East Europe & Central Asia

Executive Summary Euro Natgas Soars; LME Nickel Squeezed Euro Natgas, Nickel Soar Euro Natgas, Nickel Soar Russian Energy Minister Alexander Novak's threat to halt shipmentsof natgas on Nord Stream 1 to Europe lifted European gas prices 25% overnight, and will reverberate for years. We make the odds of a cut-off of Russian natgas exports to the EU low but not extremely low. Russia’s war is about the status of Ukraine. Russia needs the EU markets, and the EU needs Russia's gas. However, if Russia follows through on Novak's threat, it would be a major disruption for gas markets in the short term. Over the medium to long term, US shale gas producers, LNG terminal operators and exporters will benefit from new demand. On the import side, China likely benefits most from Russia's need to re-route gas. But this will require substantial infrastructure investment to monetize Russia's gas supplies and as such will take years to realize. Separately, the LME has shut down its nickel markets following an explosive 250% rally over two days that took prices above $100,000/MT. Nickel settled at ~ $80,000/MT before the LME closed the market today for margin calls on shorts squeezed by the surge in prices to make margin calls. Bottom Line: We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to oil and gas producers via the XOP ETF. We also remain long the XME and PICK ETFs to retain exposure to base metals and bulks.

Executive Summary US Can Do Without Russia's Oil, EU, NATO … Not So Much US Will Ban Russian Oil Imports US Will Ban Russian Oil Imports The US will ban Russian oil imports shortly.  This is not as big a deal markets had feared over the weekend, when news of a possible ban of Russian oil and refined products into the US and Europe was telegraphed by US officials, powering prices to $140/bbl.1 The US imported a combined 400k b/d of Russian crude oil and refined products in December 2021, the EIA reports, which accounted for less than 5% of the 8.6mm b/d of imports. Europe is another story.  Roughly 60% of Russia's 11.3mm b/d of crude oil and refined-products output goes to OECD Europe, according to the IEA. Russia considers Western sanctions to be on an equal footing with a declaration of war.2  President Putin has threatened a nuclear response if the West interferes with invasion of Ukraine, which could elicit a similar response from the West.3  US shale producers will be highly incentivized to increase output given high prices.  Our view continues to include a production increase from core OPEC 2.0 – Saudi Arabia, UAE and Kuwait.  We also anticipate a return of 1mm b/d from Iran, following a nuclear deal with the US. Bottom Line: We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to oil and gas producers via the XOP ETF. Footnotes 1     Please see Crude price jumps on talk of US oil ban as Russia steps up shelling of civilian areas, published by the Financial Times on March 6, 2022. 2     Please see Putin says Western sanctions are akin to declaration of war, published on March 5, 2022. 3    Please see How likely is the use of nuclear weapons by Russia?, published by Chatham House on March 1, 2022.  The report notes, " If Russia were to attack Ukraine with nuclear weapons, NATO countries would most likely respond on the grounds that the impact of nuclear weapons crosses borders and affects the countries surrounding Ukraine. NATO could respond either by using conventional forces on Russian strategic assets, or respond in kind using nuclear weapons as it has several options available."

Executive Summary Nuclear Worries Take Center Stage Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Vladimir Putin has now committed himself to orchestrating a regime change in Kyiv. Anything less would be seen as a defeat for him. Assuming he succeeds, and it is far from obvious that he will, the resulting insurgency will drain Russian resources. Along with continued sanctions, this will lead to a further deterioration in Russian living standards and growing domestic discontent. If Putin concludes that he has no future, the risk is that he will decide that no one else should have a future either. Although there is a huge margin of error around any estimate, subjectively, we would assign an uncomfortably high 10% chance of a civilization-ending global nuclear war over the next 12 months. These odds place some credence on Brandon Carter’s highly controversial Doomsday Argument. Even if World War III is ultimately averted, markets could experience a freak-out moment over the next few weeks, similar to what happened at the outset of the pandemic. Google searches for nuclear war are already spiking. Despite the risk of nuclear war, it makes sense to stay constructive on stocks over the next 12 months. If an ICBM is heading your way, the size and composition of your portfolio becomes irrelevant. Thus, from a purely financial perspective, you should largely ignore existential risk, even if you do care about it greatly from a personal perspective. Bottom Line: The risk of Armageddon has risen dramatically. Stay bullish on stocks over a 12-month horizon. All In on Sanctions In the criminal justice system, there is a reason why the punishment for armed robbery is lower than for murder. If the punishment were the same, an armed robber would have a perverse incentive to kill his victim in order to better conceal his crime. The same logic applies, or at least used to apply, to geopolitics: You do not impose maximum sanctions from the get-go because that removes your ability to influence your enemy with the threat of further sanctions. Following Russia’s invasion of Ukraine, the West chose to go all in on sanctions, levying every type imaginable with the exception of those entailing a big cost to the West (such as cutting off Russian energy exports). Most notably, many Russian banks have been blocked from the SWIFT messaging system while the Russian central bank’s foreign exchange reserves have been frozen. Even FIFA has barred Russia from international competition, just weeks before it was set to participate in the qualifying rounds of the 2022 World Cup. At this point, there is not much more that can be done on the sanctions front. This leaves military intervention as the only avenue available to further pressure Russia. A growing chorus of Western pundits, some of whom could not have picked out Ukraine on a map two weeks ago, have begun clamoring for regime change… this time, in Moscow. As one might imagine, this is not something that sits well with Putin. Last week, he declared that “No matter who tries to stand in our way or … create threats for our country and our people, they must know that Russia will respond immediately, and the consequences will be such as you have never seen in your entire history.” To ensure there was no uncertainty about what he was talking about, he proceeded to place Russia’s nuclear forces on “special regime of combat duty.” Yes, It’s Possible The Putin regime has used nuclear weapons of a sort in the past. The FSB likely orchestrated the poisoning of Alexander Litvinenko with polonium-210 in 2006, leaving traces of the radioactive substance scattered in dozens of places across London. As former US presidential advisor and Putin biographer Fiona Hill said in a recent interview with Politico, “Every time you think, “No, he wouldn’t, would he?” Well, yes, he would.” Admittedly, there is a big difference between dropping polonium into a cup of tea at the Millennium hotel in Mayfair and dropping a 10-megaton nuclear bomb on London or any other major Western city. Still, if Putin feels that he has no future, he may try to take everyone down with him. The collapse in the ruble, and what is sure to be a major plunge of living standards across Russia, could foment internal opposition to Putin. A quiet retirement is not an option for him. Based on the latest exchange rates, Russia’s GDP is smaller than Mexico’s and barely higher than that of Illinois (Chart 1). While denying gas to Europe is a very real threat, it has a limited shelf life. Europe will aggressively build out infrastructure to process LNG imports. Chart 1Russia's Economic Power Has Faded Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse In a few years, the one viable weapon that Russia will have at its disposal is its nuclear arsenal. As Dutch historian Jolle Demmers has said, “It is precisely the decline and contraction of Russian power, coupled with the possession of nuclear weapons and a tormented repressive president, that poses great risks.” Some of the world’s most prominent strategic thinkers flagged these risks before the invasion, but with little effect. The Mother of All Risks In simulated war games, it is generally difficult to get participants to cross the nuclear threshold, but once they do, a full-blown nuclear exchange usually ensues.1 The idea of “limited” nuclear war is a mirage.  How high are the odds of such a full-blown war? I must confess that my own feelings on the matter are heavily colored by my writings on existential risk. As I argued in Section XII of my special report, “Life, Death, and Finance in the Cosmic Multiverse,” we are probably greatly understating existential risk, especially when we look prospectively into the future. Although there is a huge margin of error around any estimate, subjectively, we would assign an uncomfortably high 10% chance of a civilization-ending global nuclear war over the next 12 months. These odds place some credence on Brandon Carter’s highly controversial Doomsday argument (See Box 1). A Paradox for Investors For investors, existential risk represents a paradoxical concept. If an ICBM is heading your way, the question of whether you are overweight or underweight stocks would be pretty far down on your list of priorities. And even if you were inclined to think about your portfolio, how would you alter it? In a full-blown global nuclear war, most stocks would go to zero while governments would probably be forced to default or inflate away their debt. Gold might retain some value – provided that you kept it in your physical possession – but even then, you would still have trouble exchanging it for anything of value if nothing of value were available to purchase. This means that from a purely financial perspective, you should largely ignore existential risk, even if you do care greatly about it from a personal perspective. What, then, can we say about the current market environment? I touched on many of the key issues in Monday’s Special Alert, in which we tactically downgraded global equities from overweight to neutral. I encourage readers to consult that report for our latest market views. In the remainder of today’s report, allow me to elaborate on a couple of key themes. A Freak-Out Moment Is Coming Chart 2Nuclear Worries Take Center Stage Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse The market today reminds me of early 2020. We wrote a report on February 21 of that year entitled “Markets Too Complacent About The Coronavirus,” in which we noted that a full-blown pandemic “could lead to 20 million deaths worldwide,” and that “This would likely trigger a global downturn as deep as the Great Recession of 2008/09, with the only consolation being that the recovery would be much more rapid than the one following the financial crisis.” Many saw that report as alarmist, just as they saw our subsequent decision to upgrade stocks in March as cavalier.  Even if you knew in February 2020 that the S&P 500 would reach an all-time high later that year, you should have still shorted equities aggressively on a tactical basis. I feel the same way about the present. Google searches for nuclear war are spiking (Chart 2). A freak-out moment is coming, which will present a good buying opportunity for investors. Just to be on the safe side, I picked up a couple of bottles of Potassium Iodide earlier this week. When I checked the pharmacy again yesterday, all the bottles were sold out. They are now being hawked on Amazon for ten times the regular price. From Cold War to Hot Economy? The spike in commodity prices – especially energy prices – will have a negative near-term impact on global growth, while also limiting the ability of central banks to slow the pace of planned rate hikes (Chart 3). In general, inflation expectations and oil prices move together (Chart 4).   Chart 3Central Banks: Caught Between A Rock And A Hard Place Central Banks: Caught Between A Rock And A Hard Place Central Banks: Caught Between A Rock And A Hard Place   Chart 4Inflation Expectations And Oil Prices Go Hand-In-Hand Inflation Expectations And Oil Prices Go Hand-In-Hand Inflation Expectations And Oil Prices Go Hand-In-Hand Assuming the geopolitical situation stabilizes in a few months, oil prices should come down. The forward curve for oil is heavily backwardated now: The spot price for Brent is $111/bbl while the December 2022 price is $93/bbl (Chart 5). BCA’s commodity strategists expect the price of Brent oil to fall to $88/bbl by year-end. The decline in energy prices should provide some relief to global growth and risk assets in the back half of the year, which is one reason we are more constructive on equities over a 12-month horizon than a 3-month horizon. Looking out beyond the next year or two, the new cold war will lead to higher, not lower, interest rates. Increased spending on defense and alternative energy sources will prop up aggregate demand, especially in Europe where the need to diversify away from Russian gas is greatest. As Chart 6 shows, capex in the euro area cratered following the euro debt crisis. Capital spending via the Recovery Fund and other sources will rise significantly over the next few years. Chart 5The Brent Curve Is Heavily Backwardated Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Chart 6European Capex Is Poised To Increase European Capex Is Poised To Increase European Capex Is Poised To Increase In addition, the shift to a multipolar world will expedite the retreat from globalization. Rising globalization was an important force restraining inflation – and interest rates – over the past few decades. Lastly, the ever-present danger of war could prompt households to reduce savings. It does not make sense to save for a rainy day if that day never arrives. Lower savings implies a higher equilibrium rate of interest. As we discussed in our recent report entitled “A Two-Stage Fed Tightening Cycle,” after raising rates modesty this year, the Fed will resume hiking rates towards the end of 2023 or in 2024, as it becomes clear that the neutral rate in nominal terms is closer to 3%-to-4% rather than the 2% that the market assumes. The secular bull market in equities will likely end at that point. In summary, equity investors should be somewhat cautious over the next three months, more optimistic over a 12-month horizon, but more cautious again over a longer-term horizon of 2-to-5 years. Box 1The Doomsday Argument In A Nutshell Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1     For example, an article from the Center for Arms Control and Non-Proliferation discusses a Reagan administration war game called “Proud Prophet,” an exercise the Americans hatched to test the theory of limited nuclear strikes. The result of this exercise was that the “Soviet Union perceived even a low-yield nuclear strike as an attack, and responded with a massive missile salvo.” Global Investment Strategy View Matrix Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Special Trade Recommendations Current MacroQuant Model Scores Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse

Executive Summary Russia Not Prepared To Invade West Ukraine Yet Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) Russia is escalating its aggressiveness in Ukraine, marked by the shelling of a nuclear power station, troop reinforcements, and rhetorical threats of nuclear attack. Global financial markets will continue to suffer from negative news arising from this event until Russia achieves its aims in eastern Ukraine. Private sector boycotts on Russian commodity exports are imposing severe strains on the Russian economy, provoking it to apply more pressure on Ukraine and the West. Western governments are losing the ability to control the pace of strategic escalation, a dangerous dynamic. Moscow’s demand for security guarantees from Finland and Sweden will lead to a further escalation of strategic tensions between Russia and the West. During the Cold War the US and USSR saw a “balance of terror” due to rapidly expanding nuclear arms, which prevented them from waging war against each other. Today the same balance will probably prevent nuclear war but a nuclear scare that rattles financial markets may be required first. Trade Recommendation Inception Date Return Long Gold (Strategic) 2019-12-06 32.1% Bottom Line: Russia’s aggressiveness toward the US and Europe, including nuclear threats and diplomatic demands, will continue to escalate until it achieves its core military objectives. Investors should stick to safe havens and defensive equity markets and sectors on a tactical basis. Book profits on tactical trade long Japan/Germany industrials at close of trading on March 4. Feature Russian military forces shelled the Zaporizhzhia Nuclear Power Station on March 4, causing a fire. The International Atomic Energy Agency (IAEA) declared that “essential equipment” was not damaged and that the facility possessed adequate containment structures to prevent a nuclear meltdown. Local authorities said the facility was “secured.” This incident, which may or may not be settled, should be added to several others to highlight that Russia is escalating its aggression in Ukraine and global financial markets face more bad news that they will be forced to discount. Signposts For Further Escalation Map 1 shows the status of the Russian invasion of Ukraine, along with icons for the nuclear power plants. Map 1War In Ukraine, Status Of Russian Invasion As Of March 2, 2022 Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) To understand the end-game in Ukraine – and why we think the war will escalate and are keeping open our bearish trade recommendations – we need to review our net assessment for this conflict: Our 65% “limited invasion” scenario included the seizure of strategic territory east of the Dnieper river and all of the southern coastline. Energy trade would be exempt from sanctions, saving Europe from a recession and limiting the magnitude of global energy shock. We gave 10% odds to a “full-scale invasion of all of Ukraine” (deliberate wording) because we viewed it as highly unlikely that Russia would invade the mountainous and guerilla-happy far west, the ethnic Ukrainian core. Energy trade would be sanctioned, delivering a global energy shock and European recession. A handful of clients have criticized us for not predicting that Russia would attack Kiev and for not defining a full-scale invasion as one that involved replacing the government. We never gave a view on whether Russia would invade Kiev. It is not clear that the focus on Kiev is warranted since the US and EU had committed to powerful sanctions in the event of any invasion at all. This fixed price of invasion may have given Moscow the perverse incentive to invade Kiev. Either way, Russia invaded Kiev and eastern Ukraine and the US and EU imposed crippling sanctions but exempted the energy trade. Thus anything that breaks off energy trade between the EU and Russia – and any Russian attempt to invade the west of the country to Poland – should be seen as a significant escalation. Unfortunately there are signs that the energy trade is being disrupted. Any westward campaign to Poland will be delayed until Putin sacks Kiev and controls the east and south of Ukraine, at which point he will be forced either to invade the west to cut off the supply lines of the insurgency or, more likely, to negotiate a ceasefire that partitions Ukraine. Global investors will not care about the war in Ukraine as long as strategic stability is achieved between Russia and the West. But that is far away. Today, as Russia’s economic situation deteriorates, Putin is escalating on the nuclear front. Bottom Line: Russia’s showdown with the West is escalating. Good news for the Ukrainians will lead to bad news for financial markets. Global investors should not view the situation as stabilized and should maintain safe haven trades and defensive equity positioning. Energy Boycotts Will Antagonize Russia Chart 1Russia Not Prepared To Invade West Ukraine Yet Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) So far Russia has not conducted a full-scale invasion of all of Ukraine. The reason is that it does not have the necessary military forces, as we have highlighted. Russia is limiting its invasion force to around 200,000 troops while Ukraine consists of 30 million prime age citizens (Chart 1). Unless Russia massively reinforces its troops, it does not have the basic three-to-one troop ratio that is the minimum necessary to invade, conquer, and hold the entire country. However, Russia is likely to increase troop sizes. We are inclined to believe that Russia has started shifting troops from its southern and eastern military districts to reinforce the Ukraine effort, according to the Kyiv Independent, citing the Ukrainian armed forces’ general staff. Apparently it aims to conquer the east and then either invade further west or negotiate a new ceasefire with greater advantage. Investors should not accept the consensus narrative in the western world that Russia is losing the war in the east. Russia is encountering various difficulties but it is gradually surrounding and blockading Ukraine and cutting its power supply. It is capable of improving its supply lines and increasing the size and destructiveness of its forces. Remember that the US took 20 days to sack Baghdad in 2003. Russia has only been fighting for nine days. Having incurred crippling economic sanctions, Putin cannot afford to withdraw without changing the government in Kiev. The odds of Ukraine “winning” the war are low, while the odds of Russia dramatically intensifying its efforts are high. This is why new developments on the energy front and worrisome: Chart 2Energy Trade Remains The Fulcrum Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) While western governments refrained from sanctioning Russian energy as predicted, private companies are boycotting Russian energy to avoid sanctions and unpopularity. Estimates vary but about 20% of Russian oil exports could be affected so far.1 Russian oil will make its way to global markets – Russian, Chinese, and other third parties will pick up the slack – but in the meantime the Russian economy is suffering more than expected due to the cutoff. Energy is the vital remaining source of Russian economic stability and Russo-European relations (Chart 2). If it fails then Russia could grow more desperate while Europe’s economy would fall into recession and Europe would become less stable and less coordinated in its responses to the conflict. These private boycotts make it beyond the control of western governments to control the pace and intensity of pressure tactics, since it is politically impractical to demand that companies trade with the enemy. Bottom Line: With the rapidly mounting economic pressure, it should be no surprise that Russia is escalating its threats – it is under increasing economic pressure and wants to drive the conflict to a quick decision in its favor. Russia’s Nuclear Threats And Putin’s Mental State Russia is terrorizing Ukraine and the western world with threats of either nuclear missile attacks or a nuclear meltdown. Putin put the country’s nuclear deterrent forces on “special combat status” on February 27. His forces began shelling the Zaporizhzhia nuclear power plant on March 4. Russia is also demanding security guarantees from Finland and Sweden, which are becoming more favorable toward joining the NATO alliance.2 Their lack of membership in NATO, while maintaining a strong military deterrent with defense support from the US, was a linchpin of stability in the Cold War but is now at risk. They will retain the right to choose their alliances at which point Russia will need to threaten them with attack. Since Russia cannot plausibly invade them with full armies while invading Ukraine, it may resort to nuclear brinksmanship. The western media is greatly amplifying a narrative in which Russia’s actions can only be understood in the context of Putin’s insanity or fanaticism. This may be true. But it is also suspicious because it saves the West from having to address the problem of NATO enlargement, which, along with Russia’s domestic weaknesses, contributed to Russia’s decision over the past 17 years to stage an aggressive campaign to control Ukraine and the former Soviet Union. There is a swirl of conspiracy theories in the news about Putin’s illnesses, age, vaccines, or psychology, none of which are falsifiable. Putin has an incentive to appear reckless and insane so that his enemies capitulate sooner. The decision to invade a non-NATO member, rather than a NATO member, suggests that he is still making rational calculations. Rational, that is, from the perspective of Russian history and an anarchic international system in which nation states that seek to survive, secure themselves, and expand their power. If Ukraine were to become a military ally of the US then Russian security would suffer a permanent degradation. Of course, Putin may be a fanatic and it is possible that he grows desperate or miscalculates. The western public (and global investors) will thus be reminded of the “balance of terror” that prevailed throughout the Cold War, in which the world lived and conducted business under the shadow of nuclear holocaust. Today Russia has 1,588 deployed strategic nuclear warheads, contra the US’s 1,644. Both countries can deliver nuclear weapons via ballistic missiles, submarines, and bombers and are capable of destroying hundreds of each other’s cities on short notice (Table 1). While the US has at times contemplated the potential for nuclear attacks to occur but remain limited, the Soviet Union’s nuclear doctrine ultimately rejected the likelihood of limitations and anticipated maximum escalation.3 Table 1The Return Of The Balance Of Terror Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) Ultimately the US and Russia avoided nuclear war in the Cold War because it entailed “mutually assured destruction” which violated the law of self-preservation. Neither Stalin nor Mao used nukes on their opponents, including when they lost conflicts (e.g. to Afghanistan and Vietnam). The US tied with North Korea and lost to Vietnam without using nukes. However in the current context the US has been wary of antagonizing Putin for fear of his unpredictable and aggressive posture. In response to Putin’s activation of combat-ready nuclear forces, the US called attention to its own nuclear deterrent subtly by canceling the regular test of a ballistic missile and issuing a press statement highlighting the fact and saying that it was too responsible to bandy in nuclear threats. Yet the autocratic nature of Putin’s regime means that if Putin ultimately does prove to be a lunatic then large parts of the world face existential danger. Our Global Investment Strategist Peter Berezin ascribes Russian Roulette odds to nuclear Armageddon – while arguing that investors should stay invested over the long run anyway. Sanctions on the Russian central bank have frozen roughly half of the country’s $630 billion foreign exchange reserves (Table 2). If the energy trade also stops, then the economy will crash and Putin could become desperate. Table 2Western Sanctions On Russia As Of March 4, 2022 Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) Bottom Line: Global financial markets have yet to experience the full scare that is likely as Russia escalates its aggression and nuclear brinksmanship to ensure it achieves it strategic aims in Ukraine and prevents Finland from joining NATO. GeoRisk Indicators In March In what follows we provide our monthly update of our quantitative, market-based GeoRisk Indicators. Russian geopolitical risk is surging as the ruble and equity markets collapse (Chart 3). The violent swings of the underlying macroeconomic variables as Russia saw a V-shaped recovery from the COVID-19 lockdowns, then sharply decelerated again, prevented our risk indicator from picking up the full scale of the geopolitical risk until recently. But alternative measures of Russian risk show the historic increase more clearly – and it can also be demonstrated by reducing the weighting of the underlying macroeconomic variables relative to the USD-RUB exchange rate in the indicator’s calculation (Chart 4). Chart 3Russian GeoRisk Indicator Russian GeoRisk Indicator Russian GeoRisk Indicator Chart 4Other Measures Of Russian Geopolitical Risk Other Measures Of Russian Geopolitical Risk Other Measures Of Russian Geopolitical Risk This problem of dramatically volatile pandemic-era macro data skewing our risk indicators has been evident over the past year and is more apparent with some indicators than with others. China’s geopolitical risk as measured by the markets is starting to peak and stall but we do not recommend investors try to take advantage of the situation. China’s domestic and international political risk will remain elevated through the twentieth national party congress this fall. The sharp increase in commodity prices will amplify the problem. The earliest China’s political environment can improve substantially is in 2023 after President Xi Jinping cements another ten years’ in power (Chart 5). And yet that very process is negative for long-term political stability. Chart 5China GeoRisk Indicator China GeoRisk Indicator China GeoRisk Indicator British geopolitical risk is contained. It enjoys some insulation from the war on the continent, underpinning our long GBP-CZK trade and long UK equities trade relative to developed markets other than the United States (Chart 6). Chart 6United Kingdom GeoRisk Indicator United Kingdom GeoRisk Indicator United Kingdom GeoRisk Indicator German and French geopolitical risk is being priced higher as expected (Charts 7 and 8). Of these two Germany is the more exposed due to the risk of energy shortages. France is nuclear-armed and nuclear-powered, and unlikely to see a change of president in the April presidential elections. Italian risk was already at a higher level than these countries but the Russian conflict and high energy supply risk will keep it elevated (Chart 9). Chart 7Germany GeoRisk Indicator Germany GeoRisk Indicator Germany GeoRisk Indicator Chart 8France GeoRisk Indicator France GeoRisk Indicator France GeoRisk Indicator Chart 9Italy GeoRisk Indicator Italy GeoRisk Indicator Italy GeoRisk Indicator Canada’s trucker strikes are over and the loonie will benefit from the country’s status as energy producer and insulation from geopolitical threats due to proximity with the United States (Chart 10). Chart 10Canada GeoRisk Indicator Canada GeoRisk Indicator Canada GeoRisk Indicator Spain still has substantial domestic political polarization but this will have little impact on markets amid the Ukraine war. Spain is distant from the fighting and will act as a conduit for liquefied natural gas imports into Europe (Chart 11). Chart 11Spain GeoRisk Indicator Spain GeoRisk Indicator Spain GeoRisk Indicator Australia’s political risk will remain elevated due to its clash with China amid the emerging global conflict between democracies and autocracies as well as the country’s looming general election, which threatens a change of ruling party (Chart 12). However, as a commodity and LNG producer and staunch US ally the country’s risks are overrated. Chart 12Australia GeoRisk Indicator Australia GeoRisk Indicator Australia GeoRisk Indicator Markets are gradually starting to price the risk of an eventual China-Taiwan military conflict as a result of the Ukrainian conflict. China is unlikely to invade Taiwan on Russia’s time frame given the greater difficulties and risks associated with an amphibious invasion of a much more strategically critical territory in the world. But Taiwan’s situation is comparable to that of Ukraine and it is ultimately geopolitically unsustainable, so we expect Taiwanese assets to suffer a higher risk premium over the long run (Chart 13). Chart 13Taiwan Territory GeoRisk Indicator Taiwan Territory GeoRisk Indicator Taiwan Territory GeoRisk Indicator South Korea faces a change of ruling parties in its March 9 general election as well as uncertainties emanating from China and a new cycle of provocations from North Korea (Chart 14). However these risks are probably not sufficient to prevent a rally in South Korean equities on a relative basis as China stabilizes its economy. Chart 14Korea GeoRisk Indicator Korea GeoRisk Indicator Korea GeoRisk Indicator Turkey’s international environment has gotten even worse as a result of Russia’s invasion of Ukraine and effective closure of the Black Sea to international trade. Turkey has invoked the 1936 Montreux Convention to close the Dardanelles and Bosporus straits to Russian warships, although it will let those ships return to home from outside the Black Sea. The Black Sea is highly vulnerable to “Black Swan” events, highlighted by the sinking of an Estonian ship off Ukraine’s coast in recent days. Turkey’s domestic political situation will also generate a political risk premium through the 2023 presidential election (Chart 15), as President Recep Erdogan’s reelection bid may benefit from international chaos and yet he is an unorthodox and market-negative leader, and if he loses the country will be plunged into factional conflict. Chart 15Turkey GeoRisk Indicator Brazil GeoRisk Indicator Brazil GeoRisk Indicator South Africa looks surprisingly attractive in the current environment given our assessment that the government is stable and relatively friendly to financial markets, the next general election is years away, and the search for commodity alternatives to Russia amid a high commodity price context will benefit South Africa (Chart 16). Chart 16South Africa GeoRisk Indicator South Africa GeoRisk Indicator South Africa GeoRisk Indicator India And Brazil: A Tale Of Two Emerging Markets Russia’s invasion of Ukraine will have a minimal impact on the growth engines of India and Brazil. This is because Russia directly accounts for a smidgeon of both these countries trade pie. However, the main route through which this war will be felt in both markets is through commodity prices. Brazil by virtue of being a commodity exporter is better positioned as compared to India which is a commodity importer and is richly valued to boot. The year 2022 promises to be important from the perspective of domestic politics in both countries and will add to the policy risks confronting both EMs. Our Brazilian GeoRisk indicator has collapsed but is highly likely to recover and rise from here (Chart 17). Chart 17Brazil GeoRisk Indicator Brazil GeoRisk Indicator Brazil GeoRisk Indicator Commodity Price Spike – Advantage Brazil Politically India and Brazil have a lot in common today. The popularity ratings of their respective right-leaning heads of states, Prime Minister Narendra Modi in India and President Jair Bolsonaro in Brazil, have suffered over the last two years. The economic prospects of the median voter in both countries have weakened over the last year (Chart 18). Policymakers in both countries face a dilemma: they cannot stimulate their way out of their problems without an adverse market reaction since both countries are loaded with public debt. Chart 18Economic Miseries Rising For Both India's And Brazil's Median Voter Economic Miseries Rising For Both India's And Brazil's Median Voter Economic Miseries Rising For Both India's And Brazil's Median Voter Despite these commonalties, Brazil’s equity markets have outperformed relative to EMs whilst India has underperformed (Chart 19). On a tactical horizon, we expect this divergent performance to continue as the effects of the Russian invasion feed through commodity markets. Chart 19India Is Richly Valued, Brazil Has Outperformed EMs India Is Richly Valued, Brazil Has Outperformed EMs India Is Richly Valued, Brazil Has Outperformed EMs ​​​​​ Commodity markets were tight even before the Russian invasion. The ongoing war will force inventories to draw across a range of commodities including oil, iron ore and even corn. Given that India is a net importer of oil whilst Brazil is a net commodity exporter, the current spike in commodity prices will benefit Brazil over India in the short term. However, our Commodity & Energy Strategy team expects supply responses from oil producers to eventually come through, thereby sending the price of Brent crude to $85 per barrel by the end of 2022. Hence if Indian equities correct in response to the current oil spike or domestic politics (see below), then investors can turn constructive on India on a tactical horizon. Elections Stoke Policy Risks – In India And Brazil Results of key state elections in India will be announced on March 10, 2022. Of all the state elections, the results that the market will most closely watch will be those of Uttar Pradesh, the most populous state of India. In a base case scenario, we expect the Bhartiya Janata Party (BJP) which rules this state, to cross the 50% seat share mark and retain power. But the BJP will not be able to beat the extraordinary 77% seat share it won at the 2017 elections in Uttar Pradesh. A sharp deviation from this benchmark may lead the BJP to focus on populism ahead of the next round of state elections due in 4Q 2022. At a time when the Indian government’s appetite to take on structural reforms is waning, we worry that such a populist tilt could perturb Indian equity markets. Also, general elections are due in India in 2024. If the latest state election results suggest that the BJP has ceded a high vote share to regional parties (such as the Samajwadi Party in Uttar Pradesh or Aam Aadmi Party in Punjab), then this would mean that regional parties can pose a credible threat to BJP’s ability to maintain a comfortable majority in 2024. In Brazil, some polls show that left-leaning former president Lula da Silva's lead on President Bolsonaro may have narrowed. While we expect Lula to win the presidential elections due in Brazil in October 2022, the road to victory will not be as smooth as markets expect. If the difference between the two competitors’ popularity stays narrow, then there is real a chance that President Bolsonaro will make a last-ditch effort to cling to power. He will resort to fiscal populism and attacks on Brazil’s institutions, potentially opening up institutional or civil-military rifts that generate substantially greater uncertainty among investors. Bolsonaro already appears to be planning a cut in fuel prices and a bill to further this could be tabled as soon as next week. He has coddled Russian President Putin to shore up his base of authoritarian sentiment at home. To conclude, investors must balance these two opposing forces affecting Brazilian markets today. On one hand are the latent policy risks engendered by a far-right populist who still has a few months left in office. On the other hand, in a year’s time Bolsonaro will likely be gone while Brazil stands to benefit as commodity prices rise and EM investors shift funds into commodity exporters like Brazil. Against this backdrop, we re-iterate our view that investors should take-on selective tactical exposure in Brazil. Risk-adjusted returns in Brazil at this juncture can be maximized by buying into sectors like financials as these sectors’ inherent political and policy sensitivity is low. Postscript: Is India’s Foreign Policy Reverting To Non-Alignment? India traditionally has followed a foreign policy of non-alignment, carefully maintaining ties with both America and Russia through the Cold War. Things changed in the 2000s as Russia under President Putin courted closer ties with China while the US tried to warm up to India. India’s decision to join the newly energized US-led “quadrilateral” alliance in 2017 is a clear sign that India is gradually shedding its historical stance of neutrality and veering towards America. However, this thesis is being questioned as India, like China, is continuing to trade and transact with Russia despite its invasion of Ukraine, providing Russia with a lifeline as it suffers punishing sanctions from the US and European Union. India repeatedly abstained from voting resolutions critical of Russia at the United Nations in recent weeks. In other words, India’s process of transitioning over to the US alignment will be “definitive yet slow,” owing to reasons of both history and practicality. The former Soviet Union’s support played a critical role in helping India win several regional battles like the Indo-Pakistan war of 1971. Russia’s military and security influence in Central Asia makes it useful to India, which seeks a counter to Pakistan on its flank in Afghanistan. India sees Russia as a fairly dependable partner that cannot be abandoned until America is willing to provide much greater and more reliable guarantees and subsidies to India – through military support and beneficial trade deals. The backbone of Indo-Russia relations has been their arms trade (Chart 20). India’s reliance on Russia for arms could decline in the long term. But in the short term, as India tilts towards the US at a calibrated pace, India could remain a source of meaningful defense revenue for Russia. It is possible but not likely that the US would impose sanctions on India for maintaining this trade. Chart 20India Today Is A Key Buyer Of Russian Weapons Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) The fundamental long-term dynamic is that Russia has foreclosed its relations with the West and will therefore be lashed to China, at least until the Putin regime falls and a Russian diplomatic reset with the West can be arranged. In the face of this combined geopolitical bloc, India will gradually be driven to cooperate more closely with the United States. But India will not lead the transition away from Russia – rather it will react appropriately depending on the US’s focus and resolve in countering China and assisting India’s economy.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      Energy Aspects long-term estimate. 2     Tzvi Joffre, “Russian FM repeats nuclear war rhetoric as invasion of Ukraine continues,” Reuters, March 3, 2022. 3     Jack L. Snyder, “The Soviet Strategic Culture : Implications for Limited Nuclear Operations,” Rand Corporation, R-2154-AF (1977), argues that Soviet and American strategic cultures differ greatly and that the US should not be “sanguine about the likelihood that the Soviets would abide by American-formulated rules of intrawar restraint." Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades (2022) Section III: Geopolitical Calendar

Executive Summary Russian Stocks Are Breaking Below Their 2008 And 2015 Lows Russian Stocks Are Breaking Below Their 2008 And 2015 Lows Russian Stocks Are Breaking Below Their 2008 And 2015 Lows The Kremlin will not halt its military operations in Ukraine for now. The strategic objective of Putin is to bring Ukraine back into its geopolitical and economic orbit. His immediate goal is to unseat the current government in Kyiv and install a pro-Kremlin administration. Russia is embracing a long period of economic and financial isolation. Russian financial markets will remain uninvestable for an extended period. We are downgrading Central European equities and local currency bonds to underweight within their respective EM portfolios. As a new trade, we recommend shorting the Polish zloty versus the US dollar. Recommendation Inception Date Return Short PLN / Long USD Mar 02, 2022   Bottom Line: The security situation in Europe will continue to deteriorate, especially if the Russian army fails to secure a rapid military victory. This poses a risk to global and EM risk assets. Within a global equity portfolio, investors should overweight the US, and underweight EM and Europe. Feature Global macro has taken a back seat and geopolitics has become the dominant driver of financial markets. Still, we believe geopolitical risks are underappreciated by global financial markets. Will Western Sanctions Halt Russia’s Military Operation? While sanctions have started and will continue to hurt the Russian economy and its financial system, the Kremlin will not halt its military operations in Ukraine for now. The strategic objective of Putin is to bring Ukraine back into its geopolitical and economic orbit. His immediate goal is to unseat the current government in Kyiv and install a pro-Kremlin administration. In fact, having already incurred considerable economic and financial costs, Russia will not pull back its army anytime soon. If anything, Russia’s rhetoric and actions will get more aggressive in the coming weeks. For now, the Kremlin will not agree to anything short of the surrender of Ukraine’s government and its army. In turn, Ukraine authorities and its military intend to continue fighting with the support of arms supplies from the West. As a result, any peace talks will be futile. The situation will thus continue to escalate and the risk premium in global financial markets will rise further. The global political uncertainty index will be rising and, as a rule of thumb, it heralds a lower P/E ratio for global equities (Chart 1). Chart 1Rising Geopolitical Risks = Lower P/E Ratio Rising Geopolitical Risks = Lower P/E Ratio Rising Geopolitical Risks = Lower P/E Ratio The main question is, therefore, how bad could it get? We believe the conflict might take a turn for the worse. If the Russian military fails to achieve its goal to remove the current government in Kyiv, Putin will go all out. Losing this war is not an option for him. The failure of the Kremlin to secure a rapid military victory implies a massive escalation on two fronts: (1) the military actions of the Russian army in Ukraine will intensify and civilian infrastructure and potentially the population at large might be threatened; and (2) Russia will become more aggressive in its threats to the West. If and when Putin perceives that his military operation is failing or his power is threatened at home, he will resort to the extreme actions he has been warning about. Putin will bolster his military threats to Europe and to the US. In such a scenario, global risk assets will tank. Bottom Line: The security situation in Europe will continue to deteriorate, especially if the Russian army fails to secure a rapid military victory. Investors should position their portfolio to account for the fact that things will get worse before they improve. Russian Markets Are Uninvestable Chart 2No Buyers For Russian Bonds No Buyers For Russian Bonds No Buyers For Russian Bonds Russian markets have become uninvestable and will remain so for some time (Chart 2). The elevated odds of further military escalation in Ukraine entails more downside in Russian financial assets. Additional sanctions on the Russian economy cannot be ruled out at this point. These sanctions as well as the capital controls imposed by Russia on both residents and non-residents make Russian financial markets uninvestable. We downgraded Russian stocks to underweight within an EM equity portfolio on December 17, 2021, arguing that geopolitical tensions surrounding Ukraine would escalate. Chart 3 suggests that Russian share prices in USD terms are about to break below their 2008 and 2015 lows. Technically speaking, if this transpires, it will entail considerable downside. Similarly, the ruble versus an equally-weighted basket of the US dollar and euro on a total return basis has formed a technically bearish head-and-shoulders configuration (Chart 4, top panel). Notably, the ruble’s real effective exchange rate based on both CPI and PPI is not as cheap as it was in 1998 and 2015 (Chart 4, bottom panel). Chart 4More Downside In The Ruble More Downside In The Ruble More Downside In The Ruble Chart 3Russian Stocks Are Breaking Below Their 2008 And 2015 Lows Russian Stocks Are Breaking Below Their 2008 And 2015 Lows Russian Stocks Are Breaking Below Their 2008 And 2015 Lows The sanctions have effectively cut off the largest Russian commercial banks1 from the SWIFT electronic system and frozen the central bank of Russia’s (CBR) foreign exchange reserves deposited at foreign institutions. As of June 2021, roughly US$ 377 billion out of US$ 585 billion of Russian foreign exchange reserves were held in Western commercial banks or institutions, most of it in liquid financial securities. Meanwhile, the rest were held either in gold physical holdings (US$ 127 billion) or at Chinese institutions (US$ 80 billion). If all western countries freeze the CRB’s assets held at their banks, Russia’s effective foreign exchange reserves will be down to US$ 207 billion. This assumes the amount of international reserves at western banks has not changed since June 2021. As a result, the ratio of the central bank’s foreign reserves-to-broad money supply (all household and corporate local currency deposits) has dropped from 0.9 to 0.6 (Chart 5). This suggests that the central bank’s available amount of foreign exchange reserves coverage of broad money supply has been reduced dramatically in recent days due to economic and financial sanctions. This and a massive flight of capital out of the country has led the authorities to impose capital controls. Also, the government is compelling domestic exporting firms to sell 80% of their foreign generated revenues. Will the West lift sanctions right after the war in Ukraine ends? We doubt it. In our view, Russia is embracing a long period of economic and financial isolation. Besides, Russia lacks the manufacturing capabilities needed to mitigate the effects of these sanctions. Chart 6 shows that Russia has been investing little outside resource sectors and real estate. At 8-8.5% of GDP, investment in non-resource sectors excluding properties has been too low for too long. Chart 5Russia: FX Reserves' Coverage Of Money Supply Russia: FX Reserves' Coverage Of Money Supply Russia: FX Reserves' Coverage Of Money Supply Chart 6Russia Has Not Been Investing Much Russia Has Not Been Investing Much Russia Has Not Been Investing Much   This entails that Russia cannot become self-sufficient in many manufacturing sectors and technology. Trade with China will be the main channel that Russia can secure the manufacturing goods, machinery and technology it requires. Still, this will not allow the Russian economy to avoid a prolonged period of stagflation. Bottom Line: Odds are high that Russian financial markets will remain uninvestable for an extended period. The Russia economy is facing years of stagflation. Central European Financial Markets: Contagion Or An Existential Threat? Chart 7Central European Currencies Will Depreciate Central European Currencies Will Depreciate Central European Currencies Will Depreciate Although Central European countries are not at risk from Russia’s military attack, their financial markets will remain jittery for a while. We are downgrading Polish, Czech and Hungarian equities, currencies and domestic bonds to underweight (Chart 7). The likelihood of strikes on Poland, the Baltic states or any other neighboring NATO member country is very low. Attacking a NATO member would trigger Article V of NATO and force the organization to defend its member. Importantly, we do not think the Kremlin has the appetite for war against NATO. Even though Russia is unlikely to stage an attack on any NATO member, there could still be threats from Moscow and escalation involving central European countries. This will be especially so if Putin fails to secure the change of government in Kyiv in the coming weeks and starts threatening the West due to the latter’s support of Ukraine. As a result, Central European financial markets will continue selling off further in response to this potential escalation. Bottom Line: We are downgrading Central European equities and local currency bonds to underweight within a respective EM universe. We are maintaining the long CZK / short HUF trade. As a new trade, we recommend shorting the Polish zloty versus the US dollar. Investment Recommendations Global share prices will continue selling off. Our US equity capitulation indicator has fallen significantly but is not yet at 2010, 2011, 2015-16 and 2018 levels (Chart 8). It will at least reach this level before the S&P 500 bottoms. Chart 8The S&P 500 Selloff Is Not Over The S&P 500 Selloff Is Not Over The S&P 500 Selloff Is Not Over Our capitulation indicator for EM stocks is not low yet either (Chart 9). Hence, there is more downside. Investors should continue to take a defensive stance. Chart 9EM Stocks: Is There A Capitulation Phase Still Ahead? EM Stocks: Is There A Capitulation Phase Still Ahead? EM Stocks: Is There A Capitulation Phase Still Ahead? Chart 10US Stocks Are About To Resume Their Relative Outperformance US Stocks Are About To Resume Their Relative Outperformance US Stocks Are About To Resume Their Relative Outperformance Within a global equity portfolio, investors should overweight the US, and underweight EM and Europe. As US/global bond yields drop due to geopolitical jitters, the US stock market and growth stocks will resume their outperformance, at least for a period of time (Chart 10). Within an EM equity portfolio, we recommend overweighting Brazil, Mexico, Chinese A-shares, Singapore and Korea and underweighting Russia, Central Europe, South Africa, Indonesia, Turkey, Peru, Chinese Investable Stocks, Colombia and Chile. EM currencies and fixed-income markets remain vulnerable as the global risk off move causes the US dollar to spike. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes 1     Following the invasion of Ukraine on February 26, the US administration added the two largest Russian banks, Sberbank and VTB Bank, to the sanction lists. Both banks combined total assets represent close to 40% of total Russian banking system assets. ​​​​​​

Executive Summary Stronger Capex Than Last Decade Fallout From Ukraine Fallout From Ukraine The fog of war continues, but the worst potential outcome for the market—a freeze of Russian energy exports to Europe—has been avoided. Energy inflation is reaching its apex. Markets will remain volatile in the near term as uncertainty remains elevated in the coming days. Moreover, a transition from a recovery driven by consumer durable goods to services remains a hurdle against near-term European outperformance. Italian bonds and European banks are attractive, but it is not yet prudent to plunge headfirst into the euro. The longer-term consequences of the conflicts point toward greater capex and public deficits in Europe. This will boost the neutral rate of interest and European yields. Industrials and defense stocks are also key structural beneficiaries. Bottom Line: Keep hedges in place for the near term, as uncertainty remains rife. Buy Italian bonds and European banks, which will benefit from ECB support. Industrials still face near-term hurdles but should be a structural overweight position in European equity portfolios, along with financials and defense stocks. Feature The situation in Ukraine is reaching a climax. Following Russia’s recognition of the breakaway Luhansk and Donetsk People’s Republics (LPR and DPR) and its invasion of Ukraine, the S&P 500 entered correction territory. Importantly, the Dow Jones Euro Stoxx 50 is now down 10% since its January 5th high, which validates our repeated call over the past four weeks to hedge risk asset portfolios by selling EUR/CHF and EUR/JPY. An international conflict has begun and a human tragedy is unfolding; but, at the time of writing, it looks like the worst-case scenario for markets will be avoided. Germany is folding Nord Stream 2 indeterminably and Western allies have imposed painful economic sanctions on Russia. However, an expulsion of the SWIFT payment system is not in the cards. This is crucial because it greatly limits the risk that Russia will stop sending natural gas and oil to the EU. Ultimately, neither Russia nor the EU wants this outcome, since it imposes an enormous loss of revenues on the former (which needs hard currency to finance its war) and guarantees a recession for the latter (Chart 1). The war will still cost Europe. European natural gas prices surged again on Thursday, rising by more than 60% intraday. While a spike above EUR200/MWh is unlikely in the absence of an oil embargo, 20% of European natural gas imports pass through Ukraine. The conflict suggests that these flows will remain disrupted for now and that natural gas prices will remain between EUR80/MWh and EUR100/MWh for the next few months. This translates into elevated energy and electricity costs for the EU (Chart 2). Chart 1A European Recession Averted Fallout From Ukraine Fallout From Ukraine Chart 2Peaking But Elevated Fallout From Ukraine Fallout From Ukraine Chart 3Ebbing Energy Inflation Fallout From Ukraine Fallout From Ukraine Oil markets are set to peak soon. The run-up in Brent prices in recent weeks was largely driven by geopolitical concerns. With the odds of an oil embargo declining, the pressure on Brent will also recede. Bob Ryan, BCA’s commodity and energy strategist, believes that Saudi Arabia, the UAE, and Kuwait will increase their own production in coming weeks to burnish their credentials as reliable oil producers, especially if oil experiences more turmoil.  Bob expects crude prices to drop to $85/bbl by the second half of 2022. These dynamics are important because they imply that European headline inflation will soon peak. Yes, the recent spike in natural gas prices will keep energy inflation higher for a few more months, but, ultimately, ebbing base effects will bring down energy CPI. As Chart 3 highlights, even if Brent and natural gas prices stay at today’s levels for the remainder of the year, their year-on-year inflation rates will collapse, which will drive HICP lower. Near-Term Market Dynamics In this context, what to do with European assets? It is probably still too early to abandon our hedges, but we will likely do so next week or soon after. While the market has probably bottomed, prudence remains of prime consideration as a war is taking place and the situation on the ground may deteriorate. Chart 4A Buying Opportunity Fallout From Ukraine Fallout From Ukraine The clearest near-term investment implication comes for European peripheral bonds. Italian spreads have widened significantly in the wake of the hawkish pivot by the ECB (Chart 4). However, we argued that, when interest rate expectations priced in 50bps of the hike for 2022, the move was excessive and that only one ECB hike in the fourth quarter was likely this year. Now that the Ukrainian crisis is reaching a climax, even some of the ECB’s most hawkish members, such as Robert Holzmann, Governor of the Austrian National Bank, indicate that the removal of liquidity will be slower than originally anticipated. This means that the ECB is likely to continue to backstop the European peripheral bond markets. Italian and Greek bonds, which offer spreads of 165bps and 249bps over German bunds, are appealing in light of this explicit backstop. European financials are another attractive buy. Investors should buy banks outright. As Chart 5 highlights, all the major Eurozone countries’ banking stocks have suffered widespread selloffs. However, the exposure to Russian debt is limited at $67 billion (Chart 6). Additionally, the European yield curve slope is unlikely to flatten significantly from here. The ECB will limit the upside in the German 2-year yields by not hiking until Q4 2022, while the terminal rate proxy in Europe has significant upside from here. A steeper yield curve will boost the appeal of banks, especially in a context in which peripheral spreads are likely to narrow. Chart 5Too Much Of A Dive Fallout From Ukraine Fallout From Ukraine Chart 6Limited Russian Exposure Fallout From Ukraine Fallout From Ukraine The outlook for the euro is more complex. Narrower peripheral spreads would boost the euro’s appeal, a cheap currency currently trading at a 17% discount to its PPP fair value. EUR/USD also trades at a 5% discount to the BCA Intermediate-Term Timing Model, which suggests that considerable bad news is already embedded in the exchange rate (Chart 7). The fact that the EUR/USD did not close below its January 27th low in the face of a major war on European soil adds to the notion that the euro already embeds a significant risk premium. However, there are still ample reasons to worry about additional volatility in the coming week or so. The ECB is sounding less hawkish, while the Fed is not changing its tone. Meanwhile, 1-month and 3-month risk reversals are not at levels consistent with a bearish capitulation, which suggests that the euro could suffer one last wave of liquidation (Chart 8). Thus, we are not buying the euro yet and are willing to forego the first few cents of gains for a clearer signal. Chart 7EUR/USD Is Cheap Fallout From Ukraine Fallout From Ukraine Chart 8Sentiment Could Get More Negative Fallout From Ukraine Fallout From Ukraine Circling back to the equity front, European equities had become very oversold after the 14-day RSI fell below 30. The diminishing risk of an energy crisis will also help. However, global equities face more risks than just Ukraine. As we wrote earlier this week, the transition away from consumer durable goods as the driver of global growth to services will involve some adjustments for stocks, especially in an environment in which the Fed is allowing global monetary conditions to deteriorate (Chart 9). Thus, the window of volatility in stocks is unlikely to close in the near term. The relative performance of European equities vis-a-vis the US is complex as well. European equities have undone most of the relative gains accrued so far in 2022 (Chart 10). On the one hand, the global growth transition will hurt European equities more than US ones, as a result of their greater exposure to manufacturing activity. Additionally, high energy costs are more of a problem for Europe right now than the US. On the other hand, the continued hawkishness of the Fed is likely to limit the ability of tech stocks to extend the rebound that began last Thursday. As a result, the most likely pattern is for some churning in the relative performance of Europe and the US in the coming week. Chart 10Vanishing Outperformance Fallout From Ukraine Fallout From Ukraine Chart 9Tightening US Liquidity Conditions Fallout From Ukraine Fallout From Ukraine For the remainder of the year, we expect the European equity outperformance to re-establish itself in view of the favorable relative profits picture for 2022, a topic that we will explore more deeply in the coming weeks. Bottom Line: The near-term outlook for European assets remains extremely murky. Not only is a war in Ukraine a major threat that can hurt sentiment further, but European assets still have to handle the short-term implications of a change in global growth leadership away from goods consumption. Nonetheless, the dovish message of the ECB in the wake of the Ukrainian invasion suggests that the collapse in Italian bonds and European banks in recent weeks is overdone. European stocks will likely continue to churn against US stocks in the near term but outperform for the remainder of the year. The sell-off in the euro is advanced, but prudence prevents us from buying EUR/USD today. Keep short EUR/CHF and short EUR/JPY hedges in place for now. Longer-Term Implications The crisis in Ukraine heightens Europe’s need to diversify its energy sourcing away from Russia. However, this is not a transition that can be executed on a dime. It will take years. For now, Europe remains dependent on Russian energy, which greatly limits the EU’s options. However, time offers many more possibilities. First, kicking Russia out of SWIFT will become feasible, because it will increase the robustness of the SPFS payment system, allowing Russia to receive funds for its energy, even if it is out of SWIFT. Second, and most importantly, time will allow Europe to find new energy sources. For example, Qatari LNG is often mentioned as a potential replacement for Russian natural gas. Qatar currently does not have the capacity to service Europe extensively, while fulfilling its previous contractual obligations, but the expansion of the production in its North Field East will increase capacity to 126MTPA by 2027. The LNG export capacity of the US may also increase over the coming years. Even if Qatar and the US could send enough LNG to satisfy the hole left by Russia tomorrow, Europe would not be able to accept delivery, as it does not have enough terminals to accommodate these shipments. Thus, investments in that sector will expand. Chart 11The Renewables Envelope Will Expand Fallout From Ukraine Fallout From Ukraine Chart 12Nuclear Skepticism Remains Fallout From Ukraine Fallout From Ukraine Most importantly, Europe will accelerate its transition toward renewable energy. Renewables are already a major focus of the NGEU program (Chart 11). However, we expect that, for the remainder of the decade, the NGEU program will be enlarged to allow greater investments in that space. Not only does it fit European green goals, but this policy would also increase the region energy security. More investment in nuclear electricity production is also possible but lacks popular support (Chart 12). The main message of these observations is that European infrastructure spending is likely to remain elevated in the coming years. As a result, industrial stocks may face some near-term headwinds as the global economy transitions away from the consumer goods-buying binge of COVID-19, but they will ultimately benefit greatly from an expansion of the capital stock around the world. Another long-term theme derived from the current crisis is that European defense stocks will fare well on a structural basis. The current crisis will force greater European unity. The presence of a common enemy will incentivize European nations to increase military spending, especially as the US continues to pivot toward Asia. Investors should overweight these stocks. In terms of bond market developments, more military spending and investment in energy infrastructures means that European budget deficits will be wider than if the Ukrainian crisis had not emerged. More accommodative fiscal policy will support aggregate demand, which will feed through greater capex (Chart 13). Thus, the experience of the last decade, whereby aggregate demand was curtailed by unnecessarily stringent European fiscal policy, will not be repeated. This confirms our expectation that the neutral rate of interest will rise in Europe and that Europe will escape an environment of zero rates (Chart 14). Therefore, German bunds yields have upside, the yield curve can steepen, and the outlook for European financials is positive on a long-term basis, not just on a near-term one. Chart 13Stronger Capex Than Last Decade... Fallout From Ukraine Fallout From Ukraine Chart 14...Means Higher Yields And A steeper Curve Fallout From Ukraine Fallout From Ukraine Chart 15Ebbing Fixed-Income Outflows? Fallout From Ukraine Fallout From Ukraine Finally, the picture for the euro is murky. On the one hand, its inexpensiveness is a major advantage while a higher neutral rate of interest will limit the European fixed-income outflows that have plagues the Euro for the past decade (Chart 15). However, if we are correct that European capex will increase and that budget deficits will remain wider than in the last decade, this also means that the European current account surplus will narrow as excess savings recede. This implies that one of the key underpinnings of the euro will dissipate. In the end, productivity will be the long-term arbiter of the exchange rate. Europe still lags behind the US on this front, which augurs poorly for the performance of the euro (Chart 16). Reforms and capex may save the day, but it is too early to make this call. Chart 16The Productivity Handicap Fallout From Ukraine Fallout From Ukraine ​​​​​​​ Bottom Line: The events in Ukraine portend a structural shift in European capex. Europe will need to ween itself off its Russian energy dependency, which will require major investments in LNG facilities and renewable power. Moreover, European defense spending will rise. These will continue to support fiscal and infrastructure spending. As a result, industrials will benefit from a structural tailwind, as will European defense stocks. These same forces will put upward pressure on European risk-free yields, which will benefit beleaguered European financials and banks. The long-term outlook for the euro is murkier. More research must be conducted before making a definitive directional bet.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Highlights The Russian invasion of Ukraine is a geopolitical incident that is likely to be limited in scope. A wholesale energy cutoff to Europe is the chief risk to global economic activity, but the sanction response from the US and EU does not point to this outcome. This implies that a large geopolitical risk premium may linger over the very near term, but that equities and other risk assets will ultimately recover. We continue to expect above-trend growth and above-target inflation in the US and other developed economies this year. Q1 growth in the US is likely to be closer to 4% after removing the effect of changing inventories, and incoming information still points to the view that the pandemic will continue to recede in importance over the coming several months. Given the magnitude of the rise in consumer prices in the US and other developed economies, above-trend growth also underpins the significantly hawkish monetary policy shift that has recently occurred. There are legitimate arguments in favor of a very aggressive pace of Fed tightening. Still, our view is that seven rate hikes from the Fed over the coming 12 months is likely too aggressive: A peak in headline inflation over the coming months will help restrain longer-term household inflation expectations, the surge in wage growth continues to reflect pandemic-driven labor market distortions that could unwind, and a significant further flattening of the yield curve – despite likely being a false signal of a recession – would probably cause a temporary period of tighter financial conditions that the Fed would respond to. We believe it is likely that the Fed will initially seek to raise interest rates at a pace that is in line with current market pricing, but that it will likely slow the pace at some point beyond the next 3-4 months. As such, we expect that the Fed will ultimately end up raising interest rates 5 or 6 times over the coming year, less than investors currently expect. The case for aggressive ECB hikes was weak even before Russia’s invasion of Ukraine. European core inflation is nowhere near as strong as it is in the US, and nominal output in the euro area has not yet recovered to its pre-pandemic trend (in heavy contrast to the US). Russia’s invasion has caused a disruption of natural gas flows that will keep European gas prices at elevated levels, and aggressive tightening in response risks repeating the mistakes the ECB made in 2008 and 2011 when it raised rates in the face of an ultimately deflationary supply shock. On a 6-12 month time horizon, we are only likely to recommend downgrading global stocks once 5-year/5-year forward US Treasury yields break above 2.5%, barring a more severe shock to global economic activity from the Ukrainian crisis than currently appears likely. On Russia’s Invasion Of Ukraine Yesterday, BCA Research published a Special Alert in response to Russia’s invasion of Ukraine.1 In the report, we outlined Russia’s motivation for invading, and noted that it will not withdraw troops until it has changed the government and seized key territories – such as coastal regions to ensure the long-term ability to blockade the country. Crucially, we noted that while the US and EU will levy sweeping sanctions against Russia, that the EU would not halt Russian energy exports. We regard the decision to maintain Russia’s access to the SWIFT system as consistent with that view. Given this, we believe that the Russian invasion of Ukraine is a geopolitical incident that is likely to be limited in scope. A wholesale energy cutoff to Europe is the chief risk to global economic activity, but the sanction response from the US and EU does not point to this outcome. This implies that a large geopolitical risk premium may linger over the very near term, but that growth, inflation, and monetary policy will ultimately return as the drivers of equities and other risk assets over the coming weeks and months. Beyond Ukraine: Growth, Inflation, And Monetary Policy In The DM World Chart I-1Recent US Data Has Looked Smoewhat Stagflationary Recent US Data Has Looked Smoewhat Stagflationary Recent US Data Has Looked Smoewhat Stagflationary BCA Research presented three possible growth and inflation scenarios for this year in our 2022 Annual Outlook report. Our base case scenario, to which we assigned 60% odds, was one of above-trend growth and above-target inflation. We assigned 30% odds to a “stagflation-lite” scenario of above-target inflation with below-trend growth, and a 10% chance of a recession. Since we published our Annual Outlook, we raised the odds of the second, stagflation-lite scenario – mostly due to the impact that the Omicron variant of COVID-19 could have on the Chinese supply chain. But until recently, US economic data was also looking somewhat stagflationary: US real GDP only grew at a 2.3% annualized basis in Q3, and the strong Q4 number was mostly boosted by inventories. Real goods spending has slowed over the past few months without a major increase in services spending, and US auto production continues to be restrained by semiconductor shortages (Chart I-1). Supply-side constraints on production and spending have occurred against the backdrop of a significant acceleration in US consumer prices, the combination of which seemingly points more to the second growth and inflation scenario that we outlined, rather than our base case. However, our view is that above-trend growth in the US and other developed economies remains the most likely outcome this year, even given ongoing supply-side constraints and Russia’s invasion of Ukraine. In addition to the sizeable amount of excess savings that have been accumulated during the pandemic and the enormous increase in household net worth that has occurred over the past two years, two other factors point to above-trend DM growth. In the US, following the release of the January retail sales report, the Atlanta Fed GDPNow model is forecasting below-trend growth for Q1, but with a -2.3% contribution from the change in private inventories. Chart I-2 highlights that the Atlanta Fed’s model is projecting 3.6% annualized growth in Q1 of final sales of domestic product, a measure of GDP that excludes the effect of changing inventories (whose contribution to growth averages to zero over time). This would be above the trend rate of real GDP growth, and would represent an acceleration relative to the past few quarters. Beyond the next few months, the other factor pointing to above-trend growth is the indication that the pandemic will indeed continue to recede in importance over the course of the year, in line with what we laid out in our Annual Outlook. Chart I-3 highlights that the Omicron-driven surge in hospitalizations in G7 countries has been short-lived, and Chart I-4 highlights that deliveries of Pfizer’s anti-viral treatment Paxlovid, while still in their early stages, have begun. Chart I-2Q1 US Economic Growth Likely To Be Above-Trend Q1 US Economic Growth Likely To Be Above-Trend Q1 US Economic Growth Likely To Be Above-Trend Chart I-3Hospitalizations Are Falling Sharply Hospitalizations Are Falling Sharply Hospitalizations Are Falling Sharply In a recent study, Paxlovid was found to have an 89% efficacy in preventing COVID hospitalizations and deaths, with less serious adverse events or discontinuations than the placebo group.2 Its high effectiveness against all SARS-CoV-2 variants suggests that its increased deployment over the course of the year should significantly reduce the impact of COVID-19 on the medical system as well as lower the fear of the disease amongst consumers, even as new variants of the virus emerge and spread around the world. Consequently, it is likely that the output gap in advanced economies will turn positive this year despite ongoing supply-side constraints unless Russian energy exports to the EU are ceased, triggered either by a European boycott or a Russian embargo. Prior to Russia’s invasion, consensus growth expectations implied above-trend growth for this year (Chart I-5), which we see as consistent with the base case growth and inflation view that we presented in our Annual Outlook if Russian energy exports continue. However, given the magnitude of the rise in consumer prices in the US and other developed economies, above-trend growth also underpins the significantly hawkish monetary policy shift that has occurred over the past 2 months. Chart I-5We Agree With Consensus Expectations For Growth This Year We Agree With Consensus Expectations For Growth This Year We Agree With Consensus Expectations For Growth This Year Chart I-4US Paxlovid Deliveries Are Creeping Higher US Paxlovid Deliveries Are Creeping Higher US Paxlovid Deliveries Are Creeping Higher   The Case For, And Against, Aggressive Fed Tightening Just since the beginning of the year, investors have moved to price in an additional 100 basis points of rate hikes from the Fed (Chart I-6). Earlier this month, comments by St. Louis Fed President James Bullard signaling his desire for a full percentage point of interest rate hikes by July had a sizeable effect on US Treasury yields, with market participants still pricing in meaningful odds of a 50 basis point rate hike in March despite recent pushback from key Fed officials and Russia’s invasion of Ukraine. Chart I-6The Monetary Policy Outlook Has Shifted Rapidly In A Hawkish Direction The Monetary Policy Outlook Has Shifted Rapidly In A Hawkish Direction The Monetary Policy Outlook Has Shifted Rapidly In A Hawkish Direction Last year, The Bank Credit Analyst service warned on several occasions that a return to maximum employment was likely to occur faster than investors expected, and that a hawkish shift from the Fed was probable. We noted in our July report that the cumulative odds of a rate hike by some point in Q2 2022 were close to 40%,3 and in our September Special Report we reinforced the view that a mid-2022 rate hike was likely.4 Still, even relative to our (then) comparatively hawkish expectations, the monetary policy outlook has shifted very aggressively towards more and earlier rate hikes. This shift has partially occurred due to the labor market dynamics that we projected last year, but also due to a significant broadening of inflation over the past four months. Chart I-7 highlights that the 6-month rate of change in US core CPI excluding cars and COVID-impacted services was not meaningfully different in October than it was in the latter half of late-2019, in heavy contrast to overall headline and core inflation. However, over the past four months this measure has accelerated by 175 basis points, highlighting that inflationary pressures are becoming broader – and that an earlier and more forceful response from the Fed may be warranted. Chart I-7US Inflation Has Broadened, And Quickly So US Inflation Has Broadened, And Quickly So US Inflation Has Broadened, And Quickly So Does the broadening in US inflationary pressure that has occurred over the past few months justify the seven rate hikes currently expected by investors over the coming year? We present the detailed case for and against that view below, and conclude that seven rate hikes over the coming 12 months is likely too aggressive. The Case For Aggressive Tightening The most prominent argument in favor of aggressive Fed rate hikes is not just to slow the pace of inflation, but to address the fact that broadening inflationary pressures risk unanchoring inflation expectations. As we discussed in our January 2021 Special Report,5 inflation is determined not just by the output gap, but as well by inflation expectations. Economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to cyclically fluctuate, but those fluctuations are relative to a level that is determined by inflation expectations – not the Fed’s inflation target. It is only if inflation expectations are consistent with the Fed’s target that actual inflation will equal that target, abstracting from the business cycle and other distorting events. A deeply negative output gap for several years following the global financial crisis caused inflation expectations to be vulnerable to shocks, and the collapse in oil prices in 2014 served as a large enough surprise that expectations unanchored to the downside. This event ultimately motivated the Fed’s introduction of its average inflation targeting policy, but Chart I-8 highlights that inflation expectations are no longer chronically low and that they may unanchor to the upside without meaningfully tighter monetary policy. A temporary period of higher food prices stemming from Russia’s invasion of Ukraine also raises the risk of unanchored inflation expectations among households. The second argument in favor of aggressive Fed rate hikes is that the unemployment rate has essentially fallen back to its pre-pandemic level, and median wage growth has already risen to its strongest level in 20 years (Chart I-9). Given that a large amount of excess savings and a very significant wealth effect are likely to continue to support aggregate demand, the inference is that overall wage growth may accelerate significantly further as the unemployment rate continues to fall. Chart I-8Inflation Expectations Are No Longer Depressed Inflation Expectations Are No Longer Depressed Inflation Expectations Are No Longer Depressed Chart I-9Wage Growth Has Risen Very Significantly Wage Growth Has Risen Very Significantly Wage Growth Has Risen Very Significantly The third argument in favor of rapid tightening is that the natural/neutral rate of interest is likely higher than both investors and the Federal reserve believe, meaning that monetary policy is even easier today than is generally recognized. We have written about this issue at length: in March 2020 we explained why the most cited measure of “R-star” was wrong,6 and noted in our April 2021 Special Report why we no longer believe that a gap between interest rates and trend rates of economic growth are justified. This perspective also suggests that investors should look past the quasi-recessionary signal currently being flagged by the 2/10 yield curve, as curve inversion is likely to be a false signal of a recession – as it was in 2019 (see Box I-1). BOX I-1 The Sino-US Trade War, The Yield Curve, And The COVID-19 Pandemic The US yield curve has historically provided a highly reliable signal of the likelihood of a recession. Investors have taken an inverted yield curve as a sign that short-term interest rates have risen to a level that is not likely to be sustained over the longer term, meaning that monetary policy has become tight. An inverted yield curve has indeed preceded several US recessions, although its track record at predicting contractions globally has been less reliable. While it is a counterfactual assertion, we believe that the yield curve provided a false signal when it inverted in 2019. Clearly the inversion did not predict the COVID-19 pandemic; the question is whether the US would have experienced a recession had the pandemic not occurred. In our view, the evidence does not point to that conclusion. Charts I-B1 and I-B2 highlight that the yield curve responded to an economic slowdown that was mostly caused by the Sino-US trade war, as well as an ongoing slowdown in Chinese credit growth and economic activity. It does not appear to have occurred due to interest rates having risen to a level that would be unsustainable absent these non-monetary shocks. Chart I-B1The Yield Curve Inverted Well After The Trade War Hit… March 2022 March 2022 Chart I-B2…And The Economy Started Improving After The Inversion March 2022 March 2022 In addition, the signal from the yield curve lagged that of the equity market: Chart I-B1 highlights that the US equity market fell just shy of 20% eleven months before the yield curve inverted. In fact, stock prices were rising sharply just prior to the emergence of the pandemic in response to expectations of monetary easing and the Phase I US trade deal, and the US Markit manufacturing and services PMIs were also turning up. None of these signs point to the likelihood of a contraction in US output had the COVID-19 pandemic not emerged. The key point for investors is that an inversion of the yield curve, were it to occur over the coming 12-18 months, would not necessarily signal a recession unless it were coupled with a major non-monetary shock. It would, however, be significant from a strategy standpoint, as the Fed would likely take it as a sign of tightening financial conditions. The Case Against Aggressive Fed Action Chart I-10Inflation Expectations Have Risen, But Are Not Out Of Control Inflation Expectations Have Risen, But Are Not Out Of Control Inflation Expectations Have Risen, But Are Not Out Of Control There are several counterpoints to the arguments noted above, as well as a few additional reasons to suggest that 7 rate hikes over the coming year is too aggressive. First, on the issue of inflation expectations, while it is true that expectations are no longer chronically low, longer-term expectations have not yet exceeded their pre-global financial crisis (GFC) range (Chart I-10). In addition, despite the temporary spike in energy and food prices stemming from Russia’s invasion of Ukraine, headline inflation is likely to peak at some point over the coming months, which will act to restrain longer-term household inflation expectations. Importantly, inflation is likely to peak even without any Fed tightening. A comparison of the recent pace of advance in both headline and core CPI suggests that the former has up to 200 basis points of downside if crude oil prices remain at $100/bbl. Our Commodity & Energy Strategy team expects that Russia’s invasion of Ukraine will prompt increased production from core OPEC producers to reduce the elevated risk premium and allow refiners to boost inventories. We now expect Brent oil to average $85/bbl in the second half of 2022, implying eventual deflation from energy prices and a slowdown in the pace of advance in headline CPI over the coming months – potentially below that of core. That would represent a very significant easing in headline inflation relative to current levels, and we do not expect that long-term household expectations for inflation would rise much further in such a scenario. The easing in the prices paid component of the ISM manufacturing index also points to an imminent peak in headline inflation and, by extension, household inflation expectations (Chart I-11). Second, while it is true that overall wage growth has recently accelerated quite significantly, it is still the case that this is being driven by the lowest-paid workers. Chart I-12 highlights that 1st and 2nd quartile wage growth are between 0.4-1.2% higher than they were prior to the pandemic, but that 3rd and 4th quartile wage growth is either the same or lower. Chart I-12Lower-Pay Wage Inflation Is Due To The Pandemic... Lower-Pay Wage Inflation Is Due To The Pandemic... Lower-Pay Wage Inflation Is Due To The Pandemic... Chart I-11The Prices Paid Components Of Manufacturing PMIs Also Points To Lower Headline Inflation The Prices Paid Components Of Manufacturing PMIs Also Points To Lower Headline Inflation The Prices Paid Components Of Manufacturing PMIs Also Points To Lower Headline Inflation   This surge in wages for low-paid workers largely reflects pandemic-driven labor market distortions, rather than excess demand. Chart I-13 highlights that real US services spending remains close to 5% below its pre-pandemic trend, and Table I-1 highlights that the leisure & hospitality industry now accounts for the vast majority of the jobs gap relative to pre-pandemic levels. Chart I-14 also highlights that while the leisure & hospitality jobs gap is smaller in red states than in blue states (which may be disproportionately affected by lost services jobs in central business districts due to work-from-home policies), it is still larger today that it was during the depths of the 2008/2009 recession. Chart I-13...Not Excessive Services Demand ...Not Excessive Services Demand ...Not Excessive Services Demand The key takeaway from Table I-1 and Charts I-13 and I-14 is that rising 1st and 2nd quartile wage growth is being caused by labor scarcity in low paying industries, which we attribute to the fact that working conditions in these jobs became more difficult during the pandemic and the fact that many of these positions involve close contact with customers. And clearly, raising interest rates will not hasten the return of leisure & hospitality workers to the labor market.   Table I-1Leisure & Hospitality And Education Now Make Up Almost All Of The US Jobs Gap March 2022 March 2022 Chart I-14The Leisure & Hospitality Employment Gap Does Not Seem Related To Work-From-Home Trends The Leisure & Hospitality Employment Gap Does Not Seem Related To Work-From-Home Trends The Leisure & Hospitality Employment Gap Does Not Seem Related To Work-From-Home Trends Third, even though we think the natural/neutral rate of interest is higher than both investors and the Federal reserve believe and that the yield curve provided a false signal of a recession in 2019, a significant further flattening of the yield curve would probably cause a tightening in financial conditions, at least for a time. The Fed is unlikely to be dissuaded from raising rates due to a valuation-driven decline in equity prices, but it is likely to respond to market-based signals of a material slowdown in economic activity – even if those signals ultimately prove to be false. The yield curve is an important reflection of how far bond investors believe the economic cycle has progressed (Chart I-15), and an increase in short-term interest rates at the pace that investors are currently expecting would flatten the 2/10 yield curve very close to (or into) negative territory. It seems likely that a rapid flattening in the curve would precipitate a growth scare in financial markets for a time, leading to falling equity prices (due to concerns about earnings, not just valuation), a rising US dollar, and a widening in corporate credit spreads. Chart I-15For The Fed, The Yield Curve Is An Important Market Indicator Of A Recession For The Fed, The Yield Curve Is An Important Market Indicator Of A Recession For The Fed, The Yield Curve Is An Important Market Indicator Of A Recession To conclude on this point, the Fed will feel that it is justified in hiking rates aggressively while inflation is well above its target levels and the unemployment rate is low and falling, but it is likely to change this assessment if financial markets begin to behave in a way that signals a rising risk of a significant slowdown in jobs growth. That would lead to a tactical period of weakness for risky asset prices, but it would ultimately be cyclically positive if the Fed revises its pace of tightening to a rate that is slower than investors currently expect. Our View Netting out the arguments presented above, the Fed may initially seek to raise interest rates at a pace that is in line with current market pricing, but it will likely slow that pace at some point beyond the next 3-4 months. As such, we expect that the Fed will ultimately end up raising interest rates 5 or 6 times over the coming year, less than investors currently expect. Our view also has important implications for the euro area interest rate outlook, given the significantly weaker case for aggressive ECB action that existed even before Russia’s invasion of Ukraine. A Flimsy Case For Aggressive ECB Rate Hikes, Even Before Russia’s Invasion Chart I-16The European Inflation Situation Is Not As Bad As In The US The European Inflation Situation Is Not As Bad As In The US The European Inflation Situation Is Not As Bad As In The US At the early-February ECB meeting, President Christine Lagarde signaled a more hawkish outlook for euro area monetary policy than investors had been expecting. Since the beginning of the year, the OIS market has moved to price-in roughly 70 bps of hikes over the coming 12 months, German 2-year bund yields have risen 20 basis points, and 10-year yields have risen back into positive territory. Italian and Greek 10-year yield spreads (relative to Bunds) have risen by 35 and 90 basis points, respectively. From our perspective, investors are pricing a too-aggressive path for the ECB policy rate, and we would probably characterize an ECB decision to raise rates in line with current market expectations as a policy mistake. As highlighted in a recent report by my colleague Mathieu Savary, BCA’s Chief European Strategist, several arguments support this view. First, Chart I-16 highlights that euro area core inflation is running at a considerably slower rate than headline inflation or core inflation in the US, and that our core inflation diffusion index for the euro area has peaked. It is true that core inflation is much higher in Germany than in other key euro area economies, and it is also true that aggregate euro area core inflation is above the ECB’s 2% target. But high German core inflation is seemingly driven by particularly acute passthrough effects from high natural gas prices, and recent IMF research underscores that over half of the increase in German manufacturing price inflation has occurred due to supply shocks rather than demand (Chart I-17). Chart I-18 shows that expectations for euro area inflation and actual wage growth do not, in any way, suggest that the ECB’s 2% target is under threat, underscoring that aggressive tightening over the coming several months risks repeating the mistakes the ECB made in 2008 and 2011 when it tightened policy in the face of an ultimately deflationary supply shock. Chart I-17German Core Inflation Is Being Disproportionately Driven By Supply Shocks March 2022 March 2022 The second argument is that nominal output in the euro area has not yet recovered to its pre-pandemic trend, in heavy contrast to the US (Chart I-19). This is particularly true for Italy and Spain, and reflects the nature of the euro area fiscal response to the COVID-19 pandemic. Chart I-20 highlights that the cumulative growth in euro area disposable income has been lower than what would have been expected absent the pandemic, unlike what occurred in the US and Canada – two countries that provided sizeable direct transfers to households as part of their fiscal response. Chart I-19Key Euro Area Economies Have Recovered Far Less Than The US Has Key Euro Area Economies Have Recovered Far Less Than The US Has Key Euro Area Economies Have Recovered Far Less Than The US Has Chart I-18Euro Area Inflation Expectations And Wage Growth Do Not Signal The ECB's Inflation Target Is Under Threat Euro Area Inflation Expectations And Wage Growth Do Not Signal The ECB's Inflation Target Is Under Threat Euro Area Inflation Expectations And Wage Growth Do Not Signal The ECB's Inflation Target Is Under Threat     Third, Russia’s invasion has caused a disruption of natural gas flows via Ukraine that will keep European gas prices at elevated levels even beyond the winter period, which will have a negative impact on the euro area economy. Chart I-21 highlights that European natural gas prices are now seven times as high as they were at the beginning of 2021. Unlike the prior rise in European natural gas prices, which was somewhat related to global demand for goods, the post-invasion surge is a pure supply shock – echoing our point about the ECB’s previous policy mistakes. Chart I-20Euro Area Disposable Income Is Lower Than Its Pre-Pandemic Trend, In Contrast To The US March 2022 March 2022 Chart I-21Russia's Invasion of Ukraine Has Created A Pure Natural Gas Supply Shock Russia's Invasion of Ukraine Has Created A Pure Natural Gas Supply Shock Russia's Invasion of Ukraine Has Created A Pure Natural Gas Supply Shock The fact that Italy’s nominal economic recovery has been comparatively weak has helped explain the rise in its 10-year government bond yield relative to 10-year German Bunds. Allowing for a further economic recovery in those countries before raising rates would let the ECB ultimately increase rates further down the road – and thus exit more cleanly from negative policy rates in Europe. Our European Strategy Team continues to expect that the ECB is on track to raise interest rates only once in Q4 2022, to be then followed by more aggressive hikes in 2023. Investment Conclusions For fixed-income investors, the investment implications of policy rates moving higher over the coming year at a pace that is less rapid than currently expected would normally imply that an at or above-benchmark duration stance is warranted. However, Chart I-22 highlights that there is still upside for 10-year US Treasury yields even in a scenario where the Fed raises rates at a pace of 100 basis points per year. As such, we continue to recommend that investors remain short duration on a 6-12 month time horizon, although we agree with BCA’s fixed-income team’s recommendation to tactically raise duration to neutral given the potential for the European energy crisis to worsen further and the fact that 10-year US Treasury yields do not have as much upside on a cyclical basis as they did when we published our Annual Outlook.7 For equities, we do not find the case for a tactical downgrade to be compelling at current levels, given that global stocks have already fallen 10% from their mid-November highs. Over the near term, we expect the continued underperformance of euro area equities, be we doubt that the negative economic impact of higher natural gas and oil prices would persist beyond a 0-3 month time horizon. On a 6-12 month time horizon, our expectation that monetary policy will tighten at a less aggressive pace than investors expect suggests that the earnings risk to global stocks is not substantial, underscoring that a meaningful contraction in equity multiples would likely be required for stocks to register negative 12-month returns from current levels. In the US, business surveys suggest that sales growth is set to slow to a still-healthy level, and that profit margins are likely to be flat over the coming year (Chart I-23). This is in line with the view that we presented in our Annual Outlook, namely that US earnings growth in 2022 would be driven mainly by top-line growth. Chart I-22Investors Should Still Be Cyclically Short Duration Investors Should Still Be Cyclically Short Duration Investors Should Still Be Cyclically Short Duration Chart I-23Surveys Imply Strong Revenue Growth And Flat Margins, And Thus Positive Earnings Growth Surveys Imply Strong Revenue Growth And Flat Margins, And Thus Positive Earnings Growth Surveys Imply Strong Revenue Growth And Flat Margins, And Thus Positive Earnings Growth Chart I-24Still No Sign That The Secular Stagnation Narrative Is Under Attach. That Is Good For Stocks. Still No Sign That The Secular Stagnation Narrative Is Under Attach. That Is Good For Stocks. Still No Sign That The Secular Stagnation Narrative Is Under Attach. That Is Good For Stocks. Similarly, the risk of a serious interest rate-driven contraction in equity multiples over the coming year does not appear to be elevated. Investors are far more inclined to use long-maturity bond yields to discount future cash flows than short-term interest rates, and we have noted that the rise in long-maturity bond yields is necessarily self-limiting unless investor expectations about the natural/neutral rate of interest change. Chart I-24 highlights that despite an extremely rapid shift in monetary policy outlook amid the highest US headline inflation in 40 years, 5-year/5-year forward US Treasury yields remain only fractionally above 2%. This underscores that fixed-income investors will need to see evidence that a progressively higher Fed funds rate is not disrupting economic activity before they are likely to abandon the secular stagnation narrative. While the equity risk premium will remain elevated over the near term due to the situation in Ukraine, the bond market’s continued belief in secular stagnation will likely support equity multiples – at least for the remainder of the year. As such, we recommend that investors position in favor of the following over the coming 6-12 months: Overweight equities versus long-maturity government bonds Overweight value versus growth stocks Short duration within a fixed-income portfolio, with a neutral tactical overlay Overweight speculative-grade corporate bonds with a credit portfolio Overweight non-resource cyclicals versus defensives and small caps versus large Short the US dollar versus major currencies Jonathan LaBerge, CFA Vice President The Bank Credit Analyst February 25, 2022 Next Report: March 31, 2022 II. Canada: How High Can Rates Rise? The buildup of excessive household debt in Canada over the past two decades has occurred because of outsized demand for housing, not because of the impact of constrained housing supply on house prices. Outsized demand for housing has occurred because interest rates have been persistently too low, pointing to the need for the Bank of Canada to tighten monetary policy in order to prevent even further leveraging. The burden of Canada’s household sector debt may exceed its pre-pandemic level next year given current market expectations for the path of rate hikes. This implies that the prior peak in the Canadian policy rate (1.75%) likely reflects a high-end estimate of the neutral rate of interest in Canada. Regulatory changes have occurred in recognition of Canada’s extreme levels of household debt. Although a massive decline in Canadian house prices would cause a very severe recession, it would not likely precipitate a Lehman-style collapse of the Canadian financial system. Over the next twelve months, investors should position favorably toward CAD-USD. As the Canadian policy rate approaches our estimate of the neutral rate, a short CAD position and an overweight stance towards long-maturity Canadian bonds versus US Treasurys will likely be warranted. Within a global equity portfolio, exposure to relatively high-yielding Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. The outlook for monetary policy in advanced economies has shifted rapidly in a hawkish direction over the past few months. While we believe that the Fed and other central banks will end up raising interest rates this year fewer times than investors currently expect, it is clear that monetary policy will tighten in the DM world over the coming 12-18 months. This has raised the question of how high policy rates may rise before monetary policy begins to restrict economic activity. Some investors have specifically focused this question on countries like Canada, which has a highly indebted household sector and has seen house prices rise at a 7% average annual pace for the past 20 years. In this report, we explore the root cause of Canada’s extreme household debt and argue against the constrained housing supply view. Instead, we conclude that persistently low interest rates have fueled excessive housing demand and that the prior peak in the Canadian policy rate (1.75%) probably reflects a high-end estimate of the neutral rate of interest in Canada – in contrast with that of the US. Finally, we note that the regulatory changes that have occurred in recognition of the risk from excessive household debt suggest that a massive decline in Canadian house prices would not likely precipitate a Lehman-style collapse of the Canadian financial system – it would, however, clearly cause a severe recession. Over the next twelve months, investors should position favorably toward CAD-USD. As the Canadian policy rate approaches our estimate of the neutral rate, a short CAD position and an overweight stance towards long-maturity Canadian bonds versus US Treasurys will likely be warranted. Within a global equity portfolio, exposure to relatively high-yielding Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. The Root Cause Of Canada’s Extreme Household Debt Chart II-1Canadian Households Are Massively Indebted Canadian Households Are Massively Indebted Canadian Households Are Massively Indebted Relative to disposable income, Canadian household debt has risen substantially over the past two decades. Chart II-1 highlights that Canada’s household debt to disposable income ratio has risen by 180% since 2000, and is currently over 50 percentage points higher than that in the US, even when nonfinancial noncorporate debt is included in the latter.8 Rising Canadian household indebtedness is a problem that is well known to investors, policymakers, regulators, banks, and consumers themselves. Organizations such as the IMF have repeatedly warned that excess household debt poses a potential economic stability risk. In the years prior to the pandemic, policymakers have responded with a series of macroprudential measures designed to limit speculation and foreign ownership in the housing market and to reduce the incremental risk to the economy posed by new borrowers. When asked why Canadian households have leveraged themselves so significantly over the past 20 years, most market commentators in Canada point to insufficient housing supply as the main driver of excessive house prices. Given normal ongoing demand for housing, they argue, persistent supply-side pressure on housing prices will naturally lead to a rising stock of debt relative to income. According to this narrative, the solution to Canada’s housing crisis is centered squarely on incentives to build more homes. Raising interest rates to cool mortgage demand will simply exacerbate the housing affordability problem, while simultaneously discouraging additional residential investment needed to decrease home prices structurally. Chart II-2The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... The Supply Of Non-Apartment Dwellings Has Indeed Declined Over Time... We hold a different perspective. We do agree that there are some limitations on the supply side that likely are unduly boosting prices of certain dwelling types. For example, the Greenbelt that surrounds Ontario’s Golden Horseshoe region - a permanently protected area of land - has likely constrained some housing activity, and Chart II-2 highlights that single detached, semi-detached, and row/townhouses have fallen significantly as a share of overall housing completions. Apartments and other dwellings now account for a clear majority of new housing construction in Canada. However, there is a great deal of evidence positioned against the view that supply-side factors are the primary cause of outsized housing inflation and, by extension, a massive increase in Canadian household debt to GDP: Based on real residential investment, the pace of housing construction in Canada has not fallen relative to GDP or the population. Chart II-3 highlights that, compared with the US, residential investment has trended higher over the past 20 years. Based on Canadian housing completion data, Chart II-4 highlights that the number of completions has generally kept pace with half of the change in Canada’s population, a ratio that is easily consistent with two or more people per household. In addition, the chart highlights that the periods when houses were completed at a below-average rate relative to population growth have not been the same as when Canadian household debt has increased relative to disposable income. Chart II-3...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population ...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population ...But Overall Real Residential Investment Has Kept Pace With Canada's GDP And Population Chart II-4Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Housing Supply Has Not Been The Main Driver Of Rising Canadian Indebtedness Chart II-5Prices For All Canadian Property Types Have Surged Over The Past Two Decades Prices For All Canadian Property Types Have Surged Over The Past Two Decades Prices For All Canadian Property Types Have Surged Over The Past Two Decades If the rise in Canadian household indebtedness has been caused by the increasing scarcity of single-detached, semi-detached, and row/townhouses, then we would expect to see a persistent and growing divergence between overall Canadian house prices and those of apartment/condominiums. Chart II-5 highlights that this is not the case: while apartment/condo prices have at times grown at a slower rate than overall home prices over the past 15 years (as in the period from 2011 to 2016), they have also at times grown at a faster rate. The chart clearly highlights that the Canadian housing market is driven by a common factor, and that average house price gains have not been significantly different across property types over time. Similarly, if a scarcity of housing supply was the main driver of rising house prices and household debt, we would not expect to see a significant increase in the homeownership rate. Chart II-6 highlights that the Canadian homeownership rate did rise substantially from the mid-1990s to 2016 (the last available datapoint). While it is not clear what the sustainable or “equilibrium” homeownership rate is, it is notable that the most recent datapoint was not significantly lower than the peak rate reached in the US following that country’s massive housing bubble. Finally, Chart II-7 reiterates a point we made in our June 2021 Special Report: in several economies (including Canada), interest rates have remained well below levels that macroeconomic theory would traditionally consider to be in equilibrium over the past two decades. This has occurred alongside significant household sector leveraging. Chart II-7Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Too-Low Interest Rates Have Fueled Rising Household Indebtedness In Canada (And Other DM Economies) Chart II-6The Canadian Homeownership Rate Has Risen Significantly, Pointing To Excess Housing Demand March 2022 March 2022     These factors strongly point to rising household debt levels as being driven by demand-side rather than supply-side factors – demand that has been fueled by persistently low interest rates. How High Can The Bank Of Canada Raise Interest Rates? Over the next 12 months, investors expect the Bank of Canada (BoC) to raise interest rates by 180 basis points, in line with the Fed (Chart II-8). Over the longer term, the BoC believes that interest rates will average between 1.75% and 2.75%. In the US, the 2/10 yield curve has flattened significantly in response to the Fed’s hawkish shift, and neither the explosion in headline consumer price inflation nor the Fed’s about face have significantly raised the market’s longer-term expectations for interest rates (which are even below the Fed’s estimates). In Canada, investors expect essentially the same long-term interest rate outlook, as evidenced by 5-year / 5-year forward government bond yields (Chart II-9). Chart II-8Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Investors Expect A Similar Magnitude Of Tightening In Canada And The US Over The Next Year... Chart II-9...And A Similar Average Interest Rate Over The Longer Term ...And A Similar Average Interest Rate Over The Longer Term ...And A Similar Average Interest Rate Over The Longer Term As in the case in the US, the hawkish shift among major central banks has left investors asking how high the BoC can raise interest rates, and what implications that might have for Canadian assets – especially the CAD and long-maturity Canadian government bonds. In our view, the best way for investors to assess the impact of rising interest rates on the private sector – especially a highly indebted one – is to project the impact that an increase in interest rates will have on the debt service ratio (DSR). The burden of servicing debt, rather than the stock of debt relative to income, is the right way to measure the impact of shifting monetary policy because it considers the combined effect of changes in leverage, income, and interest rates. The primary drawback of debt service ratio analysis is that the question of sustainability must be answered empirically. In countries experiencing an ever-rising debt service ratio, it can be difficult for investors to judge where the breaking point will be. Cross-country comparisons may sometimes be helpful in this respect, but Chart II-10 highlights that BIS estimates for household debt service ratios vary widely even among advanced economies. However, in Canada, the 2017-2019 tightening cycle provides a useful framework. As we anticipated in a 2017 Special Report,9 the rise in Canadian interest rates during that period caused the household debt service ratio to exceed the level reached in 2007, which contributed to a collapse in Canadian house price appreciation to its lowest level since the global financial crisis (Chart II-11). The decline in house prices during this period was also caused by the introduction of new macroprudential measures (particularly the introduction of a minimum qualifying rate for mortgages, more commonly referred to as a mortgage “stress test” rule), but the impact of higher interest rates was likely significant. Chart II-11The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices The Last Tightening Cycle In Canada Contributed Significantly To A Major Slowdown In Canadian House Prices Chart II-10Private Sector Debt Service Ratios Vary Significantly Across DM Countries Private Sector Debt Service Ratios Vary Significantly Across DM Countries Private Sector Debt Service Ratios Vary Significantly Across DM Countries   Chart II-11 highlights that the Canadian household debt service ratio collapsed during the pandemic, which seems to suggest that the Bank of Canada has ample room to raise interest rates. However, the decline in the DSR occurred not only because of falling interest rates, but also because of the significant excess savings amassed as a result of the pandemic. As in the US, excess savings in Canada were the result of reduced spending on services and the generation of significant excess income from government transfers (see Chart I-20 from Section 1 of this month’s report). These fiscal transfers will eventually disappear, implying that the Canadian household DSR is artificially low. Chart II-12 shows our estimate of the evolution of the overall Canadian household sector DSR based on the following assumptions: Mortgage rates rise in line with market expectations for the change in the policy rate Government transfers fall back to their pre-pandemic trend Disposable income growth ex-transfers grows in line with consensus expectations for nominal GDP growth The overall debt-to-disposable income ratio, using our estimate for total disposable income, remains flat. The chart highlights that the Canadian household sector DSR may exceed its pre-pandemic level next year, and that a 1.75% policy rate is the threshold at which the DSR will hit a new high. The implication of our projection is that the re-acceleration in household sector debt that has occurred during the pandemic, shown in Chart II-13, will again contribute to a significant slowdown in the Canadian housing market as the BoC begins to raise interest rates as in 2018/2019. It also implies that the prior peak in the Canadian policy rate probably reflects a high-end estimate of the neutral rate of interest in Canada. Chart II-12Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Market Expectations For The Canadian Policy Rate Imply A Record High Debt Burden Chart II-13Canadian Household Loan Growth Has Reaccelerated During The Pandemic Canadian Household Loan Growth Has Reaccelerated During The Pandemic Canadian Household Loan Growth Has Reaccelerated During The Pandemic   As we discuss below, this is likely to lead to significant implications for CAD-USD and an allocation to long-maturity Canadian government bonds, once investors begin to upwardly revise their expectations for the US neutral rate. Extreme Household Debt And Canadian Financial Stability The question of financial stability is often posed by investors when discussing Canada’s extreme household debt burden. Some investors view the US subprime financial crisis as the likely template for the Canadian economy, given the fact that the US credit bubble also focused on the housing market. Despite our pessimistic assessment of the capacity of the Canadian economy to tolerate higher interest rates (unlike the US today), we do not share the view that the Canadian financial system faces a potential insolvency risk, like the US banking system did in 2008. We see two potential arguments in favor of the instability view. The first is related to the sheer concentration of debt in Canada relative to other countries. Chart II-14 highlights that the median debt-to-income ratio of indebted Canadian households is currently the second highest in the world (after Norway) among the 29 countries that the OECD tracks. This concentration measure has worsened considerably since we published our 2017 Special Report. The combination of a very high average level of debt and extremely high leverage among those who are indebted suggests that Canadian banks may be exposed to significant credit losses in the event of a serious housing market crash. Chart II-14The Degree Of Concentration In Canadian Household Debt Is A Potential Financial Stability Risk March 2022 March 2022 Chart II-15A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning A Decline In The CMHC's Footprint In The Mortgage Insurance Market Is Also Concerning The second argument relates to the declining share of mortgages insured by the Canada Mortgage and Housing Corporation (CMHC). The CMHC is a Crown corporation that provides mortgage-default insurance to Canadian banks. Banks must purchase such insurance when a borrower’s loan-to-value ratio exceeds 80%. The CMHC has seen increased competition from two private mortgage insurers, and Chart II-15 highlights that the number of mortgages with CHMC insurance has been steadily falling over time. In order for the CMHC to be able to reduce systemic risk during a crisis, it must be present enough in the mortgage market to be able to replace private insurers in the event of a shock that causes them to leave the market. In effect, the CMHC should be able to act as a ballast to prevent a sharp tightening in Canadian mortgage lending standards and credit provision, which could occur if banks find themselves unable to purchase mortgage insurance to cover borrowers with relatively small down payments. In this respect, the reduced footprint of the CMHC is concerning. However, these risks have to be weighed against two key structural changes that legitimately lower the systemic risk facing the Canadian banking system (or lower the impact of a major adverse housing event). The first of these changes is the introduction of the minimum qualifying rate for mortgages in Canada (the mortgage stress test), which we regard as one of the most important macroprudential policies that Canada has enacted to reduce the systemic risk of rising household debt. The stress test rules – which apply to all borrowers – force mortgage borrowers to pass the CMHC’s gross debt and total debt service ratio thresholds under the assumption of higher interest rates than borrowers will actually pay: either the contracted mortgage rate plus 2 percentage points, or 5.65% – whichever is higher. Given prevailing mortgage rates in Canada, this effectively means that new borrowers will not exceed the CMHC’s debt service thresholds until the Bank of Canada’s policy rate exceeds 2.5%. That is positive from a financial stability perspective, although it does not rule out the slowdown in household spending that we would expect if the aggregate household debt service ratio hits a new high next year in response to BoC tightening. The second important risk-reducing structural change is a significant improvement in Canadian bank capital levels. Chart II-16 highlights that Tier 1 capital has risen significantly relative to risk-weighted assets for Canadian depository institutions, and is now on par with US levels (in contrast to a typically lower level over the past decade). The IMF stress tested Canadian banks in 2019, when capital levels were lower than they are today. They found that most Canadian banks would run down conservation capital buffers in the adverse economic scenario that they modeled, subjecting them to dividend restrictions for a period of time following the adverse event. However, Canadian banks would not breach their minimum capital requirements in the scenario modeled by the IMF, which involved a 40% decline in house prices and a 2% cumulative decline in Canadian real GDP over a two year period – which is essentially what occurred in the US and Canada in 2008 and 2009 (Chart II-17). Chart II-16Canadian Bank Capital Appears Sufficient To Weather A Storm Canadian Bank Capital Appears Sufficient To Weather A Storm Canadian Bank Capital Appears Sufficient To Weather A Storm Chart II-17The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis The IMF's Stress Tests Modeled A Repeat Of The 2008/2009 Crisis To conclude on the question of financial stability, it is clear that the magnitude and concentration of household debt implies that the impact of a serious housing market crash on the Canadian economy would be severe. But the fact that regulatory changes have occurred in recognition of this risk suggests that although a massive decline in Canadian house prices would cause a very severe recession, it would not likely precipitate a Lehman-style collapse of the Canadian financial system. Investment Conclusions Three conclusions emerge from our report. First, when considering the total experience of the past two decades, it is clear that the buildup of excessive household debt in Canada has occurred because of outsized demand for housing, not because of the impact of constrained housing supply on house prices. Outsized demand for housing has occurred because interest rates have been persistently below what traditional monetary policy rules such as the Taylor Rule would prescribe, pointing to the need for the Bank of Canada to tighten monetary policy in order to prevent even further leveraging. While US interest rates were also below what the Taylor Rule would have suggested for several years following the global financial crisis, the US household sector did not leverage itself significantly during that period because of the multi-year impact of the 2008/2009 financial crisis on US household balance sheets (Chart II-18). Canadian households did not suffer the same type of balance sheet impairment, and yet the Bank of Canada wrongly imported hyper-accommodative US monetary policy in an attempt to prevent a significant further increase in the exchange rate (which was still persistently strong for several years following the crisis). Through its actions, the Bank of Canada succeeded in staving off “Dutch Disease”, but at the cost of fueling a substantial housing and credit market bubble. Second, the fact that the Bank of Canada is likely to struggle to raise interest rates above 1.75% implies that a sizeable divergence may emerge between Canadian and US monetary policy over the coming few years if we are correct in our view that the US neutral rate is higher than the Fed currently expects. While such a divergence is not likely to occur over the coming year, Chart II-19 highlights that a 125 basis point policy rate spread – consistent with a nominal neutral rate of 1.75% in Canada and 3% in the US – last occurred in the mid-to-late 1990s, when CAD-USD ultimately declined to 0.65. Chart II-18The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble The Bank Of Canada Staved Off "Dutch Disease", At The Cost Of Fueling A Major Housing And Credit Bubble Chart II-19Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Some Potentially Large Downside For CAD If US Neutral Rate Expectations Move Higher Over the coming year, we expect Canadian dollar strength rather than weakness: we are generally bearish toward the US dollar on the expectation of above-trend global growth, and our fundamental intermediate-term model suggests that CAD should strengthen. Thus, while it is too early to short the Canadian dollar, we would be inclined to turn bearish in response to rising long-term US interest rate expectations. We would draw similar conclusions for Canadian government bonds: investors should raise exposure to long-dated Canadian government bonds versus similar maturity US Treasurys as the Bank of Canada raises its policy rate toward our estimate of the neutral rate. Chart II-20Relative ROE Justifies A Valuation Premium For Canadian Banks Relative ROE Justifies A Valuation Premium For Canadian Banks Relative ROE Justifies A Valuation Premium For Canadian Banks Finally, the improvements that have been made over the past several years to dampen the impact of a housing market crash on the Canadian financial system suggests that exposure to Canadian banks should not be reduced until hard evidence of a significant slowdown in the housing market emerges. Chart II-20 highlights that the valuation premium of Canadian banks appears to be supported by a sizeable ROE advantage relative to global banks. Panel 2 highlights how composite relative valuation indicator for Canadian banks suggests that they have been persistently expensive for some time, but not extremely so. Canadian banks would certainly underperform their global peers should the adverse scenario modeled by the IMF’s 2019 stress test of the banking system to occur, especially if it implied that Canadian banks would be forced to restrict dividends for a time to bolster capital adequacy. However, we would advise investors against shorting relatively high-yielding Canadian banks as Canadian interest rates rise, until they see clear signs of Canada-specific slowdown in housing demand in response to higher rates. Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Gabriel Di Lullo Research Associate III. Indicators And Reference Charts BCA’s equity indicators highlight that the “easy” money from expectations of an eventual end to the pandemic have already been made. Our valuation, and sentiment indicators remain very extended, highlighting that investors should expect positive but relatively modest returns from stocks over the coming 6-12 months. Our technical indicator has declined from extremely overbought levels in response to January’s US equity sell-off and Russia’s invasion of Ukraine, but it has not yet reached oversold territory. Still, we believe that the equity market’s reaction to rising bond yields is overdone, especially for value stocks. Forward equity earnings are pricing in a substantial further rise in earnings per share. Net earnings revisions and net positive earnings surprises have rolled over, but from extremely elevated levels and there is no meaningful sign yet of a decline in the level of forward earnings. Bottom-up analyst earning expectations remain too high, but stocks are still likely to be supported by robust revenue growth over the coming year. Within a global equity portfolio, we continue to recommend that investors position for the underperformance of financial assets that are negatively correlated with long-maturity government bond yields (such as growth stocks). The 10-Year Treasury Yield has broken convincingly above its 200-day moving average following the Fed’s hawkish shift, but remains below the fair value implied by our bond valuation index and the FOMC-implied fair value in a March 2022 rate hike scenario. We continue to expect that long-maturity bond yields will move higher over the coming year. Commodity prices remain elevated, and our composite technical indicator highlights that they remain overbought. An eventual slowdown in US goods spending, coupled with eventual supply-chain normalization, could weigh on commodity prices at some point over the coming 6-12 months. We are more comfortable with a bullish view towards industrial metals in the latter half of 2022. US and global LEIs have rolled over from very elevated levels. Our global LEI diffusion index has declined very significantly, but this likely reflects the outsized impact of a few emerging market countries. Still-strong leading and coincident indicators underscore that the global demand for goods is robust, and that output gaps are negative in many advanced economies because of very weak services spending. The latter will recover significantly at some point over the coming year, as the severity of the pandemic wanes. EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators Chart III-4US Stock Market Breadth US Stock Market Breadth US Stock Market Breadth Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging Chart III-36US Financial Conditions US Financial Conditions US Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Jonathan LaBerge, CFA Vice President The Bank Credit Analyst Footnotes 1     Please see BCA Special Alert "Russia Takes Ukraine: What Next?," dated February 24, 2022, available at bca.bcaresearch.com 2    Jennifer Hammond et al. “Oral Nirmatrelvir for High-Risk, Nonhospitalized Adults with Covid-19.” The New England Journal of Medicine, February 16, 2022. 3    Please see The Bank Credit Analyst "July 2021," dated June 24, 2021, available at bca.bcaresearch.com 4   Please see The Bank Credit Analyst "The Return To Maximum Employment: It May Be Faster Than You Think," dated August 26, 2021, available at bca.bcaresearch.com 5    Please see The Bank Credit Analyst "The Modern-Day Phillips Curve, Future Inflation, And What To Do About It," dated December 18, 2020, available at bca.bcaresearch.com 6    Please see Global Investment Strategy "Revisiting The Neutral Rate Of Interest: A Contrarian View In A Time Of Crisis," dated March 20, 2020, available at gis.bcaresearch.com 7    BCA Webcast Positioning For A Rate Hike Cycle, February 15, 2022. 8   For an explanation of why we add US nonfinancial noncorporate debt to the numerator of the US household sector debt to disposable income ratio when comparing Canada to the US, please see: “Reconciling Canadian-U.S. measures of household disposable income and household debt: Update”. 9    Please see Global Investment Strategy "Canada: A (Probably) Happy Moment In An Otherwise Sad Story," dated July 14, 2017, available at gis.bcaresearch.com

Executive Summary Risk Premium Abates, But Does Not Disappear Oil Risk Premium Abates, But Still Remains Oil Risk Premium Abates, But Still Remains The risk premium in crude oil and natural gas prices is abating, and we expect that to continue. In the immediate aftermath of Russia's invasion, Brent crude oil traded close to $105/bbl on Thursday. At the urging of China's Xi Jinping, Russian President Vladimir Putin suggested he is prepared to enter negotiations with Ukraine in Minsk to discuss the latter's neutrality. Whether Ukraine is amenable to negotiations framed in this manner remains to be seen. Nothing has changed in supply-demand balances for oil or natgas. Markets are tight, and more supply is needed. In this highly fluid situation, we project Brent crude oil will average $100.00/bbl in 1Q22; $90.30/bbl in 2Q22; $85.00/bbl in 3Q22; and $85.00/bbl in 4Q22 (see Chart). Our estimate for 2023 Brent averages $85.00/bbl. Upside risk dominates in the near term. We expect the Kingdom of Saudi Arabia (KSA), the United Arab Emirates (UAE), and Kuwait, the only members of OPEC 2.0 with the capacity to increase and sustain higher production, to lift output by 1.75mm b/d. The Iran nuclear deal likely gets a boost from the Russian invasion, which will hasten the return of ~ 1.0mm b/d of production in 2H22, perhaps sooner. We also expect the US, and possibly the OECD, to release strategic petroleum reserves, but, as typically is the case, this will have a fleeting impact on markets and pricing. These supply increases will return prices closer to our base case forecast, which we raise slightly to $85/bbl from 2H22 to end-2023. If we fail to see an increase in core-OPEC production, or the US shales, or if Iranian barrels are not returned to export markets, oil prices have a good chance of moving to $140/bbl, as can be seen in the accompanying Chart. Bottom Line: We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to oil and gas producers via the XOP ETF.  

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