Elections

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

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

Executive Summary China's Unemployment Questions From The Road Questions From The Road Over the past week we have been visiting clients along the US west coast. In this report we hit some of the highlights from the most important and frequently asked questions. Xi Jinping is seizing absolute power just as the country’s decades-long property boom turns to bust. He will stimulate the economy but Chinese stimulus is less effective than it used to be. The US and Israel are underscoring their red line against Iranian nuclear weaponization. If Iran does not freeze its nuclear program, the Middle East will begin to unravel again. The UK’s domestic instability is returning, with Scotland threatening to leave the union. Brexit, the pandemic, and inflation make a Scottish referendum a more serious risk than in the past. Shinzo Abe’s assassination makes him a martyr for a vision of Japan as a “normal country” – i.e. one that is not pacifist but capable of defending itself. Japan’s rearmament, like Germany’s, points to the decline of the WWII peace settlement and the return of great power competition. Bottom Line: Investors need a new global balance to be achieved through US diplomacy with Russia, China, and Iran. That is not forthcoming, as the chief nations face instability at home and a stagflationary global economy. Feature The world is becoming less stable as stagflation combines with great power competition. Global uncertainty is through the roof. From a macroeconomic perspective, investors need to know whether central banks can whip inflation without triggering a recession. From a geopolitical perspective, investors need to know whether Russia’s conflict with the West will expand, whether US-China and US-Iran tensions will escalate in a damaging way, and whether domestic political rotations in the US and China this fall will lead to more stable and productive economies. China: What Will Happen At The Communist Party Reshuffle? General Secretary Xi Jinping will cement another five-to-10 years in power while promoting members of his faction into key positions on the Politburo and Politburo Standing Committee. By December Xi will roll out a pro-growth strategy for 2023 and the government will signal that it will start relaxing Covid-19 restrictions. But China’s structural problems ensure that this good news for global growth will only have a fleeting effect. China’s governance is shifting from single-party rule to single-person rule. It is also shifting from commercially focused decentralization to national security focused centralization. Xi has concentrated power in himself, in the party, and in Beijing at the expense of political opponents, the private economy, and outlying regions like Hong Kong, the South China Sea, and Xinjiang. The subordination of Taiwan is the next major project, ensuring that China will ally with Russia and that the US and China cannot repair or deepen their economic partnership. Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Xi and the Communist Party began centralizing political power and economic control shortly after the Great Recession. At that time it became clear that a painful transition away from export manufacturing and close relations with the United States was necessary. The transition would jeopardize China’s long-term economic, social, political, and geopolitical stability. The Communist Party believed it needed to revive strongman leadership (autocracy) rather than pursuing greater liberalization that would ultimately increase the odds of political revolution (democratization). The Xi administration has struggled to manage the country’s vast debt bubble, given that total debt standing has surged to 287% of GDP. The global pandemic forced the government to launch another large stimulus package, which it then attempted to contain. Corporate and household deleveraging ensued. The property and infrastructure boom of the past three decades has stalled, as the regime has imposed liquidity and capital requirements on banks and property developers to try to avoid a financial crisis. Regulatory tightening occurred in other sectors to try to steer investment into government-approved sectors and reduce the odds of technological advancement fanning social dissent. China’s draconian “zero Covid” policy sought to limit the disease’s toll, improve China’s economic self-reliance, and eliminate the threat of social protest during the year of the twentieth party congress. But it also slammed the brakes on growth. China is highly vulnerable to social instability for both structural and cyclical reasons. Chinese social unrest was our number one “Black Swan” for this year and it is now starting to take shape in the form of angry mortgage owners across the country refusing to make mortgage payments on houses that were pre-purchased but not yet built and delivered (Chart 1). Chart 1China: Mortgage Payment Boycott Questions From The Road Questions From The Road The mortgage payment boycott is important because it is stemming from the outstanding economic and financial imbalance – the property sector – and because it is a form of cross-regional social organization, which the Communist Party will disapprove. There are other social protests emerging, including low-level bank runs, which must be monitored very closely. Local authorities will act quickly to stop the spread of the mortgage boycott. But unhappy homeowners will be a persistent problem due to the decline of the property sector and industry. China’s property sector looks uncomfortably like the American property sector ahead of the 2006-08 bust. Prices for existing homes are falling while new house prices are on the verge of falling (Chart 2). While mortgages only make up 15% of bank assets, and household debt is only 62% of GDP, households are no longer taking on new debt (Chart 3). Chart 2China's Falling Property Prices China's Falling Property Prices China's Falling Property Prices ​​​​​​ Chart 3China's Property Crisis China's Property Crisis China's Property Crisis ​​​​​​ Chart 4China's Unemployment China's Unemployment China's Unemployment Most likely China’s property sector is entering the bust phase that we have long expected – if not, then the reason will be a rapid and aggressive move by authorities to expand monetary and fiscal stimulus and loosen economic restrictions. That process of broad-based easing – “letting 100 flowers bloom” – will not fully get under way until after the party congress, say in December. Unemployment is rising across China as the economy slows, another point of comparison with the United States ahead of the 2008 property collapse (Chart 4). Unemployment is a manipulated statistic so real conditions are likely worse. There is no more important indicator. China’s government will be forced to ease policy, creating a positive impact on global growth in 2023, but the impact will be fleeting. Bottom Line: The underlying debt-deflationary context will prevail before long in China, weighing on global growth and inflation expectations on a cyclical basis. Middle East: Why Did Biden Go And What Will He Get? President Biden traveled to Israel and now Saudi Arabia because he wants Saudi Arabia and the Gulf Arab members of OPEC to increase oil production to reduce gasoline prices at the pump for Americans ahead of the midterm elections (Chart 5). Chart 5Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia True, fears of recession are already weighing on prices, but Biden embarked on this mission before the growth slowdown was fully appreciated and he is not going to lightly abandon the anti-inflation fight before the midterm election. Biden also went because one of his top foreign policy priorities – the renegotiation of the 2015 nuclear deal with Iran – is falling apart. The Iranians do not want to freeze their nuclear program because they want regime survival and security. While Biden is offering a return to the 2015 deal, the conditions that produced the deal are no longer applicable: Russia and China are not cooperating with the US and EU to isolate Iran. Russia is courting Iran, oil prices are high and sanction enforcement is weak (unlike 2015). The Iranians now know, after the Trump administration, that they cannot trust the Americans to give credible security guarantees that will last across parties and administrations. The war in Ukraine also underscores the weakness of diplomatic security guarantees as opposed to a nuclear deterrent. Hence the joint US and Israeli declaration that Iran will never be allowed to obtain nuclear weapons. The good news is that this kind of joint statement is precisely what needed to occur – the underscoring of the red line – to try to change Ayatollah Ali Khamenei’s calculus regarding his drive to achieve nuclear breakout. In 2015 Khamenei gave diplomacy a chance to try to improve the economy, stave off social unrest, prepare the way for his eventual leadership succession process, and secure the Islamic Republic. The bad news is that Khamenei probably cannot make the same decision this time, as the hawkish faction now runs his government, the Americans are unreliable, and Russia and China are offering an alternative strategic orientation. The Saudis will pump more oil if necessary to save the global business cycle but not at the beck and call of a US president. The drop in oil prices reduces their urgency. The Americans can reassure the Saudis and Israel as long as the deal with Iran is not going forward. That looks to be the case. But then the US and Israel will have to undertake joint actions to underline their threat to Iran – and Iran will have to threaten to stage attacks across the region so as to deter any attack. Bottom Line: If a US-Iran deal does not materialize at the last minute, Middle Eastern instability will revive and a new source of oil supply constraint will plague the global economy. We continue to believe a US-Iran deal is unlikely, with only 40% odds of happening. Europe: Will Russia Turn Back On The Natural Gas? Russia’s objective in cutting off European natural gas is to inflict a recession on Europe. It wants a better bargaining position on strategic matters. Therefore we assume Russia will continue to squeeze supplies from now through the winter, when European demand rises and Russian leverage will peak. If Russia allows some flow to return, then it will be part of the negotiating process and will not preclude another cutoff before winter. It is possible that Russia is merely giving Europe a warning and will revert back to supplying natural gas. The problem is that Russia’s purpose is to achieve a strategic victory in Ukraine and in negotiations over NATO’s role in the Nordic countries. Russia has not achieved these goals, so natural gas cutoff will likely continue. Russia also hopes that by utilizing its energy leverage – while it still has it – it will bring forward the economic pain of Europe’s transition away from reliance on Russian energy. In that case European countries will experience recession and households will begin to change their view of the situation. European governments will be more likely to change their policies, to become more pragmatic and less confrontational toward Russia. Or European governments will be voted out of power and do the same thing. Other states could join Hungary in saying that Europe should never impose a full natural gas embargo on Russia. Russia would be able to salvage some of its energy trade with Europe over the long run, despite the war in Ukraine and the inevitable European energy diversification. In recent months we highlighted Italy as the weakest link in the European chain and the country most likely to see such a shift in policy occur. Italy’s national unity coalition had lost its reason for being, while the combination of rising bond yields and natural gas prices weighed on the economy. The Italian bond spread over German bunds has long served as our indicator of European political stress – and it is spiking now, forcing the European Central Bank to rush to plan an anti-fragmentation strategy that would theoretically enable it to tighten monetary policy while preventing an Italian debt crisis (Chart 6). The European Union remains unlikely to break up – Russian aggression was always one of our chief arguments for why the EU would stick together. But Italy will undergo a recession and an election (due by June 2023 but that could easily happen this fall), likely producing a new government that is more pragmatic with regard to Russia so as to reduce the energy strain. Chart 6Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy’s political turmoil shows that European states are feeling the energy crisis and will begin to shift policies to reduce the burden on households. Households will lose their appetite for conflict with Russia on behalf of Ukrainians, especially if Russia begins offering a ceasefire after completing its conquest of the Donetsk area. If Russia expands its invasion, then Europe will expand sanctions and the risk of further strategic instability will go up. But most likely Russia will seek to quit while it is ahead and twist Europe’s arm into foisting a ceasefire onto Ukraine. Bottom Line: A change of government in Italy will increase the odds that the EU will engage in diplomacy with Russia in the coming year, if Russia offers, so as to reach a new understanding, restore natural gas flows, and salvage the economy. This would leave NATO enlargement unresolved but a shift in favor of a ceasefire in Ukraine in 2023 would be less negative for European assets and the euro. UK: Who Will Replace Boris Johnson? Last week UK Prime Minister Boris Johnson fell from power and now the Conservative Party is engaging in a leadership competition to replace him. We gave up on Johnson after he survived his no-confidence vote and yet it became clear that he could not recover in popular opinion. The inflation outburst destroyed his premiership and wiped away whatever support he had gained from executing Brexit. In fact it reinforced the faction that believed Brexit was the wrong decision. Going forward the UK will be consumed with domestic political turmoil as the cost of stagflation mounts, and geopolitical turmoil as Scotland attempts to hold a second independence referendum, possibly by October 2023. Global investors should focus primarily on Scotland’s attempt to secede, since the breakup of the United Kingdom would be a momentous historical event and a huge negative shock for pound sterling. While only 44.7% of Scots voted for independence in 2014, now they have witnessed Brexit, Covid-19, and stagflation, producing tailwinds for the Scots nationalist vote (Chart 7). Chart 7Forget Bojo's Exit, Watch Scotland Questions From The Road Questions From The Road There are still major limitations on Scotland exiting, since its national capabilities are limited, it would need to join the European Union, and Spain and possibly others will threaten to veto its membership in the European Union for fear of feeding their own secessionist movements. But any new referendum – including one done without the approval of Westminster – should be taken very seriously by investors. Bottom Line: Johnson’s removal will only marginally improve the Tories’ ability to manage the rebellion brewing in the north. A snap election that brings the Labour Party back into power would have a greater chance of keeping Scotland in the union, although it is not clear that such a snap election will happen in time to affect any Scottish decision. The UK faces economic and political turmoil between now and any referendum and investors should steer clear of the pound. (Though we still favor GBP over eastern European currencies). Britain will remain aggressive toward Russia but its ability to affect the Russian dynamic will fall, leaving the US and EU to decide the fate of Russian relations. Japan: What Is The Significance Of Shinzo Abe’s Assassination? Former Japanese Prime Minister Shinzo Abe was assassinated by a lone fanatic with a handmade gun. The significance of the incident is that Abe will become a martyr for a certain vision of Japan – his vision of Japan, which is that Japan can become a “normal country” that moves beyond the shackles of the guilt of its imperial aggression in World War II. A normal country is one that is economically stable and militarily capable of defending itself – not a pacifist country mired in debt-deflation. Abe stood for domestic reflation and a proactive foreign policy, along with the normalization of the Japanese Self-Defense Forces (JSDF). True, economic policy can become less dovish if necessary to deal with inflation. Some changes at the Bank of Japan may usher in a less dovish shift in monetary policy in particular. But monetary policy cannot become outright hawkish like it was before Abe. And Abe’s fiscal policy was never as loose as it was made out to be, given that he executed several hikes to the consumption tax. Japan’s structural demographic decline and large debt burden will continue to weigh on economic activity whenever real rates and the yen rise. The government will be forced to reflate using monetary and fiscal policy whenever deflation threatens to return. Debt monetization will remain an option for future Japanese governments, even if it is restrained during times of high inflation. Chart 8Shinzo Abe's Legacy Questions From The Road Questions From The Road ​​​​​​​ This is not only because Japanese households will become depressed if deflation is left unchecked but also because economic growth must be maintained in order to sustain the nation’s new and growing national defense budgets. Japan’s growing need for self defense stems from China’s strategic rise, Russia’s aggression, and North Korea’s nuclearization, plus uncertainty about the future of American foreign policy. These trends will not change anytime soon. Indeed the Liberal Democratic Party’s popularity has increased under Abe’s successor, Prime Minister Fumio Kishida, who will largely sustain Abe’s vision. The Diet still has a supermajority in favor of constitutional revision so as to enshrine the self-defense forces (Chart 8). And the de facto policy of rearmament continues even without formal revision. Bottom Line: Any Japanese leader who attempts to promote a hawkish BoJ, and a dovish JSDF, will fail sooner rather than later. The revolving door of prime ministers will accelerate. As Japan’s longest-serving prime minister, Shinzo Abe opened up the reliable pathway, which is that of a dovish BoJ and a hawkish foreign policy. This is important for the world, as well as Japan, because a more hawkish Japan will increase China’s fears of strategic containment. The frozen conflicts in Asia will continue to thaw, perpetuating the secular rise in geopolitical risk. We remain long JPY-KRW, since the BoJ may adjust in the short term and Chinese stimulus is still compromised, but that trade is on downgrade watch. Investment Takeaways Russia’s energy cutoff is aimed at pushing Europe into recession so as to force policy changes or government changes in Europe that will improve Russia’s position at the negotiating table over Ukraine, NATO, and other strategic disputes. Hence Russia is unlikely to increase the natural gas flow until it believes it has achieved its strategic aims and multiple veto players in the EU will prevent the EU from ever implementing a full-blown natural gas embargo. Chinese stimulus cannot be fully effective until it relaxes Covid-19 restrictions, likely beginning in December or next year when Xi Jinping uses his renewed political capital to try to stabilize the economy. However, China’s government powers alone are insufficient to prevent the debt-deflationary tendency of the property bust. The Middle East faces rising geopolitical tensions that will take markets by surprise with additional energy supply constraints. The implication is continued oil volatility given that global growth is faltering. Once global demand stabilizes, the Middle East’s turmoil will add to existing oil supply constraints to create new price pressures. The odds are not very high of the Federal Reserve achieving a “soft landing” in the context of a global energy shock and a stagflationary Europe and China.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com ​​​​​​​ Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar

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

Executive Summary Russia Squeezes EU Natural Gas Russia Squeezes EU Natural Gas Russia Squeezes EU Natural Gas Major geopolitical shocks tend to coincide with bear markets, so the market is getting closer to pricing this year’s bad news. But investors are not out of the woods yet. Russia is cutting off Europe’s natural gas supply ahead of this winter in retaliation to Europe’s oil embargo. Europe is sliding toward recession. China is reverting to autocratic rule and suffering a cyclical and structural downshift in growth rates. Only after Xi Jinping consolidates power will the ruling party focus exclusively on economic stabilization. The US can afford to take risks with Russia, opening up the possibility of a direct confrontation between the two giants before the US midterm election. A new strategic equilibrium is not yet at hand. Tactical Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 18.3% Bottom Line: Maintain a defensive posture in the third quarter but look for opportunities to buy oversold assets with long-term macro and policy tailwinds. Feature 2022 is a year of geopolitics and supply shocks. Global investors should remain defensive at least until the Chinese national party congress and US midterm election have passed. More fundamentally, an equilibrium must be established between Russia and NATO and between the US and Iran. Until then supply shocks will destroy demand. Checking Up On Our Three Key Views For 2022 Our three key views for the year are broadly on track: 1.  China’s Reversion To Autocracy: For ten years now, the fall in Chinese potential economic growth has coincided with a rise in neo-Maoist autocracy and foreign policy assertiveness, leading to capital flight, international tensions, and depressed animal spirits (Chart 1). Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Rising incomes provided legitimacy for the Communist Party over the past four decades. Less rapidly rising incomes – and extreme disparities in standards of living – undermine the party and force it to find other sources of public support. Fighting pollution and expanding the social safety net are positives for political stability and potentially for economic productivity. But converting the political system from single-party rule to single-person rule is negative for productivity. Mercantilist trade policy and nationalist security policy are also negative. China’s political crackdown, struggle with Covid-19, waning exports, and deflating property market have led to an abrupt slowdown this year. The government is responding by easing monetary, fiscal, and regulatory policy, though so far with limited effect (Chart 2). Economic policy will not be decisive in the third quarter unless a crash forces the administration to stimulate aggressively. Chart 1China's Slowdown Leads To Maoism, Nationalism China's Slowdown Leads To Maoism, Nationalism China's Slowdown Leads To Maoism, Nationalism ​​​​​​ Chart 2Chinese Policy Easing: Limited Effect So Far Chinese Policy Easing: Limited Effect So Far Chinese Policy Easing: Limited Effect So Far ​​​​​ Chart 3Nascent Rally In Chinese Shares Will Be Dashed Nascent Rally In Chinese Shares Will Be Dashed Nascent Rally In Chinese Shares Will Be Dashed Once General Secretary Xi Jinping secures another five-to-ten years in power at the twentieth national party congress this fall, he will be able to “let 100 flowers bloom,” i.e. ease policy further and focus exclusively on securing the economic recovery in 2023. But policy uncertainty will remain high until then. The party may have to crack down anew to ensure Xi’s power consolidation goes according to plan. China is highly vulnerable to social unrest for both structural and cyclical reasons. The US would jump to slap sanctions on China for human rights abuses. Hence the nascent recovery in Chinese domestic and offshore equities can easily be interrupted until the political reshuffle is over (Chart 3). If China’s economy stabilizes and a recession is avoided, investors will pile into the rally, but over the long run they will still be vulnerable to stranded capital due to Chinese autocracy and US-China cold war. If the Politburo and Politburo Standing Committee are stacked with members of Xi’s faction, as one should expect, then the reduction in policy uncertainty will only be temporary. Autocracy will lead to unpredictable and draconian policy measures – and it cannot solve the problem of a shrinking and overly indebted population. If the Communist Party changes course and stacks the Politburo with Xi’s factional rivals, to prevent China from going down the Maoist, Stalinist, and Putinist route, then global financial markets will cheer. But that outcome is unlikely. Hawkish foreign policy means that China will continue to increase its military threats against Taiwan, while not yet invading outright. Beijing has tightened its grip over Tibet, Xinjiang, and Hong Kong since 2008; Taiwan and the South China Sea are the only critical buffer areas that remain to be subjugated. Taiwan’s midterm elections, US midterms, and China’s party congress will keep uncertainty elevated. Taiwan has underperformed global and emerging market equities as the semiconductor boom and shortage has declined (Chart 4). Hong Kong is vulnerable to another outbreak of social unrest and government repression. Quality of life has deteriorated for the native population. Democracy activists are disaffected and prone to radicalization. Singapore will continue to benefit at Hong Kong’s expense (Chart 5). Chart 4Taiwan Equity Relative Performance Peaked Taiwan Equity Relative Performance Peaked Taiwan Equity Relative Performance Peaked ​​​​​​ Chart 5Hong Kong Faces More Troubles Hong Kong Faces More Troubles Hong Kong Faces More Troubles ​​​​​​ Chart 6Japan Undercuts China Japan Undercuts China Japan Undercuts China China and Japan are likely to engage in clashes in the East China Sea. Beijing’s military modernization, nuclear weapons expansion, and technological development pose a threat to Japanese security. The gradual encirclement of Taiwan jeopardizes Japan’s vital sea lines of communication. Prime Minister Fumio Kishida is well positioned to lead the Liberal Democratic Party into the upper house election on July 10 – he does not need to trigger a diplomatic showdown but he would not suffer from it. Meanwhile China is hungry for foreign distractions and unhappy that Japan is reviving its military and depreciating its currency (Chart 6). A Sino-Japanese crisis cannot be ruled out, especially if the Biden administration looks as if it will lose its nerve in containing China. Financial markets would react negatively, depending on the magnitude of the crisis. North Korea is going back to testing ballistic missiles and likely nuclear weapons. It is expanding its doctrine for the use of such weapons. It could take advantage of China’s and America’s domestic politics to stage aggressive provocations. South Korea, which has a hawkish new president who lacks parliamentary support, is strengthening its deterrence with the United States. These efforts could provoke a negative response from the North. Financial markets will only temporarily react to North Korean provocations unless they are serious enough to elicit military threats from Japan or the United States. China would be happy to offer negotiations to distract the Biden administration from Xi’s power grab. South Korean equities will benefit on a relative basis as China adds more stimulus. 2.  America’s Policy Insularity: President Biden’s net approval rating, at -15%, is now worse than President Trump’s in 2018, when the Republicans suffered a beating in midterm elections (Chart 7). Biden is now fighting inflation to try to salvage the elections for his party. That means US foreign policy will be domestically focused and erratic in the third quarter. Aside from “letting” the Federal Reserve hike rates, Biden’s executive options are limited. Pausing the federal gasoline tax requires congressional approval, and yet if he unilaterally orders tax collectors to stand down, the result will be a $10 billion tax cut – a drop in the bucket. Biden is considering waiving some of former President Trump’s tariffs on China, which he can do on his own. But doing so will hurt his standing in Rust Belt swing states without reducing inflation enough to get a payoff at the voting booth – after all, import prices are growing slower from China than elsewhere (Chart 8). He would also give Xi Jinping a last-minute victory over America that would silence Xi’s critics and cement his dictatorship at the critical hour. Chart 7Democrats Face Shellacking In Midterm Elections Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning ​​​​​​ Chart 8Paring Trump Tariffs Won't Reduce Inflation Much Paring Trump Tariffs Won't Reduce Inflation Much Paring Trump Tariffs Won't Reduce Inflation Much ​​​​​​ Chart 9Only OPEC Can Help Biden - And Help May Come Late Only OPEC Can Help Biden - And Help May Come Late Only OPEC Can Help Biden - And Help May Come Late Biden is offering to lift sanctions on Iran, which would free up 1.3 million barrels of oil per day. But Iran is not being forced to freeze its nuclear program by weak oil prices or Russian and Chinese pressure – quite the opposite. If Biden eases sanctions anyway, prices at the pump may not fall enough to win votes. Hence Biden is traveling to Saudi Arabia to make amends with Crown Prince Mohammed bin Salman. OPEC’s interest lies in producing enough oil to prevent a global recession, not in flooding the market on Biden’s whims to rescue the Democratic Party. Saudi and Emirati production may come but it may not come early in the third quarter. Lifting sanctions on Venezuela is a joke and Libya recently collapsed again (Chart 9). Even in dealing with Russia the Biden administration will exhibit an insular perspective. The US is not immediately threatened, like Europe, so it can afford to take risks, such as selling Ukraine advanced and long-range weapons and providing intelligence used to sink Russian ships. If Russia reacts negatively, a direct US-Russia confrontation will generate a rally around the flag that would help the Democrats, as it did under President John F. Kennedy in 1962 – one of the rare years in which the ruling party minimized its midterm election losses (Chart 10). The Cuban Missile Crisis counted more with voters than the earlier stock market slide. 3.  Petro-States’ Geopolitical Leverage: Oil-producing states have immense geopolitical leverage this year thanks to the commodity cycle. Russia will not be forced to conclude its assault on Ukraine until global energy prices collapse, as occurred in 2014. In fact Russia’s leverage over Europe will be greatly reduced in the coming years since Europe is diversifying away from Russian energy exports. Hence Moscow is cutting natural gas flows to Europe today while it still can (Chart 11). Chart 10Biden Can Afford To Take Risks With Russia Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning ​​​​​​ Chart 11Russia Squeezes EU's Natural Gas Russia Squeezes EU's Natural Gas Russia Squeezes EU's Natural Gas ​​​​​​ Chart 12EU/China Slowdown Will Weigh On World Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning Russia’s objective is to inflict a recession and cause changes in either policy or government in Europe. This will make it easier to conclude a favorable ceasefire in Ukraine. More importantly it will increase the odds that the EU’s 27 members, having suffered the cost of their coal and oil embargo, will fail to agree to a natural gas embargo by 2027 as they intend. Italy, for example, faces an election by June 2023, which could come earlier. The national unity coalition was formed to distribute the EU’s pandemic recovery funds. Now those funds are drying up, the economy is sliding toward recession, and the coalition is cracking. The most popular party is an anti-establishment right-wing party, the Brothers of Italy, which is waiting in the wings and can ally with the populist League, which has some sympathies with Russia. A recession could very easily produce a change in government and a more pragmatic approach to Moscow. The Italian economy is getting squeezed by energy prices and rising interest rates at the same time and cannot withstand the combination very long. A European recession or near-recession will cause further downgrades to global growth, especially when considering the knock-on effects in China, where the slowdown is more pronounced than is likely reported. The US economy is more robust but it will have to be very robust indeed to withstand a recession in Europe and growth recession in China (Chart 12). Russia does not have to retaliate against Finland and Sweden joining NATO until Turkey clears the path for them to join, which may not be until just before the Turkish general election due in June 2023. But imposing a recession on Europe is already retaliation – maybe a government change will produce a new veto against NATO enlargement. Russian retaliation against Lithuania for blocking 50% of its shipments to the Kaliningrad exclave is also forthcoming – unless Lithuania effectively stops enforcing the EU’s sanctions on Russian resources. Russia cannot wage a full-scale attack on the Baltic states without triggering direct hostilities with NATO since they are members of NATO. But it can retaliate in other ways. In a negative scenario Moscow could stage a small “accidental” attack against Lithuania to test NATO. But that would force Biden to uphold his pledge to defend “every inch” of NATO territory. Biden would probably do so by staging a proportionate military response or coordinating with an ally to do it. The target would be the Russian origin of attack or comparable assets in the Baltic Sea, the Black Sea, Ukraine, Belarus, or elsewhere. The result would be a dangerous escalation. Russia could also opt for cyber-attacks or economic warfare – such as squeezing Europe’s natural gas supply further. Ultimately Russia can afford to take greater risks than the US over Kaliningrad, other territories, and its periphery more broadly. That is the difference between Kennedy and Biden – the confrontation is not over Cuba. Russia is also likely to take a page out of Josef Stalin’s playbook and open a new front – not so much in Nicaragua as in the Middle East and North Africa. The US betrayal of the 2015 nuclear deal with Iran opens the opportunity for Russia to strengthen cooperation with Iran, stir up the Iranians’ courage, sell them weapons, and generate a security crisis in the Middle East. The US military would be distracted keeping peace in the Persian Gulf while the Europeans would lose their long-term energy alternative to Russia – and energy prices would rise. The Iranians – who also have leverage during a time of high oil prices – are not inclined to freeze their nuclear program. That would be to trade their long-term regime survival for economic benefits that the next American president can revoke unilaterally. Bottom Line: Xi Jinping is converting China back into an autocracy, the Biden administration lacks options and is willing to have a showdown with Russia, and the Putin administration is trying to inflict a European recession and political upheaval. Stay defensive. Checking Up On Our Strategic Themes For The 2020s As for our long-term themes, the following points are relevant after what we have learned in the second quarter: 1.  Great Power Rivalry: The war in Ukraine has reminded investors of the primacy of national security. In an anarchic international system, if a single great nation pursues power to the neglect of its neighbors’ interests, then its neighbors need to pursue power to defend themselves. Before long every nation is out for itself. At least until a new equilibrium is established. For example, Russia’s decision to neutralize Ukraine by force is driving Germany to abandon its formerly liberal policy of energy cooperation in order to reduce Russia’s energy revenues and avoid feeding its military ambitions. Russia in turn is reducing natural gas exports to weaken Europe’s economy this winter. Germany will re-arm, Finland and Sweden will eventually join NATO, and Russia will underscore its red line against NATO bases or forces in Finland and Sweden. If this red line is violated then a larger war could ensue. Chart 13China Will Shift To Russian Energy China Will Shift To Russian Energy China Will Shift To Russian Energy Until Russia and NATO come to a new understanding, neither Europe nor Russia can be secure. Meanwhile China cannot reject Russia’s turn to the east. China believes it may need to use force to prevent Taiwan independence at some point, so it must prepare for the US and its allies to treat it the same way that they have treated Russia. It must secure energy supply from Russia, Central Asia, and the Middle East via land routes that the US navy cannot blockade (Chart 13). Beijing must also diversify away from the US dollar, lest the Treasury Department freeze its foreign exchange reserves like it did Russia’s. Global investors will see diversification as a sign of China’s exit from the international order and preparation for conflict, which is negative for its economic future. However, the Russo-Chinese alliance presents a historic threat to the US’s security, coming close to the geopolitical nightmare of a unified Eurasia. The US is bound to oppose this development, whether coherently or not, and whether alone or in concert with its allies. After all, the US cannot offer credible security guarantees to negotiate a détente with China or Iran because its domestic divisions are so extreme that its foreign policy can change overnight. Other powers cannot be sure that the US will not suffer a radical domestic policy change or revolution that leads to belligerent foreign policy. Insecurity will drive the US and China apart rather than bringing them together. For example, Russia’s difficulties in Ukraine will encourage Chinese strategists to go back to the drawing board to adjust their plans for military contingencies in Taiwan. But the American lesson from Ukraine is to increase deterrence in Taiwan. That will provoke China and encourage the belief that China cannot wait forever to resolve the Taiwan problem. Until there is a strategic understanding between Russia and NATO, and the US and China, the world will remain in a painful and dangerous transitional phase – a multipolar disequilibrium. Chart 14Hypo-Globalization: Globalizing Less Than Potential Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning 2.  Hypo-Globalization: If national security rises to the fore, then economics becomes a tool of state power. Mercantilism becomes the basis of globalization rather than free market liberalism. Hypo-globalization is the result. The term is fitting because the trade intensity of global growth is not yet in a total free fall (i.e. de-globalization) but merely dropping off from its peaks during the phase of “hyper-globalization” in the 1990s and early 2000s (Chart 14). Hypo-globalization is probably a structural rather than cyclical phenomenon. The EU cannot re-engage with Russia and ease sanctions without rehabilitating Russia’s economy and hence its military capacity – which could enable Russia to attack Europe again. The US and China can try to re-engage but they will fail. Russo-Chinese alliance ensures that the US would be enriching not one but both of its greatest strategic rivals if it reopened its doors to Chinese technology acquisition and intellectual property theft. Iran will see its security in alliance with Russia and China. China has an incentive to develop Iran’s economy so as not to depend solely on Russia and Central Asia. Russia has an incentive to develop Iran’s military capacity so as to deprive Europe of an energy alternative. Both Russia and China wish to deprive the US of strategic hegemony in the Middle East. By contrast the US and EU cannot offer ironclad security guarantees to Iran because of its nuclear ambitions and America’s occasional belligerence. Thus the world can see expanding Russian and Chinese economic integration with Eurasia, and expanding American and European integration with various regions, but it cannot see further European integration with Russia or American integration with China. And ultimately Europe and China will be forced to sever links (Chart 15). Globalization will not cease – it is a multi-millennial trend – but it will slow down. It will be subordinated to national security and mercantilist economic theory. 3.  Populism/Nationalism: In theory, domestic instability can cause introversion or extroversion. But in practice we are seeing extroversion, which is dangerous for global stability (Chart 16). Chart 15Global Economic Disintegration Global Economic Disintegration Global Economic Disintegration ​​​​​​ Chart 16Internal Sources Of Nationalism Internal Sources Of Nationalism Internal Sources Of Nationalism ​​​​​​ Russia’s invasion of Ukraine derived from domestic Russian instability – and instability across the former Soviet space, including Belarus, which the Kremlin feared could suffer a color revolution after the rigged election and mass protests of 2020-21. The reason the northern European countries are rapidly revising their national defense and foreign policies to counter Russia is because they perceive that the threat to their security is driven by factors within the former Soviet sphere that they cannot easily remove. These factors will get worse as a result of the Ukraine war. Russian aggression still poses the risk of spilling out of Ukraine’s borders. China’s Maoist nostalgia and return to autocratic government is also about nationalism. The end of the rapid growth phase of industrialization is giving way to the Asian scourge: debt-deflation. The Communist Party is trying to orchestrate a great leap forward into the next phase of development. But in case that leap fails like the last one, Beijing is promoting “the great rejuvenation of the Chinese nation” and blaming the rest of the world for excluding and containing China. Taiwan, unfortunately, is the last relic of China’s past humiliation at the hands of western imperialists. China will also seek to control the strategic approach to Taiwan, i.e. the South China Sea. China’s claim that the Taiwan Strait is sovereign sea, not international waters, will force the American navy to assert freedom of passage. American efforts to upgrade Taiwan relations and increase deterrence will be perceived as neo-imperialism. The United States, for its part, could also see nationalism convert into international aggression. The US is veering on the brink of a miniature civil war as nationalist forces in the interior of the country struggle with the political establishment in the coastal states. Polarization has abated since 2020, as stagflation has discredited the Democrats. But it is now likely to rebound, making congressional gridlock all but inevitable. A Republican-controlled House will find a reason to impeach President Biden in 2023-24, in hopes of undermining his party and reclaiming the presidency. Another hotly contested election is possible, or worse, a full-blown constitutional crisis. American institutions proved impervious to the attempt of former President Trump and his followers to disrupt the certification of the Electoral College vote. However, security forces will be much more aggressive against rebellions of whatever stripe in future, which could lead to episodes in which social unrest is aggravated by police repression. If the GOP retakes the White House – especially if it is a second-term Trump presidency with a vendetta against political enemies and nothing to lose – then the US will return to aggressive foreign policy, whether directed at China or Iran or both. In short, polarization has contaminated foreign policy such that the most powerful country in the world cannot lead with a steady hand. Over the long run polarization will decline in the face of common foreign enemies but for now the trend vitiates global stability. Chart 17Germany And Japan Rearming Third Quarter Geopolitical Outlook: Thunder And Lightning Third Quarter Geopolitical Outlook: Thunder And Lightning It goes without saying that nationalism is also an active force in Iran, where 83-year-old Supreme Leader Ayatollah Khamenei is attempting to ensure the survival of his regime in the face of youthful social unrest and an unclear succession process. If Khamenei takes advantage of the commodity cycle, and American and Israeli disarray, he can make a mad dash for the bomb and try to achieve regime security. But if he does so then nationalism will betray him, since Israel and/or the US are willing to conduct air strikes to uphold the red line against nuclear weaponization. If any more proof of global nationalism is needed, look no further than Germany and Japan, the principal aggressors of World War II. Their pacifist foreign policies have served as the linchpins of the post-war international order. Now they are both pursuing rearmament and a more proactive foreign policy (Chart 17). Nationalism may be very nascent in Germany but it has clearly made a comeback in Japan, which exacerbates China’s fears of containment. The rise of nationalism in India is widely known and reinforces the trend. Bottom Line: Great power rivalry is intensifying because of Russia’s conflict with the West and China’s inability to reject Russia. Hypo-globalization is the result since EU-Russia and US-China economic integration cannot easily be mended in the context of great power struggle. Domestic instability in Russia, China, and the US is leading to nationalism and aggressive foreign policy, as leaders find themselves unwilling or unable to stabilize domestic politics through productive economic pursuits. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds (Chart 18). Chart 18BCA House View: Neutral Stocks Versus Bonds BCA House View: Neutral Stocks Versus Bonds BCA House View: Neutral Stocks Versus Bonds Geopolitical Strategy remains defensively positioned, favoring defensive markets and sectors, albeit with some exceptions that reflect our long-term views. Tactically stay long US 10-year Treasuries, large caps versus small caps, and defensives versus cyclicals. Stay long Mexico and short the UAE (Chart 19). Strategically stay long gold, US equities relative to global, and aerospace/defense sectors (Chart 20). Among currencies favor the USD, EUR, JPY, and GBP. Chart 19Stay Defensive In Q3 2022 Stay Defensive In Q3 2022 Stay Defensive In Q3 2022 ​​​​​​ Chart 20Stick To Long-Term Geopolitical Trades Stick To Long-Term Geopolitical Trades Stick To Long-Term Geopolitical Trades ​​​​​​ Chart 21Favor Semiconductors But Not Taiwan Favor Semiconductors But Not Taiwan Favor Semiconductors But Not Taiwan ​​​​​ Chart 22Indian Tech Will Rebound Amid China's Geopolitical Risks Indian Tech Will Rebound Amid China's Geopolitical Risks Indian Tech Will Rebound Amid China's Geopolitical Risks ​​​​​ Chart 23Overweight ASEAN Overweight ASEAN Overweight ASEAN Go long US semiconductors and semi equipment versus Taiwan broad market (Chart 21). While we correctly called the peak in Taiwanese stocks relative to global and EM equities, our long Korea / short Taiwan trade was the wrong way to articulate this view and remains deeply in the red. Similarly our attempt to double down on Indian tech versus Chinese tech was ill-timed. China eased tech regulations sooner than we expected. However, the long-term profile of the trade is still attractive and Chinese tech will still suffer from excessive government and foreign interference (Chart 22). Go long Singapore over Hong Kong, as Asian financial leadership continues to rotate (see Chart 5 above). Stay long ASEAN among emerging markets. We will also put Malaysia on upgrade watch, given recent Malaysian equity outperformance on the back of Chinese stimulus and growing western interest in alternatives to China (Chart 23).     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Inflationary Pressures To Fade Inflationary Pressures To Fade Inflationary Pressures To Fade The biggest problem for the European economy is surging inflation. Inflation has eroded household real disposable income and is hurting consumption. Inflation is set to roll over this summer, which should allow European economies to begin recovering in the fourth quarter of 2022. The ECB is likely to pause after exiting negative interest rates in Q3. European credit is becoming more attractive, but the risks to our view of European growth could still cause major problems for this asset class. Swiss stocks are vulnerable to a pullback relative to German ones. In France, President Emmanuel Macron is likely to get a legislative majority in June.     Bottom Line: European growth should recover after inflation rolls over this summer. The peak in inflation will allow the ECB to pause after its deposit rate gets to zero. Despite this positive view, the large risks hanging over Europe suggest prudence is still warranted.   European assets are rebounding in conjunction with the decline in risk aversion visible around global markets. The euro is catching a welcome bid too. However, as we wrote last week, while the conditions are falling in place to see a rally in Europe, too many risks continue to lurk in the background.  Therefore, we maintain our conservative approach to European markets, and we still recommend a defensive portfolio. Related Report  European Investment StrategyDon’t Be A Hero To shift to a less defensive stance, we want first to observe a peak in European inflation. Inflation represents the greatest problem for the European economy. If inflation continues to surge, the purchasing power of households will deteriorate further and the ECB will ratchet up its hawkish rhetoric, which will cause considerable mayhem in the European economy.   A Reprieve For Europe? Only when the income suppressing impact of inflation recedes will European growth strengthen. Chart 1Paying More For The Same Paying More For The Same Paying More For The Same Higher prices continue to hurt European consumption. As witnessed in the US, European retail sales are rising in nominal terms (Chart 1). However, households are not consuming more; they are spending more to purchase the same amount of goods, which is illustrated by the stagnation in retail sales volumes over the past twelve months. Households are not increasing the size of their consumption baskets, because their incomes are not keeping up with inflation. Unlike in the US, Eurozone households never saw their real disposable income spike during the pandemic because European governments focused on preserving jobs rather than distributing large handouts to households. As a result, European real disposable income began to lag its pre-pandemic trend (Chart 2). As the economy recovered, disposable income did not converge back to trend. Now that food and energy prices have spiked, the gap between real disposable income and its trend is only widening. Wages are not coming to the rescue either. The European labor market has been incapable of generating the same kind of wage growth that the US labor market has enjoyed. Even the recent uptick in negotiated wages is not as strong as it seems. German workers benefited from a one-off payment that caused wages to spike by 6.7%, elevating the Euro Area average to 2.8% from 1.6%. However, without that adjustment, German underlying wage growth fell from 3.9% to 1.6% (Chart 3), which means that the underlying European wage only rose by 2%. Chart 2Inflation Destroys Purchasing Power Inflation Destroys Purchasing Power Inflation Destroys Purchasing Power Chart 3Not As Strong As It Seems Not As Strong As It Seems Not As Strong As It Seems The distinction between one-off payments and underlying wages matters. As per Milton Friedman’s permanent income hypothesis, households are unlikely to shift their consumption pattern based on a temporary boost to income. They will save it, or in today’s case, use their one-off payment to cover their food and energy price increases. If today’s wage boost is not repeated, but inflation remains elevated, consumption will suffer. Europe’s tourism industry would be another major beneficiary from the peak in inflation. Prior to the pandemic, tourism contributed to 13%, 14% and 9% of the Italian, Spanish, and French economies, respectively. This sector was decimated during the pandemic after travel came to a halt. We are seeing positive signs emerge on this front. In the spring of 2021, nights spent at hotels were 80% below their spring 2019 levels for the Euro Area (Chart 4). As of March 2022, this variable is now between 15% and 30% below their March 2019 levels in Italy and France, respectively. Moreover, Google Mobility indices for the retail and recreation sectors have almost fully recovered (Chart 5). Thus, we can expect these trends to gather steam once inflation slows, because it will free up household disposable income. Europe’s periphery is particularly well placed to benefit from this eventual positive development. Chart 4Improving Tourism Sector Improving Tourism Sector Improving Tourism Sector Chart 5Mobility Pick-Up Mobility Pick-Up Mobility Pick-Up Positively, European inflation will peak soon. Commodity prices remain elevated, but commodity inflation has decelerated significantly. Hence, the commodity impulse is consistent with an imminent decline in Euro Area HICP (Chart 6). A simulation using BCA’s Commodity & Energy forecast for Brent, which also assumes that European natural gas prices will continue to hover around EUR100/MWh and that EUR/USD will hit 1.1 by year-end, confirms that energy inflation will swoon (Chart 7). Even if we assume a sudden surge in energy prices due to a Russian natural gas cutoff, energy inflation will recede in the second half of 2022 after spiking this summer. Chart 6Peak Inflation? Peak Inflation? Peak Inflation? Chart 7Beware The Russia Cutoff Risk Beware The Russia Cutoff Risk Beware The Russia Cutoff Risk Chart 8Less Pressure From The Consumer Of Last Resort Less Pressure From The Consumer Of Last Resort Less Pressure From The Consumer Of Last Resort Beyond the energy market, global forces also point toward a peak in European inflation in the coming months. The surge in US goods consumption over the past 24 months was felt globally and generated inflationary pressures in Europe as well. However, US durable goods consumption is declining (Chart 8). As a result, this important driver of European inflation will recede. Bottom Line: European consumption will not recover until inflation peaks. Without a deceleration in inflation, household disposable income will remain weak and consumers will remain careful. The good news is that European inflation is still on track to begin its descent this summer, which will boost the prospect for consumer spending and tourism. ECB Update: A Fall Pause? In a blog post last Monday, ECB president Christine Lagarde confirmed that the central bank will lift interest rates in July and will push the deposit rate to zero by September. Chart 9Too Much Priced In Too Much Priced In Too Much Priced In The economy is likely able to handle those two rate hikes. Our ECB monitor highlights the need to remove monetary accommodation in the Eurozone (Chart 9). Moreover, the German 2-/10-year yield curve has steepened this year, despite the hawkish shift in the ECB’s rhetoric, which confirms that monetary conditions are extremely accommodative. We expect the ECB to pause its rate hike campaign after exiting negative rates this fall to reassess economic conditions. Constraints on the ECB remain potent. If the central bank ignores these limiting factors, a policy mistake will ensue. Inflation is likely to decelerate by the end of the summer, which will undercut the hawks driving the consensus at the Governing Council today. Inflation is the factor pushing the ECB Monitor higher right now, not growth conditions (Chart 9, second panel). Thus, the case for lifting rates will weaken considerably when inflation slows. Growth is unlikely to have recovered enough by September to justify additional rate hikes after inflation slows. The expected improvement in consumption and household finances discussed earlier will be embryonic by the end of the summer and will not offer a clear case to lift rates further. Instead, the ECB will still have to juggle the tightening in financial conditions created by wider bond spreads in the European periphery and the impact of China’s slowdown on European exports. Meanwhile, capex is unlikely to strengthen meaningfully as long as global trade softens. As a result, we stay long the June 2023 Euribor futures. An extended pause after the September meeting will prevent the ECB from hiking rates as much as money markets expect over the coming twelve months (Chart 9, bottom panel). If the ECB goes ahead and continues to lift rates in the fall and early winter, the European economy will weaken considerably more and the previous rate hikes will have to be undone. Both scenarios are bullish for the June 2023 Euribor contract. Bottom Line: The ECB is likely to pause after pushing its deposit rate to zero in the third quarter in order to reassess economic conditions. Inflation is the main factor behind higher rates, and it will peak this summer. Meanwhile, the economy is still not strong enough to justify significantly higher interest rates. The market’s pricing in the ESTR curve is much too aggressive considering this context. Stay long June 2023 Euribor futures. Credit Update: Don’t Be A Hero Chart 10Cautious In Absolute Terms, Positive On Relative Performance Cautious In Absolute Terms, Positive On Relative Performance Cautious In Absolute Terms, Positive On Relative Performance Credit markets are experiencing a second episode of spread widening this year. The first episode was triggered by the invasion of Ukraine by Russia. The current one reflects strong inflation, weaker growth prospects, and the ECB’s policy shift. Year-to-date, European investment grade and high-yield corporate bond option-adjusted spreads have widened by 74bps and 188bps, respectively (Chart 10, top panel). As we wrote last week, if the global economic situation were to stabilize, then European assets would be a buy at current levels. This is especially true for European credit. Beyond attractive valuations, corporate bond issuers’ balance sheets are in good shape and the default risk is low.   However, the same risks that prevent us from being buyers of the euro and European stocks today also hang over the credit market. Specifically, a further deterioration of the energy flows between Russia and the EU and/or a policy mistake, whereby the ECB delivers the seven rate hikes priced in the overnight index swap market, would cause spreads to widen meaningfully from their current elevated levels. Therefore, we recommend investors remain on the sidelines and wait for a safer entry point over the coming weeks. Once inflation has peaked and stagflation/recession fears recede, then credit spreads will have ample room to narrow, especially if the ECB decides to pause after lifting the deposit rate to 0% (Chart 10, second panel). In the meantime, expected policy rate differentials are still supportive of an overweight on European credit relative to US credit (Chart 10, bottom panel). Bottom Line: European spreads are most likely peaking. However, the same risks that hang over EUR/USD and European equities prevent us from buying this asset class just yet. Swiss Stocks Are Getting Expensive Chart 11Swiss Stocks Getting Ahead Of Earnings Swiss Stocks Getting Ahead Of Earnings Swiss Stocks Getting Ahead Of Earnings The defensive Swiss market has greatly outperformed its Euro Area counterpart this year. However, the recent bout of Swiss outperformance has been completely dissociated from the trend in Swiss EPS relative to those of the Euro Area (Chart 11). Now, Swiss equities are particularly expensive and sport multiples 45% greater than the P/E ratio of the Eurozone MSCI benchmark. This bifurcation between the relative performance of Swiss stocks and their relative earnings represents a trading opportunity. Specifically, Swiss shares look vulnerable against German ones, which have been seriously beaten down in recent years. Chart 12Priced For The Apocalypse Priced For The Apocalypse Priced For The Apocalypse Swiss stocks have been re-rated on the back of many forces. First, the valuations of Swiss stocks relative to German ones have risen in tandem with the Eurozone’s headline and core inflation (Chart 12, top and second panel). Swiss relative valuations have also benefited from the significant tailwind created by higher 2-year rates in the Eurozone (Chart 12, third panel) and from the weakness in the euro (Chart 12, fourth panel). Finally, Swiss relative valuations seem to have already priced in a significant deterioration in European manufacturing activity, which would have lifted their appeal as a defensive play (Chart 12, bottom panel). We recommend selling Swiss stocks against German ones. We anticipate European inflation to peak this summer. Our ECB view is consistent with a decline in Germany’s 2-year bond yields. We also expect the euro to bottom and, even though we have written about a deterioration in European manufacturing activity, the recent explosion of Swiss multiples relative to German ones looks overdone. This trade may be seen as our first attempt to dip our toe into cyclical assets, even if we generally favor capital preservation over risk taking at this juncture. Bottom Line: The outperformance of Swiss equities is overextended and is already pricing in a dire outcome for European economies. Selling Swiss shares relative to German stocks is an attractive way to add tentatively some risk to a European portfolio. France Update: Likely Legislative Majority For Macron Chart 13French Polls Suggest Macron Will Get His Legislative Majority Looking Beyond Europe’s Inflation Peak Looking Beyond Europe’s Inflation Peak President Emmanuel Macron’s political party, Renaissance (previously En Marche!), may surprise to the upside in this year’s legislative election. An aggregate of recent polls (Chart 13) suggests that the presidential coalition (which includes Renaissance and its allies) will obtain between 295 and 340 seats in the Assemblée Nationale, more than the 289 seats needed to achieve a majority. The odds of seeing an historically low voter turnout should also play in the French president’s favor. Chart 14Favor French Small-Caps & Avoid Consumer Stocks Favor French Small-Caps & Avoid Consumer Stocks Favor French Small-Caps & Avoid Consumer Stocks Macron will not have to compromise to build a coalition in favor of his reform agenda, which bodes well for French productivity and trend growth. This election should not have an impact on French assets beyond that. We continue to recommend investors favor French small-caps, as they will benefit from an improvement in domestic consumer confidence and an eventual strengthening in the euro (Chart 14). Meanwhile, we still see more downside for French consumer stocks (Chart 14, bottom panel).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Editor/Strategist JeremieP@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates The neutral interest rate in Australia is lower than in past cycles, for several reasons: low potential growth, weak productivity, high household debt and inflated housing valuations. Interest rate markets are discounting a very aggressive monetary tightening cycle in Australia, with the RBA Cash Rate expected to reach 2.6% by end-2022 and 3.1% by end-2023. Australian inflation will peak in H2/2022, and the RBA will not need to raise rates beyond the midpoint of the RBA's estimated neutral range of 2-3%. The Australian dollar has not responded to rising interest rate expectations or high commodity prices, largely due to weak Chinese growth. The Aussie is cheap and has upside if China delivers more economic stimulus. The newly-elected Labor-led government will not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Expect modest fiscal stimulus, with increased spending, but also minor tax hikes for multinational corporations and high-income earners. Bottom Line: For global bond investors, an overweight allocation to Australian government bonds is warranted with the RBA likely to disappoint aggressive market rate hike expectations. For currency investors, the undervalued Australian dollar is an attractive play on an eventual rebound of Chinese growth. Feature The month of May has been eventful for investors in Australia. The Reserve Bank of Australia (RBA) delivered its first interest rate hike since 2010 on May 3, a move that markets had expected but which was much earlier than the RBA’s prior forward guidance. The May 21 federal election returned the Labor party to power for the first time since 2013. These events introduce new risks for the Australian economy and financial markets, altering a policy backdrop that had been highly stimulative - and, more importantly, highly predictable - during the pandemic but must now change in response to the new reality of high inflation. In this Special Report, jointly published by BCA Research Global Fixed Income Strategy, Foreign Exchange Strategy and Geopolitical Strategy, we discuss the investment implications of the start of the monetary tightening cycle and the new government in Australia. Our main conclusions: markets are somehow pricing in both too many RBA rate hikes and not enough currency upside for the Australian dollar, while expectations for major fiscal policy changes should be tempered. Will The RBA Kill The Economic Recovery? Australian government bonds have been one of the worst performers in the developed world so far in 2022 (Chart 1), delivering a total return of -9.1% in AUD terms, and -9% in USD-hedged terms, according to Bloomberg. The benchmark 10-year yield now sits at 3.20%, up +142bps since the start of the year but off the 8-year intraday high of 3.6% reached in early May. Australia has historically been a “high-beta” bond market that sees yields rise more when global bond yields are rising. That is a legacy of the days when the RBA had to push policy rates to levels that exceeded other major central banks like the Fed during global tightening cycles. But by the RBA’s own admission, the neutral policy interest rate is now lower than in previous years, perhaps no more than 0% in real terms according to RBA Governor Philip Lowe. Our RBA Monitor, which consists of economic and financial variables that typically correlate to pressure on the RBA to tighten or ease policy, has been signaling since mid-2021 that higher interest rates were increasingly likely (Chart 2). However, markets have moved to price in a very rapid and aggressive tightening, with a whopping 268bps of rate hikes discounted over the next year in the Australian overnight index swap (OIS) curve. Chart 1Australian Bond Yields Have Surged Vs Global Peers Australian Bond Yields Have Surged Vs Global Peers Australian Bond Yields Have Surged Vs Global Peers ​​​​​ Chart 2Markets Expect Very Aggressive RBA Tightening Markets Expect Very Aggressive RBA Tightening Markets Expect Very Aggressive RBA Tightening ​​​​​​ The growth component of the RBA Monitor will likely soon ease up with the OECD leading economic indicator for Australia in a clear downtrend (bottom panel). However, the inflation component of the RBA Monitor will stay elevated for longer given current high inflation - headline CPI inflation in Australia hit a 20-year high of 5.1% in Q1/2022 - and the tight Australian labor market. Even with those robust inflation pressures, markets are pricing in a peak level of interest rates that appears far more restrictive than the RBA is willing, and likely able, to deliver. We see three primary reasons for this. Weak Potential Growth Implies A Lower Neutral Rate The OIS curve is priced for the RBA Cash Rate staying between 3-4% over the next decade (Chart 3). The real policy rate (adjusted by CPI swap forwards as the proxy for inflation expectations), is expected to average around 1% over that same period. Those are the highest “terminal rate” estimates among the G10 economies. At the press conference following the May 3 rate hike, RBA Governor Lowe noted that “it’s not unreasonable to expect that the normalization of interest rates over the period ahead could see interest rates rise to 2.5%”. Lowe said that was the midpoint of the RBA’s 2-3% inflation target, thus the expected normalization of policy rates would take the inflation-adjusted real rate to 0%. That is a far cry from the more aggressive increase in real rates discounted in the Australian OIS and CPI swap curves. Lowe also noted that a real rate above 0% “over time […] would require stronger productivity growth in Australia.” On that front, the data is not suggesting that the RBA will need to reconsider its views on the neutral real interest rate anytime soon. The 5-year annualized growth rate of labor productivity is an anemic -0.8%, down from the mid-2010s peak of around 1.5% and far below the late-1990s peak of around 2.5% (Chart 4). Chart 3Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates ​​​​​ Chart 4A Powerful Structural Reason For A Lower Australian Neutral Rate A Powerful Structural Reason For A Lower Australian Neutral Rate A Powerful Structural Reason For A Lower Australian Neutral Rate ​​​​​ Chart 5The Australian Housing Cycle Is Peaking The Australian Housing Cycle Is Peaking The Australian Housing Cycle Is Peaking Assuming a pre-pandemic growth rate of the working age population of between 1-1.5%, and productivity around 0.5%, Australia’s potential GDP growth rate is, at best, around 2% (middle panel) and is likely even lower than that. The working-age population growth rate fell to 0% during the pandemic due to migration restrictions that have yet to be lifted. However, population growth had already been slowing pre-COVID due to falling birth rates and reduced worker visa caps in 2018-19. High Household Debt Raises Interest Rate Sensitivity Of Consumer Demand Sluggish trend growth is not the only reason why Australia’s neutral interest rate is lower than markets are discounting. Given elevated housing valuations and aggressive lending practices, highly indebted Australian households are now more sensitive to rate increases than in years past. Australian mortgage lenders began aggressively issuing shorter-term (typically 3-year) fixed rate mortgages in 2020 after the collapse in bond yields due to the initial COVID shock, to entice borrowers to lock in low interest rates. This raised the share of new fixed rate mortgages from a historic average around 15% of all new mortgages to nearly 50%. Since the RBA ended its yield curve control policy last November, which targeted 3-year bond yields, 3-year fixed mortgage rates have surged from 2.93% to 4.34%. That already has had an impact on housing demand - home price growth has peaked in the major cities according to CoreLogic, while building approvals are contracting on a year-over-year basis (Chart 5). As the surge of fixed rate mortgage loans begin to mature in 2023, Australian homeowners will see a major spike in refinancing costs, both for fixed rate and variable rate lending. This trend should weaken home demand, and house price inflation, even further. Inflation Will Soon Peak The RBA expects softer house price inflation to help slow overall Australian inflation rates. The central bank is projecting headline CPI inflation to fall from the latest 5.1% to 4.3% by June 2023 and 2.9% by June 2024 (Chart 6). That would still be a level near the top of the RBA target band, but the downtrend could be even faster than that. As in many other countries, the latest surge in Australian inflation has been led by a rapid increase in goods prices related to severe demand/supply mismatches at a time of global supply chain bottlenecks. Australian goods inflation hit an 31-year high of 6.6% in Q1/2022, essentially matching the housing component of the CPI index (Chart 7). Yet with US goods inflation having already peaked, as have global shipping costs, it is likely that Australia goods inflation will soon follow suit. This will lower headline Australian inflation to levels more consistent with services inflation, which reached 3% in Q1/2022. Chart 6The RBA Sees Persistent Above-Target Inflation The RBA Sees Persistent Above-Target Inflation The RBA Sees Persistent Above-Target Inflation That floor in more domestically-driven services inflation will also be influenced by the pace of wage growth in Australia. The latest reading on the best wage indicator Down Under, the Wage Price Index, showed that year-over-year wage growth only reached 2.4% in Q1/2022. Chart 7Australia Goods Inflation Should Soon Peak Australia Goods Inflation Should Soon Peak Australia Goods Inflation Should Soon Peak ​​​​​ This is a surprisingly low outcome given the tightness of the Australian labor market with the unemployment rate at an all-time low of 3.9% (Chart 8). Depressed labor supply is not a factor keeping the unemployment rate low, as the labor force participation rate and hours worked are both above pre-pandemic levels. Prior to the rate hike at the May 3 policy meeting, the RBA had been highlighting soft wage growth as a reason to delay the start of the monetary tightening cycle. After the May meeting, RBA Governor Lowe noted that according to the RBA’s “liaison” surveys of Australian businesses, nearly 40% of respondents said they were giving wage increases above 3%. The RBA believes that wage growth in the 3-4% range is consistent with Australian inflation remaining within the RBA’s 2-3% target band, a condition that was deemed necessary before rate hikes could begin. The message from the RBA liaison surveys was enough to trigger the start of the tightening cycle. While the Australia OIS curve is priced for an aggressive series of rate hikes, and shorter-term interest rate expectations are elevated, there is less inflationary concern priced into medium-term inflation expectations. The 5-year/5-year forward Australia CPI swap is at 2.2%, down -15bps since the start of 2022 and barely within the RBA target band. Some of that is a global factor – the 5-year/5-year forward US TIPS breakeven has declined by -44bps over just the past month. However, the Australia 5-year/5-year forward CPI swap peaked at the start of the year, just as Australian interest rate expectations began to ratchet higher (the 2-year Australia government bond yield was 0.35% at the start of 2022 and now sits at 2.61%). An increasing amount of discounted rate hikes, occurring alongside falling inflation expectations, is a sign that markets are incrementally pricing in a restrictive monetary policy. We agree with RBA Governor Lowe’s assessment that the neutral nominal Cash Rate is, at best, 2.5%. Thus, the current discounted peak in the Cash Rate of 3.2% would be restrictive. Very strong consumer spending growth at a time when inflation was already high could be a sign that a restrictive monetary stance is now necessary. However, the outlook for Australian consumption is not without risks. Consumer confidence has plunged alongside declining purchasing power, as wage growth has lagged the inflation upturn (Chart 9). While the expectation is that inflation will peak and wage growth will pick up over the latter half of 2022, it is still uncertain if the relative moves will be large enough to give a meaningful lift to real wage growth and consumer spending power. Chart 8Medium-Term Inflation Expectations Falling, Despite Low Unemployment Medium-Term Inflation Expectations Falling, Despite Low Unemployment Medium-Term Inflation Expectations Falling, Despite Low Unemployment ​​​​​​ Chart 9Headwinds For The Australian Consumer Headwinds For The Australian Consumer Headwinds For The Australian Consumer ​​​​​​ The RBA believes that consumer spending will be supported by the high level of savings, with the household saving rate currently at 13.6%. Yet the high level of household debt means that debt service burdens will rise as interest rates move higher, which may limit the degree to which Australian consumers run down savings to fuel greater consumer spending. Another reason why a more restrictive monetary policy could be needed is if there was a substantial loosening of fiscal policy that was fueling faster growth, especially at a time when inflation was already overshooting. This makes an analysis of the latest election results highly relevant to the path of Australian interest rates. Bottom Line: Markets are pricing in a shift to a restrictive level of interest rates in Australia, an outcome that is not necessary with inflation set to peak at a time of high household leverage. Labor Party Takes Power With Limited Political Capital Australia’s federal election on May 21 brought a Labor Party government into power, headed by new Prime Minister Anthony Albanese. National policy is unlikely to change substantially. Australia has low political risk but high geopolitical risk – meaning that domestic politics are manageable for investors but China’s conflict with the West and other geopolitical events are revolutionizing Australia’s place in the world. The previous Liberal-National Coalition government had been in power since 2013, had never found a stable leader, and had been buffeted by a series of external shocks: a commodity bust, China trade conflict, the COVID-19 pandemic, and inflation. Hence it is no surprise that Labor came back to power – it almost did so in 2019. However, Labor’s popularity is questionable. The new government does not have a robust political mandate: Labor will fall short of a single-party majority (or will have a very thin majority at best): As we go to press, Labor won 74 seats out of 151 in the House of Representatives. A party needs 76 seats for a majority. Labor will likely rely on three Green Party seats and some of the 10 independents to pass legislation. These minor parties will have considerable influence. Labor’s popular vote share is underwhelming: Labor won 32.8% of the popular vote, down from 33.3% in 2019, and beneath the 36% of the vote won by the outgoing Liberal-National Coalition (Table 1). The Green Party rose to 12% of the vote. While this only translates to three seats in parliament, the Greens will hold the balance of power. Table 1Australian Federal Election Results, 2022 The New Normal In Australia The New Normal In Australia Labor does not control the Senate: A bill requires a majority vote in both the House and Senate for passage. A majority requires 38 seats, but Labor and the Greens are currently slated to fall short at 36 seats. Hence, as in the House, the Labor Party will rely on “cross-bench” votes from minor parties to get a majority for bills. Labor won through pragmatism and moderation: Having suffered a surprise defeat in 2019, the Labor Party adopted a more moderate and pragmatic tone in the current election. Prime Minister Albanese campaigned on a motto of “safe change,” declared that he was “not woke,” and adopted a relatively hawkish tilt on trade and foreign policy (China relations) and immigration (“boat people”). Labor has limited room for maneuver in international relations: China’s economy is slowing down and stimulus does not work as well as it used to. China’s political system is reverting to autocracy and the Xi Jinping administration is attempting to carve a sphere of influence in the region, increasing long-term security threats to Australia in Southeast Asia and the Pacific Islands. China has declared a “no limits” strategic partnership with a belligerent Russia, leaving the US no option but to pursue containment strategy against both powers. Prime Minister Albanese has already met with President Biden and the Quadrilateral Dialogue to emphasize Australia’s need to counter China’s newly assertive foreign policy. While Albanese may attempt to reduce trade tensions with China, any such moves will be heavily constrained. Inflation, not climate change, brought Labor to power: The media is hailing the election as a historic shift on the question of climate change and climate policy. But popular opinion has not changed much on this topic in recent years and the election results only partially support the thesis. A better explanation is that the pandemic and its inflationary aftermath galvanized opposition to the ruling Liberal-National Coalition. Hence both fiscal policy and climate policy – the most important areas of change – will be constrained by inflation. Chart 10Australia Cannot Cut Defense Amid China Challenge The New Normal In Australia The New Normal In Australia There are two key policy takeaways from the above assessment: First, on fiscal policy, the new Labor-led government will face limitations due to inflation and the macroeconomic cycle. It will likely respond to inflation – the crisis that got it elected – even though China’s slowdown will produce negative surprises for global and Australian growth. The government will not be able to cut defense spending given the geopolitical setting (Chart 10). That means it will also not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Tax hikes are coming for multinational corporations and high-income earners. In terms of the size of the fiscal impact, the Labor Party promised spending increases worth AUD$18.9 billion (1.0% of GDP), to be offset by tax hikes amounting to AUD$11.5 billion in new revenue (0.6% of GDP). The result would be an AUD$7.5 billion increase in the budget deficit (0.4% of GDP) – a net fiscal stimulus (Chart 11). Currently the IMF projects a 1.84% fiscal drag in the cyclically adjusted budget deficit for 2023, so Labor’s plans would reduce that drag by 0.4%. However, the fiscal plans will change once the new Treasurer James Chalmers produces a new budget proposal in October. Comparison with a like-minded economy is therefore useful to put the policy change into perspective. Canada’s politics shifted from center-right to center-left in 2015 and the left-leaning government at that time put forward an agenda similar to Australia’s Labor Party today. Ultimately the budget balance declined from 0.17% to -0.45% of GDP from peak to trough (Chart 12). This 0.62% of GDP stimulus provides a point of comparison. Yet inflation was not a constraint on government spending at that time. The new Australian government may not exceed that size of stimulus in an inflationary context. But it could easily surpass it if the global economy falls back into recession. Chart 11Australian Labor’s Proposed Fiscal Stimulus The New Normal In Australia The New Normal In Australia ​​​​​​ Chart 12Canada Offers Clue To Size Of Australian Stimulus The New Normal In Australia The New Normal In Australia ​​​​​​ Second, on climate policy, the new ruling coalition probably will pass major climate legislation, given the importance of Greens and left-leaning independents. But Labor will have to constrain the smaller parties’ climate ambitions to preserve popular support in areas where fossil fuel industries remain strong. Australia consumes substantially more carbon per capita than other developed economies and will continue to rely on fossil fuel exports for growth. In other words, climate policy will bring incremental rather than radical change. Bottom Line: If a global recession is avoided, then the new government’s counter-cyclical fiscal policies may work. If not, they will produce a double whammy for the Australian economy: new corporate and resource taxes on top of a slowdown in exports. The AUD As A Shock Absorber Despite a higher repricing of the interest rate curve in Australia, and elevated commodity prices, the Australian dollar (AUD) has been very soft. Part of the story is broad-based US dollar strength that has sapped any potential rebound in the AUD. More specifically, a survey of the key drivers of the AUD unveils the main source of currency weakness, by process of elimination: The divergence in monetary policy between the RBA and the Fed? No. Clearly, that has not been a driver this time around as the RBA is expected to lift rates to 3.2% over the next 12 months, in line with market pricing for rate hikes from the Federal Reserve. The commodity cycle? No. Commodity prices are softening, after being in a supply-driven bull market. As a premier resource producer, the Australian economy is intricately intertwined with the outlook for coal, iron ore, copper and even liquefied natural gas prices. As Chart 13 highlights, the AUD has massively deviated from the level implied by rising terms of trade for Australia. This is a departure from a historical correlation that has been in place since the end of the Bretton Woods system. Resource booms tend to be either demand or supply driven, or a combination of both. This time around supply restrictions have played a major role. The message from the AUD is that it responds much better to improving demand conditions. Global and relative growth dynamics? YES: The overarching driver of a weak AUD as hinted above has been slowing Chinese demand. The Zero COVID-19 policy in China has led to a drastic reduction in import volumes. This is hurting Australia’s external balance at the margin, as Chinese import volumes contract (Chart 14). Chart 13The AUD Has Lagged Terms Of Trade The AUD Has Lagged Terms Of Trade The AUD Has Lagged Terms Of Trade ​​​​​ Chart 14The AUD Is Very Sensitive To China The AUD Is Very Sensitive To China The AUD Is Very Sensitive To China There are two key takeaways from the above analysis. First, the hawkish path for interest rates priced for the RBA is not yet reflected in a weak AUD. This implies that currency and bond markets are on a collision course. Either the RBA ratifies market pricing and triggers a coiled spring rebound in the AUD, or hawkish expectations will be tempered as inflationary pressures moderate. Second, the AUD will be very sensitive to any improvement in Chinese demand, the overarching driver of currency weakness. We expect the Chinese authorities to ramp up credit stimulus, to offset weakening demand from the Zero COVID-19 policy. The AUD has historically been very sensitive to changes in Chinese money and credit variables (Chart 15). From a fundamental perspective, a lot of pessimism is embedded in the Aussie dollar. Australian GDP has already recovered above pre-pandemic levels and could be on a path to achieve escape velocity if China recovers. Chinese fiscal and monetary policy should be eased going forward. Chinese bond yields have already dropped, reflecting an easing in domestic financial conditions. Meanwhile, Australia’s commodity exposure is well suited for a green energy shift. Besides being relatively competitive in supplying the types of raw materials that China needs and wants, (higher-grade ore, which is more expensive, but pollutes less, and is in high demand in China), Australia is a big exporter of liquefied natural gas, whose prices have been soaring in recent months and is critical in the Russia-Ukraine conflict and green energy shift (Chart 16). This will provide a multi-year tailwind for Australian export volumes and terms of trade. Chart 15The Chinese Economy Could Be Bottoming The Chinese Economy Could Be Bottoming The Chinese Economy Could Be Bottoming ​​​​​ Chart 16Australia Is Resource Superstar Australia Is Resource Superstar Australia Is Resource Superstar ​​​​​ Bottom Line: BCA Research Foreign Exchange Strategy went long AUD at 72 cents. In the near term, this position could prove quite volatile as markets try to discern a clear path for global growth. But given cheap valuations and beaten down sentiment, it should prove profitable in the longer term. Investment Conclusions For Fixed Income Investors Chart 17Australian Government Bond Investment Recommendations Australian Government Bond Investment Recommendations Australian Government Bond Investment Recommendations Our careful analysis of Australian growth, inflation, the RBA’s likely next moves leads us to the following investment conclusions for Australian bonds (Chart 17): Maintain neutral duration exposure within dedicated Australian bond portfolios (for now): On a forward basis, the entire Australian yield curve is converging to that discounted 3.5% peak in the Cash Rate (top panel). Eventually, Australian bond yields will fall once inflation clearly peaks in H2/2022 and markets realize that the RBA will not be hiking as fast as expected, justifying an above-benchmark duration tilt. Until then, Australian bond yields will be rangebound, especially with the RBA no longer buying bonds via quantitative easing, leaving more bond issuance to be absorbed by private investors. Underweight Australian inflation-linked bonds versus nominal-paying government bonds: Inflation will soon peak, and the discounted RBA stance is too hawkish – a recipe for lower inflation breakevens. Overweight Australian government bonds within global bond portfolios: Australia has returned to its “high-yield-beta” status, which means that an overweight stance is warranted when global bond yields are stable or falling. BCA Research Global Fixed Income Strategy’s Global Duration Indicator, a growth-focused leading indicator of the momentum of global bond yields, is signalling a more stable backdrop for global yields over the rest of 2022. The Duration Indicator is also a fine leading indicator of the relative return performance of Australian government bonds (middle panel) and is supportive of an overweight stance on Australian debt. Go Long December 2022 Australia Bank Bill futures: This is a tactical trade (i.e. investment horizon of no more than six months), based on the extreme pricing of rate hikes by year-end. The market price of the December 2022 futures contract is currently 97.11, or an implied interest rate of 2.89% compared to the current RBA Cash Rate of 0.35%. That contract is priced for far too many rate hikes than will be delivered over the remaining seven RBA meetings of 2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Chief Foreign Exchange Strategist ChesterN@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com

Executive Summary Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates The neutral interest rate in Australia is lower than in past cycles, for several reasons: low potential growth, weak productivity, high household debt and inflated housing valuations. Interest rate markets are discounting a very aggressive monetary tightening cycle in Australia, with the RBA Cash Rate expected to reach 2.6% by end-2022 and 3.1% by end-2023. Australian inflation will peak in H2/2022, and the RBA will not need to raise rates beyond the midpoint of the RBA's estimated neutral range of 2-3%. The Australian dollar has not responded to rising interest rate expectations or high commodity prices, largely due to weak Chinese growth. The Aussie is cheap and has upside if China delivers more economic stimulus. The newly-elected Labor-led government will not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Expect modest fiscal stimulus, with increased spending, but also minor tax hikes for multinational corporations and high-income earners. Bottom Line: For global bond investors, an overweight allocation to Australian government bonds is warranted with the RBA likely to disappoint aggressive market rate hike expectations. For currency investors, the undervalued Australian dollar is an attractive play on an eventual rebound of Chinese growth. Feature The month of May has been eventful for investors in Australia. The Reserve Bank of Australia (RBA) delivered its first interest rate hike since 2010 on May 3, a move that markets had expected but which was much earlier than the RBA’s prior forward guidance. The May 21 federal election returned the Labor party to power for the first time since 2013. These events introduce new risks for the Australian economy and financial markets, altering a policy backdrop that had been highly stimulative - and, more importantly, highly predictable - during the pandemic but must now change in response to the new reality of high inflation. In this Special Report, jointly published by BCA Research Global Fixed Income Strategy, Foreign Exchange Strategy and Geopolitical Strategy, we discuss the investment implications of the start of the monetary tightening cycle and the new government in Australia. Our main conclusions: markets are somehow pricing in both too many RBA rate hikes and not enough currency upside for the Australian dollar, while expectations for major fiscal policy changes should be tempered. Will The RBA Kill The Economic Recovery? Australian government bonds have been one of the worst performers in the developed world so far in 2022 (Chart 1), delivering a total return of -9.1% in AUD terms, and -9% in USD-hedged terms, according to Bloomberg. The benchmark 10-year yield now sits at 3.20%, up +142bps since the start of the year but off the 8-year intraday high of 3.6% reached in early May. Australia has historically been a “high-beta” bond market that sees yields rise more when global bond yields are rising. That is a legacy of the days when the RBA had to push policy rates to levels that exceeded other major central banks like the Fed during global tightening cycles. But by the RBA’s own admission, the neutral policy interest rate is now lower than in previous years, perhaps no more than 0% in real terms according to RBA Governor Philip Lowe. Our RBA Monitor, which consists of economic and financial variables that typically correlate to pressure on the RBA to tighten or ease policy, has been signaling since mid-2021 that higher interest rates were increasingly likely (Chart 2). However, markets have moved to price in a very rapid and aggressive tightening, with a whopping 268bps of rate hikes discounted over the next year in the Australian overnight index swap (OIS) curve. Chart 1Australian Bond Yields Have Surged Vs Global Peers Australian Bond Yields Have Surged Vs Global Peers Australian Bond Yields Have Surged Vs Global Peers ​​​​​ Chart 2Markets Expect Very Aggressive RBA Tightening Markets Expect Very Aggressive RBA Tightening Markets Expect Very Aggressive RBA Tightening ​​​​​​ The growth component of the RBA Monitor will likely soon ease up with the OECD leading economic indicator for Australia in a clear downtrend (bottom panel). However, the inflation component of the RBA Monitor will stay elevated for longer given current high inflation - headline CPI inflation in Australia hit a 20-year high of 5.1% in Q1/2022 - and the tight Australian labor market. Even with those robust inflation pressures, markets are pricing in a peak level of interest rates that appears far more restrictive than the RBA is willing, and likely able, to deliver. We see three primary reasons for this. Weak Potential Growth Implies A Lower Neutral Rate The OIS curve is priced for the RBA Cash Rate staying between 3-4% over the next decade (Chart 3). The real policy rate (adjusted by CPI swap forwards as the proxy for inflation expectations), is expected to average around 1% over that same period. Those are the highest “terminal rate” estimates among the G10 economies. At the press conference following the May 3 rate hike, RBA Governor Lowe noted that “it’s not unreasonable to expect that the normalization of interest rates over the period ahead could see interest rates rise to 2.5%”. Lowe said that was the midpoint of the RBA’s 2-3% inflation target, thus the expected normalization of policy rates would take the inflation-adjusted real rate to 0%. That is a far cry from the more aggressive increase in real rates discounted in the Australian OIS and CPI swap curves. Lowe also noted that a real rate above 0% “over time […] would require stronger productivity growth in Australia.” On that front, the data is not suggesting that the RBA will need to reconsider its views on the neutral real interest rate anytime soon. The 5-year annualized growth rate of labor productivity is an anemic -0.8%, down from the mid-2010s peak of around 1.5% and far below the late-1990s peak of around 2.5% (Chart 4). Chart 3Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates Markets Priced For A Restrictive Level Of Australian Rates ​​​​​ Chart 4A Powerful Structural Reason For A Lower Australian Neutral Rate A Powerful Structural Reason For A Lower Australian Neutral Rate A Powerful Structural Reason For A Lower Australian Neutral Rate ​​​​​ Chart 5The Australian Housing Cycle Is Peaking The Australian Housing Cycle Is Peaking The Australian Housing Cycle Is Peaking Assuming a pre-pandemic growth rate of the working age population of between 1-1.5%, and productivity around 0.5%, Australia’s potential GDP growth rate is, at best, around 2% (middle panel) and is likely even lower than that. The working-age population growth rate fell to 0% during the pandemic due to migration restrictions that have yet to be lifted. However, population growth had already been slowing pre-COVID due to falling birth rates and reduced worker visa caps in 2018-19. High Household Debt Raises Interest Rate Sensitivity Of Consumer Demand Sluggish trend growth is not the only reason why Australia’s neutral interest rate is lower than markets are discounting. Given elevated housing valuations and aggressive lending practices, highly indebted Australian households are now more sensitive to rate increases than in years past. Australian mortgage lenders began aggressively issuing shorter-term (typically 3-year) fixed rate mortgages in 2020 after the collapse in bond yields due to the initial COVID shock, to entice borrowers to lock in low interest rates. This raised the share of new fixed rate mortgages from a historic average around 15% of all new mortgages to nearly 50%. Since the RBA ended its yield curve control policy last November, which targeted 3-year bond yields, 3-year fixed mortgage rates have surged from 2.93% to 4.34%. That already has had an impact on housing demand - home price growth has peaked in the major cities according to CoreLogic, while building approvals are contracting on a year-over-year basis (Chart 5). As the surge of fixed rate mortgage loans begin to mature in 2023, Australian homeowners will see a major spike in refinancing costs, both for fixed rate and variable rate lending. This trend should weaken home demand, and house price inflation, even further. Inflation Will Soon Peak The RBA expects softer house price inflation to help slow overall Australian inflation rates. The central bank is projecting headline CPI inflation to fall from the latest 5.1% to 4.3% by June 2023 and 2.9% by June 2024 (Chart 6). That would still be a level near the top of the RBA target band, but the downtrend could be even faster than that. As in many other countries, the latest surge in Australian inflation has been led by a rapid increase in goods prices related to severe demand/supply mismatches at a time of global supply chain bottlenecks. Australian goods inflation hit an 31-year high of 6.6% in Q1/2022, essentially matching the housing component of the CPI index (Chart 7). Yet with US goods inflation having already peaked, as have global shipping costs, it is likely that Australia goods inflation will soon follow suit. This will lower headline Australian inflation to levels more consistent with services inflation, which reached 3% in Q1/2022. Chart 6The RBA Sees Persistent Above-Target Inflation The RBA Sees Persistent Above-Target Inflation The RBA Sees Persistent Above-Target Inflation That floor in more domestically-driven services inflation will also be influenced by the pace of wage growth in Australia. The latest reading on the best wage indicator Down Under, the Wage Price Index, showed that year-over-year wage growth only reached 2.4% in Q1/2022. Chart 7Australia Goods Inflation Should Soon Peak Australia Goods Inflation Should Soon Peak Australia Goods Inflation Should Soon Peak ​​​​​ This is a surprisingly low outcome given the tightness of the Australian labor market with the unemployment rate at an all-time low of 3.9% (Chart 8). Depressed labor supply is not a factor keeping the unemployment rate low, as the labor force participation rate and hours worked are both above pre-pandemic levels. Prior to the rate hike at the May 3 policy meeting, the RBA had been highlighting soft wage growth as a reason to delay the start of the monetary tightening cycle. After the May meeting, RBA Governor Lowe noted that according to the RBA’s “liaison” surveys of Australian businesses, nearly 40% of respondents said they were giving wage increases above 3%. The RBA believes that wage growth in the 3-4% range is consistent with Australian inflation remaining within the RBA’s 2-3% target band, a condition that was deemed necessary before rate hikes could begin. The message from the RBA liaison surveys was enough to trigger the start of the tightening cycle. While the Australia OIS curve is priced for an aggressive series of rate hikes, and shorter-term interest rate expectations are elevated, there is less inflationary concern priced into medium-term inflation expectations. The 5-year/5-year forward Australia CPI swap is at 2.2%, down -15bps since the start of 2022 and barely within the RBA target band. Some of that is a global factor – the 5-year/5-year forward US TIPS breakeven has declined by -44bps over just the past month. However, the Australia 5-year/5-year forward CPI swap peaked at the start of the year, just as Australian interest rate expectations began to ratchet higher (the 2-year Australia government bond yield was 0.35% at the start of 2022 and now sits at 2.61%). An increasing amount of discounted rate hikes, occurring alongside falling inflation expectations, is a sign that markets are incrementally pricing in a restrictive monetary policy. We agree with RBA Governor Lowe’s assessment that the neutral nominal Cash Rate is, at best, 2.5%. Thus, the current discounted peak in the Cash Rate of 3.2% would be restrictive. Very strong consumer spending growth at a time when inflation was already high could be a sign that a restrictive monetary stance is now necessary. However, the outlook for Australian consumption is not without risks. Consumer confidence has plunged alongside declining purchasing power, as wage growth has lagged the inflation upturn (Chart 9). While the expectation is that inflation will peak and wage growth will pick up over the latter half of 2022, it is still uncertain if the relative moves will be large enough to give a meaningful lift to real wage growth and consumer spending power. Chart 8Medium-Term Inflation Expectations Falling, Despite Low Unemployment Medium-Term Inflation Expectations Falling, Despite Low Unemployment Medium-Term Inflation Expectations Falling, Despite Low Unemployment ​​​​​​ Chart 9Headwinds For The Australian Consumer Headwinds For The Australian Consumer Headwinds For The Australian Consumer ​​​​​​ The RBA believes that consumer spending will be supported by the high level of savings, with the household saving rate currently at 13.6%. Yet the high level of household debt means that debt service burdens will rise as interest rates move higher, which may limit the degree to which Australian consumers run down savings to fuel greater consumer spending. Another reason why a more restrictive monetary policy could be needed is if there was a substantial loosening of fiscal policy that was fueling faster growth, especially at a time when inflation was already overshooting. This makes an analysis of the latest election results highly relevant to the path of Australian interest rates. Bottom Line: Markets are pricing in a shift to a restrictive level of interest rates in Australia, an outcome that is not necessary with inflation set to peak at a time of high household leverage. Labor Party Takes Power With Limited Political Capital Australia’s federal election on May 21 brought a Labor Party government into power, headed by new Prime Minister Anthony Albanese. National policy is unlikely to change substantially. Australia has low political risk but high geopolitical risk – meaning that domestic politics are manageable for investors but China’s conflict with the West and other geopolitical events are revolutionizing Australia’s place in the world. The previous Liberal-National Coalition government had been in power since 2013, had never found a stable leader, and had been buffeted by a series of external shocks: a commodity bust, China trade conflict, the COVID-19 pandemic, and inflation. Hence it is no surprise that Labor came back to power – it almost did so in 2019. However, Labor’s popularity is questionable. The new government does not have a robust political mandate: Labor will fall short of a single-party majority (or will have a very thin majority at best): As we go to press, Labor won 74 seats out of 151 in the House of Representatives. A party needs 76 seats for a majority. Labor will likely rely on three Green Party seats and some of the 10 independents to pass legislation. These minor parties will have considerable influence. Labor’s popular vote share is underwhelming: Labor won 32.8% of the popular vote, down from 33.3% in 2019, and beneath the 36% of the vote won by the outgoing Liberal-National Coalition (Table 1). The Green Party rose to 12% of the vote. While this only translates to three seats in parliament, the Greens will hold the balance of power. Table 1Australian Federal Election Results, 2022 The New Normal In Australia The New Normal In Australia Labor does not control the Senate: A bill requires a majority vote in both the House and Senate for passage. A majority requires 38 seats, but Labor and the Greens are currently slated to fall short at 36 seats. Hence, as in the House, the Labor Party will rely on “cross-bench” votes from minor parties to get a majority for bills. Labor won through pragmatism and moderation: Having suffered a surprise defeat in 2019, the Labor Party adopted a more moderate and pragmatic tone in the current election. Prime Minister Albanese campaigned on a motto of “safe change,” declared that he was “not woke,” and adopted a relatively hawkish tilt on trade and foreign policy (China relations) and immigration (“boat people”). Labor has limited room for maneuver in international relations: China’s economy is slowing down and stimulus does not work as well as it used to. China’s political system is reverting to autocracy and the Xi Jinping administration is attempting to carve a sphere of influence in the region, increasing long-term security threats to Australia in Southeast Asia and the Pacific Islands. China has declared a “no limits” strategic partnership with a belligerent Russia, leaving the US no option but to pursue containment strategy against both powers. Prime Minister Albanese has already met with President Biden and the Quadrilateral Dialogue to emphasize Australia’s need to counter China’s newly assertive foreign policy. While Albanese may attempt to reduce trade tensions with China, any such moves will be heavily constrained. Inflation, not climate change, brought Labor to power: The media is hailing the election as a historic shift on the question of climate change and climate policy. But popular opinion has not changed much on this topic in recent years and the election results only partially support the thesis. A better explanation is that the pandemic and its inflationary aftermath galvanized opposition to the ruling Liberal-National Coalition. Hence both fiscal policy and climate policy – the most important areas of change – will be constrained by inflation. Chart 10Australia Cannot Cut Defense Amid China Challenge The New Normal In Australia The New Normal In Australia There are two key policy takeaways from the above assessment: First, on fiscal policy, the new Labor-led government will face limitations due to inflation and the macroeconomic cycle. It will likely respond to inflation – the crisis that got it elected – even though China’s slowdown will produce negative surprises for global and Australian growth. The government will not be able to cut defense spending given the geopolitical setting (Chart 10). That means it will also not be able to pursue its ambitious social and environmental agenda without finding more revenue to offset the inflationary impact of larger budget deficits. Tax hikes are coming for multinational corporations and high-income earners. In terms of the size of the fiscal impact, the Labor Party promised spending increases worth AUD$18.9 billion (1.0% of GDP), to be offset by tax hikes amounting to AUD$11.5 billion in new revenue (0.6% of GDP). The result would be an AUD$7.5 billion increase in the budget deficit (0.4% of GDP) – a net fiscal stimulus (Chart 11). Currently the IMF projects a 1.84% fiscal drag in the cyclically adjusted budget deficit for 2023, so Labor’s plans would reduce that drag by 0.4%. However, the fiscal plans will change once the new Treasurer James Chalmers produces a new budget proposal in October. Comparison with a like-minded economy is therefore useful to put the policy change into perspective. Canada’s politics shifted from center-right to center-left in 2015 and the left-leaning government at that time put forward an agenda similar to Australia’s Labor Party today. Ultimately the budget balance declined from 0.17% to -0.45% of GDP from peak to trough (Chart 12). This 0.62% of GDP stimulus provides a point of comparison. Yet inflation was not a constraint on government spending at that time. The new Australian government may not exceed that size of stimulus in an inflationary context. But it could easily surpass it if the global economy falls back into recession. Chart 11Australian Labor’s Proposed Fiscal Stimulus The New Normal In Australia The New Normal In Australia ​​​​​​ Chart 12Canada Offers Clue To Size Of Australian Stimulus The New Normal In Australia The New Normal In Australia ​​​​​​ Second, on climate policy, the new ruling coalition probably will pass major climate legislation, given the importance of Greens and left-leaning independents. But Labor will have to constrain the smaller parties’ climate ambitions to preserve popular support in areas where fossil fuel industries remain strong. Australia consumes substantially more carbon per capita than other developed economies and will continue to rely on fossil fuel exports for growth. In other words, climate policy will bring incremental rather than radical change. Bottom Line: If a global recession is avoided, then the new government’s counter-cyclical fiscal policies may work. If not, they will produce a double whammy for the Australian economy: new corporate and resource taxes on top of a slowdown in exports. The AUD As A Shock Absorber Despite a higher repricing of the interest rate curve in Australia, and elevated commodity prices, the Australian dollar (AUD) has been very soft. Part of the story is broad-based US dollar strength that has sapped any potential rebound in the AUD. More specifically, a survey of the key drivers of the AUD unveils the main source of currency weakness, by process of elimination: The divergence in monetary policy between the RBA and the Fed? No. Clearly, that has not been a driver this time around as the RBA is expected to lift rates to 3.2% over the next 12 months, in line with market pricing for rate hikes from the Federal Reserve. The commodity cycle? No. Commodity prices are softening, after being in a supply-driven bull market. As a premier resource producer, the Australian economy is intricately intertwined with the outlook for coal, iron ore, copper and even liquefied natural gas prices. As Chart 13 highlights, the AUD has massively deviated from the level implied by rising terms of trade for Australia. This is a departure from a historical correlation that has been in place since the end of the Bretton Woods system. Resource booms tend to be either demand or supply driven, or a combination of both. This time around supply restrictions have played a major role. The message from the AUD is that it responds much better to improving demand conditions. Global and relative growth dynamics? YES: The overarching driver of a weak AUD as hinted above has been slowing Chinese demand. The Zero COVID-19 policy in China has led to a drastic reduction in import volumes. This is hurting Australia’s external balance at the margin, as Chinese import volumes contract (Chart 14). Chart 13The AUD Has Lagged Terms Of Trade The AUD Has Lagged Terms Of Trade The AUD Has Lagged Terms Of Trade ​​​​​ Chart 14The AUD Is Very Sensitive To China The AUD Is Very Sensitive To China The AUD Is Very Sensitive To China There are two key takeaways from the above analysis. First, the hawkish path for interest rates priced for the RBA is not yet reflected in a weak AUD. This implies that currency and bond markets are on a collision course. Either the RBA ratifies market pricing and triggers a coiled spring rebound in the AUD, or hawkish expectations will be tempered as inflationary pressures moderate. Second, the AUD will be very sensitive to any improvement in Chinese demand, the overarching driver of currency weakness. We expect the Chinese authorities to ramp up credit stimulus, to offset weakening demand from the Zero COVID-19 policy. The AUD has historically been very sensitive to changes in Chinese money and credit variables (Chart 15). From a fundamental perspective, a lot of pessimism is embedded in the Aussie dollar. Australian GDP has already recovered above pre-pandemic levels and could be on a path to achieve escape velocity if China recovers. Chinese fiscal and monetary policy should be eased going forward. Chinese bond yields have already dropped, reflecting an easing in domestic financial conditions. Meanwhile, Australia’s commodity exposure is well suited for a green energy shift. Besides being relatively competitive in supplying the types of raw materials that China needs and wants, (higher-grade ore, which is more expensive, but pollutes less, and is in high demand in China), Australia is a big exporter of liquefied natural gas, whose prices have been soaring in recent months and is critical in the Russia-Ukraine conflict and green energy shift (Chart 16). This will provide a multi-year tailwind for Australian export volumes and terms of trade. Chart 15The Chinese Economy Could Be Bottoming The Chinese Economy Could Be Bottoming The Chinese Economy Could Be Bottoming ​​​​​ Chart 16Australia Is Resource Superstar Australia Is Resource Superstar Australia Is Resource Superstar ​​​​​ Bottom Line: BCA Research Foreign Exchange Strategy went long AUD at 72 cents. In the near term, this position could prove quite volatile as markets try to discern a clear path for global growth. But given cheap valuations and beaten down sentiment, it should prove profitable in the longer term. Investment Conclusions For Fixed Income Investors Chart 17Australian Government Bond Investment Recommendations Australian Government Bond Investment Recommendations Australian Government Bond Investment Recommendations Our careful analysis of Australian growth, inflation, the RBA’s likely next moves leads us to the following investment conclusions for Australian bonds (Chart 17): Maintain neutral duration exposure within dedicated Australian bond portfolios (for now): On a forward basis, the entire Australian yield curve is converging to that discounted 3.5% peak in the Cash Rate (top panel). Eventually, Australian bond yields will fall once inflation clearly peaks in H2/2022 and markets realize that the RBA will not be hiking as fast as expected, justifying an above-benchmark duration tilt. Until then, Australian bond yields will be rangebound, especially with the RBA no longer buying bonds via quantitative easing, leaving more bond issuance to be absorbed by private investors. Underweight Australian inflation-linked bonds versus nominal-paying government bonds: Inflation will soon peak, and the discounted RBA stance is too hawkish – a recipe for lower inflation breakevens. Overweight Australian government bonds within global bond portfolios: Australia has returned to its “high-yield-beta” status, which means that an overweight stance is warranted when global bond yields are stable or falling. BCA Research Global Fixed Income Strategy’s Global Duration Indicator, a growth-focused leading indicator of the momentum of global bond yields, is signalling a more stable backdrop for global yields over the rest of 2022. The Duration Indicator is also a fine leading indicator of the relative return performance of Australian government bonds (middle panel) and is supportive of an overweight stance on Australian debt. Go Long December 2022 Australia Bank Bill futures: This is a tactical trade (i.e. investment horizon of no more than six months), based on the extreme pricing of rate hikes by year-end. The market price of the December 2022 futures contract is currently 97.11, or an implied interest rate of 2.89% compared to the current RBA Cash Rate of 0.35%. That contract is priced for far too many rate hikes than will be delivered over the remaining seven RBA meetings of 2022.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor Chief Foreign Exchange Strategist ChesterN@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com

Executive Summary Indian Voter’s Economic Miseries Are Ascendant Indian Voter's Economic Miseries Are Ascendant Indian Voter's Economic Miseries Are Ascendant India has a strong strategic geopolitical position but is likely to face turbulence in the short term. This is because India remains expensive, and investors worry if the record political stability shown by India since 2014 can last. We highlight that the ruling Bhartiya Janata Party (BJP) may lose some seats in the near term. India’s most populous states could witness a few cases of social conflict as economic miseries grow. India may also temporarily resort to a degree of fiscal populism. But the BJP will be able to hold power for a third consecutive term in 2024, that too with a simple majority. The burst of fiscal populism will be temporary. Moreover, the next tier of India’s most populous states are well-positioned to drive India’s growth story in the long run. We urge investors to tactically short India / long Brazil financials given that India may see some turbulence in the short run. Strategic investors should consider long India tech / short China tech. Trade Recommendation Inception Date Return SHORT INDIA / LONG BRAZIL FINANCIALS 2022-02-10 12.5% Bottom Line: The ruling political party in India may face some political setbacks in the short term. It could even resort to fiscal populism. But the ruling party in a base case, should be able to retain power for a third term in 2024. On a tactical timeframe we advise caution on India but remain constructive on a strategic horizon. Feature The woods are lovely, dark and deep, But I have promises to keep, And miles to go before I sleep, And miles to go before I sleep. – Robert Frost, Stopping By Woods On A Snowy Evening (New Hampshire, 1923)   The protagonist in this famous poem is overwhelmed by the beauty of the wintry woods, but then must stay vigilant about the here and now. The situation that confronts an investor into India today, is surprisingly similar. India has a strong strategic geopolitical position, a position that has strengthened following the Ukraine war. However, Indian markets might face turbulence in the short term. This is because India remains expensive and its ability to keep promises (about high degrees of political stability or about its fiscal discipline) could be tested on a tactical time horizon. In specific, investors with exposure to India worry about three politico-economic challenges: The Anti-Incumbency Challenge Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em 13 September 2013 is a key date in India’s modern history. On this day the Bhartiya Janata Party (BJP) announced Narendra Modi as BJP’s prime ministerial (PM) candidate just a few months ahead of the 2014 general elections. From 13 September 2013 till date, MSCI India has incidentally outperformed MSCI EM by a resounding 94.8%. In 2013, markets celebrated the rise of the Modi-led BJP government since such a dispensation was new, and it promised to deliver structural reform. But now when general elections will be held in 2024, the BJP must deal with a middling report card on reforms and a two-term anti-incumbency to boot. Given this clients worry if 2024 could see India go back to an era of coalition governments? The Fiscal Challenge India under BJP has displayed impressive degrees of fiscal discipline. With rising inflation now adding to Indian voters’ miseries and with a loaded state election calendar due in 2023, investors ask if India’s notable streak of fiscal fortitude can last? The Demographics Challenge As China’s weak demographic future becomes clearer, India’s youthful demographics keep attracting paeans. This is partially responsible for the fact that India has traded at a five-year average premium of 54.5% to China on forward price to earnings. With increasing reports of communal violence and inflation-related protests breaking out in India, investors also worry about India’s so-called demographic dividend and how best to play the game? In a foundational GPS Special Report published in 2018 we had made the point that, “Predicting political outcomes is difficult, but to generate geopolitical alpha investors should focus on ‘beating the spread’ not predicting the match winner”. At a time when there is much uncertainty about India’s immediate future, we highlight three key base case predictions with respect to India. By highlighting these key predictions, we hope investors can position themselves for generating geopolitical alpha. We conclude the report with actionable investment recommendations. India’s High Political Stability, Likely To Stay In 2024 Chart 1Bhartiya Janata Party’s (BJP) Win In India In 2014 Was Historic Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... The Bhartiya Janata Party (BJP) stormed into power in 2014. Its assumption of power under PM Modi’s leadership was historic. This is because this was the first time since 1984 that a single political party had managed to secure a simple majority on its own steam (Chart 1). The rise of BJP in this resurrected avatar marked a structural break from the past, in three distinct ways: End To Instability Of Nineties: The rise of BJP 2.0 in 2014 marked an end to the political instability seen in the nineties when governments struggled to complete their full five-year terms. This is a problem that India’s South Asian neighbors like Sri Lanka and Pakistan are yet to overcome. End Of Coalition Politics Of Early 2000s: BJP’s rise in 2014 also marked an end to the coalition politics of the early 2000s. While three coalition governments in India managed to complete their five-year terms from 1999-2014, the reform agenda over this period was often held at ransom by smaller coalition partners. India’s ability to break away from coalition governments back in 2014 was commendable given that several developing countries as well as developed countries still have coalition governments at the helm. Regime Continuity: The BJP’s rise in 2014 and their re-election in 2019 meant that the same political party was able to hold power in India (that too with a simple majority) for a decade. Other EMs have not seen this quality of continuity over the last few years.  Owing to this streak of unprecedented political stability that India has been able to offer since 2014, India has attracted a high premium relative to democratic EM peers (Chart 2). But with India’s general elections due in 2024, investors into India are keen to know if India will continue to attract this high political stability premium. This worry is justified for two sets of reasons: (1)    The last time any government in India was able to pull off three consecutive full five-year terms, was way back in the sixties. There is no recent precedent to BJP’s pursuit for a third consecutive term in India. (2)   The most recent election held in India’s largest state i.e., Uttar Pradesh saw the BJP retain power but saw its seat count fall by 18%. This, investors worry could be an indicator of BJP losing traction in the politically critical region of northern India. Reading the tea leaves left behind after all recent elections suggests that India is most likely to see a single political party maintain a simple majority for a third consecutive term in 2024. BJP’s footprint northern in India will be dented owing to anti-incumbency. But despite this, the BJP should be able to maintain a simple majority at the national level in 2024. This is because the BJP appears to be working on deploying a crucial strategy i.e., to offset declines in north India with gains elsewhere. India’s northern states account for 45% of India’s population. Whilst the BJP’s rise in 2014 was pivoted on this geography, its ability to retain power beyond a decade will be dependent on its ability to offset losses in India’s sprawling north with gains in other large states. Interestingly, the BJP’s predecessor i.e., the Congress party had to deal with the reciprocal of this problem. The Congress party stayed in power for a decade (from 2004-14) owing to support from southern and western Indian states. But then the Congress party’s reign could not last beyond a decade because it failed to break into northern India (Chart 3); at a time when it was losing popularity in India’s west and south. Chart 2India Has Been Trading At A Premium To EM Democracies India Has Been Trading At A Premium To EM Democracies India Has Been Trading At A Premium To EM Democracies ​​​​​​ Chart 3Congress Party-Led UPA Alliance Could Not Break Into North India Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ The fact that the BJP is now working to straddle both i.e. (1) its traditional base in the north and west as well as (2) new geographies in the east and south is evident from the recent election results: 2019 General Elections: Even as BJP’s seat count in the north Indian states of Uttar Pradesh and Bihar fell in 2019 (Chart 3) it managed to offset this decline by increasing presence in India’s east (in states like West Bengal and Orissa) and in India’s south (in states like Karnataka and Telangana). Consequently, the share of BJP’s seats accounted for by major states outside north India notably increased in 2019 from 2014 (Chart 4). Recent State Elections: The BJP has evidently been able to offset losses in its core northern base (in states like Uttar Pradesh), by increasing its presence in India’s east (in states like West Bengal and Bihar) (Chart 5). Chart 4BJP Is Growing Its Influence Outside North India Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Chart 5BJP Is Offsetting Losses In North With Gains In East Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Chart 6In a Base Case, BJP Should Cross The Halfway Mark At 2024 General Elections Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... In fact, it is critical to note that state elections are due in Gujarat in December 2022, where the BJP is highly likely to lose seat share as it faces a five-term anti-incumbency. Given that Gujarat as a region too is part of BJP’s core voter base, BJP’s seat losses in Gujarat could trigger a wave of selling on India’s bourses. If this leads India’s expensive valuations to be driven down, then this could present a buying opportunity because as long as the BJP keeps compensating for losses in traditional constituencies with inroads into newer realms (like say Karnataka where state elections are due in May 2023 or in Rajasthan and Madhya Pradesh where elections are due in end-2023); BJP’s standalone seat count in 2024 is highly likely to cross the half-way mark (Chart 6). To conclude, we re-iterate our constructive outlook on India on a strategic horizon, in view of the high probability of regime continuity lasting in this EM beyond a decade. In a worst-case scenario, we expect a BJP-led coalition to assume power in India in 2024 but this coalition too will be stable and should need the support of a maximum of two regional parties. Bottom Line: The BJP will lose seat share in parts of north and west India but should be able to retain power in 2024 by offsetting these losses with gains in India’s east and south. Most recent election results confirm that the BJP is working meticulously to make this formula work. If BJP’s political losses in its traditional constituencies triggers a market correction, then this should be used as a buying opportunity by strategic investors. Fiscal Risks In India Are Not Dead; They Will Surface, Before Receding Again In 1952 when India’s first national assembly was formed, left-leaning parties were the mainstay of India’s national politics. Back then a left-of-center party i.e., the Congress Party was in power with +70% seats in the national assembly. Then, the leftist Communist Party of India (CPI) was the second largest political party. As the decades went by left-leaning policies kept losing importance in India but the left-of-center national parties influenced Indian politics in a big way right up until 2014. Cut to 2014, the rise of the Bhartiya Janata Party (BJP) meant that the mainstay of Indian politics now became right-of-center politics. Left-leaning parties became too insignificant to matter at the national level with the Congress Party and the Communist Party of India (M) now cumulatively accounting for only about 11% seats in the national assembly. India’s political pendulum swinging to the right was accompanied by another key development i.e., India’s fiscal management became more prudent (Chart 7). Doles and transfer payments were restrained, and efforts were also made to shore-up tax revenues. But does the BJP-led transition to right-of-center politics mean that left-of-center politics in India are dead, as are the associated risks of fiscal populism? The Indian bond market seems to think so. India’s 10-year bond yield is up only 85 bps since 1 Jan 2020 to date, which is lower than a 106 bps increase seen in the US or 573 bps increase seen in a large emerging market like Brazil. Notwithstanding the superior fiscal discipline maintained by BJP-led governments so far, it is worth asking if this streak of fiscal resilience can last over the next two years? We highlight that even as the right-of-center BJP will remain a force to reckon with, we expect the BJP’s fiscal policy to temporarily swerve to the left owing to three sets of reasons: Miseries Breed Populism: It is true that recent BJP-led governments have maintained superior fiscal discipline (Chart 7). However high levels of inflation are known to feed populist tendencies of governments globally. India will be no exception to this trend because economic miseries of India’s median voter have worsened over the last six months (Chart 8). Chart 7BJP Led Governments Have Maintained Tighter Fiscal Deficits In India Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Chart 8Economic Miseries Of India's Median Voter Have Been Worsening Economic Miseries Of India's Median Voter Have Been Worsening Economic Miseries Of India's Median Voter Have Been Worsening ​​​​​​ Chart 9Government Spends Tend To Pick Up In The Run-Up To General Elections Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... Political Cycle: History also suggests that there is a cyclical element to fiscal laxity in India. Populism as a theme tends to become more defined in the two years leading to a general election (Chart 9). This cyclicality in fiscal expansion could also be driven by the fact that India tends to have a loaded state election calendar in the year just before a general election. Competition: As the BJP’s reign matures, it will increasingly face competition from regional parties (Chart 10). Given that most major regional political parties in India operate on the segment between the center and the left of political spectrum (Chart 10), BJP may see sense in metamorphosizing its fiscal policy into one which is closer to the left, albeit temporarily. Chart 10Regional Parties Like SP And AAP Could Grow Their National Footprint Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... Chart 11India’s Debt Levels Are High And Rising Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... It is worth noting that as compared to major EMs, India’s debt levels are high today (Chart 11). Against this backdrop an expansion of India’s fiscal deficit could result in turbulence in Indian markets. Bottom Line: The BJP is highly likely to temporarily switch to an expansive fiscal policy stance in the run up to the 2024 general elections. This shift will be driven by the need to retain power in the face of rising miseries of its median voter and to overcome competition from influential regional players. Most Populous Regions, May Not Necessarily Be Drivers Of India’s Growth The ‘demographic dividend’ narrative is often used to justify a bullish stance on India. But such a narrative oversimplifies India’s investment case and may even yield poor investment outcomes. India’s demographics power its consumption engine, but the same demographics can also be a liability sometimes. This is because while India is young, its populace is also poor and large. The combination of a massive population (that creates pressure on limited resources) and nascent institutions (that are yet to ensure a fair use of resources) is at the heart of corruption in India. For instance, the coming to light of the 2G-spectrum scam a decade ago on 16 November 2010 saw Indian markets correct by 6% over the next ten days. Hence ‘corruption’ is one of the ways in which India’s demographics can end-up being a drag on India’s investment returns. Chart 12Six Indian States Account For India’s Political Nucleus Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... With China’s population likely to have peaked last year, India’s population which is likely to peak in the 2040s - keeps attracting investor interest. In this report we peel the onion around India’s demographics in a way that allows investors to make the most of its demographics, whilst avoiding pitfalls associated with the same. We highlight that paradoxically; India’s most populous states may not be the main drivers of India’s growth over the next decade. On the other hand, investing in the ‘next eight’ most populous states, could present a superior opportunity to profit from India’s demographics. Six Indian states account for more than half of India’s population (Chart 12) and each of these states are larger than Germany or Turkey in terms of population (Map 1). Despite being populous, these states could emerge as flashpoints of social conflict over the next decade. This is because it is possible that these states’ economic growth fails to be brisk enough to meet aspirations of its vast populace. Early signs of this phenomenon are evident from the fact that these states’ share in India’s population has been rising, but their share in national income has fallen (Chart 13). Today these six states account for more than half of India’s population but generate less than half of its national GDP (Chart 14). Map 1India’s Most Populous States, May Not Necessarily Lead On Growth Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... Chart 13Most Populous States Of India, Are Not Necessarily Leading On Growth Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Chart 14Next Eight Largest States Of India Are Economically Dynamic Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Despite accounting for the lion’s share of India’s population, these six states’ growth potential could be compromised by: Economic Weakness: Primary sectors account for an unusually large share of the local economies of the most populous states today (Chart 15). Social Complexity: Most of the populous states are also characterized by greater social complexity as compared to other Indian states (Chart 16). In other words, their populations are young but are also poor and more heterogenous, which in turn exposes these states to a higher risk of social conflict. Chart 15Primary Activities Account For A Large Chunk Of Populous States’ GDP Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Chart 16The Risk Of Social Conflict Is Higher, In The More Populous States Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ ​​​Leverage: The debt to GDP ratio of the more populous states often tends to be higher too (Chart 17).​​​​​​​ Now contrary to the situation in India’s most populous states, India’s ‘next eight’ largest states (by population) could emerge as hubs of economic dynamism (Map 1). This is because: Faster Growth: These states' share in national GDP is growing faster than the pace at which their share in India’s population is growing (Chart 13). As of today, the next eight states account for less than a third of India’s population but more than a third of India’s national income (Chart 14). Fewer Constraints: The next eight most populous states have more modern economic structures (Chart 15), lower risk of social conflict (Chart 16) and mildly superior public finances (Chart 17). Last but not the least, the ‘next eight’ states are poised favorably from a political perspective as well. This is because the Bhartiya Janta Party (i.e., BJP) has a weak footprint in these states (Chart 18) and will be keen to offer supportive economic policies to win over their median voter. Chart 17More Populous States, Also Can Be More Leveraged Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Chart 18Next Eight Most Populous States Likely To Attract More Political Attention Going Forward Indian Politics: The Woods Are Lovely... Indian Politics: The Woods Are Lovely... ​​​​​​ Bottom Line: While the demographic dividend that India enjoys is real, its benefits will not be spread uniformly across India’s geographies. For instance, some of the most populous states of India could lag on the growth front. To profit from India’s demographics and yet mitigate risks associated with the same, we urge investors to build portfolios that maximize exposure to the second tier of populous states in India. Investment Conclusion The Bhartiya Janta Party (BJP) in India appears set to emerge as the first party in India’s modern history to retain power beyond a decade with a simple majority. But to pull off this rare feat, it will have to metamorphosize and may exhibit some changes such as: Develop a focus on regions that are outside its core constituency, in a bid to offset anti-incumbency in its core constituencies. Sharpen its policy focus on the next tier of populous states, given that some of these states have greater growth potential and given that the BJP’s footprint in the second tier of populous states has room to grow. Adopt an expansive fiscal policy in the run up to the 2024 elections, to combat the rising economic miseries of India’s median voter. To play these dynamics, we urge clients to consider the following trades: Strategic Trades For clients with a holding period mandate of more than 12 months, we urge such investors to go strategically long Indian tech / short Chinese tech (Chart 19). The trade allows investors to play the unique and high degrees of political stability that India will offer on a strategic horizon. Chart 19Strategic Trade: Long Indian Tech / Short Chinese Tech Strategic Trade: Long Indian Tech / Short Chinese Tech Strategic Trade: Long Indian Tech / Short Chinese Tech ​​​​​​ Chart 20Tactical Trade: Short India / Long Brazilian Financials Tactical Trade: Short India / Long Brazilian Financials Tactical Trade: Short India / Long Brazilian Financials ​​​​​​ Moreover, it is notable the Indian tech industry’s key bases are concentrated in Karnataka, Andhra Pradesh and Telangana. All three states fall within the next tier of populous states of India. Thus, this trade allows investors to maximize exposure to both an economically vibrant region and sector of India. Tactical Trades For investors with a holding period mandate of less than 12 months, a trade that can be activated to profit from India’s short-term geopolitical risks is to short India / long Brazilian Financials (Chart 20). This allows investors to profit from the cyclical risks that will affect India (1) as commodity prices stay high and (2) as rising economic miseries fan fiscal risks.​​​​​​​   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Favor ASEAN And The Philippines Favor ASEAN And The Philippines Favor ASEAN And The Philippines Southeast Asia is suffering from fading macro and geopolitical tailwinds but there are still investment opportunities on a relative basis. The peace dividend, globalization dividend, and demographic dividend are all eroding and will continue to erode, though there are relative winners and losers. The Philippines and Thailand are most secure; the Philippines and Indonesia are least dependent on trade; and the Philippines and Vietnam have the highest potential GDP growth. Geopolitical risk premiums have risen for Russia, Eastern Europe, China, and will rise for the Middle East. This leaves ASEAN states as relatively attractive emerging markets. Trade Recommendation Inception Date Return LONG PHILIPPINES / EM EQUITIES 2022-05-12   LONG ASEAN / ACW EQUITIES 2022-05-12   Bottom Line: ASEAN’s geopolitical outlook is less ugly than many other emerging markets. Cyclically, go long ASEAN versus global equities and long Philippine equities versus EM. Feature Chart 1Hypo-Globalization A Headwind For Trading States Hypo-Globalization A Headwind For Trading States Hypo-Globalization A Headwind For Trading States The Philippines elected its second “strongman” leader in a row on May 9, provoking the usual round of editorials about the death of liberalism. Investors know well by now that such political narratives do as much to occlude economic reality as to clarify it. Still, there is a fundamental need to understand the changing global political order since it will ultimately impact the investment landscape. If the global order stabilizes – e.g. US-Russia and US-China relations normalize – then trade and investment may recover from recent shocks. A new era of “Re-Globalization” could ensue. Asia Pacific would be a prime beneficiary as it is full of trading economies (Chart 1). Related Report  Geopolitical StrategySecond Quarter Outlook 2022: When It Rains, It Pours By contrast, if Great Power Rivalry escalates further, then trade and investment will suffer, the current paradigm of Hypo-Globalization will continue, and East Asia’s frozen conflicts from 1945-52 will thaw and heat up. Asian states will have to shift focus from trade to security and their economies will suffer relative to previous expectations. How will Southeast Asia fare in this context? Will it fall victim to great power conflict, like Eastern Europe? Or will it keep a balance between the great powers and extract maximum benefits? Three Dividends Three dividends have underpinned Southeast Asia’s growth and prosperity in recent decades: 1.  Peace Dividend – A relative lack of war and inter-state conflict. 2.  Globalization Dividend – Advantageous maritime geography and access to major economies. 3.  Demographic Dividend – Young demographics and strong potential GDP growth. All three of these dividends are eroding, so the macro and geopolitical investment case for ASEAN has weakened relative to twenty years ago. Nevertheless in a world where Russia, China, and the Gulf Arab markets face a higher and persistent geopolitical risk premium, ASEAN still offers attractive investment opportunities, particularly if the most geopolitically insecure countries are avoided. Peace Dividend Favors The Philippines And Thailand Since the end of the US and Chinese wars with Vietnam, military conflicts in Southeast Asia have been low intensity. Lack of inter-state conflict encouraged economic prosperity and security complacency. The five major Southeast Asian nations saw military spending decline since the 1990s and only Vietnam spends more than 2% of GDP (Chart 2). Chart 2Peace Brought Prosperity Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines Unfortunately that is about to change. China has large import dependencies, an insufficient tradition of sea power, and feels hemmed in by its geography and the US alliance system. Beijing’s solution is to build and modernize its navy and prepare for potential conflict with the US, particularly over Taiwan. The result is rising tension across East Asia, including in Southeast Asia and the South China Sea. The ASEAN states fear China will walk over them, China fears they will league with the US against China, and the US tries to get them to do exactly that. Hence ASEAN’s defense spending has not kept up with its geopolitical importance and will have to rise going forward. Consider the following: Vietnam risks conflict with China. Vietnam has the most capable and experienced naval force within ASEAN due to its sporadic conflicts with China. Its equipment is supplied mainly by Russia, pitting it squarely against China’s Soviet or Soviet-inspired equipment. But Russia-China ties are tightening, especially after Russia’s divorce with Europe. While Vietnam will not reject Russia, it is increasingly partnering with the United States. The pandemic added to the Vietnamese public’s distrust of China, which is ancient but has ramped up in recent years due to clashes in the South China Sea. While Vietnam officially maintains that it will never host the US military, it is tacitly bonding with the US as a hedge against China. Yet Vietnam does not have a mutual defense treaty with the US, so it is vulnerable to Chinese military aggression over time. Indonesia distances itself from China. Rising security tensions are also forcing Indonesia to change its strategy toward China. Indonesia lacks experience in naval warfare and is not a claimant in the territorial disputes in the South China Sea. It is reluctant to take sides due to its traditionally non-aligned diplomatic status, its military culture of prioritizing internal stability (which is hard to maintain across thousands of islands), and China’s investment in its economy. However, China is encroaching on Indonesia’s exclusive economic zone and Indonesia has signaled its displeasure through diplomatic snubs and high-profile infrastructure contracts. Indonesia is trying to bulk up its naval and air capabilities, including via arms purchases from the West. Malaysia distances itself from China. Malaysia and the Philippines have the weakest naval forces and both face pressure from China’s navy and coast guard due to maritime-territorial disputes. But while the Philippines gets help from the US and its allies and partners, Malaysia has no such allies. Traditionally it was non-aligned. Instead it utilizes economic statecraft, as it has often done against more powerful countries. It recently paused Chinese economic projects in the country to conduct reviews and chose Ericsson over Huawei to build the 5G network. Ongoing maritime and energy disputes will motivate defense spending. The Philippines preserves alliance with United States. Outgoing President Rodrigo Duterte tried but failed to strengthen ties with China and Russia. Beijing continued to swarm the Philippines’ economic zone with ships and threaten its control of neighboring rocks and reefs. Ultimately Duterte renewed his country’s Visiting Forces Agreement with the US in July 2021. The newly elected President “Bong Bong” Marcos is even less likely to try to pivot away from the US. Instead the Philippines will work with the US to try to deter China. Thailand preserves alliance with United States. Thailand is the most insulated from the South China Sea disputes and often acts as mediator between China and other ASEAN states. However, Thailand is also a formal US defense ally and assisted with logistics during the Korean and Vietnamese wars. While US military aid was suspended after the 2014 military coup, non-military aid from the US continued. The State Department certified Thailand’s return to democracy in 2019, relations were normalized, and the annual Cobra Gold exercise resumed in 2020. The US’s hasty normalization shows Thailand’s importance to its regional strategy. On their own, the ASEAN states cannot counter China – they are simply outgunned (Chart 3). Hence their grand strategy of balancing Chinese trade relations with American security relations. Chart 3Outgunned By China Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines Chart 4Opinion Shifts Against China Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines In recent decades, with the US divided and distracted, they sought to entice China through commercial deals, in hopes that it would reduce its encroachments on the high seas. This strategy failed, as China’s expansion of economic and military influence in the region is driven by China’s own imperatives. Beijing’s lack of transparency about Covid-19 also sowed distrust. As a result, public opinion became more critical of China and defensive of national sovereignty (Chart 4). Southeast Asia will continue trading with China but changing public opinion, the US-China clash, and tensions in the South China Sea will inject greater geopolitical risk into this once peaceful and prosperous region. Military weakness will also lead the ASEAN states to welcome the US, EU, Japan, and Australia into the region as economic and security hedges against China. This trend risks inflaming regional tensions in the short run – and China may not be deterred over the long run, since its encroachments in the region are driven by its own needs and insecurities. Decades of under-investment in defense will result in ASEAN rearmament, which will weigh on fiscal balances and potentially economic competitiveness. Investors should not take the past three decades of peace for granted. Bottom Line: Vietnam (like Taiwan) is in a geopolitical predicament where it could provoke China’s wrath and yet lacks an American security guarantee. The Philippines and Thailand benefit from American security guarantees. Indonesia and Malaysia benefit from distance from China. All of these states will attempt to balance US and China relations – but in the future that means devoting more resources to national security, which will weigh on fiscal budgets and take away funds from human capital development. Waning Globalization Dividend Favors Indonesia And The Philippines All the ASEAN states rely heavily on both the US and China for export markets. This reliance grew as trade recovered in the wake of the global pandemic (Chart 5). Now global trade is slowing down cyclically, while US-China power struggle will weigh on the structural globalization process, penalizing the most trade-dependent ASEAN states relative to their less trade-dependent neighbors. So far US-China economic divorce is redistributing US-China trade in a way that is positive for Southeast Asia. China is rerouting exports through Vietnam, for example, while the US is shifting supply chains to other Asian states (Chart 6). The US will accelerate down this path because it cannot afford substantively to reengage with China’s economy for fear of strengthening the Russo-Chinese bloc. Chart 5Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance Trade Rebounded But Hypo-Globalization Will Force Domestic Reliance ​​​​​ Chart 6ASEAN’s Exports To US Surge Ahead Of China’s ASEAN's Exports To US Surge Ahead Of China's ASEAN's Exports To US Surge Ahead Of China's Hence the US will become more reliant on Southeast Asian exporters. Whatever the US stops buying from China will have to be sourced from other countries, so countries that export a similar basket of goods will benefit from the switch. Comparing the types of goods that China and ASEAN export to the US, Thailand is the closest substitute for China, whereas Malaysia is the farthest (Chart 7). That is not to say that Malaysia will suffer from US-China divorce. It is already ahead of China in exporting high-tech goods to the US, which is the very reason its export profile is so different. In 2020, 58% of Malaysia’s exports to the US are high-tech versus 35% for China’s. At the same time, Southeast Asian exports to China may not grow as fast as expected – cyclically China’s economy may accelerate on the back of current stimulus efforts, but structurally China is pursuing self-sufficiency and import substitution via a range of industrial policies (“Made in China 2025,” “dual circulation,” etc). These policies aim to make Chinese industrials competitive with European, US, Japanese, and Korean industrials. But they will also make China more competitive with medium-tech and fledging high-tech exports from Southeast Asia. Thus while China will keep importing low value products and commodities, such as unrefined ores, from Southeast Asia, imports of high-tech products will be limited due to China’s preference for indigenous producers. US export controls will also interfere with ASEAN’s ability to export high-tech goods to China. (In order to retain their US trade, in the face of Chinese import substitution, ASEAN states will have to comply with US export controls at least partially.) Even the low-to-medium tech goods that China currently imports from Southeast Asia may not grow as fast in the coming years as they have in the past. The ten provinces in China with the lowest GDP per capita exported a total of $129 billion to the world in 2020, whereas China’s imports from the top five ASEAN states amounted to $154 billion USD in 2020 (Chart 8). If Beijing insists on creating a domestic market for its poor provinces’ exports, then Southeast Asian exports to China will suffer. China might do this not only for strategic sufficiency but also to avoid US and western sanctions, which could be imposed for labor, environmental, human rights, or strategic reasons. Chart 7The US Sees Thailand And Vietnam As Substitutes For China Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Chart 8China Threatens ASEAN With Import Substitution Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Chart 9Trade Rebound Increased Exposure To US, China Trade Rebound Increased Exposure To US, China Trade Rebound Increased Exposure To US, China China, unlike the US during the 1990s and 2000s, cannot afford to open up its doors and become a ravenous consumer and importer of all Asia’s goods. This would be a way to buy influence in the region, as the US has done in Latin America. But China still has significant domestic development left to do. This development must be done for the sake of jobs and income – otherwise the Communist Party will face sociopolitical upheaval. Malaysia, Vietnam, and Thailand are the most vulnerable to China’s dual circulation strategy because of their sizeable exports to China, which stand at 12%, 15% and 7.6% of GDP respectively (Chart 9). Even though the Southeast Asian states have formed into a common market, and have joined major new trade blocs such as the CPTPP and RCEP, they will not see unfettered liberalization within these agreements – and they will not be drawn exclusively into China’s orbit. Instead they will face a China that wishes to expand export market share while substituting away from imports. The US and India, which are not part of these new trade blocs, will still increase their trade with ASEAN, as they will seek to substitute ASEAN for China, and ASEAN will be forced to substitute them for China. Thus globalization will weaken into regionalization and will not provide as positive of a force for Southeast Asia as it did over the 1980s-2000s. Going forward, the new paradigm of Hypo-Globalization will weigh on trade-dependent countries like Malaysia, Vietnam, and Thailand relative to their neighbors. Within this cohort, Malaysia and the Philippines will benefit from selling high-tech goods to the US, while Thailand and Vietnam will benefit from selling low- and mid-tech goods. China will remain a huge and critical market for ASEAN states but its autarkic policies will drive them to pursue other markets. Those with large and growing domestic markets, like Indonesia and the Philippines, will weather hypo-globalization better than their neighbors. Vietnam, Malaysia, and Thailand are all extremely dependent on foreign trade and hence vulnerable if international trade linkages weaken. Bottom Line: Global trade is likely to slow on a cyclical basis. Structurally, Hypo-Globalization is the new paradigm and will remove a tailwind that super-charged Southeast Asian development over the past several decades. Indonesia and the Philippines stand to suffer least and benefit most. Potential Growth Dividend Favors The Philippines And Vietnam Countries that can generate endogenous growth will perform the best under hypo-globalization. Indonesia, the Philippines, and Vietnam have the largest populations within ASEAN. But we must also take into account population growth, which contributes directly to potential GDP growth. A domestic market grows through population growth and/or income growth. For example, China benefitted from its growing population but now must switch to income generation as its population growth is stagnating. In Southeast Asia, the Philippines, Malaysia, and Indonesia have the highest population growth, while Thailand has the lowest. Thai population growth is even weak compared to China. The total fertility rate reinforces this trend – it is highest in Philippines but lowest in Thailand (Chart 10). A population that is too young or too old needs significant support that diverts resources away from the most productive age group. Philippines and Indonesia have the lowest median age, while Thailand has the highest. The youth of Indonesia and Philippines will come of age in the next decade, augmenting labor force and potential GDP growth. By contrast, Vietnam and especially Thailand, like China, will be weighed down by a shrinking labor force in the coming decade (Chart 11). Chart 10Fertility Rates Robust In ASEAN Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Chart 11Falling Support Ratio Weighs On Thailand, Vietnam Southeast Asia: Favor The Philippines Southeast Asia: Favor The Philippines ​​​​​​ Hence Indonesia and Philippines will prosper while Thailand, and to some extent Vietnam, lack the ability to diversify away from trade through domestic market growth. Malaysia sits in the middle: it is trade dependent and has the smallest population, but it has a young and growing population, and its labor force is still growing. Yet falling population growth is not a disaster if productivity and income growth are high. Productivity trends often contrast with population trends: Indonesia had the weakest productivity growth despite having a large, young, and growing population, while Vietnam had the strongest growth, despite a population slowdown. In fact Vietnam has the strongest productivity growth in Southeast Asia, at a 5-year, pre-pandemic average of 6.3%, followed by the Philippines (Chart 12A). By comparison China’s productivity growth averaged between 3%-6.6%, depending on the data source. Chart 12AProductivity And Potential GDP Productivity And Potential GDP Productivity And Potential GDP ​​​​​​ Chart 12BProductivity And Potential GDP Productivity And Potential GDP Productivity And Potential GDP ​​​​​​ Chart 13Capital Formation Favors Philippines Capital Formation Favors Philippines Capital Formation Favors Philippines Productivity growth adds to labor force growth to form potential GDP. In 2019, Philippines had the highest potential GDP growth at 6.9%, followed by the Vietnam at 6.8%, Indonesia at 5.6%, Malaysia at 3.9% and Thailand at 2.3%. In comparison China’s potential GDP growth was 3.6%-5.9%, again depending on data. Thailand is undoubtedly the weakest from both a population and productivity standpoint, while the Philippines has strength in both (Chart 12B). Countries invest in their economies to increase productivity. In 2019, Vietnam recorded the highest growth in grossed fixed capital formation at around 10.6%, followed by Indonesia at 6.9%, Philippines at 6.3%, and Thailand at 2.2%. Gross fixed capital formation has rebounded from the contractions countries suffered during the pandemic lockdowns in 2020 (Chart 13). Bottom Line: The Philippines has strong potential GDP growth, but Indonesia is not far behind as it invests in its economy. Vietnam has the highest investment and productivity growth, but its demographic dividend is waning. Malaysia is slightly better than Thailand because it has a growing population, but it has stopped investing and it is as trade dependent as Thailand. Thailand is weak on all accounts: it is trade dependent, has a shrinking population, and has a low potential GDP growth. Investment Takeaways Bringing it all together, ASEAN is witnessing the erosion of key dividends (peace, globalization, and demographics). Yet it offers attractive investment opportunities on a relative basis, given the permanent step up in geopolitical risk premiums for other major emerging markets like Russia, eastern Europe, China, and (soon) the Gulf Arab states (Charts 14A & 14B). Indeed the long under-performance of ASEAN stocks as a bloc, relative to global stocks, has recently reversed. As investors recognize China’s historic confluence of internal and external risks, they increasingly turn to ASEAN despite its flaws. Chart 14AASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China The US and China will use rewards and punishments to try to win over ASEAN states as strategic and economic partners. Those that have a US security guarantee, or are most distant from potential conflict, will see a lower geopolitical risk premium. Chart 14BASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China ASEAN Will Continue To Outperform China ​​​​​​ Chart 15Favor The Philippines Favor The Philippines Favor The Philippines The Philippines is the most attractive Southeast Asian market based on our criteria: it has an American security guarantee, domestic-oriented growth, and high productivity. Populism in the Philippines has come with productivity improvements and yet has not overthrown the US alliance. Philippine equities can outperform their emerging market peers (Chart 15). Indonesia is the second most attractive – it does not have direct territorial disputes with China, maintains defense ties with the West, is not excessively trade reliant, and keeps up decent productivity growth. It is vulnerable to nationalism and populism but its democracy is effective overall and the regime has maintained general political stability after near-dissolution in 1998. Thailand is geopolitically secure but lacking in potential growth. Vietnam has high potential growth but is geopolitically insecure over the long run. Investors should only pursue tactical investments in these markets. We maintain our long-term favorable view of Malaysia, although it is trade dependent and productivity has weakened. In future reports we will examine ASEAN markets in greater depth and with closer consideration of their domestic political risks.   Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix