, including the ability to shut down the Strait of Hormuz (Chart 4). The Biden administration wants to delay this downward spiral or avoid it altogether. Chart 5US Strategic Constraint: Avoid Mideast Quagmires Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? The fourth constraint is strategic. The Biden administration wants to avoid conflict if possible because it is attempting to reduce America’s burden in the Middle East so that it can focus on emerging great power competition in Eastern Europe and East Asia. The original motivation for the Iran deal was to enable the US to “pivot to Asia” and counter China. Iranian hegemony in the Middle East is less of a threat than Chinese hegemony in East Asia (Chart 5). This logic is sound if Iran can really be brought to halt its nuclear program. The Europeans need to stabilize and open up the Middle East to create an alternative energy supply to Russia. The Americans need to avoid a nuclear arms race and war in the Middle East that distracts them from China. However, if Iran continues to pursue a nuclear weapon, then the US suffers strategically for doing a short-term deal that provides Iran with time and access to funds. Ultimately the only thing that can dissuade Iran from going nuclear is American power projection in the Middle East – and this capability is also one of the US’s greatest advantages over China. Bottom Line: The US has a strategic, military, and economic interest in concluding a deal that freezes Iran’s nuclear program. It arguably has an interest in a deal even if Iran violates the deal and pursues nuclear weaponization, since that will provide a legitimate basis for what would then become a necessary military intervention. The Biden administration faces some political blowback for a deal but will suffer more if failure to get a deal leads to a Middle Eastern oil shock. For all these reasons Biden administration is attempting to clinch a deal. But Iran is the sticking point. Iran’s Constraints Our reasons for pessimism regarding the nuclear talks hinge on Iran, not the United States. Supreme Leader Ayatollah Ali Khamenei’s goal is to secure the regime and arrange for a stable succession in the coming years. A deal with the Americans made sense in that context. But going forward, if dealing with the Americans does not bring credible security guarantees and yet makes the economy vulnerable again to a future snapback of sanctions, then the justification for the deal falls apart. We cannot read Khamenei’s mind any more than we can read Biden’s mind, so we will look at the material limitations. Chart 6Iran's Economic Constraint: Stagflation Iran's Economic Constraint: Stagflation Iran's Economic Constraint: Stagflation First, the economic constraint: The Iranian economy suffered a huge negative shock from the reimposition of sanctions in 2019 (Chart 6). However, the economy has sputtered through this shock and the Covid-19 shock without collapsing. Social unrest is an ever-present risk but it has not spiraled out of control. There has not been an attempted democratic revolution like in 2009. The upswing in the global commodity cycle has reinforced the regime. Sanctions do not prevent exports entirely. There is still a huge monetary incentive to let the Biden administration lift sanctions if it wants to do so: a deal is estimated to free up $100 billion dollars per year in revenue for the regime for ten years.2 Realistically this should be understood as more than $275 billion for two years since the longevity of the deal is in question. The problem is that Iran’s economy would be fully exposed to sanctions again if the US changed its mind. The bottom line is that the economic constraint does not force Iran to accept a deal but it is enticing. Second comes the political constraint. President Ebrahim Raisi hopes to become supreme leader someday and is loath to put his name on a deal with weak foundations. He originally opposed the deal, was vindicated, and does not now want to jeopardize his political future by making the same mistake as his hapless predecessor, Hassan Rouhani. Opinion polls may not be reliable in putting Raisi as the most popular politician in Iran but they probably are reliable in showing Rouhani at the bottom of the heap (Chart 7). There is a significant political constraint against rejoining the deal. Chart 7Iran’s Political Constraint: Risk Of American Betrayal Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? Chart 8Iran’s Military Constraint: Outgunned, Unsure Of Allies Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? Third comes the military constraint. While Iran is extremely vulnerable to Israeli and American military attack, it is also a fortress of a country, nestled in mountains, and airstrikes may not succeed in destroying the entire nuclear program or bringing down the regime. An attack by Israel could convert an entirely new generation to the Islamic revolution. And Iran may believe that the US lacks the popular support for military action in the wake of Iraq and Afghanistan. Iran may also believe that China and Russia will provide military and economic support (Chart 8). Ultimately, America has demonstrated a willingness to attack rogue states and Iran will try to avoid that outcome, since it could succeed in toppling the regime. But if Iran believes it can acquire a deliverable nuclear weapon in a few short years, then it may make a dash for it, since this solution would be a permanent solution: a nuclear deterrent against western attack, as opposed to temporary diplomatic promises. We often compare Iran’s strategic predicament to that of Ukraine, Libya, and North Korea. Ukraine gave up its Soviet nuclear weapons after the 1994 Budapest Memorandum, which promised that Russia, the US, the UK, France, and China would guarantee its security. Yet Russia ended up invading 20 years later – and none of the others prevented it or sent troops to halt the Russian advance. Separately Libya gave up its nuclear program in 2003 but NATO attacked and toppled the regime in 2011 anyway. Meanwhile North Korea played the diplomatic game with the US, ever inching along on the path toward nuclear weapons, and today has achieved nuclear-armed status and greater regime security. The outflow of refugees from the various regimes shows why Iran will emulate North Korea (Chart 9). Chart 9Iran’s Strategic Constraint: The Need For A Nuclear Deterrent Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? Bottom Line: Iran has a short-term economic incentive to agree to a deal and a long-term military incentive. But ultimately the US cannot provide ironclad security guarantees that would justify halting the quest for a nuclear deterrent. A nuclear deterrent would overcome the military constraint. Therefore Iran will continue on that path. Any deal will be a ruse to buy time. Final Assessment The 2015 deal occurred in a context of Iranian strategic isolation, when American implementation was credible, oil prices were weak, and Iran had not achieved nuclear breakout capacity. Today Iran is not isolated (thanks to US quarrels with Russia and China), American guarantees are not credible (thanks to the polarization of foreign policy), oil prices are not weak (thanks to Russia), and Iran has already achieved nuclear breakout (Table 4). Table 4Iran’s Nuclear Program Status Check, Aug. 31, 2022 Will Iran Crisis Be Averted? Will Iran Crisis Be Averted? The US’s strategic aim is to create a balance of power in the region but Iran’s strategic aim is to ensure regime survival. The US’s emerging balancing coalition (Israel and the Gulf Arab states) increases the strategic threat to Iran and hence its need for a nuclear deterrent. While Russia and China formally support the 2015 deal, they each see Iran as a valuable asset in a great power struggle with the United States. Iran sees them the same way. Russia needs Iran as a partner to bypass western sanctions. Regardless, it benefits from Middle Eastern instability, which could entangle the United States. China must develop a deep long-term partnership with Iran for its own strategic reasons and does not look forward to a time when the US divests from that region to impose tougher strategic containment on China. China can survive a US conflict with Iran – and such a conflict could reduce the US ability to defend Taiwan. While neither Russia nor China positively desire Iran to obtain nuclear weapons, neither power stopped North Korea from obtaining the bomb – far from it. Russia assumes that Israel and the US will take military action to prevent weaponization, which would be catastrophic for the region but positive for Russia. China also assumes Israel and the US will act, which reinforces its need to diversify energy options so that it can access Russian, Central Asian, and Middle Eastern oil via pipeline. Investment Takeaways Our negative view on the global economy and geopolitical backdrop is once again being priced into global financial markets as equities fall anew. An Iran deal would delay a notable geopolitical risk for roughly the next 24 months and hence remove a major upside risk for oil prices. This would be marginally positive for global equities, although it will not be the driver. Europe’s and China’s economic woes are the drivers. The failure of a deal would bring major upside risks for oil into the near term and as such would be negative for equities – and could even become the global driver, as Middle Eastern oil disruptions will follow promptly from any failure of the deal. We continue to recommend that investors overweight US equities relative to global, defensive sectors relative to cyclicals, and large caps relative to small caps. We are overweight aerospace and defense stocks, India and Southeast Asia within emerging markets, and underweight China and Taiwan.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      See Iran International, “Exclusive: Ex-IAEA Official Says US And Iran To Sign Deal Soon,” August 30, 2022, iranintl.com. See also Francois Murphy, “Iran enriching uranium with more IR-6 centrifuges at Natanz -IAEA,” Reuters, August 31, 2022, reuters.com. 2     See Saeed Ghasseminejad, “Tehran’s $1 Trillion Deal: An Updated Forecast of Iran’s Financial Windfall From a New Nuclear Agreement,” Foundation for Defense of Democracies, August 19, 2022, fdd.org. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

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

Listen to a short summary of this report.     Executive Summary Back From The Future: An Investor’s Almanac Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis Stocks will rally over the next six months as recession risks abate but then begin to swoon as it becomes clear the Fed will not cut rates in 2023. A second wave of inflation will begin in mid-2023, forcing the Fed to raise rates to 5%. The 10-year US Treasury yield will rise above 4%. While financial conditions are currently not tight enough to induce a recession, they will be by the end of next year. In the past, the US unemployment rate has gone through a 20-to-22 month bottoming phase. This suggests that a recession will start in early 2024. The US dollar will soften over the next six months but then get a second wind as the Fed is forced to turn hawkish again. Over the long haul, the dollar will weaken, reflecting today’s extremely stretched valuations.   Bottom Line: Investors should remain tactically overweight global equities but look to turn defensive early next year. Somewhere in Hilbert Space I have long believed that anything that can possibly happen in financial markets (as well as in life) will happen. Sometimes, however, it is useful to focus on a “base case” or “modal” outcome of what the world will look like. In this week’s report, we do just that, describing the evolution of the global economy from the perspective of someone who has already seen the future unfold. September 2022 – Goldilocks! US headline inflation continues to decline thanks to lower food and gasoline prices (Chart 1). Supply-chain bottlenecks ease, as evidenced by falling transportation costs and faster delivery times (Chart 2). Most measures of economic activity bottom out and then begin to rebound. The surge in bond yields earlier in 2022 pushed down aggregate demand, but with yields having temporarily stabilized, demand growth returns to trend. The S&P 500 moves up to 4,400. Chart 1ALower Food And Gasoline Prices Will Drag Down Headline Inflation (I) Lower Food And Gasoline Prices Will Drag Down Headline Inflation (I) Lower Food And Gasoline Prices Will Drag Down Headline Inflation (I) Chart 1BLower Food And Gasoline Prices Will Drag Down Headline Inflation (II) Lower Food And Gasoline Prices Will Drag Down Headline Inflation (II) Lower Food And Gasoline Prices Will Drag Down Headline Inflation (II)   October 2022 – Europe’s Prospects of Avoiding a Deep Freeze Improve: Economic shocks are most damaging when they come out of the blue. With about half a year to prepare for a cut-off of Russian gas, the EU responds with uncharacteristic haste: Coal-fired electricity production ramps up; the planned closure of Germany’s nuclear power plants is postponed; the French government boosts nuclear capacity, which had been running at less than 50% earlier in 2022; and, for its part, the Dutch government agrees to raise output from the massive Groningen natural gas field after the EU commits to establishing a fund to compensate the surrounding community for any damage from increased seismic activity. EUR/USD rallies to 1.06.  November 2022 – Divided Congress and Trump 2.0: In line with pre-election polling, the Democrats retain the Senate but lose the House (Chart 3). Markets largely ignore the outcome. To no one’s surprise, Donald Trump announces his candidacy for the 2024 election. Over the following months, however, the former president has trouble rekindling the magic of his 2016 bid. His attacks on his main rival, Florida governor Ron DeSantis, fall flat. At one rally in early 2023, Trump’s claim that “Ron is no better than Jeb” is greeted with boos. Chart 2Supply-Chain Pressures Are Easing Supply-Chain Pressures Are Easing Supply-Chain Pressures Are Easing Chart 3Democrats Will Lose The House But Retain The Senate Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis   December 2022 – China’s “At Least One Child Policy”: The 20th Party Congress takes place against the backdrop of strict Covid restrictions and a flailing housing market. In addition to reaffirming his Common Prosperity Initiative, President Xi stresses the need for actions that promote “family formation.” The number of births declined by nearly 30% between 2019 and 2021 and all indications suggest that the birth rate fell further in 2022 (Chart 4). Importantly for investors, Xi says that housing policy should focus not on boosting demand but increasing supply, even if this comes at the expense of lower property prices down the road. Base metal prices rally on the news. Chart 4China's Baby Bust China's Baby Bust China's Baby Bust January 2023 – Putin Declares Victory: Faced with continued resistance by Ukrainian forces – which now have wider access to advanced western military technology – Putin declares that Russia’s objectives in Ukraine have been met. Following the playbook in Crimea and the Donbass, he orders referenda to be held in Zaporizhia, Kherson, and parts of Kharkiv, asking the local populations if they wish to join Russia. The legitimacy of the referenda is immediately rejected by the Ukrainian government and the EU. Nevertheless, the Russian military advance halts. While the West pledges to maintain sanctions against Russia, the geopolitical risk premium in oil prices decreases. February 2023 – Credit Spreads Narrow Further: At the worst point for credit in early July 2022, US high-yield spreads were pricing in a default rate of 8.1% over the following 12 months (Chart 5). By late August, the expected default rate has fallen to 5.2%, and by January 2023, it has dropped to 4.5%. Perceived default risks decline even more in Europe, where the economy is on the cusp of a V-shaped recovery following the prior year’s energy crunch. Chart 5The Spread-Implied Default Rate Has Room To Fall If Recession Fears Abate The Spread-Implied Default Rate Has Room To Fall If Recession Fears Abate The Spread-Implied Default Rate Has Room To Fall If Recession Fears Abate March 2023 – Wages: The New Core CPI? US inflation continues to drop, but a heated debate erupts over whether this merely reflects the unwinding of various pandemic-related dislocations or whether it marks true progress in cooling down the economy. Those who argue that higher interest rates are cooling demand point to the decline in job openings. Skeptics retort that the drop in job openings has been matched by rising employment (Chart 6). To the extent that firms have been converting openings into new jobs, the skeptics conclude that labor demand has not declined. In a series of comments, Jay Powell stresses the need to focus on wage growth as a key barometer of underlying inflationary pressures. Given that wage growth remains elevated, market participants regard this as a hawkish signal (Chart 7). The 10-year Treasury yield rises to 3.2%. The DXY index, having swooned from over 108 in July 2022 to just under 100 in February 2023, moves back to 102. After hitting a 52-week high of 4,689 the prior month, the S&P 500 drops back below 4,500. Chart 6Drop In Job Openings Is Matched By Rise In Employment Drop In Job Openings Is Matched By Rise In Employment Drop In Job Openings Is Matched By Rise In Employment Chart 7Wage Growth Remains Strong Wage Growth Remains Strong Wage Growth Remains Strong   April 2023 – Covid Erupts Across China: After successfully holding back Covid for over three years, the dam breaks. When lockdowns fail to suppress the outbreak, the government shifts to a mitigation strategy, requiring all elderly and unvaccinated people to isolate at home. It helps that China’s new mRNA vaccines, launched in late 2022, prove to be successful. By early 2023, China also has sufficient supplies of Pfizer’s Paxlovid anti-viral drug. Nevertheless, the outbreak in China temporarily leads to renewed supply-chain bottlenecks. May 2023 – Biden Confirms He Will Stand for Re-Election: Saying he is “fit as a fiddle,” President Biden confirms that he will seek a second term in office. Little does he know that the US will be in a recession during most of his re-election campaign. Chart 8Consumer Confidence And Real Wages Tend To Move Together Consumer Confidence And Real Wages Tend To Move Together Consumer Confidence And Real Wages Tend To Move Together June 2023 – Inflation: The Second Wave Begins: The decline in inflation between mid-2022 and mid-2023 sows the seeds of its own demise. As prices at the pump and in the grocery store decline, real wage growth turns positive. Consumer confidence recovers (Chart 8). Household spending, which never weakened that much to begin with, surges. The economy starts to overheat again, leading to higher inflation. After having paused raising rates at 3.5% in early 2023, the Fed indicates that further hikes may be necessary. The DXY index strengthens to 104. The S&P 500 dips to 4,300. July 2023 – Tech Stock Malaise: Higher bond yields weigh on tech stocks. Making matters worse, investors start to worry that many of the most popular US tech names have gone “ex-growth.” The evolution of tech companies often follows three stages. In the first stage, when the founders are in charge, the company grows fast thanks to the introduction of new, highly innovative products or services. In the second stage, as the tech company matures, the founders often cede control to professional managers. Company profits continue to grow quickly, but less because of innovation and more because the professional managers are able to squeeze money from the firm’s customers. In the third stage, with all the low-lying fruits already picked, the company succumbs to bureaucratic inertia. As 2023 wears on, it becomes apparent that many US tech titans are entering this third stage. August 2023 – Long-term Inflation Expectations Move Up: Unlike in 2021-22, when long-term inflation expectations remained well anchored in the face of rising realized inflation, the second inflation wave in 2023 is accompanied by a clear rise in long-term inflation expectations. Consumer expectations of inflation 5-to-10 years out in the University of Michigan survey jump to 3.5%. Whereas back in August 2022, the OIS curve was discounting 100 basis points of Fed easing starting in early 2023, it now discounts rate hikes over the remainder of 2023 (Chart 9). The 10-year yield rises to 3.8%. The 10-year TIPS yield spikes to 1.2%, as investors price in a higher real terminal rate. The S&P 500 drops to 4,200. The financial press is awash with comparisons to the early 1980s (Chart 10). Chart 9The Markets Expect The Fed To Cut Rates By Over 100 Basis Points Starting In 2023 The Markets Expect The Fed To Cut Rates By Over 100 Basis Points Starting In 2023 The Markets Expect The Fed To Cut Rates By Over 100 Basis Points Starting In 2023 Chart 10The Early-1980s Playbook The Early-1980s Playbook The Early-1980s Playbook October 2023 – Hawks in Charge: After a second round of tightening, featuring three successive 50 basis-point hikes, the Fed funds rate reaches a cycle peak of 5%. The 10-year Treasury yield gets up to as high as 4.28%. The 10-year TIPS yield hits 1.62%. The DXY index rises to 106. The S&P 500 falls to 4,050. November 2023 – Housing Stumbles: With mortgage yields back above 6%, the US housing market weakens anew. The fallout from rising global bond yields is far worse in some smaller developed economies such as Canada, Australia, and New Zealand, where home price valuations are more stretched (Chart 11). Chart 11Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets Rising Rates Will Weigh On Developed Economies With Pricey Housing Markets January 2024 – Unemployment Starts to Rise: After moving sideways since March 2022, the US unemployment rate suddenly jumps 0.2 percentage points to 3.6%, with payrolls contracting for the first time since the start of the pandemic. The 22-month stretch of a flat unemployment rate is broadly in line with the historic average (Table 1). Table 1In Past Cycles, The Unemployment Rate Has Moved Sideways For Nearly Two Years Before A Recession Began Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis February 2024 – The US Recession Begins: Although there was considerable debate about whether the US was entering a recession at the time, in early 2025, the NBER would end up declaring that February 2024 marked the start of the recession. The 10-year yield falls back below 4% while the S&P 500 drops to 3,700. Lower bond yields are no longer protecting stocks.  March 2024 – The Fed Remains in Neutral: Jay Powell says further rate hikes are unwarranted in light of the weakening economy, but with core inflation still running at 3.5%, the Fed is in no position to ease. April 2024 – The Global Recession Intensifies: The US unemployment rate rises to 4.7%. The economic downdraft is especially sharp in America’s neighbor to the north, where the Canadian housing market is in shambles. Back in June 2022, the Canadian 10-year yield was 21 basis points above the US yield. By April 2024, it is 45 basis points below. Europe and Japan also fall into recession. Commodity prices continue to drop, with Brent oil hitting $60/bbl. May 2024 – The Fed Cuts Rates: Reversing its position from just two months earlier, the Federal Reserve cuts rates for the first time since March 2020, lowering the Fed funds rate from 5% to 4.5%. The Fed funds rate will ultimately bottom at 2.5%, below the range of 3.5%-to-4% that most economists will eventually recognize as neutral. August 2024 – Republican National Convention: Unwilling to spend much of his own money on the campaign, and with most donations flowing to DeSantis, Trump’s bid to reclaim the White House fizzles. While the former president never formally bows out of the race, the last few months of his primary campaign end up being a nostalgia tour of his past accomplishments, interspersed with complaints about all the ways that he has been wronged. In the end, though, Trump makes a lasting imprint on the Republican party. During his acceptance speech, in typical Trumpian style, Ron DeSantis attacks Joe Biden for “eating ice cream while the economy burns” and declares, to thunderous applause, that “Americans are sick and tired of having woke nonsense hurled in their faces and then being dared to deny it at the risk of losing their jobs.” Chart 12The Dollar Is Very Overvalued The Dollar Is Very Overvalued The Dollar Is Very Overvalued October 2024 – The Stock Market Hits Bottom: While the unemployment rate continues to rise for another 12 months, ultimately reaching 6.4%, the S&P troughs at 3,200. The 10-year Treasury yield settles at 3.1% before starting to drift higher. The US dollar, which began to weaken anew after the Fed starts cutting rates, enters a prolonged bear market. As in past cycles, the dollar is unable to defy the gravitational force from extremely stretched valuations (Chart 12). November 2024 – President DeSantis: Against the backdrop of rising unemployment, uncomfortably high inflation, and a sinking stock market, Ron DeSantis cruises to victory in the 2024 presidential election. Unlike Trump, DeSantis deemphasizes corporate tax cuts and deregulation during his presidency, focusing instead on cultural issues. With the Democrats still committed to progressive causes, big US corporations discover that for the first time in modern history, neither of the two major political parties are willing to champion their interests. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on LinkedIn & Twitter Global Investment Strategy View Matrix Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis Special Trade Recommendations Current MacroQuant Model Scores Dispatches From The Future: From Goldilocks To President DeSantis Dispatches From The Future: From Goldilocks To President DeSantis      

Executive Summary With the fourth Taiwan Strait crisis materializing, the odds of a major war between the world’s great powers have gone up. Our decision trees suggest the odds are around 20%, or double where they stood from the Russian war in Ukraine alone. The world is playing “Russian roulette” … with a five-round revolver. Going forward, our base case is for Taiwan tensions to flatten out (but not fall) after the US and Chinese domestic political events conclude this autumn. However, if China escalates tensions after the twentieth national party congress, then the odds of an invasion will rise significantly. If conflict erupts in Taiwan, then the odds of Russia turning even more aggressive in Europe will rise. Iran is highly likely to pursue nuclear weapons. Not A Lot Of Positive Catalysts In H2 2022 Roulette With A Five-Shooter Roulette With A Five-Shooter Tactical Recommendation Inception Date Return LONG US 10-YEAR TREASURY 2022-04-14 1.3% LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 13.8% Bottom Line: Investors should remain defensively positioned at least until the Chinese party congress and the US midterm election conclude this fall. Geopolitical risk next year will depend on China’s actions in the Taiwan Strait. Feature Chart 1Speculation Rising About WWIII Roulette With A Five-Shooter Roulette With A Five-Shooter Pessimists who pay attention to world events have grown concerned in recent years about the risk that the third world war might break out. The term has picked up in online searches since 2019, though it is the underlying trend of global multipolarity, rather than the specific crisis events, that justifies the worry (Chart 1).1 What are the odds of a major war between the US and China, or the US and Russia? How might that be calculated? In this report we present a series of “decision trees” to formalize the different scenarios and probabilities. If we define WWIII as a war in which the United States engages in direct warfare with either Russia or China, or both, then we arrive at a 20% chance that WWIII will break out in the next couple of years! Those are frighteningly high odds – but history teaches that these odds are not unrealistic and that investors should not be complacent. Political scientist Graham Allison has shown that the odds of a US-China war over the long term are about 75% based on historical analogies. The takeaway is that nations will have to confront this WWIII risk and reject it for the global political environment to improve. Most likely they will do so as WWIII, and the risk of nuclear warfare that it would bring, constitutes the ultimate constraint. But the current behavior of the great powers suggests that they have not recognized their constraints yet and are willing to continue with brinksmanship in the short term. The Odds Of A Chinese Invasion Of Taiwan The first question is whether China will invade Taiwan. In April 2021 we predicted that the fourth Taiwan Strait crisis would occur within 12-24 months but that it would not devolve into full-scale war. This view is now being tested. In Diagram 1 we provide a decision tree to map out China’s policy options toward Taiwan and assign probabilities to each option. Diagram 1Decision Tree For Fourth Taiwan Strait Crisis (Next 24 Months) Roulette With A Five-Shooter Roulette With A Five-Shooter While China has achieved the capability to invade Taiwan, the odds of failure remain too high, especially without more progress on its nuclear triad. Hence we give only a 20% chance that China will mobilize for invasion immediately. Needless to say any concrete signs that China is planning an invasion should be taken seriously. Investors and the media dismissed Russia’s military buildup around Ukraine in 2021 to their detriment. At the same time, there is a good chance that the US and China are merely testing the status quo in the Taiwan Strait, which will be reinforced after the current episode. After all, this crisis was the fourth Taiwan Strait crisis – none of the previous crises led to war. If Presidents Biden and Xi Jinping are merely flexing their muscles ahead of important domestic political events this fall, then they have already achieved their objective. No further shows of force are necessary on either side, at least for the next few years. We give 40% odds to this scenario, in which the past week’s tensions will linger but the status quo is reinforced. In that case, the structural problem of the Taiwan Strait would flare up again sometime after the US and Taiwanese presidential elections in 2024, i.e. outside the time frame of the diagram. Unfortunately we are pessimistic over the long run and would give high probability to war in Taiwan. For that reason, we give equal odds (40%) to a deteriorating situation within the coming two years. If China expands drills and sanctions after the party congress, after Xi has consolidated power, then it will be clear that Xi is not merely performing for his domestic audience. Similarly if the Biden administration continues pushing for tighter high-tech export controls against China after the midterm election, and insists that US allies and partners do the same, then the US implicitly believes that China is preparing some kind of offensive operation. The danger of invasion would rise from 20% to 40%. Even in that case, one should still believe that crisis diplomacy between the US and China will prevent full-scale war in 2023-24. But the risk of miscalculation would be very high. The last element of this decision tree holds that China will prefer “gray zone tactics” or hybrid warfare rather than conventional amphibious invasion of the kind witnessed in WWII. The reasons are several. First, amphibious invasions are the most difficult military operations. Second, Chinese forces are inexperienced while the US and its allies are entrenched. Third, hybrid warfare will sow division among the US allies about how best to respond. Fourth, Russia has demonstrated several times over the past 14 years that hybrid warfare works. It is a way of maximizing strategic benefits and minimizing costs. The world knows how the West reacts to small invasions: it uses economic sanctions. It does not yet know how the West reacts to big invasions. So China will be incentivized to take small bites. And yet in Taiwan’s case those tactics may not be sustainable. Our Taiwan decision tree does not account for the likelihood that a hybrid war or “proxy war” will evolve into a major war. But that likelihood is in fact high. So we are hardly overrating the risk of a major US-China war. Bottom Line: Over the next two years, the subjective odds of a US-China proxy war over Taiwan are about 32% while the odds of a direct US-China war are about 4%. The true test comes after Xi Jinping consolidates power at this fall’s party congress. We expect Xi to focus on rebooting the economy so we continue to favor emerging Asian markets excluding China and Taiwan. The Odds Of Russian War With NATO The second question is whether Russia’s war in Ukraine will morph into a broader war with the West. The odds of a major Russia-West war are greater in this case than in China’s, as a war is already raging, whereas tensions in the Taiwan Strait are merely shadow boxing so far. An investor’s base case should hold that the Ukraine war will remain contained in Ukraine, as Europeans do not want to fight a devastating war with Russia merely because of the Donbas. But things often go wrong in times of war. The critical question is whether Russia will attack any NATO members. That would trigger Article Five of the alliance’s treaty, which holds that “an armed attack against one or more [alliance members] in Europe or North America shall be considered an attack against them all,” justifying the use of armed force if necessary to restore security. Since Russia’s invasion of Ukraine this year, President Biden has repeatedly stated that the US will “defend every inch of NATO territory,” including the Baltic states of Latvia, Lithuania, and Estonia, which joined NATO in 2004. This is not a change of policy but it is the US’s red line and highly likely to be defended. Hence it is a major constraint on Russia. In Diagram 2 we map out Russia’s different options and assign probabilities. Diagram 2Decision Tree For Russia-Ukraine War (Next 24 Months) Roulette With A Five-Shooter Roulette With A Five-Shooter We give 55% odds that Russia will declare victory after completing the conquest of Ukraine’s Donbas region and the land bridge to Crimea. It will start looking to legitimize its conquests by means of some diplomatic agreement, i.e. a ceasefire. This is our base case for 2023. There is evidence that Russia is already starting to move toward diplomacy.2 The reason is that Russia’s economy is suffering, global commodity prices are falling, Russian blood and treasure are being spent. President Putin will have largely achieved his goal of hobbling Ukraine as long as he controls the mouth of the Dnieper river and the rest of the territory he has invaded. Putin needs to seal his conquests and try to salvage the economy and society. The sooner the better for Russia, so that Europe can be prevented from forming a consensus and implementing a full natural gas embargo in the coming years. However, there is a risk that Putin’s ambition gets the better of him. So we give 35% odds that the invasion expands to southwestern Ukraine, including the strategic port city of Odessa, and to eastern Moldova, where Russian troops are stationed in the breakaway region of Transdniestria. This new campaign would render Ukraine fully landlocked, neutralize Moldova, and give Russia greater maritime access. But it would unify the EU, precipitate a natural gas embargo, and weaken Russia to a point where it could become desperate. It could retaliate and that retaliation could conceivably lead to a broader war. We allot only a 7% chance that Putin attacks Finland or Sweden for attempting to join NATO. Stalin failed in Finland and Putin’s army could not even conquer Kiev. The UK has pledged to support these states, so an attack on them will most likely trigger a war with NATO. A decision to attack Finland would only occur if Russia believed that NATO planned to station military bases there – i.e. Russia’s declared red line. Any Russian attack on the Baltic states is less likely because they are already in NATO. But there is some risk it could happen if Putin grows desperate. We put the risk of a Baltic invasion at 3%. In short, if Russia uses its energy stranglehold on Europe not to negotiate a favorable ceasefire but rather to expand its invasions, then the odds of a broader war will rise. Bottom Line: The result is a 55% chance of de-escalation over the next 24 months, a 35% chance of a small escalation (e.g. Odessa, Moldova), and a 10% chance of major escalation that involves NATO members and likely leads to a NATO-Russia war. Tactically, investors should buy developed-market European currency and assets if the global economy rebounds and Russia makes a clear pivot to halting its military campaign and pursuing ceasefire talks. Cyclically, there needs to be a deeper US-Russia understanding for a durable bull market in European assets. The Odds Of US-Israeli Strikes On Iran The third geopolitical crisis taking place this year could be postponed as we go to press – if President Biden and Ayatollah Ali Khamenei agree to rejoin the 2015 US-Iran nuclear deal. But we remain skeptical. The Biden administration wants to rejoin the 2015 nuclear deal and free up about one million barrels per day of Iranian crude oil to reduce prices at the pump before the midterm election. US grand strategy also wants to engage with Iran and stabilize the Middle East so that the US can pivot to Asia. The EU is proposing the deal since it has even greater need for Iranian resources and wants to prevent Iran from getting nuclear weapons. Russia and China are also supportive as they want to remove US sanctions for trading with Iran and do not necessarily want Iran to get nukes. There is only one problem: Iran needs nuclear weapons to ensure its regime’s survival over the long run. The question is whether Khamenei is willing to authorize a deal with the Americans a second time. The first deal was betrayed at great cost to his regime. President Ebrahim Raisi, who hopes to replace the 83-year-old Khamenei before long, is surely staunchly opposed to wagering his career and personal security on whether Republicans win the 2024 election. Iran has already achieved nuclear breakout capacity – it has enough 60%-enriched uranium to construct nuclear devices – and it is unclear why it would achieve this capacity if it did not ultimately seek to obtain a nuclear deterrent. Especially given that it may someday need to protect its regime from military attacks by the US and its allies. However, our conviction level is medium because President Biden wants to lift sanctions and can do so unilaterally. The Biden administration has not taken any of the preliminary actions to make a deal come together but that could change.3 There is a good cyclical case to be made for short-term, stop-gap deal. According to BCA’s Commodity & Energy Strategist Bob Ryan, Saudi Arabia and the UAE only have about 1.5 million barrels of spare oil production capacity between them. The EU oil embargo and western sanctions on Russia will force about two million barrels per day to be stopped, soaking up most of OPEC’s capacity. Hence the Biden administration needs the one million barrels that Iran can bring. We cannot deny that the Iranians may sign a deal to allow Biden to lift sanctions. That would benefit their economy. They could allow nuclear inspectors while secretly shifting their focus to warhead and ballistic missile development. While Iran will not give up the long pursuit of a nuclear deterrent, it is adept at playing for time. Still, Iran’s domestic politics do not support a deal – and its grand strategy only supports a deal if the US can provide credible security guarantees, which the US cannot do because its foreign policy is inconsistent. US grand strategy supports a deal but only if it is verifiable, i.e. not if Iran uses it as cover to pursue a bomb anyway. Iran has not capitulated after three years of maximum US sanctions, a pandemic, and global turmoil. And Iran sees a much greater prospect of extracting strategic benefits from Russia and China now that they have turned aggressive against the West. Moscow and Beijing can be strategic partners due to their shared acrimony toward Washington. Whereas the US can betray the Raisi administration just as easily as it betrayed the Rouhani administration, with the result that the economy would be whipsawed again and the Supreme Leader and the political establishment would be twice the fools in the eyes of the public. Diagram 3 spells out Iran’s choices. Diagram 3Decision Tree For Iran Nuclear Crisis (Next 24 Months) Roulette With A Five-Shooter Roulette With A Five-Shooter If negotiations collapse (50% odds), then Iran will make a mad dash for a nuclear weapon before the US and Israel attack. If the US and Iran agree to a deal (40%), then Iran might comply with the deal’s terms through the 2024 US election, removing the issue from investor concerns for now. But their long-term interest in obtaining a nuclear deterrent will not change and the conflict will revive after 2024. If talks continue without resolution (10%), Iran will make gradual progress on its nuclear program without the restraints of the deal (though it may not need to make a mad dash). In short, Russia and China need Iran regardless of whether it freezes its nuclear program, whereas the US and Israel will form a balance-of-power Abraham Alliance to contain Iran even if it does freeze its nuclear program. Bottom Line: Investors should allot 40% odds to a short-term, stop-gap US-Iran nuclear deal. The oil price drop would be fleeting. Long-term supply will not be expanded because the US cannot provide Iran with the security guarantees that it needs to halt its nuclear program irreversibly. The Odds Of World War III Now comes the impossible part, where we try to put these three geopolitical crises together. In what follows we are oversimplifying. But the purpose is to formalize our thinking about the different players and their options. Diagram 4 begins with our conclusions regarding the China/Taiwan conflict, adjusts the odds of a broader Russian war as a result, and adds our view that Iran is highly likely to pursue nuclear weapons. Again the time frame is two years. Diagram 4Decision Tree For World War III (Next 24 Months) Roulette With A Five-Shooter Roulette With A Five-Shooter The alternate conflict scenario to WWIII consists of “limited wars” – a dangerous concept that refers to hybrid and proxy wars in which the US is not involved, or only involved indirectly. Or it could be a conflict with Iran that does not involve Russia and China. We begin with China because China is the most capable and most ambitious global power today. China’s strategic rise is upsetting the global order and challenging the United States. We also start with China because we have some evidence this year that Russia does not intend to expand the war beyond Ukraine. Either China takes further aggressive action in Taiwan – creating a unique opportunity for Russia to take greater risks – or not. If not, then the odds of WWIII fall precipitously over the two-year period. This scenario is our base case. But if China attacks Taiwan and the US defends Taiwan, we give a high probability to Russia invading the Baltics. If China stages hybrid attacks and the US only supports Taiwan indirectly, then we increase the odds of Russian aggression only marginally. The result is 20% odds of WWIII, i.e. a direct war between the US and Russia, or China, or both. Whether this war could remain limited is debatable. War gaming since 1945 shows that any war between major nuclear powers will more likely escalate than not. But nuclear weapons bring mutually assured destruction, the ultimate constraint. The nuclear escalation risk is why we round down the probability of WWIII in our decision trees. The more likely 59% risk scenario of “limited wars” may seem like a positive outcome but it includes major increases in geopolitical tensions from today’s level, such as a Chinese hybrid war against Taiwan. Bottom Line: According to this exercise the odds of WWIII could be as high as 20%. This is twice the level in our Russia decision tree, which is appropriate given that our Taiwan crisis forecast has materialized. The critical factor is whether Beijing continues escalating the pressure on Taiwan after the party congress this fall. That could unleash a dangerous chain reaction. The global economy and financial markets still face downside risk from geopolitics but 2023 could see improvements if Russia moves toward a ceasefire and China delays action against Taiwan to reboot its economy. Investment Takeaways When Russia invaded Ukraine earlier this year, our colleague Peter Berezin, Chief Global Strategist, argued that the odds of nuclear Armageddon were 10%. At very least this is a reasonable probability for the odds that Russia and NATO come to blows. Now the expected Taiwan crisis has materialized. We guess that the odds of a major war have doubled to 20%. The corollary is an 80% chance of a better outcome. Analytically, we still see Russia as pursuing a limited objective – neutralizing Ukraine so that it cannot be prosperous and militarily powerful – while China also pursues a limited objective – intimidating Taiwan so that it pursues subordination rather than nationhood. Unless these objectives change, we are still far from World War III. The world can live with a hobbled Ukraine and a subordinated Taiwan. However, there can be no denying that the trajectory of global affairs since the 2008 global financial crisis has followed a pathway uncomfortably similar to the lead up to World War II: financial crisis, economic recession, deflation, domestic unrest, currency depreciation, trade protectionism, debt monetization, military buildup, inflation, and wars of aggression. If roulette is the game, then the odds of a global war are one-sixth or 17%, not far from the 20% outcome of our decision trees. Even assuming that we are alarmist, the fact that we can make a cogent, formal argument that the odds of WWIII are as high as 20% suggests that investors should wait for the current tensions over Ukraine and Taiwan to decrease before making large new risky bets. A simple checklist shows that the global macro and geopolitical context is gloomy (Table 1). We need improvement on the checklist before becoming more optimistic. Table 1Not A Lot Of Positive Catalysts In H2 2022 Roulette With A Five-Shooter Roulette With A Five-Shooter Chart 2Stay Defensively Positioned In H2 2022 Stay Defensively Positioned In H2 2022 Stay Defensively Positioned In H2 2022 Specifically what investors need is to be reasonably reassured that Russia will not expand the war to NATO and that China will not invade Taiwan anytime soon. This requires a new diplomatic understanding between the Washington and Moscow and Washington and Beijing that forestalls conflict. That kind of understanding can only be forged in crisis. The relevant crises are under way but not yet complete. There is likely more downside for global equity investors before war risks are dispelled through the usual solution: diplomacy. Wait for concrete and credible improvements to the global system before taking a generally overweight stance toward risky assets. Favor government bonds over stocks, US stocks over global stocks, defensive sectors over cyclicals, and disfavor Chinese and Taiwanese currency and assets (Chart 2).     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      See Graham Allison, Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Miffin Harcourt, 2017). 2     For example, the Turkish brokered deal to ship grain out of Odessa, diplomatic support for rejoining the 2015 Iran nuclear deal, referendums in conquered territories like Kherson, and attempts to build up leverage in arms reduction talks. Cutting off Europe’s energy is ultimately a plan to coerce Europe into settling a ceasefire favorable for Russia. 3     Iran is still making extraneous demands – most recently that the IAEA drop a probe into how certain manmade uranium particles appeared in undisclosed nuclear sites in Iran. The IAEA has not dropped this probe and its credibility will suffer if it does. Meanwhile Biden is raising not lowering sanctions on Iran, even though sanction relief is a core Iranian demand. Biden has not removed the Iranian Revolutionary Guards or the Qods Force from the terrorism list. None of these hurdles are prohibitive but we would at least expect to see some movement before changing our view that a deal is more likely to fail than succeed. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades ()

Executive Summary Biden Taps China-Bashing Consensus Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake House Speaker Nancy Pelosi’s visit to Taiwan reflects one of our emerging views in 2022: the Biden administration’s willingness to take foreign policy risks ahead of the midterm elections. Biden’s foreign policy will continue to be reactive and focused on domestic politics through the midterms. Hence global policy uncertainty and geopolitical risk will remain elevated at least until November 8.  Biden is seeing progress on his legislative agenda. Congress is passing a bill to compete with China while the Democrats are increasingly likely to pass a second reconciliation bill, both as predicted. These developments support our view that President Biden’s approval rating will stabilize and election races will tighten, keeping domestic US policy uncertainty elevated through November. These trends pose a risk to our view that Republicans will take the Senate, but the prevailing macroeconomic and geopolitical environment is still negative for the ruling Democratic Party. We expect legislative gridlock and frozen US fiscal policy in 2023-24. Close Recommendation (Tactical) Initiation Date  Return Long Refinitiv Renewables Vs. S&P 500 Mar 30, 2022 25.4% Long Biotech Vs. Pharmaceuticals Jul 8,  2022 -3.3% Bottom Line: While US and global uncertainty remain high, we will stay long US dollar, long large caps over small caps, and long US Treasuries versus TIPS. But these are tactical trades and are watching closely to see if macroeconomic and geopolitical factors improve later this year. Feature President Biden’s average monthly job approval rating hit its lowest point, 38.5%, in July 2022. However, Biden’s anti-inflation campaign and midterm election tactics are starting to bear fruit: gasoline prices have fallen from a peak of $5 per gallon to $4.2 today, the Democratic Congress is securing some last-minute legislative wins, and women voters are mobilizing to preserve abortion access.  These developments mean that the Democratic Party’s electoral prospects will improve marginally between now and the midterm election, causing Senate and congressional races to tighten – as we have expected. US policy uncertainty will increase. Investors will see a rising risk that Democrats will keep control of the Senate – and conceivably even the House – and hence retain unified control of the executive and legislative branches. This “Blue Sweep” risk will challenge the market consensus, which overwhelmingly (and still correctly) expects congressional gridlock in 2023-24. A continued blue sweep would mean larger tax hikes and social spending, while gridlock would neutralize fiscal policy for the next two years. Investors should fade this inflationary blue sweep risk and continue to plan for disinflationary gridlock. First, our quantitative election models still predict that Democrats will lose control of both House and Senate (Appendix). Second, Biden’s midterm tactics face very significant limitations, particularly emanating from geopolitics – the snake in this report’s title. Pelosi’s Trip To Taiwan Raises Near-Term Market Risks One of Biden’s election tactics is our third key view for 2022: reactive foreign policy. Initially we viewed this reactiveness as “risk-averse” but in May we began to argue that Biden could take risky bets given his collapsing approval ratings. Either way, Biden is using foreign policy as a means of improving his party’s domestic political fortunes. In particular, he is willing to take big risks with China, Russia, Iran, and terrorist groups like Al Qaeda. The template is the 1962 congressional election, when President John F. Kennedy largely defied the midterm election curse by taking a tough stance against Russia in the Cuban Missile Crisis (Chart 1). If Biden achieves a foreign policy victory, then Democrats will benefit. If he instigates a crisis, voters will rally around his administration out of patriotism. Nancy Pelosi’s visit to Taipei is the prominent example of this key view. The trip required full support from the US executive branch and military and was not only the swan song of a single politician. It was one element of the Biden administration’s decision to maintain the Trump administration’s hawkish China policy. Thus while Congress passes the $52 billion Chips and Science Act to enhance US competitiveness in technology and semiconductor manufacturing, Biden is also contemplating tightening export controls on computer chip equipment that China needs to upgrade its industry.1 Biden is reacting to a bipartisan and popular consensus holding that the US needs to take concrete measures to challenge China and protect American industry (Chart 2). This is different from the old norm of rhetorical China-bashing during midterms. Chart 1Biden Provokes Foreign Rivals Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart 2Biden Taps China-Bashing Consensus Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Reactive US foreign policy will continue through November and possibly beyond – including but not limited to China. The US chose to sell long-range weapons to Ukraine and provide intelligence targeting Russian forces, prompting Russia to declare that the US is now “directly” involved in the Ukraine conflict. The US decision to eradicate Al Qaeda leader Ayman Al-Zawahiri also reflects this foreign policy trend. Reactive foreign policy will increase the near-term risk of new negative geopolitical surprises for markets. Note that the 1962 Cuban Missile Crisis analogy is inverted when it comes to the Taiwan Strait. China is willing to take much greater risks than the US in its sphere of influence. The same goes for Russia in Ukraine. If US policy backfires then it may assist the Democrats in the election – but not if Biden suffers a humiliation or if the US economy suffers as a result. Chart 3US Import Prices Will Stay High From Greater China US Import Prices Will Stay High From Greater China US Import Prices Will Stay High From Greater China US import prices will continue to rise from Greater China (Chart 3), undermining Biden’s anti-inflation agenda. Supply kinks in the semiconductor industry will become relevant again whenever demand rebounds  (Chart 4). Global energy prices will also remain high as a result of the EU’s oil embargo and Russia’s continued tightening of European natural gas supplies. Chart 4New Semiconductor Kinks Will Appear When Demand Recovers New Semiconductor Kinks Will Appear When Demand Recovers New Semiconductor Kinks Will Appear When Demand Recovers OPEC has decided only to increase oil production by 100,000 barrels per day, despite Biden’s visit to Saudi Arabia cap in hand. We argued that the Saudis would give a token but would largely focus on weakening global demand rather than pumping substantially more oil to help Biden and the Democrats in the election. The Saudis know that Biden is still attempting to negotiate a nuclear deal with Iran that would free up Iranian exports. So the Saudis are not giving much relief, and if Biden fails on Iran, oil supply disruptions will increase. Bottom Line: Price pressures will intensify as a result of the US-China and US-Russia standoffs – and probably also the US-Iran standoff. Hawkish foreign policy is not conducive to reducing inflationary ills. Global policy uncertainty and geopolitical risk will remain high throughout the midterm election season, causing continued volatility for US equities. Abortion Boosts Democratic Election Odds Earlier this year we highlighted that the Supreme Court’s overturning of the 1972 Roe v. Wade decision would lead to a significant mobilization of women voters in favor of the Democratic Party ahead of the midterm election. The first major electoral test since the court’s ruling, a popular referendum in the state of Kansas, produced a surprising result on August 2 that confirms and strengthens this thesis. Kansas is a deeply religious and conservative state where President Trump defeated President Biden by a 15% margin in 2020. The referendum was held during the primary election season, when electoral turnout skews heavily toward conservatives and the elderly. Yet Kansans voted by an 18% margin (59% versus 41%) not to amend the constitution, i.e. not to empower the legislature to tighten regulations on abortion. Voter turnout is not yet reported but likely far higher than in recent non-presidential primary elections. Kansans voted in the direction of  nationwide opinion polling on whether abortion should be accessible in cases where the mother’s health is endangered. They did not vote in accordance with more expansive defenses of abortion, which are less popular (Chart 5). If the red state of Kansas votes this way then other states will see an even more substantial effect, at least when abortion is on the ballot. Chart 5Abortion Will Mitigate Democrats’ Losses Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake The question is how much of this Roe v. Wade effect will carry over to the general congressional elections. The referendum focused exclusively on abortion. Voters did not vote on party lines. Voters never like it when governments try to take away rights or privileges that have previously been granted. But in November the election will center on other topics, including inflation and the economy. And midterm elections almost always penalize the incumbent party. Our quantitative election models imply that Democrats will lose 22 seats in the House and two seats in the Senate, yielding Congress to the Republicans next year (Appendix). Still, women’s turnout presents a risk to our models. Women’s support for the Democratic Party has not improved markedly since the Supreme Court ruling, as we have shown in recent reports (Chart 6). But the polling could pick up again. Women’s turnout could be a significant tailwind in a year of headwinds for the Democrats. Bottom Line: Democrats’ electoral prospects have improved, as we anticipated earlier this year (Chart 7). This trend will continue as a result of the mobilization of women. Republicans are still highly likely to take Congress but our conviction on the Senate is much lower than it is on the House. Chart 6Biden’s And Democrats’ Approval Among Women Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart 7Democrats’ Odds Will Improve On Margin Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Reconciliation Bill: Still 65% Chance Of Passing Ultimately Democrats’ electoral performance will depend on inflation, the economy, and cyclical dynamics. If inflation falls over the course of the next three months, then Democrats will have a much better chance of stemming midterm losses. That is why President Biden rebranded his slimmed down “Build Back Better” reconciliation bill as the “Inflation Reduction Act.” We maintain our 65% odds that the bill will pass, as we have done all year. There is still at least a 35% chance that Senator Kyrsten Sinema of Arizona could defect from the Democrats, given that she opposed any new tax hikes and the reconciliation bill will impose a 15% minimum tax on corporations. A single absence or defection would topple the budget reconciliation process, which enables Democrats to pass the bill on a simple majority vote. We have always argued that Sinema would ultimately fall in line rather than betraying her party at the last minute before the election. This is even more likely given that moderate-in-chief, Senator Joe Manchin of West Virginia, negotiated and now champions the bill. But some other surprise could still erase the Democrats’ single-seat majority, so we stick with 65% odds. Most notably the bill will succeed because it actually reduces the budget deficit – by an estimated $300 billion over a decade (Table 1). Deficit reduction was the original purpose of lowering the number of votes required to pass a bill under the budget reconciliation process. Now Democrats are using savings generated from new government caps on pharmaceuticals (a popular measure) to fund health and climate subsidies. Given deficit reduction, it is conceivable that a moderate Republican could even vote for the bill. Table 1Democrats’ Inflation Reduction Act (Budget Reconciliation) Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Bottom Line: Democrats are more likely than ever to pass their fiscal 2022 reconciliation bill by the September 30 deadline. The bill will cap some drug prices and reduce the deficit marginally, so it can be packaged as an anti-inflation bill, giving Democrats a legislative win ahead of the midterm. However, its anti-inflationary impact will ultimately be negligible as $300 billion in savings hardly effects the long-term rising trajectory of US budget deficits relative to output. The bill will add to voters’ discretionary income and spur the renewable energy industry. And if it helps the Democrats retain power, then it enables further spending and tax hikes down the road, which would prove inflationary. The reconciliation bill, annual appropriations, and the China competition bill were the remaining bills that we argued would narrowly pass before the US Congress became gridlocked again. So far this view is on track.   Investment Takeaways Companies that paid a high effective corporate tax rate before President Trump’s tax cuts have benefited relative to those that paid a low effective rate. They stood to suffer most if Trump’s tax cuts were repealed. But Democrats were forced to discard their attempt to raise the overall corporate tax rate last year. Instead the minimum corporate rate will rise to 15%, hitting those that paid the lowest effective rate, such as Big Tech companies, relative to high-tax rate sectors such as energy (Chart 8, top panel). Tactically energy may still underperform tech but cyclically energy could outperform and the reconciliation bill would feed into that trend. Similarly, companies that faced high foreign tax risk, because they made good income abroad but paid low foreign tax rates, stand to suffer most from the imposition of a minimum corporate tax rate (Chart 8, bottom panel). Again, Big Tech stands to suffer, although it has already priced a lot of bad news and may not perform poorly in the near term. Chart 8Market Responds To Minimum Corporate Tax Market Responds To Minimum Corporate Tax Market Responds To Minimum Corporate Tax Chart 9Market Responds To New Climate Subsidies Market Responds To New Climate Subsidies Market Responds To New Climate Subsidies Renewable energy stocks have rallied sharply on the news of the Democrats’ reconciliation bill getting back on track (Chart 9). We are booking a 25.4% gain on this tactical trade and will move to the sidelines for now, although renewable energy remains a secular investment theme. Health stocks, particularly pharmaceuticals, have taken a hit from the new legislation as we expected. However, biotech has not outperformed pharmaceuticals as we expected, so we will close this tactical trade for a loss of 3.3%. The reconciliation bill will cap drug prices for only the most popular generic drugs and does not pose as much of a threat to biotech companies (Chart 10). Biotech should perform well tactically as long bond yields decline – they are also historically undervalued, as noted by Dhaval Joshi of our Counterpoint strategy service. So we will stick to long Biotech versus the broad market. US semiconductors remain in a long bull market and will be in heavy demand once global and US economic activity stabilize. They are also likely to outperform competitors in Greater China that face a high and persistent geopolitical risk premium (Chart 11).  Chart 10Market Responds To Drug Price Caps Market Responds To Drug Price Caps Market Responds To Drug Price Caps Chart 11Market Responds To China Competition Bill Market Responds To China Competition Bill Market Responds To China Competition Bill Tactically we prefer bonds to stocks, US equities to global equities, defensive sectors to cyclicals, large caps to small caps, and growth stocks to value stocks (Chart 12). The US is entering a technical recession, Europe is entering recession, China’s economy is weak, and geopolitical tensions are at extreme highs over Ukraine, Taiwan, and Iran. The US is facing an increasingly uncertain midterm election. These trends prevent us from adding risk in our portfolio in the short term. However, much bad news is priced and we are on the lookout for positive economic surprises and successful diplomatic initiatives to change the investment outlook for 2023. If the US and China recommit to the status quo in the Taiwan Strait, if Russia moves toward ceasefire talks in Ukraine, if the US and Iran rejoin the 2015 nuclear deal, then we will take a much more optimistic attitude. Some political and geopolitical risks could begin to recede in the fourth quarter – although that remains to be seen. And even then, geopolitical risk is rising on a secular basis. Chart 12Tactically Recession And Geopolitics Will Weigh On Risk Assets Tactically Recession And Geopolitics Will Weigh On Risk Assets Tactically Recession And Geopolitics Will Weigh On Risk Assets Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com       Footnotes 1     Alexandra Alper and Karen Freifeld, “U.S. considers crackdown on memory chip makers in China,” Reuters, August 1, 2022, reuters.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A3US Political Capital Index Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Chart A1Presidential Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort Chart A2Senate Election Model Third Quarter US Political Outlook: Last Ditch Effort Third Quarter US Political Outlook: Last Ditch Effort  Table A4House Election Model Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5APolitical Capital: White House And Congress Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5BPolitical Capital: Household And Business Sentiment Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake Table A5CPolitical Capital: The Economy And Markets Biden's Midterm Tactics Bear Fruit… But There's A Snake Biden's Midterm Tactics Bear Fruit… But There's A Snake

Executive Summary Biden Can Take Risks Ahead Of Midterms The Fourth Taiwan Strait Crisis The Fourth Taiwan Strait Crisis News reports suggest House Speaker Nancy Pelosi will travel to Taiwan and meet with Taiwanese President Tsai Ing-wen in the coming days. China has promised military counter-measures if she visits. Structural factors suggest US-China tensions over Taiwan could explode: China’s reversion to autocracy and hawkish foreign policy, Taiwan’s assertion of autonomy, and the US’s political instability and foreign policy reactiveness. Cyclical factors also suggest that tensions could escalate: China’s instability in the wake of Covid-19, the ramifications of Russia’s invasion of Ukraine, the budding Russo-Chinese alliance, the Biden administration’s domestic political vulnerability, and the Xi administration’s domestic political vulnerability. In particular, Xi cannot back down. A diplomatic crisis or military showdown is likely in the short run but not yet a full-scale war. Taiwan is harder to invade than Ukraine, the US is not attempting a radical boost to Taiwan’s military, Taiwan is not moving toward formal independence, and the Chinese economy is not yet collapsing beyond all hope. However, over the long run we fear that a Taiwan war is more likely than not. Tactically investors should prefer government bonds to equities, US equities to global, defensive sectors to cyclicals, and safe havens to risky assets. Investors should short Chinese and Taiwanese currencies and assets. Tactical Recommendation Inception Date Return LONG US SEMICONDUCTOR & SEMI EQUIPMENT / TAIWAN EQUITIES 2022-06-23 14.6% LONG KOREA/ SHORT TAIWAN EQUITIES 2020-03-27 -23.5% Bottom Line: Tactically investors should buy safe-haven assets and await a resolution of the US-China confrontation over Taiwan, which could cause a dramatic escalation in strategic tensions. Feature A fourth Taiwan Strait crisis is likely upon us. Speaker of the US House of Representatives Nancy Pelosi will visit Taiwan during her travel around Asia Pacific this week, according to the Wall Street Journal on August 1. Chinese President Xi Jinping warned US President Joe Biden in a phone conversation on July 28 that “those who play with fire will eventually get burned,” referring specifically to US relations with Taiwan. Chinese foreign ministry officials have threatened “forceful” countermeasures if Pelosi visits the island, explicitly saying that the People’s Liberation Army would respond in some way.   There is still some uncertainty over whether Pelosi will go. She delayed the trip in April. Rumors emerged over July that she would resume but President Joe Biden suggested on July 20 that US military officials opposed the trip, believed the timing to be inappropriate. Taiwan was not mentioned in Pelosi’s official itinerary published on July 31, which includes Singapore, Japan, South Korea, and Malaysia. But the Wall Street Journal report has been corroborated by US and Taiwanese officials. Assuming Pelosi goes, China will respond with some military show of force. The US may pretend that one hand (the White House, the Department of Defense) does not know what the other hand is doing (the House of Representatives). But China will not be convinced. There are three major reasons that we have predicted a fourth Taiwan Strait crisis: 1.   China’s reversion to autocracy and foreign policy hawkishness: After the Great Recession, China was forced into a painful downshift in potential economic growth, stemming from a contracting labor force, excessive debt, and changes in the international economy (Chart 1). As economic growth has slowed, China has pursued political centralization, economic mercantilism, military modernization, and foreign policy assertiveness, offering nationalism as a distraction from the disappointments of the new middle class. While China may not be ready to launch a full-scale invasion of Taiwan, it is willing to do so if the Communist Party regime’s survival is at stake. Chart 1China's Slowdown Leads To Hawkishness China's Slowdown Leads To Hawkishness China's Slowdown Leads To Hawkishness 2.   Taiwan’s reassertion of autonomy: Taiwanese people began to sour on mainland China with the Great Recession and increasingly developed an independent identity (Chart 2). China’s growing economic influence, combined with Xi Jinping’s re-centralization of power across Greater China, provoked a backlash in Taiwan beginning in 2013 that culminated in the nominally pro-independence Democratic Progressive Party gaining full control of the island in 2016. The US-China trade war, China’s imposition of control over critical buffer spaces (including the South China Sea and Hong Kong), and US export controls on advanced technologies thrust Taiwan into the middle of a strategic confrontation. While Taiwan is not seeking war or formal political independence, it is seeking closer ties with the US and democratic allies to protect against Beijing’s encroachment.     3.   US political instability and foreign policy reaction: The Great Recession brought the US’s latent political instability from a simmer to a boil. The Washington establishment withdrew from the war on terrorism only to face discontent at home and strategic competition from China and Russia. China intensified its acquisition of US technology while North Korea obtained a nuclear arsenal under China’s watch. A surge in populism led the US to initiate a trade war against China and to impose restrictions on critical technologies to slow China’s modernization. While the US political factions bickered over domestic policy, they both tapped into a popular consensus on economic nationalism and hawkishness toward China (Chart 3). While the US is struggling to curb Russia and Iran, its greatest long-term challenge stems from China and it is increasingly focused on containing China’s economy and strategic ambitions. Chart 2Taiwanese Souring On China The Fourth Taiwan Strait Crisis The Fourth Taiwan Strait Crisis Chart 3US Hawkish Consensus On China The Fourth Taiwan Strait Crisis The Fourth Taiwan Strait Crisis In addition, there are important cyclical reasons why investors should take very seriously the risk of a major geopolitical crisis emanating from Taiwan in the short run: The Covid-19 pandemic intensified US (and global) distrust of China and accelerated the divorce of the US and Chinese economies. It also threw the Chinese economy into a downward spin, threatening Xi Jinping’s personal security and the Communist Party’s regime security. Hypo-globalization reduces critical economic constraints on military conflict. The Ukraine war highlighted the willingness of ambitious strongman regimes to go to war to prevent neighboring countries from allying with the United States. Taiwan is critical to Chinese security just as Ukraine is critical to Russian. Taiwan, like Ukraine, lacks a mutual defense treaty with the US and yet is attempting to create a de facto treaty through political, economic, and military cooperation – a scenario that will incentivize Chinese military action if it ever believes the US will take irrevocable steps to increase its commitment to defend Taiwan. At the same time, the US will try to deter China more effectively, since its deterrence failed in the case of Ukraine, which entails upgrading the Taiwanese relationship. Hence China will feel threatened and accuse the US of altering the status quo. Russo-Chinese alliance prevents US-China reengagement. Russia threw itself into China’s arms by cutting off natural gas to Europe. China cannot reject Russia’s overture because it needs Russia’s alliance to break through American strategic containment in the coming years. China needs Russia’s natural resources and its cooperation in gaining economic access to Central Asia and the Middle East. The US cannot pursue strategic détente with China if China is allying with Russia, since a Russo-Chinese alliance poses an unprecedented threat to American global influence and security (Chart 4). The Democratic Party is desperate to mitigate looming election losses. President Biden’s approval rating has fallen to 39%, while headline inflation hits 9% and the economy slips into a technical recession. The Republican Party is lined up for a victory in the midterm elections, yet Democrats view the populist Republicans as an existential threat. Hence Biden and Democratic leaders like Pelosi are willing to take significant risks to salvage the election, including provoking foreign rivals. The administration is contemplating tougher export controls on China’s access to semiconductor manufacturing equipment and Congress is passing bipartisan legislation to make the US more competitive against China. Any major confrontation abroad would generate a patriotic rally among voters, as did the Cuban Missile Crisis in 1962, which saved the Democrats from heavy losses in the midterms that year (Chart 5). China’s domestic politics support a foreign confrontation. As Xi attempts to cement another five-to-ten years in power at the twentieth national party congress this fall, the pandemic restrictions, political repression, property bust, and economic slowdown ensure that he has little good news to celebrate at home. He could benefit from taking an aggressive stance against the imperialist Americans over Taiwan – and he cannot afford to back down or lose face. Ultimately China’s regime legitimacy is at stake in Taiwan so it is willing to take greater risks than the United States.   Chart 4US Cannot Engage With Russo-Chinese Behemoth US Cannot Engage With Russo-Chinese Behemoth US Cannot Engage With Russo-Chinese Behemoth Chart 5Biden Can Take Risks Ahead Of Midterms The Fourth Taiwan Strait Crisis The Fourth Taiwan Strait Crisis All of the above demonstrates that investors should not be complacent but should take risk off the table until the Pelosi trip blows over. A major diplomatic or geopolitical crisis will occur if Pelosi indeed visits Taiwan, for China will be required to react to uphold the credibility of its warnings, and Beijing will have a national and political interest in overreacting rather than underreacting. The Americans will then have a national and political interest in preserving their own credibility. This dynamic could lead to a major escalation in strategic tensions. Could a crisis lead to full-scale war? Yes it could but most likely it will not – at least not yet. Here are some important limitations, which investors should monitor closely. If these are reduced or overcome, then a larger conflict becomes more probable: Taiwan is harder to invade than Ukraine. Taiwan is an island and islands that are politically unified can only be subdued with enormous cost of blood and treasure even by the most powerful armies. Taiwan is critical to the global economy, unlike Ukraine. While it lacks defense treaties, it has stronger strategic partnerships than Ukraine did. The Chinese military has not fought an expeditionary war since Vietnam in 1979. The US sent aircraft carriers to the Taiwan Strait in each of the previous three crises since the 1950s, signaling that it is willing to defend Taiwan, and currently has at least two aircraft carriers in Asia Pacific (Map 1). China needs to be prepared for potential American and Japanese intervention if it is to attack Taiwan, which requires an advanced triad of nuclear arms.    Map 1US Aircraft Carriers Suggest Taiwan Risk Is Substantial The Fourth Taiwan Strait Crisis The Fourth Taiwan Strait Crisis The US is not sending any game-changing offensive weapon systems. Instead the US is sending a mere politician. China opposes anything resembling state-to-state relations but Taiwan’s defensive capability would not be improved. Hence China would not be forced to take aggressive military action. Instead China is attempting to set a very low bar for intervening in US-Taiwan political relations. Beijing can intervene in a way that enforces the new line but remains beneath the threshold of war. Going forward, US arms sales to Taiwan will be a much riskier affair and the delivery of a weapons system could trigger conflict (Chart 6). Chinese economy is not (yet) beyond help. China still has authoritarian powers to manipulate the domestic economy, suggesting that policy makers will intervene to slow down the property bust and stimulate activity. After Xi Jinping consolidates power, we expect a pro-growth strategy to be unveiled that will lead to a stabilization of growth in 2023. This is necessary for Xi to maintain domestic stability, which is existential to the regime and its long-term security. If stimulus and interventions fail utterly and China collapses into a full-blown financial crisis, then China will lose the ability to improve its security over the long run and the risk of conflict with foreign powers will rise. But as long as China’s economy is not collapsing, China maintains the prospect of building its influence and power over time and conquering Taiwan through absorption rather than extremely risky armed conflict (Chart 7). Chart 6US Arms Sales Could Trigger A Real Conflict US Arms Sales Could Trigger A Real Conflict US Arms Sales Could Trigger A Real Conflict Chart 7More Economic Stimulus Is Coming More Economic Stimulus Is Coming More Economic Stimulus Is Coming Taiwan is not moving toward formal independence. The Tsai Ing-wen administration is nominally in favor of independence but has chosen rhetorical sleight of hand over any formal change to Taiwan’s status. Taiwanese people support the status quo knowing that they will live in a war zone if they declare independence. The long-term problem stems from the fact that a clear majority opposes unification with the mainland (Chart 8). Taiwan and the US face elections in 2022 and 2024. If the Kuomintang stages a comeback in Taiwanese politics, or the Democrats win reelection in 2024, then China still has the ability to pursue its aims through diplomacy. Whereas if the Democratic Progressive Party remains in full control of Taiwan, and the Republicans regain the White House, Beijing may conclude that little can be gained through diplomacy. Especially if these US and Taiwanese parties proceed to press their interests aggressively. Chart 8Taiwanese Not Declaring Independence The Fourth Taiwan Strait Crisis The Fourth Taiwan Strait Crisis Hence the most likely outcome if Pelosi visits Taiwan is a US-China geopolitical crisis of some sort but not a full-scale war. A crisis short of war could establish a new set of red lines over Taiwan that could govern the US-China relationship in the medium term with reduced uncertainty. But it would bring very bad news in the short run and lead to a permanent deterioration in US-China relations and global stability over the long run, which markets must price first.   Bottom Line: Tactically investors should prefer government bonds to equities, US equities to global, defensive sectors to cyclicals, and safe havens to risky assets. Stay short Chinese and Taiwanese currencies and assets. While semiconductor stocks stand at risk, investors should favor US semiconductor companies over Chinese and Taiwanese (Chart 9). Chart 9Investors Should Seek Safe Havens Investors Should Seek Safe Havens Investors Should Seek Safe Havens Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Italy’s right-wing alliance, led by Brothers of Italy, will likely outperform in  the upcoming election. The new government will prioritize the economy, posing a risk to the EU’s united front against Russia. It is conducive to an eventual ceasefire, which is marginally positive for risk assets in 2023. We recommend investors underweight Italian assets on a tactical basis. China’s political risks will remain elevated until Xi consolidates power this fall, positive news will come after, if at all. Geopolitical risk in the Taiwan Strait will remain high and persistent until China and the US reach a new understanding. Separately, we are booking a 9% gain on our long US equities relative to UAE equities trade. Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Tactical Recommendation Inception Date Return LONG US / UAE EQUITIES (CLOSED) 2022-03-11 9.0% Bottom Line: Italy’s political turmoil suggests a more pragmatic policy toward Russia going forward. Europe’s energy cutoff will also motivate governments to negotiate with Russia. Feature In this report we update our GeoRisk Indicators, with a special focus on Italy’s newest political turmoil. Italy Over the past several months, we have argued that Italy was a source of political risk within the European Union and that the market underestimated the probability of an early Italian election. In the past two weeks, this forecast has become a reality (Chart 1). Chart 1Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator The grand coalition under Prime Minister Mario Draghi had fulfilled its two main purposes – to distribute EU recovery funds and secure an establishment politician in the Italian presidency. At the same time, headline inflation hit 8.5% in June, the highest since 1986, even as the Italian and global economy slowed down, Italian government bonds sold off, and Russia induced an energy crisis. The stagflationary economic environment is biting hard and the different coalition members are looking to their individual interests ahead of election season. On July 14, Giuseppe Conte, the former prime minister, pulled its populist Five Star Movement (M5S) out of Mario Draghi’s national unity government, triggering a new round of political turmoil in Italy. Draghi’s first resignation was rejected by Italian President Mattarella later that day. However, on July 21, the League and Forza Italia also defected from the grand coalition. After Draghi’s plan of reviving the coalition collapsed, President Mattarella accepted his resignation and called for a snap election to be held on September 25, ten months ahead of the original schedule. Based on the latest public opinion polls, right-wing political parties are well-positioned for the upcoming election. The far-right Brothers of Italy is now the front runner in the election race and is expected to win around 23% of the votes. Another far-right party, the League, is the third most popular party, with nearly 15% support despite a drop in support during its time within the grand coalition. In addition, the center-right Forza Italia receives 8.5% of the support. Together, the right-wing conservative bloc amounts to 46.5% of voting intentions. There is still positive momentum for Brothers of Italy to harvest more support given that they are the flag-bearer for anti-incumbent sentiment amid the stagflationary economy. By contrast, the left-wing parties – the Democrats, the Left, and the Greens – only command about 27%. The possibility of an extended left-wing coalition, even with the inclusion of the M5S, is looking slim. On July 25, Enrico Letta, the leader of the Democratic Party, publicly expressed his anger against party leader Giuseppe Conte and ruled out any electoral pact with the M5S because of the recent political chaos they caused. He stressed that the Democratic Party would seek ties with parties that had remained loyal to Draghi’s national unity. However, there are not many parties left for the Democrats to partner with. Apart from the Left and the Greens, the Democrats’ best chance would be the center-left Action Party and Italia Viva, which is led by Matteo Renzi, who served as the secretary of the Democratic Party from 2013 to 2018. However, these four parties are small and will not enable the Democrats to form a government. Courting M5S is the Democrats’ only chance to set up an alternative to the right-wing bloc, but that will require the election to force the two parties together. Related Report  Geopolitical StrategyLe Pen And Other Hurdles (GeoRisk Update) The Democratic Party was the biggest supporter of Draghi’s government, while the Brothers of Italy were the sole major opposition. Thus the September 25 election will be a race between these two major parties. Both are expected to outperform current polling, as they will attract the most supporters from each side. The other right-wing parties, Forza Italia and the League, will at least perform in line with their polling, while the other left-wing parties will underperform. In the meantime, M5S’ popularity will continue to decline – the party is bruised over its role in Draghi’s coalition and divided over how to respond to the Ukraine war. Foreign policy is a major factor in this election. Italy has the highest share of citizens in the Eurozone who support solving the Russia-Ukraine conflict through peaceful dialogue (52% versus the Eurozone average of 35%). Italy has long maintained pragmatic relations with Russia, including the Putin administration, as it imported 40% of its natural gas from there prior to 2022. The EU is struggling to maintain a united front against Russia, and war policy will be a key focal point among the different parties. Draghi and the Democratic Party are the strongest supporters of the EU’s oil embargo on Russia and decision to send arms to support Ukraine. On the other side, the right-wing Forza Italia and the League have been more equivocal due to their traditional friendship with Russia. What’s more important is the stance of the Brothers of Italy on Russia, as it is the largest party now and will probably lead a right-wing government after the election. On July 27, the three right-wing parties struck a deal to officially form an alliance in the upcoming election and whichever party wins the most votes would determine the next prime minister if the alliance wins. This deal puts Giorgia Meloni, the leader of Brothers of Italy, one step closer to becoming Italy’s first female PM. Giorgia Meloni, unlike her right-wing peers, has endorsed Draghi’s hawkish stance towards Russia. Recently, she stressed that Italy would keep sending arms to Ukraine if her party forms a government after the election. However, Meloni’s speech could be a tactical move to win the election more than an unshakeable policy position. First, like the other two right-wing parties, the Brothers of Italy have had close connections with Russia. After the 2018 Russian presidential election, Meloni congratulated Putin and claimed his victory was “the unequivocal will of Russians.” In addition, she is close to Prime Minister Viktor Orban of Hungary and National Rally leader Marine Le Pen of France, both of whom have criticized the EU’s decision to provide military support to Kyiv. Hence her sharp change of stance this year seems calculated to avoid accusations of being pro-Russian. But that does not preclude a more pragmatic approach to Russia once in office. Second, Meloni has compromised other far-right positions to broaden her voter base. She has reversed the party’s original anti-EU stance and claimed it does not seek to leave the EU, as most European anti-establishment parties have had to do in order to make themselves electable. Being the only female in the election race, Meloni also pledged to protect women’s access to safe abortions in Italy, also a softer stance than before. Even if the Brothers of Italy distance themselves from some unpopular right-wing positions, including on Ukraine, they probably cannot form a government on their own. They will need to court Forza Italia and the League. These two parties prefer a more pragmatic approach to Russia and a peaceful resolution to the war. Thus while it will be hard to find a middle ground on the issue of Ukraine, the election will likely prevent Italy from taking a more confrontational stance toward Russia. It will probably do the opposite. Consider the context in which the next Italian government will operate. Russia declared on July 25 that it will further reduce natural gas supplies to Europe through Nord Stream 1, as we expected, bringing pipeline flows to 20% of its full capacity.  Energy prices will go up even as European economic activity and industry will suffer greater strains. If Meloni is elected as the new prime minister this September, she will have to keep talking tough on Russia while simultaneously seeking a solution to soaring energy prices and economic crisis. This solution will be diplomacy – unless Russia seeks to expand its invasion all the way to Moldova. A right-wing victory is the most likely outcome based on opinion polling, the negative cyclical economy, and the underlying structural factors supporting populism in Italy that we have monitored for years. Such a coalition will not be pro-Russian but it will be pragmatic and focused on salvaging Italy’s economy, which means it will be highly inclined toward diplomacy. If Russia halts its military advance – does not attempt to conquer southwestern Ukraine to Moldova – then this point will be greatly reinforced. Italy will become a new veto player within the European Union when it comes to any major new sanctions on Russia. While Europeans will continue diversifying their energy mix away from Russia, it will be much harder for the EU to implement a natural gas embargo in the coming years if Italy as well as Hungary oppose it. Even if we are wrong, and the Democratic Party or other left-wing parties surprise to the upside in the election, the new coalition will most likely have to focus on mitigating the economic crisis and thus pursuing diplomacy with Russia. That is, as long as Russia pushes for a ceasefire after it achieves its military aims in Donetsk, the last holdout within the south-southeastern territories Russia is trying to conquer. Bottom Line: Due to persistent political uncertainty, we recommend investors underweight Italian stocks and bonds at least until a new government takes shape, which could take months even after the election. However, government bonds will remain vulnerable if a right-wing coalition assumes power, since it will pursue loose fiscal policies and will eschew structural reforms. Overall Italy’s early elections will lead to a new government that is focused on short-term economic growth, likely including pragmatism toward Russia. From an investment point of view that will not be a negative development, though much depends on whether Russia expands its invasion or declares victory after Donetsk. Russia Market-based measures of Russian geopolitical risk are rebounding after subsiding from peak levels hit during the invasion of Ukraine in February (Chart 2). Chart 2Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia’s continued tightening of natural gas supplies (and food exports) this week is precisely what we predicted would happen despite a wave of wishful thinking from investors over the past month. The optimists claimed that Russia would resume Nord Stream 1 pipeline flows after a regular “maintenance” period. They also said that Canada’s cooperation in resolving some “technical” issues around turbines would stabilize natural gas supply. The truth is that Russia is seeking to achieve its war aims in Ukraine. Until it has achieved its aims, it will use a range of leverage, including tightening food and energy supplies. Most likely Russia will halt the advance after completing the conquest of the Donbas region and land-bridge to Crimea. Then it will seek to legitimize its conquests through a ceasefire agreement. However, it could launch a new phase of the war to try to take Odessa and Transniestria, which would cement European resolve, even in Italy, and trigger a new round of sanctions. Bottom Line: Russia faces a fork in the road once it completes the conquest of Donetsk. Most likely it will declare victory and start pushing for a ceasefire late this year or early next year. Movement toward a ceasefire would reduce geopolitical risk for global financial markets in 2023. But there is still a substantial risk that Russia could expand the invasion to eastern Moldova, which would escalate the overarching Russia-West conflict and sustain the high level of geopolitical risk for markets. China Chinese political and geopolitical risk will continue to rise and the bounce in Chinese relative equity performance is faltering as we expected (Chart 3). Chart 3China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator China’s leaders will hold their secretive annual meeting at Beidaihe in August ahead of the critical Communist Party national congress this fall. General Secretary Xi Jinping is attempting to cement himself as the paramount leader in China, comparable to Chairman Mao Zedong, transforming China’s governance from that of single-party rule to single-person rule. The reversion to autocratic government is coinciding with a historic economic slowdown consisting of cyclical factors (weak domestic demand, weakening foreign demand, draconian Covid-19 restrictions) and structural factors (labor force contraction, property sector bust, social change and unrest). Both Xi and US President Biden face major domestic political challenges in the coming months with the party congress and the US midterm election. Hence they are holding talks to try to stabilize relations. But we do not think they will succeed. China cannot reject Russia’s strategic overture, while the US cannot afford to re-engage with a China that is partnering with Russia in a challenge to the liberal-democratic world order. In addition, US policies are erratic and the US cannot credibly promise China that it will not pursue a containment strategy even if China offers trade concessions. Bottom Line: China-related political and geopolitical risks will remain very high until at least after the twentieth party congress. At that point we expect President Xi to loosen a range of policies to stabilize the economy and foreign trade relations. These policies may bring positive news in 2023, though China’s biggest macroeconomic and geopolitical problems remain structural in nature and we remain underweight Chinese assets. Taiwan For many years we have warned of a “fourth Taiwan Strait crisis” due to the unsustainable geopolitical situation between China, Taiwan, and the United States. After the war in Ukraine we argued that the US would try to boost its strategic deterrence around Taiwan, since it failed to deter Russia from invading Ukraine, but that the increased commitment to Taiwan would in fact provoke China (Chart 4). Chart 4Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Until the US and China reach a new understanding over Taiwan, we argued that the region would be susceptible to rising tensions and crisis points that would send investors fleeing from risky assets, especially risky regional assets. It is possible that we have arrived at this crisis now, with House Speaker Nancy Pelosi making preparations to visit Taiwan, China pledging “forceful” countermeasures if she does, President Biden suggesting that the US military thinks Pelosi should not visit, and Biden and Xi preparing for a phone conversation. In essence China is giving an ultimatum and setting a new bar, and a very low bar, for taking some kind of action on Taiwan, i.e. the mere visit of a US House speaker, which has happened before (House Speaker Newt Gingrich in 1997). China’s purpose is to lay the groundwork for preventing the US from upgrading Taiwan relations in any more substantial way, whether political or military. If the Biden administration calls off the Pelosi visit, then American relations with Taiwan will have been curtailed, at least for this administration. If Biden goes forward with the visit, then Beijing will need to respond with an aggressive show of force to prevent any future president from repeating the exercise or building on it. And if this show threatens US personnel or security, a full-blown diplomatic or military crisis could ensue. While we doubt it would lead to full-scale war, it could lead to a frightening confrontation. Biden may want to stabilize relations with China, since he is primarily focused on countering Russia, but his options are limited. China cannot save him from inflation but it can solidify the public perception that he is weak. Hence he is more likely to maintain his administration’s hawkish approach. Biden’s approval rating is 38% and his party faces a drubbing in the midterm elections. A confrontation with Russia, China, Iran, or anyone else would likely help his party by producing a public rally around the flag. Any unilateral concessions will merely strengthen Xi’s power consolidation at the party congress, which is detrimental to US interests. Only if the Biden administration pursues a dovish policy of re-engagement that is subsequently confirmed by the 2024 presidential election will there be potential for a substantial US-China economic re-engagement. We are pessimistic. Bottom Line: Taiwan-related geopolitical risk will rise in the short run. If there is a new US-China understanding over Taiwan, then regional and global geopolitical risk will decline over the medium term. But we remain short Taiwanese assets. Investment Takeaways Investors should remain defensively positioned until the US midterm election ends with congressional gridlock; the Chinese party congress is over and Xi Jinping launches a broad pro-growth policy; and Russia starts pushing for a ceasefire in Ukraine. We also expect that markets will need to get over new, unexpected oil supply shocks arising from the failure of US-Iran nuclear negotiations, which remains off the radar and therefore a source of negative surprises. Any US-Iran nuclear deal would be a major positive surprise that postpones this risk for a few years. Having said that, we are booking a 9% gain on our long US versus UAE equity trade for technical reasons. Democrats have reached a deal to pass a budget reconciliation bill in an effort to mitigate midterm election losses. This development reinforces the 65% odds of passage that we have maintained for this bill’s passage in our US Political Strategy reports since last year.   Yushu Ma Research Analyst yushu.ma@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Appendix UK Chart 5UK: GeoRisk Indicator United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator Germany Chart 6Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator France Chart 7France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator Spain Chart 8Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Canada Chart 9Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Australia Chart 10Australia: GeoRisk Indicator Australia: GeoRisk Indicator Australia: GeoRisk Indicator Korea Chart 11Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Brazil Chart 12Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey Chart 13Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator South Africa Chart 14South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades Geopolitical Calendar