Geopolitics

Executive Summary Inflation Surprise Reinforces Gridlock And Fiscal Drag A US recession is increasingly likely as the Fed will have to hike rates more aggressively in the short run to contain inflation. Recession would exacerbate US policy uncertainty during a period of peak polarization in the 2022-24 election cycle. The Fed’s struggle with inflation will become entangled in extreme US politics. The Fed will come under immense pressure to pause rate hikes earlier than warranted in 2023. The Fed could get blamed for both over-tightening and politicization. Investors should fade the risk of another Democratic sweep in the midterm elections. Republicans are still highly likely to gain control of the House, resulting in gridlock and a freeze to fiscal policy.   If Democrats lose the House, their odds of retaining the White House will decline. A recession would greatly reduce their odds. In this context the US faces another tumultuous political cycle, as Republicans will stage a comeback. However, reform of the Electoral Count Act could reduce the risk of a catastrophic breakdown in the electoral system. Recommendation (Tactical) INITIATION DATE Return Long DXY (Dollar Index) Feb 23, 2022 12.6% Bottom Line: Stay long US dollar for now but prepare to downgrade to neutral. Feature BCA Research hosted our annual conference at the Plaza Hotel in New York last week. Clients heard a range of views on various topics, including US politics and policy. In this report we touch on some of the insights from the conference while providing our own views on what to expect going forward. A Politicized Federal Reserve? The real Fed funds rate stands at -2.2% today despite the Federal Reserve’s decision to hike rates by 225 basis points this year. The last time the real Fed funds rate was this low was in 1975, under the chairmanship of Arthur Burns – i.e. the epitome of a politicized Fed (Chart 1). Chart 1A Politicized Federal Reserve? Is the Fed already politicized or will it become politicized in the coming years? What would that mean for monetary policy, the economy, and financial markets? The Fed waded into political territory when it began pursuing unorthodox policies in the wake of the 2008 financial crisis and again during the Covid-19 pandemic. Ideally monetary policy sets interest rates across the economy and applies equally to all economic actors. But once the Fed began quantitative easing (bond buying) and coordinating its actions with the fiscal authorities (which had bailed out major banks), it entered the game of income and wealth redistribution. Not least because asset price inflation favors asset owners over others. Now that the Fed and other central banks have pioneered these unorthodox policies, they will continue to use them in the face of future economic and political turmoil. They will also innovate new tools to deal with each crisis. As the pandemic response highlighted, the Fed will continue down the path of redistribution, which will continue to provoke political backlash from legislators and the public. At the same time, the Fed’s policy parameters today have been reined in and disciplined by the post-pandemic inflation overshoot. For example, there is not so much excited talk today about implementing Modern Monetary Theory – debt monetization – as there was in the heady days of 2019. Instead the Fed today is focused almost exclusively on fulfilling its price stability mandate, at least until inflation gets down into the 2%-3% range. The market appears over-eager for interest rate cuts in 2023 when the Fed is expecting to continue hiking rates throughout 2023 (Chart 2). The surprise in core and headline inflation in August reinforces this point. If the Fed cannot bring inflation below 3%, what will it do? Could it accept reality and modify the inflation target to 3%? A higher inflation target has long been discussed – it would enable the Fed to stimulate more effectively in the next recession. But Chairman Jerome Powell and his monetary policy strategy review rejected the idea of raising the long-term inflation target from 2% to 3% or above – and that rejection is likely to be sustained at least until the next review in 2024. Even then a higher inflation target seems unlikely as it would be very hard to achieve politically in the wake of the inflation overshoot. Chart 2Will Fed Cut Rates Next Year? Of course, a lot can happen by 2024 and new deflationary shocks could conceivably force a change to the inflation target. What is clear to us is that the Fed still has a dovish bias that took a long time to develop and has not yet been entirely overturned by the inflation overshoot (Chart 3).  Chart 3Dovish Consensus Built Up Over Time And Remains In Place For Now Meanwhile the Fed’s single-minded focus on restoring price stability will bring an entirely different set of political problems – and accusations of politicization. For example, the Fed wants tighter financial conditions – since that will help to cool the economy and bring down inflation – but cannot well speak openly about deliberately driving down stock market prices and home values. The Fed also believes that a recession with unemployment ranging from 4%-5% would not be the end of the world but it cannot well speak openly about deliberately increasing unemployment. Especially because unemployment rarely stays so low in recessions. The Fed acknowledges that it will need to pause hiking interest rates at some point, hopefully before it tightens monetary conditions so much as to trigger a recession, but it does not want to call it a “pause” since financial markets will take that as a hard stop. It could cause a premature loosening of financial conditions and be blamed for a lack of vigilance when inflation revives. Will the Fed ultimately be prevented from tightening monetary policy enough because of the pressure that higher interest rates will put on the government’s fiscal sustainability? It is entirely possible. Sustaining social programs is more popular than paying bond holders. Since the Fed pays market interest rates on reserve balances, it will stop making a profit if it hikes rates to 3.25% or above (which is slated to happen this month). Very soon the Fed will be turning a loss on its holdings, rather than remitting profits to the Department of Treasury, and it will be amply criticized for spending taxpayer money. In that case there will be plenty of ammunition from critics on all sides. When it comes to the Fed’s specific predicament in 2022-24, Chairman Powell does not want to be the next Arthur Burns, i.e. he does not want to go down in history as the chairman who made a historic mistake by not forcing inflation back into an acceptable and containable range of say 2%-3.5%. Neither he nor the Fed can afford to lose control of price stability, which would damage the US economy and the Fed’s credibility. The implication is that Powell will need to hike rates until price stability is obtained. Yet even a conservative estimate would suggest that hiking rates until inflation falls beneath 3% will require the unemployment rate to rise by more than the estimated 0.5-1.0 percentage points, likely considerably more than this, which historically implies a recession in 2023-24. Recession odds have already risen sharply as priced by the bond market, according to Jonathan LaBerge at our Bank Credit Analyst flagship service (Chart 4). Of course, recession odds have an important implication for the 2022-24 political cycle, implying that the Fed’s handling of the economy will become entangled once again in America’s extreme political polarization. Chart 4Recession Odds Rising Our past research has shown that the Fed does not pay close attention to midterm elections. The Fed is more likely to hike rates than cut rates during a midterm election year – and more likely to hike rates during a president’s first midterm election as opposed to his second. Whereas the Fed is about equally likely to cut rates as to hike them during a presidential election year. Most importantly, the Fed is more likely to hike rates during a non-election year than otherwise (Table 1). Table 1The Fed Doesn’t Care About Midterms … But Prefers To Hike In Off-Years While the Fed had no choice but to hike in 2022, supporting these data, a critical decision will emerge in 2023, when the Fed is still expected to hike but the risk of recession grows. Recessions sharply reduce the odds of the incumbent political party staying in the White House (Table 2). Moreover a recession could bring back President Trump or a Trumpist Republican candidate bent on revenge against the political establishment. The result is that the FOMC will be under immense political pressure not to overtighten monetary policy in 2023-24. In normal times, a Fed chair appointed by a Republican president could conceivably have the license to hike rates aggressively to whip inflation, knowing that if a recession occurs and a Republican comes to power, he would be likely to be reappointed. But Powell can have no such assurance from the erratic President Trump, who is still favored for the Republican nomination as things stand. Even aside from Trump, Powell and the FOMC will fear that a populist Republican Party would seek to audit the Fed or curtail its powers. Table 2Biden’s Odds Fall If Recession Occurs In sum, the Washington political establishment believes it is under attack from right-wing insurrectionists and will put immense pressure on the FOMC to avoid triggering a recession in 2023-24. This could produce an inflationary surprise. Bottom Line: A recession is likely to occur as the Fed continues hiking rates to bring inflation below 3%. This increases political uncertainty for the 2022-24 cycle. But a politicized Fed may compromise when inflation is closer to 4% for fear of a populist win in 2024. That would likely prove to be a historic monetary policy mistake, enabling long-term inflation expectations to rise substantially.   Midterm Elections: Fade The “Blue Sweep” Risk  While the Fed ignores midterm elections, investors are increasingly uncertain over fiscal policy and the outcome of the midterms. Will Congress become gridlocked, as we expect, or will Democrats retain control of Congress and continue the federal spending splurge that has played a large role in the inflation overshoot? Clearly the midterm races have tightened since President Biden changed his tone and started prioritizing the fight against inflation back in June. As inflation has abated, online betting markets have discounted Republican odds of victory, particularly in the Senate where they are now 36% (Chart 5). We anticipated that Biden’s approval ratings would stabilize on the passage of legislation and that the election would tighten in the final months, particularly on the back of women voters turning out to support Democrats in the wake of the Supreme Court’s decision to reduce abortion access. However, we also argued that gridlock would still be the most likely result based on the high odds that the House would flip to Republican control regardless of Roe. This is a consensus view that should be challenged and reassessed as November approaches. Chart 5Bookies Still Expect Gridlock In Midterms Senate elections are held statewide and are therefore more susceptible to a shift in suburban and women voters. State-level polls leave much to be desired but the overall picture is that the races are closer than they were earlier this year – and closer than the Republicans would want them to be (Charts 6A & 6B). Persistent high inflation should be the clincher in favor of Republicans but the Senate is simply too close to call at this stage. Chart 6ANeck-And-Neck Races In Senate Chart 6BNeck-And-Neck Races In Senate Yet the Senate is overrated in this election because if Democrats lose either chamber, gridlock will be the result. Gridlock is what matters most for fiscal policy and hence for investors. The gridlock view rests on the House of Representatives. While the president’s party almost always loses seats in the midterm election, losing seats is not the same as losing control. In fact, over the past 120 years, a party that controls the House and/or Senate is more likely than not to retain control in a midterm election (Chart 7). But in the post-WWII era, the president’s party is slightly more likely to lose control of the House. And in almost all midterms, the president’s party loses seats in the House.  Chart 7Presidents Do Not Always Lose Control, But Dems Have Small Cushion In 2022 The key point about 2022 is that the Democrats only have a six-seat buffer in the House. In other words, losing seats is very likely to be equivalent to losing control this year. To save the House, Biden’s Democrats would have to perform as well as John F. Kennedy’s Democrats in 1962, when they only lost four House seats. Our House model predicts they will lose 21 seats (Appendix). While Democrats could beat this prediction, they would be hard pressed to lose fewer than six seats on a net basis: inflation is high and sticky, real wages and incomes have fallen, consumer confidence has fallen, the president’s approval rating is low, and approval of Congress is low. If a president’s party loses control of the House, its odds of keeping the White House in 2024 also fall (Chart 8). This is another reason for investors to expect that fiscal policy will freeze, policy uncertainty will remain high, and the Fed will be under political pressure not to hike rates aggressively in 2023-24. Chart 8Biden’s 2024 Odds Fall If He Loses The House Bottom Line: Fade the “Blue Sweep” risk in 2022. The midterm election is tightening but Republicans are still likely to win the House. Fiscal policy will remain a drag on growth and the 2024 election will become even more uncertain, putting political pressure on the Fed to avoid overtightening. Limited Big Government Another Democratic sweep would greatly reinforce the new US policy trajectory of Big Government: a trajectory that points away from the Washington Consensus and Reagan revolution toward a future of higher taxes, larger budget deficits, higher tariffs, and more extensive regulation (Chart 9).1  But Democrats will be forced to share power. This is why we call the new policy paradigm “Limited Big Government.” It is still a shift in the direction of a larger government role in the economy and society, but it is taking place within the context of the US constitutional system of checks and balances and two-party politics. We do not expect the latter two factors to disappear. Looking at the Obama, Trump, and Biden administrations together we can see that the turn toward Big Government is also compromised by vested interests: Democrats failed to increase corporate taxes, though they did put a floor under the effective tax rate by imposing a new 15% minimum tax on corporate book income. The budget deficit is normalizing after the gargantuan pandemic stimulus. But Democratic legislation will not reduce the deficit substantially over time, contrary to Biden administration propaganda. But Republicans are fiscally profligate themselves, which is clear from Trump’s term in office as well as previous periods of single-party GOP rule. Republicans joined Democrats in passing the infrastructure bill and the Chips and Science Act, which revives US industrial policy in an era of great power competition. Biden has now accepted Trump’s tariff hikes on China. While Republican leadership may push deregulation in future, they may also believe that government regulation will be required to fight back against “woke” or socially left-wing corporations. Chart 9Buenos Aires Consensus equal Spending, Taxes, Tariffs, Regulations Thus the US’s new policy paradigm is bipartisan in nature. Of course, if Republicans take the House they will turn fiscally conservative for tactical reasons. That will put a halt to the spending splurge of 2020-22. But it will not signal a new fiscally austere paradigm since full Republican control in 2025 would be highly likely to lead to another fiscal blowout. This is even more likely to be the case now that Republicans have adopted a populist and pro-working class approach. Bottom Line: The US shift away from limited government toward Big Government is entrenched even if it suffers a setback due to gridlock from 2022-24. Given that partisan checks will prevent the US from moving too radically in any direction, we dub this paradigm “Limited Big Government.” It is marginally inflationary due to the rise in taxes, spending, regulations, and tariffs. US Electoral System: A Possible Positive Surprise Our expectation that the Fed will be politicized and that populist policies will persist stems from the underlying inequality and political polarization in the United States. Yet these same factors serve to increase overall political instability and threaten to cause a fundamental breakdown in political order. Will US institutions be able to handle the strain in the coming election cycle? There can be no doubt that polarization is reaching dangerous extremes. The US has suffered two out of five contested elections in the past 22 years. The last two Republican presidential victories have occurred without gaining the popular vote. The Biden administration’s low approval creates the risk of another tight election in 2024, implying controversy over the vote count and procedure (see Appendix). Another tight election could lead to a single state’s controversy determining the outcome of the entire election. Or it could lead to an electoral college tie in which Congress would decide the election result and could decide against the popular verdict.    It is not hard to think of scenarios where contested elections and social unrest get out of hand. For example, one important consequence of the January 6 rebellion is that future governments will suppress protests with force if they attempt to interfere with the electoral process or the workings of the legislature. But imagine if a Republican administration comes to power through a contested election in Congress and then suppresses the resulting protests against it? Or imagine if Democrats retain power and push their “domestic war on terrorism” far enough to provoke a low-level militant insurgency from disaffected nationalists? It is easy to think of scenarios on either side that could lead to a much greater breakdown in public order than what occurred in 2020.   It is unlikely that an institutional fix will occur in time for the 2024 election. However, there is one exception on the congressional agenda: a possible revision of the Electoral Count Act of 1887. This law was designed to prevent a failure of the electoral system in the wake of the “Stolen Election” of 1876. Its main achievement was to have the governor of each state certify the electoral votes of that state before sending them to Washington. However, the law also leaves open the door for state legislatures, secretaries of state, and governors to influence their state’s electoral votes. Democrats have written a revised version of the law that would close some of the loopholes and ambiguities. So far 10 Senate Republicans have co-sponsored the bill, making it very likely they will vote for it (Table 3). If these Republicans do not change their minds in the critical hour, and if all Democrats can be brought to vote for the measure, then a 60-vote, filibuster-proof majority will exist to pass the law. Table 3Republican Senators Who Support Revising The Electoral Count Act The original Electoral Count Act took ten years to pass, so there is no reason to be overly optimistic. But if 60 votes can be found in the Senate, then the electoral system will be fortified ahead of the 2024 election and structural US political risks will be at least somewhat reduced. Bottom Line: The US faces serious social and political instability in the coming years and remains at “peak polarization.” But a bipartisan law could help solidify the electoral system prior to 2024, which would reduce some of the risk of election controversies spiraling out of control. Investment Takeaways Headline consumer price inflation for August came in at 8.3% year-on-year versus an expected 8.1%, while core inflation accelerated from 5.9% to 6.3%. Financial markets took it on the chin, with the S&P500 falling by 4.3%, due to the disappointed expectation that inflation had already peaked. This disappointment is the second of its kind this year: investors have been over-eager to call the peak in inflation. Market volatility is likely to continue through the fall as investors now expect that the Fed will hike interest rates by another 75-100 basis points in September and continue hiking until inflation falls more convincingly. Twice-bitten investors will be hesitant to endorse a third rally until they are certain that inflation is coming down – but by then a recession may already be upon them. A significant increase in unemployment is likely necessary to cool inflation, which implies recession. Higher inflation will drive real wages further into the red, which is negative for the Biden administration’s midterm campaign. Otherwise the economy looked to be improving just in time for the vote. Manufacturing and non-manufacturing employment is perking up, labor force participation is reaching pre-Covid levels, and consumer confidence ticked up in the latest data, albeit still much lower than in 2021 (Chart 10). Now the tightening of financial conditions will cool the economy and sentiment in the advance of the election, reinforcing the opposition party and the expected gridlock. Inflation may indeed be peaking but not in time for the election.  Throughout this year we bet on the US dollar index. This trade is getting very toppy and net speculative positions have rolled over (Chart 11). The dollar is overvalued but its momentum remains strong given extreme macroeconomic and geopolitical uncertainty. We have put this trade on watch for a downgrade to neutral but we expect the momentum to be sustained at least through the US election and Chinese party congress this fall. Chart 10Small Bounce In Economy Will Not Save Democrats Chart 11Dollar Is Overvalued But Has Momentum     Matt Gertken Senior Vice President Chief US Political Strategy mattg@bcaresearch.com       Footnotes 1     This trajectory is the opposite of the Washington Consensus. As such, Marko Papic, the founder of BCA’s Geopolitical Strategy, has dubbed it the “Buenos Aires Consensus,” as it resembles Argentine economic policy more so than the Thatcher/Reagan policy mix.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)   Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model  Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets 

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

Dear Client, We will not be publishing the Commodity & Energy Strategy next week, as I will be participating in a panel discussion with Dr. Bassam Fattouh, Director of the Oxford Institute for Energy Studies (OIES), which will focus on global energy markets and their evolution.  Our panel will be moderated by my colleague Roukaya Ibrahim, Managing Editor of BCA Research's Daily Insights.  We will return to our regular publishing schedule on September 15, 2022. Sincerely, Robert Ryan Chief Commodity & Energy Strategist Executive Summary  The Biden administration’s Inflation Reduction Act (IRA) will throw just under $370 billion at incentivizing renewable-energy development via tax credits, grants and loans, and, in what arguably is a concession to common sense, to adding and extending incentives for conventional energy sources, carbon capture and hydrogen. In the short run, the IRA could add to systematic stress in the North American bulk power supply market, which still is contending with grid stability issues caused by solar PV generation. In a direct shot at the dominance of EV supply chains by China, the IRA subsidizes EVs assembled in North America using batteries sourced from there and critical minerals sourced either from the US or states which have a Free Trade Agreement with the US. The IRA will increase global competition for base metals supplies, which already are tight.  This will push prices higher to incentivize the development of the mines and local metals-refining operations required to satisfy this demand. IRA’s $370 Billion Allocations Bottom Line: The IRA incentivizes investment in clean energy, pollution reduction and GHG remediation, and employment in the energy-supply market writ large.  The next year likely will be taken up writing the actual regulations implementing the IRA.  If it succeeds in significantly boosting renewable energy investment and EV sales, it will stoke already-tight base metals markets and drive costs higher.  By incentivizing the development of carbon-capture and hydrogen technologies, it would extend the life of traditional hydrocarbon energy. Feature The Inflation Reduction Act (IRA) will make $370 billion available to energy providers and households via tax credits, grants and loans to incentivize green-energy production and deployment in the US (Chart 1). It also seeks to incentivize the expansion of locally built EVs in North America, the batteries that will power them, and the critical minerals crucial for green energy, as it attempts to break China’s dominance of EV and critical mineral supply chains globally. Support for carbon-capture and use, and hydrogen as a fuel also will be expanded. Chart 1IRA’s $370 Billion Allocations The US DOE estimates the IRA and the previously passed Bipartisan Infrastructure Law will reduce Greenhouse Gas (GHG) emissions by 1,150 MMT CO2e in 2030, equivalent to a 40% reduction vs 2005 GHG levels, in 2030.1 The inclusion of Carbon-Capture-Use-and-Storage (CCUS) technology in the IRA will incentivize technology that would allow for fossil fuels to be used as a bridge for the green energy transition, which, if successful, will dramatically extend the useful life of hydrocarbon resources. Per the IRA, tax credits for CCUS can reach a maximum of USD 60 – USD 85/ MT of CO2 captured depending on how successful the technology is in actually removing CO2.2 This is $25-$35/MT more than what is provided by the existing CCUS tax credits. As we argued in previous reports, lower production costs for nascent green technologies such as CCUS will spur research and development, unlocking a virtuous cycle of increased production and deployment, and lower costs.3 The IRA is technologically agnostic as to how low-carbon energy is produced – i.e., via renewables, hydrocarbons, or nuclear power. From 2025, Investment- and Production-Tax Credits (IC and PC tax credits) will be available for technology-neutral electricity production, meaning electricity from fossil fuels or nuclear power will receive tax and investment credits alongside renewables, provided no toxic GHG emissions are released. This will catalyze the development and use of CCUS technology, especially in existing power plants, which can be retrofitted with this technology. Controversy Around Oil, Gas Attends The IRA Among the more controversial features of the Act are provisions supporting oil and gas production. One of the provisions requires 2mm acres of public land and 60mm acres of water to be offered for lease to oil and gas companies a year prior to issuing new onshore solar or wind rights-of-way. We do not believe this will meaningfully increase US oil production since its main constraint isn’t a dearth of land but investor-induced drilling restraint – i.e., the capital discipline that compels oil and gas producers to only produce what can profitably be produced. We also are doubtful that increasing oil and gas royalties to 16.6-18.75% under the IRA will influence drillers’ production decisions since most states’ royalties, most notably Texas and New Mexico’s will be at parity or higher than the revised rate under the new law.4 The duration and coverage of investment and production tax credits for solar and wind projects have increased. Furthermore, energy storage technology will now receive ITCs and PTCs, which should encourage the development of this technology. Energy storage technology – e.g., utility-scale lithium batteries – will make green electricity more reliable, providing a competitive alternative to fossil fuel-generated electricity. Increasing Solar PV Resources Strain Power Grids As Chart 1 shows, renewables are receiving massive support from the IRA, particularly solar PV and wind resources. This will, over the short run, present problems for grid stability. The North American power grid is being stressed by lack of investment in systems capable of fully integrating renewables – particularly solar PV – with incumbent bulk power supplies from fossil fuels and nuclear power. This is being exacerbated by extreme-weather events (e.g., prolonged heat waves, droughts, fire storms, flooding, etc.).5 The IRA focuses on incentivizing particular power-generation technologies and, in conjunction with the Bipartisan Infrastructure Law, investing in and bolstering North American electric grids.6 This is and will remain a critical issue, given the threat to bulk power system (BPS) stability posed by the large amount of small-scale solar supplies, which are not required to meet NERC reliability standards, per the NERC’s analysis. This risk is being analysed in depth following widespread loss of solar PV power in California during the summer of 2021, which was compounded by droughts and wildfires.7 “The ongoing widespread reduction of solar PV resources continues to be a notable reliability risk to the BPS, particularly when combined with the additional loss of other generating resources on the BPS and in aggregate on the distribution system,” the April 2022 NERC report notes. In an earlier report, NERC analysts noted much of the solar PV resource operates at a smaller scale than other supplies (baseload nuclear power, e.g.), and are not part of the NERC’s bulk electric supply (BES) system (Chart 2).8 Practically speaking, the NERC noted, “the vast majority of solar PV plants connected to the BPS, totaling over half the capacity, are not considered BES and are therefore not subject to NERC Reliability Standards.” Chart 2Solar PV Resources Strain Grids In theory, this could limit the expansion of solar PV resources until the grid stability problems are addressed. Because of its intermittency, wind resources also can be unreliable sources of power, which means fossil-fuels alternatives – particularly natural-gas-fired generation – will continue to be favored to maintain grid stability and to provide back-up generation if wind or solar PV generation becomes unavailable. If CCUS technology can be harnessed to significantly reduce methane discharge – another goal of the IRA – along with particulates, natural gas production stands to increase as the US migrates to a low-carbon future. Investment Implications The recently enacted IRA law will incentivize increased investment in renewables and conventional resources. In addition, it will spur investment in energy-transmission and –transportation resources. The drafting and implementation of the regulations required to implement the law will be done over the next year or so, so it is difficult to forecast which investments will get off to the fastest start. We remain bullish base metals – the sine qua non of the renewal-energy transition – and conventional hydrocarbon resources. We continue to favor equity exposure via ETFs – the XME and XOP for exposure to miners and oil-and-gas producers, respectively. We also remain long the COMT ETF, an optimized version of the S&P GSCI to retain exposure to commodities directly.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodities Round-Up Energy: Bullish EU gas storage facilities were 80.17% full as of August 29 , reaching the bloc’s 80% target two months early (Chart 3) and raising the possibility of natgas rationing to reduce demand will not be needed this winter. The EU’s willingness to purchase gas at high prices over the summer injection months, given the dire consequences of possibly low gas storage levels in the winter withdrawal period, is responsible for this result. As Russian gas flows have dropped, the EU has had to rely on other sources, namely the US. LNG imports of 39 Bcm from the US to the EU over the first six months of this year have surpassed full year 2021 flows, according to Reuters. Elevated US gas flows to Europe have come at the expense of gas flows to states which are unable to afford the fuel at such high prices. In the US, high Henry Hub gas prices signal low domestic fuel availability primarily due to higher gas exports (Chart 4). Base Metals: Bullish High electricity and fuel prices in Europe are making metal smelting increasingly expensive, and are forcing refiners to voluntarily reduce operations. Nyrstar’s Budel zinc smelter and Norsk Hydro’s Slovalco aluminum smelter are the latest refinery operations forced to shutter operations going into the winter. Reduced domestic metal production runs counter to the continent’s aim of becoming more self-reliant on the supply of minerals critical to strategic industries such as defense and aerospace. Precious Metals: Neutral Federal Reserve chair Jerome Powell stressed the importance of price stability and reiterated the Fed’s commitment to restrictive policy to reduce inflation at the Jackson Hole conference. Gold prices fell on his speech as markets adjusted to higher interest rates than previously expected. However, counter to BCA’s US Bond Strategy view, markets still expect the Fed to start cutting rates in 2023. Two key drivers for gold prices next year will be the Fed’s rate hike regime and inflation perpetuated by potentially high oil prices following European sanctions on Russian oil and oil products. Chart 3 Chart 4       Footnotes 1     Please see The Inflation Reduction Act Will Significantly Cut the Social Costs of Climate Change, published by the US Department of Energy on August 23.  See also 8.18 InflationReductionAct_Factsheet_Final.pdf (energy.gov) for additional DOE analysis of the IRA. 2     Manufacturers of different green technologies can maximize tax credits by ensuring certain labor and materials sourcing requirements are met. 3    For a report with our most recent discussion on this issue, please see EU Gas Crisis Boosts Hydrogen’s Prospects, which we published on April 7, 2022.  See also Assessing Risks To Our Commodity Views, published on July 8, 2021, and Industrial Commodities Super-Cycle Or Bull Market?, published on March 4, 2021, for additional discussion on the need for carbon-capture investment. 4    The Permian basin, which constitutes 60% of total US shale production is located in these two states. 5    Please see the North American Electric Reliability Corporation’s recent report entitled Summer Reliability Assessment, May 2022, for an in-depth discussion of electric grid reliability going into the 2022 summer. 6    Please see “The Inflation Reduction Act Drives Significant Emissions Reductions and Positions America to Reach Our Climate Goals,” published by the US DOE as DOE/OP-0018, August 2022. 7     Please see “Multiple Solar PV Disturbances in CAISO, Disturbances between June and August 2021, April 2022,” published by the North American Electric Reliability Corporation. 8    Please see “Summary of Activities, BPS-Connected Inverter-Based Resources and Distributed Energy Resources,” published by NERC in September 2019.   Investment Views and Themes  New, Pending And Closed Trades WE WERE STOPPED OUT OF OUR LONG SPDR S&P METALS & MINING ETF (XME) TRADE ON AUGUST 29, 2022 WITH A RETURN OF 19.43%. WE WILL RE-ESTABLISH A LONG POSITION IN THE XME AT TONIGHT'S CLOSE. Strategic Recommendations Trades Closed in 2022

Dear Clients, Next week we will attend the BCA Investment Conference in New York. Therefore we will not publish our regular report. We will resume regular publication in the week of September 12. We apologize in advance for any inconvenience. Thank you, Matt Gertken, Senior Vice President US Political Strategy Executive Summary Top Issues On Voters’ Minds President Biden has a foreign policy but not yet a foreign policy doctrine.  The Biden Doctrine will emerge after critical tests. These tests are likely to be imminent, signaling more volatility and negative surprises for global investors. The three key foreign policy tests are: the Russia-EU energy crisis, the Iran nuclear crisis, and the fourth Taiwan Strait crisis. Of these, only Iran is looking like it could become a win for Biden – and a boon for markets – but even there deal is not yet confirmed. Biden’s foreign policy is domestically focused given the looming midterm elections. The result is likely to be high or higher volatility in the short run. Recommendation (Tactical) INITIATION DATE Return Long DXY (Dollar Index) Feb 23, 2022 13.1% Bottom Line: Stay defensive and long US dollar in the short run. The fourth quarter could be a turning point but for now political risk remains negative for risk assets. Feature Successful US presidents establish a foreign policy doctrine. The doctrine should not be defined by ideas and ideals but rather by the test of reality and experience – i.e. the decisions the president makes during crises. The Biden administration has a foreign policy and it has been tested in Ukraine. The focal point is to strengthen US alliances – even if that means deferring to allies’ interests on critical points. For example, while the US wanted to sell natural gas to Europe at the expense of Russia, Biden approved of Germany’s decision to finish building and operate the Nord Stream 2 pipeline to Russia in summer 2021. He condoned this decision even though Russia was already threatening Ukraine with invasion. Once Russia invaded, Germany froze the pipeline. The US had given its ally a choice, the choice ended badly, and now the ally is more certain that its interest lies with the United States. Bottom Line: The Biden administration’s foreign policy aims to restore US alliances and thus looks for the common denominator among allies. Biden’s Reactive Foreign Policy Biden’s foreign policy is fundamentally defensive, not offensive like that of the Trump administration. Trump initiated a trade war with China and others, revoked several international deals, tried to build a wall on the Mexican border, and imposed “maximum pressure” sanctions on Iran. By contrast, Biden, who entered office with a weak grip on Congress and a rebellion at the capitol, preferred to focus on domestic politics and social issues. He preferred to be reactive rather than proactive abroad, slapping sanctions on Russia only after it invaded Ukraine and so far avoiding major new sanctions on Iran or China. Biden’s foreign policy has also been reactive in the sense that it aims to win the approval of his domestic audience. Biden is a first-term US president, he faces midterm elections and the potential for re-election in 2024 – and the odds for him and his party are not great (Chart 1). Elections encourage him to maximize domestic legislation and minimize risks on the international scene. Chart 1Midterm Election Odds From The Street The second term – when the president is no longer eligible for re-election and could become a “lame duck” – is opportune for prioritizing national interests over partisan interests and taking risks abroad. The 2022 midterm election fits into this rubric: Biden’s foreign policy this year has been domestically focused and will continue to be through November. Biden’s goal must be balanced: to pursue his foreign policies but avoid worsening the Democratic Party’s difficulties at the voting booth. Our quantitative election models show that Democrats are likely to lose 21 seats in the House of Representatives (Table 1) and two seats in the Senate (Chart 2), thus losing control of all Congress to Republicans. The Senate is uncertain but the House is not. Given that the Senate is highly competitive, Biden must tread carefully to avoid worsening the economy or suffering a policy humiliation. Table 1BCA’s US House Election Quant Model Chart 2BCA’s US Senate Election Quant Model Hence while sanctions on Russia have pushed up energy prices and given ammunition to critics at home, Biden has encouraged Europe to take a pragmatic and gradual approach so as to soften the blow. The EU agrees for its own reasons and the oil embargo will not fully kick in until December 5, after the midterm election. Bottom Line: The Biden administration’s foreign policy is focused on its domestic audience, which means that midterm elections will continue to drive US foreign policy this year. Taking Risks Before The Midterms Since May we have observed that the Ukraine war and Biden’s midterm woes have stirred the administration into taking greater risks in its foreign policy. If American interests are asserted, Biden will look stronger at home. If a crisis erupts, Americans will rally around the flag. For example, Biden agreed to sell long-range artillery rockets (HIMARS) to Ukraine and provide higher value targeting intelligence to Ukraine. Biden expanded export controls on China and agreed to send legislators and eventually a new arms package to Taiwan. The current crisis in the Taiwan Strait arose because of the Biden administration’s initiatives – House Speaker Nancy Pelosi’s trip. Similarly Biden has not, as of August 31, provided Iran with the concessions necessary to clinch a nuclear agreement, raising the risk of rising tensions across the Middle East. He has slightly expanded sanctions, though, to be fair, the odds of an Iran deal are not low.1 We are contrarians on this issue and have put the odds of a deal at 40%, but rumors are swirling in the news media that a deal is at hand. In short, with his job approval rating falling to a net negative 13 percentage points (net negative 18 percentage points on his handling of the economy), Biden is increasingly willing to take foreign policy risks. The domestic focus of foreign policy is overwhelming its initial defensiveness. Biden’s policy is becoming more offensive, albeit still not to the same degree as the Trump administration’s. This shift in foreign policy does not line up well with what voters want. Voter priorities for the midterms are shaping up as follows: Economy: Voters are far more concerned about the economy than anything else (Chart 3, first panel). Biden’s foreign policy actions – sanctions on oil producers like Russia and Iran and tariffs on manufacturers like China – add to inflation, which is the top concern for voters within the economic sphere. Society: Voters are concerned about a range of social grievances such as gun policy, health care, crime, the electoral system. Abortion access and gun rights have become more important over the year, while foreign policy and energy policy have become less important (Chart 3, second panel). Foreign Policy: True, Biden’s foreign policy can tap into unfavorable views of Russia, Iran, and China (Chart 3, third panel). But voters are not demanding a more hawkish foreign policy in this election, so Biden’s decision to take more foreign policy risks this year must come from somewhere else. That somewhere else is the need to respond to foreign events, such as Russian invasions, but there is also the political expediency of stirring up nationalism, as is clear in the case of China. Chart 3Top Issues On Voters’ Minds Bottom Line: Voters are focused on the economy and social issues but Biden must respond to international challenges. In doing so, Biden is increasingly willing to take risks as the Democrats could benefit from any crisis that leads to an outburst of nationalism and patriotism. Biden’s Foreign Policy And Anti-Inflation Drive Back in June the Biden administration unveiled an anti-inflation plan that consisted of (1) Fed rate hikes (2) a reconciliation bill (3) budget discipline. We pointed out that the first option was the only one that would truly reduce inflation – but that it would also bring recession within a year or two. Once the reconciliation bill passed, we showed how the Inflation Reduction Act would increase budget deficits and inflation, especially when taken along with other new legislation like the Chips and Science Act. More recently Biden’s $500 billion plan for student debt forgiveness has underscored the continuing inflationary bent of his policies. Gasoline prices have come down slightly over the summer but not to the extent that Democrats can declare victory (Chart 4). Midterm voters will feel the year-on-year increase in headline inflation. Chart 4Prices At The Pump Market-based inflation expectations are rising again and consumers still report very high expectations for the one-year period, which is most relevant this fall (Chart 5). This brings us to Biden’s three foreign policy options for reducing inflation: reduce tensions with Russia, lift sanctions on Iran, and lift tariffs on China. Back in June we doubted that any of these would come to fruition. Now Biden faces a series of tests that will define his foreign policy doctrine: Chart 5Inflation Expectations Unabated   European Energy Crisis: Biden faces a European energy crisis stemming from Russia’s clash with NATO. Biden is providing Ukraine with extensive support in the form of money and weapons. That will continue in the short run as the Ukrainians are launching a counter-offensive against Russia. There are some signs of Russia signaling a willingness to negotiate but until Russia defeats the new counter-offensive it is highly unlikely to offer any serious concessions, or to relieve the pressure on Europe. The Biden administration has not yet accepted Russia’s broader demands, namely on the topic of NATO enlargement and whether NATO will ever try to station military bases in Finland or Sweden when they join the alliance (Table 2). Russia’s reaction to western policy is to constrict Europe’s energy supply further – namely shutting down the Nord Stream 1 pipeline – which will also tighten American energy supply via exports and exacerbate energy price inflation and expectations (Chart 6). Table 2US Response To Russia’s Demands On Finland, Sweden  Biden can allow slippage on sanction enforcement prior to the midterm but still his Russia policy will be a source of both conflict and inflation. Chart 6Russia Squeezes Europe Harder   Iranian Nuclear Crisis: Biden faces an Iranian nuclear crisis but it could be resolved quickly through a return to the 2015 nuclear deal. Apparently Biden is closer to clinching a deal. But the US and Iran do not trust each other, as shown in Chart 3 above. Biden could unilaterally relieve sanctions and allow Iranian their oil exports to pick up substantially (Chart 7). He can overcome Congress after a 30-day delay. But any deal will alienate the Saudi Arabians, who are threatening to cut oil production and reverse the oil price drop that Biden is seeking on behalf of US voters. So Iran is an option for Biden but it is not very compelling: the oil can be traded regardless of any deal. Biden’s capitulation would hurt politically without helping much economically. However, the failure of a deal poses a greater risk of instability in the Middle East and inflationary energy price shocks. So Biden faces an immediate and critical foreign policy test on this issue. Chart 7Iranian Oil Exports By Destination Fourth Taiwan Strait Crisis: Biden also faces a crisis in relations with China over the One China Policy and the status quo in the Taiwan Strait. This is the fourth such crisis since 1954. In previous crisis the US sent aircraft carriers through the strait, including in 1995-96. But it is not clear that Biden will do so given that China’s capabilities are much greater today (Map 1). The crisis probably will not be resolved before the midterm election since China will remain firm given its own domestic concerns this fall. Recently there emerged a tentative deal on the US auditing Chinese firms that list on US stock exchanges and an attempt to restart talks on climate change cooperation. The US and China are still talking despite tensions. But Biden has ruled out the option of reducing tariffs … which would only marginally have reduced inflation anyway. Map 1US Aircraft Carriers Suggest Taiwan Risk Is Substantial Bottom Line: Biden faces three foreign policy crises that threaten to exacerbate inflation. In each case he will likely uphold US security interests at the expense of higher inflation expectations in the short run. Investment Takeaways The Biden administration has a foreign policy but it does not yet have a foreign policy doctrine. The Biden Doctrine will be forged in the crucible of experience. The critical tests look to be coming soon. It will be difficult for Biden to pass the tests without fanning inflation expectations, at least in the short run. While bold action on Iran will not reduce oil prices as much as the consensus holds, a deal could avoid a worse scenario in which the Middle East destabilizes and energy shocks multiply. Investors should brace for more volatility, at least through the November 8 midterm election. Investors will need to see US-Russia, US-China, and US-Iran relations improve concretely and verifiably before determining that the geopolitical and macroeconomic backdrop are turning more favorable for risk assets.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com       Footnotes 1     See Ivana Saric, “Biden administration ramps up Iran sanctions as nuclear talks falter,” Axios, June 16, 2022, axios.com; Ellen Nakashima, “Biden administration slaps export controls on Chinese firms for aiding PLA weapons development,” Washington Post, April 8, 2021, washingtonpost.com; see also Karen Freifeld, “Biden administration reviewing China chip export policies, official says,” Reuters, July 14, 2022, reuters.com.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model  Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets 

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

Executive Summary   Reshoring And FDI Job Creation Have Accelerated After The Pandemic The US is entering a period of an industrial boom thanks to limited manufacturing capacity paired with strong demand for industrial and consumer goods. In addition, a trifecta of positive developments is further boosting US manufacturing: Onshoring, automation, and fiscal stimulus. Onshoring has accelerated after the onset of the pandemic and reshoring announcements are growing steadily. Automation and robotization allow industrial companies to circumvent labor shortages and rising wages and, hence, boost their profit margins.  The domestic political landscape in the US is also favorable for industrial stocks given the three major legislative Acts (Infrastructure Investment & Jobs, Inflation Reduction, and National Defense Authorization) that will secure a healthy demand pipeline. While long-term trends are favorable for the sector, a macroeconomic backdrop of slowing growth is a headwind.  However, thanks to a confluence of positive long-term trends, most companies are optimistic. Bottom Line: The US industrial sector is in the middle of a boom fueled by onshoring, automation, and favorable government policy. This trifecta of positives helps the sector to defy the gravity of the slowing economy. We remain overweight Industrials on both tactical and strategical time horizons but will continue to monitor it closely, watching out for potential cracks in operating performance. Feature A little over a year ago EMS, GIS, and USES co-published a report “Industrials as equity sector winner in the coming years”. In that report, we posited that the Industrial sector is poised for outperformance as it enjoys a boom thanks to strong new trends in onshoring and automation. In addition to the tectonic shifts described above, the sector has also found itself at the epicenter of the US legislative activity, which will provide a significant tailwind for its performance. Since we published the report on July 30, 2021, Industrials have performed in line with the S&P 500. However, since the beginning of the year, Industrials and Capital Goods outperformed the index by 7%, showing impressive resilience (Chart 1 and Table 1). Chart 1A Resilient Cyclical Sector In this week’s report, we take a close look at the trends highlighted above and conduct a deep dive to evaluate whether the sector is still attractive on a tactical basis considering the backdrop of rising rates and slowing economic activity. Our focus is on the Industrial sector in general, and the Capital Goods Industry Group, in particular. We will also assess which industries are best positioned for outperformance. Table 1Industrials Outperformed On The Way Down And During The Summer Rally Sneak Preview: The US industrial sector is in the middle of a boom fueled by onshoring, automation, and favorable government policy. This trifecta of positives helps the sector to defy the gravity of the slowing economy. For now, we are both strategically and tactically bullish on the sector but remain vigilant. US Manufacturing Capacity Has Been Severely Limited For Years US manufacturing capacity has been stagnant over the past 20 years, and the level of US manufacturing employment has declined by 30% since 2000 (Charts 2 & 3). Presently, manufacturing employment accounts for only 8% of total US employment. Chart 2US Manufacturing Employment Has Been Shrinking For Decades Chart 3US Manufacturing Capacity Has Not Expanded In The Past Two Decades The reason for the lack of capacity expansion over the past 20 years has been the outsourcing and shifting of production to other countries, especially China. The peak in US manufacturing capacity and employment occurred after the massive Asian currency devaluation in 1998 and China’s WTO admission in 2001. The semiconductor sector, which has recently come into the limelight, is a case in point: From 1990 to 2020, the percentage of chips manufactured in the US has fallen from 37% to 10%, with the lion’s share of chips manufactured in Asia. This trend has brought about The Chips Act which seeks to reverse the trend for national security reasons. Notably, more recently, the decline in manufacturing capacity and employment has started to reverse. More about this later. American Manufacturing Is Booming Again Limited manufacturing capacity paired with a strong demand for industrial and consumer goods translates into an industrial boom. Industrial companies are incentivized to expand given they are already operating at nearly full capacity (Chart 4) and enjoying considerable pricing power. Building industrial capacity in itself lifts demand for industrial goods and the US may be in the early innings of the new Capex cycle, unless the trend is derailed by headwinds from a significantly tighter monetary policy. After all, the age of US capital stock, at 24 years, is two years older than at previous peaks, indicating that many companies are overdue for replacing some of their equipment and machinery (Chart 5). Chart 4Industrial Companies Operate At Nearly Full Capacity Chart 5The US Capital Stock Has To Be Renewed Indeed, this may already be happening. According to S&P Dow Jones Indices, which analyzed second-quarter earnings season data, capital expenditures of the companies in the S&P 500, have been growing at a faster pace than stock repurchases for the first time since the first quarter of 2021, rising by 20% from a year earlier. Companies from Pepsi to Google to GM are investing in their production capacity, which in itself may be an encouraging sign that they are comfortable with the demand outlook. Of course, the caveat here is that industrials are late in cycle performance, as companies usually wait towards the end of the cycle to expand, only to find waning demand for their products. You Say “Reshoring,” I Say “Onshoring” A multi-decade decline in US manufacturing employment has started to reverse after the GFC, with the onset of the pandemic and geopolitical tensions accelerating the pace of reshoring and Foreign Direct Investing (FDI). Reshoring and FDI job announcements have increased from 6K in 2010 to 345K in 2022 (Chart 6). The resulting cumulative 950,000 incremental hires represent about 7% of US manufacturing employment. The acceleration of jobs coming back combined with the decline in the rate of offshoring has resulted in a 12-year steady uptrend in US manufacturing jobs. Truly amazing! Onshoring remains on top of mind for companies’ management. According to Statista, mentions of onshoring buzzwords in earnings calls and presentations of US public companies have increased from about 100 throughout 2020 to nearly 200 in Q2-2020. Chart 6Reshoring And FDI Job Creation Have Accelerated After The Pandemic According to Morgan Stanley’s survey of more than 400 executives of large corporations from the US to Germany to Japan, the most important factor in supply chain decisions is geopolitical stability, followed by skilled labor, physical infrastructure, and a developed supply chain ecosystem. On nearly every count, the US outranked Europe, China, and Mexico. Some 18% of the companies planned to significantly expand US manufacturing in the next 12 months, while 36% anticipated doing so within three years. More than 40% of US companies were taking steps to “onshore” supply chains. The reasons are well publicized: The COVID crisis has revealed over-dependence on imports. China’s decoupling from the US, tensions in the Taiwan Strait, and the Russian/Ukraine war have invoked concerns about the reliability of the existing supply chains. Supply chain disruptions have highlighted corporate vulnerabilities and had made companies realize that “just-in-case” trumps “just-in-time.” The US is pursuing protectionist policies that are to benefit companies operating in the US, Mexico, and Canada. According to Reshoring Initiative,1 Industrial and Tech companies are at the forefront of reshoring: Electrical Equipment, Chemicals, Transportation Equipment, Computer, and Electronic Products, and Medical Equipment suppliers are the leaders in onshoring (Table 2). Many large manufacturers such as Caterpillar have implemented or announced plans to bring offshore manufacturing back to the US. Table 2Reshoring Jobs By Top 5 Industries Will onshoring benefit some of the former manufacturing hubs? We believe it will, as Kentucky, North Carolina, Georgia, Ohio, and Alabama are the top five destinations (Table 3). However, there is a hitch. The US unemployment rate, which is at an all-time low of 3.5%, is certainly a speed limit. Moreover, companies that bring their businesses back home do realize that labor costs in this country are many times higher than, say, in Asia. Hence, one of the solutions they pursue is automation. After many years in the making, onshoring is finally gaining pace, benefiting the US manufacturing base. Table 32022 Projected Reshoring Jobs By Top 10 States Automation To The Rescue! The Pace of Robotization And Automation Is Accelerating A critical constraint for the expansion of US manufacturing is the labor shortage. Open vacancies in manufacturing are now at a record high, 100% above the 2018 peak (Chart 7, top panel). Notably, industrial companies have been experiencing difficulties hiring qualified staff over the past 10 years which has led to high wage growth (Chart 7, bottom panel). Chart 7US Manufacturers Cannot Fill Vacant Positions, Wages Are Surging Chart 8Automation Expands Profits Margins Of Global Industrials One remedy is automation. Replacing labor with automation/robots allows companies to produce more and avoid a profit margin squeeze (Chart 8). In a recent report published by the International Federation of Robotics, industrial robots reported record preliminary sales in 2021 with 486,800 units shipped globally, a 27% increase from 2020. The US has been lagging behind other developed countries in terms of automation and robotization (Chart 9). However, labor shortages brought about by the pandemic appear to have “moved the needle.” According to the Association for Advancing Automation (A3),2 the number of robots sold in the US in 2021 rose by 27% over 2020 with 49,900 units installed. 2022 is on pace to exceed previous records, with North American companies ordering a record 11,595 robots. Chart 9US Has Been Lagging Other Developed Nations In Robot Installations Non-automotive sales now represent 58% of the total, demonstrating a broadening reach of automation. Metals, Auto, and Food and Consumer Goods have the highest growth in the purchase of robots (Chart 10). Chart 10In 2021 The Pace Of Robot Installation Has Picked Up Implications For Industrial Companies The Industrials sector is home to companies that create robots and offer automation solutions as well as companies on the receiving end of the trend. Both sellers and buyers are to benefit: Buyers Of Robots: Manufacturing companies automating production and enlisting robots into their operations will enjoy higher operating leverage, lower labor costs, and more resilient margins. It is easier to automate processes in manufacturing than in service sectors. Consequently, we believe profit margins in manufacturing will outperform those of service sector companies, where automation will be slower. Sellers Of Robots: The sizzling demand for robots demonstrates that technological breakthroughs are no longer just about the Tech companies, and many industrial companies are to benefit from these nascent trends. Rockwell Automation, Eaton, and Caterpillar are the leaders in industrial automation. These companies also reach across the aisle to software companies to leverage their expertise in data storage, computing, and artificial intelligence. Rockwell has just recently partnered with Microsoft, while others are acquiring software companies. Deere has acquired GUSS Automation, a pioneer in semi-autonomous springs for high-value crops. These companies are to benefit from strong demand for their products and should exhibit strong sales and profit growth. To meet strong demand, industrial/manufacturing companies will automate their processes. This will allow them to boost volume and cap costs resulting in widening profit margins. Uncle Sam Loves American Manufacturing Both Biden and Trump before him, have stated that their overarching objective is to revive America’s manufacturing. However, their methods were drastically different, with Trump introducing tax cuts and tariffs, while Biden leans heavily on fiscal stimulus. The following is a recap of some of the recent laws passed by Congress and signed by President Biden. Infrastructure Investment And Jobs Act The $1.2-trillion Infrastructure Investment and Jobs Act will increase US government non-defense spending to bring it to around 3% of GDP, a level comparable to the 1980s-90s and larger than the 2010s. The bill’s focus is on traditional infrastructure – roads, bridges, ports, and electrical grid modernization – but also includes more modern elements such as $65 billion for 5G broadband Internet and $36 billion for electric vehicles and environmental remediation (Table 4). Implementation of the bill is delayed to 2023-24. Table 4Itemized Infrastructure Plan However, the market is forward-looking and companies in Construction & Engineering, and Building Products industries are already winners, and are up 12% in relative terms since the bill was passed on November 15, 2021. The potential increase in public construction will help offset a slump in residential construction on the back of the softening housing market (Chart 11). Chart 11The Increase In Public Construction Will Help Offset A Slump In Residential Construction Inflation Reduction Act (IRA) The bill earmarks $370 billion for clean energy spending as well as EV tax credits for both new and used cars. We have written on the topic of “Green and Clean” and the effect of the IRA on renewable energy and EV industries, two industries that are major beneficiaries of the bill. However, the bill also creates an enormous opportunity for industrial companies, which can build and service renewable infrastructure, such as Quanta Services (PWR) and Eaton (ETN). Companies that produce and service wind turbines (GE) and solar batteries will also get a revenue boost from the package. Chips Act Congress has passed the CHIPS+ bill to alleviate the chip shortage and shore up US competitiveness with China. Money is earmarked for domestic semiconductor production and research, and factory construction. While the key beneficiaries are chip foundries, construction of new factories will require equipment and services of a wide range from industrial companies from Construction to Machinery. National Defense Authorization Act In December, the House and Senate Armed Services Committee leadership released the Fiscal Year 2022 National Defense Authorization Act (NDAA). This bill introduces an overall discretionary authorization of $768.2 billion including $740.3 billion for base Department of Defense programs and $27.8 billion for national security programs in the Department of Energy. At a later date, another $37 billion was amended to the bill to include $2.5 billion to help pay higher fuel costs; $550 million for Ukraine, funding for five ships, eight Boeing Co-made F-18 Super Hornet fighter jets, and five Lockheed Martin C-130 Hercules planes; and about $1 billion for four Patriot missile units. For FY 2023, the House has already passed $839 billion, which is $37 billion above the White House request. The Senate will work on the bill after the summer recess. But it is already clear that defense spending has become a bipartisan issue. The increase in the defense budget, as well as additional allocation of funds towards Ukraine, have been a major boost for the Aerospace and Defense industry. We overweighted the sector back in January and it is up 24% in relative terms. Overweight Or Not, That Is The Question Macroeconomic Backdrop Business Cycle: Performance of the Industrial sector tends to lag the business cycle, as sector customers tend to wait until they are sure of recovery and have high utilization of their existing capacity before they expand their own production. However, demand is not entirely cyclical, as the need to replace obsolete or aging equipment or machines is relatively stable. There is also a stark difference in behavior of the largest industrial companies and smaller companies in their ecosystems. Larger manufacturers are long-cycle as it takes months to build machines, planes, or equipment. These companies are less sensitive to the business cycle. On the other hand, their suppliers are “short cycle” as they sell parts to many customers, turn their inventory frequently, and are very sensitive to the economic condition. At present, as economic growth is slowing, long-cycle industrial companies are preferable to short-cycle ones. Despite a bifurcation in demand, Industrials tend to underperform in a generic economic slowdown (Chart 12). This is unsurprising as the relative performance of Industrials is correlated to industrial production and the ISM PMI (Chart 13). Chart 12Historically, Industrials Underperformed During The Slowdown Stage Of The Business Cycle Chart 13Industrials Usually Underperform When IP And ISM PMI Decline Chart 14Survey Of Capex Intentions Is Weakening And while we touted the beginning of the new industrial boom in the US, and a brand new Capex cycle, we need to monitor it carefully, as multiple surveys of Capex intentions are decelerating (Chart 14). Tighter Monetary Policy: Another potential headwind comes from rising rates. After all, the higher cost of corporate borrowing may weigh on demand for industrial goods. However, historically, US industrial stocks outperformed the S&P 500 Index in the past 70 years during periods of rising bond yields, including the inflation decade of the 1970s (Chart 15). Industrial companies are well positioned to withstand inflation as strong pricing power allows them to pass on their costs to customers. Chart 15When Rates Rise, Industrials Outperform The macroeconomic backdrop presents challenges to Industrial companies Fundamentals Are Strong Significant Pricing Power: While dangers are looming in the macroeconomic backdrop, so far industrial companies have been doing well thanks to their significant pricing power (Chart 16), which they enjoy due to high capacity utilization. The relationship between capacity utilization and selling prices is not linear but exponential. When capacity reaches its limit and shortages arise, potential buyers will likely be willing to pay considerably higher prices to secure the supply of goods that they require. High Operating Leverage: In addition to high pricing power, industrial companies enjoy high operating leverage, which implies that while the economy is growing, even if at a slower pace, they can easily convert sales into profits. This will not be the case when the economy is outright contracting – then high operating leverage will become a liability. Chart 16Industrials Enjoy Substantial Pricing Power Strong Q2-2022 Earnings And Sales Results: This explains the strong Q2-2022 sales and earnings results of the Industrial sector. Industrial earnings grew at 17.4%, while its sales increased by 13.3% – a remarkable feat, considering that many companies, especially consumer-facing ones, are struggling with shrinking profitability – earnings growth of the Consumer Discretionary sector was down 12.6%. Clearly, business-to-business companies are faring much better than consumer-facing ones, whose demand was pulled forward by the pandemic, and whose customers are reeling from rising prices and are tightening their belts. Looking ahead, margins are expected to shrink by 0.5% (Chart 17), which is modest compared to the 2.5% contraction expected for the S&P 500. In terms of earnings growth expectations, they have fallen but still exceed the market by an impressive 10% even after a series of downgrades. Importantly, earnings growth in real terms is also positive (Charts 18 & 19). Chart 17Operating Margins Are Expected To Hold Up Well Chart 18Industrial Earnings Will Grow Faster Than The Market Chart 19Earnings Expectations Have Been Re-calibrated What Companies Are Saying All the charts and numbers align well with what we have heard from companies during the earnings season. For instance, nearly every major player within its own respective sub-industry reported healthy demand, low inventories, and a hefty backlog this quarter. Here are a few quotes from the largest players: Caterpillar (CAT): “We expect production and utilization levels will remain elevated, and our autonomous solutions continued to gain momentum … overall demand remained healthy across our segments … was unable to completely satisfy strong customer demand for our machines and engines.” MMM: “Continued strong demand for our solutions in semiconductor, factory automation, and automotive end markets.” GE: “In Renewables, … we are making progress. Our pricing has substantially improved onshore … we're growing our higher-margin businesses, such as grid automation, which delivered double-digit orders growth.” Honeywell (HON): “Orders were up 12% year over year and closing backlog was also up 12% year over year.” The profitability of the Industrial sector is expected to be resilient and to better the market. Valuations And Technicals The Industrial sector and the Capital Goods Industry group trade on par with the S&P 500 on a forward earnings basis (17.7x and 17.9x to 18.0x). The BCA Valuations Indicator signals a neutral level of valuation which is roughly in line with the 10-year average. From the BCA Technical Indicator standpoint, Capitals Goods are also in the neutral zone (Chart 20). Valuations and technicals are moderate for the sector. Chart 20Valuations And Technicals Investment Implications The US industrial sector is in the middle of a boom fueled by a trifecta of positives: Onshoring, automation, and favorable government policy. And while it is hard to fight the Fed and the business cycle, it appears that for now, the sector is defying gravity despite slowing manufacturing surveys and tighter monetary policy. So far fundamentals appear strong, and earnings expectations are robust thanks to the high pricing power and operating leverage of the sector. Within Capital Goods, we favor industries and companies that benefit from these tailwinds: Aerospace and Defense which is to benefit from increased federal defense spending; Robotics and Automation which is overrepresented in the Electrical Equipment industry; and Renewables, i.e., companies that manufacture and service wind turbines and solar panels. Construction and building materials will have a second breath when Infrastructure spending projects will actually get selected and approved. We are both strategically and tactically bullish on the sector but will monitor it closely from a tactical standpoint. After all, industrial surveys are at odds with the resilient earnings expectations. ETFs There are a number of very inexpensive and highly liquid ETFs from Vanguard, iShares, and State Street, that capture the performance of the Industrial sector (Table 5). Table 5Industrial Sector ETFs Bottom Line The US industrial sector is in the middle of a boom fueled by onshoring, automation, and favorable government policy. This trifecta of positives helps the sector to defy the gravity of the slowing economy. Companies are optimistic and earnings growth expectations are both robust and resilient. We are both strategically and tactically bullish on the sector but will continue to monitor it closely, watching out for potential cracks in operating performance.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     Footnotes 1     Reshoring Initiative reshorenow.org 2     https://www.automate.org/   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model  Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets 

Executive Summary   US Support For A Military Coup? A confluence of structural and cyclical factors makes the US highly prone to social and political instability, as in 2020. Today’s stagflationary economic environment further amplifies domestic political risk. The Biden administration’s decision to pursue a criminal investigation of former President Trump will drive political polarization higher, as will the overall 2022-24 political cycle. Investors should expect negative surprises from US politics, including social unrest, political violence, and domestic terrorism of whatever stripe. Such crisis events usually cause only a short-term spike in financial market volatility. A major crisis that affects election results could have a more lasting impact. The base case for US policy in 2023-24 is gridlock, which is marginally disinflationary. It would take an extraordinary surprise to change that.  On a relative basis, US assets benefit from domestic political risk because geopolitical risk rises even faster. Recommendation (Tactical) INITIATION DATE Return Long DXY (Dollar Index) Feb 23, 2022 10.8% Bottom Line: Investors should expect volatility and negative “October surprises” in the short term, at least through the midterm elections. US domestic political risk is high and will also amplify global geopolitical risk. Feature The US’s rolling political crisis is escalating again and political violence is likely to rise in the lead up to the midterm elections on November 8 and the presidential election in November 2024. The Department of Justice (DoJ) refused on August 15 to release the affidavit underpinning the Federal Bureau of Investigation’s (FBI) raid on former President Trump’s Mar-a-Lago residence in Florida. Never before has a US president suffered a raid on his home by the country’s federal law enforcement agencies – though presidents have been investigated before. It is not yet clear what charges will be brought against Trump but it is highly likely that he will be indicted for something. The Justice Department released a redacted version of the search warrant suggesting that Trump may be accused of having kept state secrets at his home in violation of the Presidential Records Act and possibly also the 1917 Espionage Act. Speculation says that some information he took back from the White House relates to nuclear weapons.1 The DoJ is pursuing a criminal investigation. The former president could very well end up on trial, or even in jail, but it is also possible that changes in political power will prevent him from going. What are the investment implications, if any? The US will see significant social and political upheaval but the main investment implication is that the US will continue to play an unpredictable and disruptive role abroad, perpetuating a flight to safety in financial markets, at least until the midterm elections are over.  Drivers Of US Political Instability The US political crisis should first be seen through the lens of geopolitics: The US is a continent-sized nation that is separated from the other world powers by large oceans. It is therefore highly defensible and economically insulated, with total exports accounting for only 10.2% of GDP.  However, this insularity and relative security create space for a fast growing and evolving society that is primarily focused on doing business rather than strengthening the state. The rapid creation of wealth is good but also produces large disparities in region, class, and race that periodically undermine stability. Maintaining domestic stability across the continent would be a constant challenge even if the government were not a federal republic with short political cycles driven by fickle popular opinion. Freedom is a source of political contention as well as wealth creation.   Over the past 70 years the society has become less religious and more secular, while the economy has become less manufacturing-oriented and more service-oriented. The shift to a high-tech and information-driven society has empowered the highly educated at the expense of the less educated. Capital owners have benefited from rising asset values, deregulation, and globalization, while labor has witnessed stagnant real wages. Agricultural and manufacturing regions have fallen behind.  Social stability is especially hard to maintain during cyclical periods of economic distress, highlighted today by the rising Misery Index (Chart 1). While inflation may subside in the short run, it will probably persist in the long run, and unemployment has nowhere to go but up. There is a demographic and generational factor that is also driving US instability today: The Baby Boom generation did not begin their adult lives with a robust policy consensus, like their parents’ generation, which shared sacrifices during the Great Depression and World War II. Instead the Boomers began with deep divisions due to the Vietnam War and social revolution of the 1960s. As they grew in wealth and power in the 1980s-90s, pro-growth tax policy, deregulation, and rapid socioeconomic changes aggravated these divisions. Inequality surged  (Chart 2). The Iraq War and 2008 financial crisis made matters worse. Chart 1US: High Misery Index Chart 2US: High Inequality Now the elites of this generation, who lead the two major parties, are trying to secure their economic and political interests before retirement and death. Bluntly, the pro-business faction is trying to prevent the pro-government faction from clawing back its wealth. Political polarization has reached the highest level since the early twentieth century (Chart 3). While polarization has subsided from the peaks of 2020, it could still exceed those peaks in the 2022-24 political cycle. The US will remain at or near “peak polarization” until generational change and geopolitical conflicts forge a new policy consensus. Bottom Line: The US is geopolitically secure but periodically struggles to maintain domestic stability. Today it is witnessing a confluence of structural and cyclical factors that generate social unrest and historic levels of political polarization. The 2022-24 election cycle will be tumultuous. Chart 3US: Peak Polarization Disaffection Can Lead To Violence Any kind of fanaticism can lead to violent extremism. Militants have emerged from secular movements on the right and left, from communism to fascism, as well as from religious movements.2 In recent years the US has seen a rise in violence, including crime and terrorism. Mass shootings have spiked since the 2008 financial crisis. Terrorism has revived to the highest levels since the 1980s, 96% of which is domestic terrorism (Chart 4). Recent improvements to the social safety net may or may not reduce violence. The stagflationary economic backdrop bodes ill. Opinion polls are of dubious accuracy when they ask people to admit to militant or criminal inclinations, but they still take the temperature of society. Several recent polls suggest that as many as 25% of Americans are willing to consider violence as a means of resolving political problems (Chart 5). Chart 4US: Domestic Terrorism, Political Violence Chart 5US Support For Political Violence? In addition, 55% of Republicans and 40% of independents claim that a military coup could be justified when there is “a lot of corruption,” a subjective standard to say the least (Chart 6). While this number has spiked over the 2020 election cycle, it also shows a substantial pre-existing willingness to entertain authoritarian solutions to political disputes. We do not take these polls at face value given the difficult subject matter. When a major violent event occurs and real people die, popular “support” for political violence will collapse across the United States. Nevertheless these data suggest a high level of disaffection and discontent, which is supported by the structural socioeconomic problems cited above.   Chart 6US Support For A Military Coup? The January 6, 2021 incident at the US Capitol was the crescendo of an explosion of social unrest that occurred across the country in 2020, triggered by the aforementioned structural factors, the Covid-19 pandemic, race riots, and political conflict over the 2020 election. The number of homicides rose to 7.4 per hundred thousand people, the highest annual number since the 1990s, higher than in 2001 when the 9/11 terrorist attacks occurred, and reminiscent of the turbulent late 1960s. This year’s midterm elections will be the first major electoral test since the chaotic events of 2020 and none of the underlying drivers of unrest have been resolved. On the contrary, recent signs are pointing to another escalation of social and political upheaval. The 2024 election will also spark unrest and violence. Bottom Line: The number of violent incidents is rising while a substantial minority of public opinion appears willing to entertain violent means of resolving political disputes. From Reality TV To Real Rebellion? The FBI’s raid on Trump’s Mar-a-Lago estate is naturally triggering a backlash from Trump supporters and Republicans. These groups were already distrustful of the federal government and particularly the FBI for spying on the Trump presidential campaign in the 2016 election.3 Republican support for the FBI and DoJ will fall sharply from its current level in opinion polling taken in 2019 (Chart 7, top panel). Trump opponents will argue that Trump is being investigated because of wrongdoing while Trump supporters will think that the Biden administration is trying to prevent him from running for re-election in 2024. Any lack of transparency by the Justice Department will heighten suspicion and acrimony. Chart 7US Views On 2021 Rebellion A fraction of radicalized Trump supporters could be motivated by this extraordinary event to conduct attacks. Already an armed suspect, allegedly linked to a right-wing extremist group and to the January 6 rebellion at the Capitol, attempted to storm an FBI field office in Cincinnati, Ohio. The Department of Homeland Security and FBI have warned about the risk of domestic terrorism for several years and have issued a new warning since the FBI raid on Mar-a-Lago.4 There is no easy way to resolve the dispute over the 2020 election or the January 6 rebellion because these events have taken on mythic status in the eyes of the different factions. For about half of Republicans, the January 6 incident was a patriotic defense of freedom – rather than an insurrection or attempt to prevent the peaceful and democratic transfer of power (Chart 7, bottom panel). Some small portion of those who view the election as stolen could become radicalized and act out violently. Trump received 46% of the popular vote in 2016 and 47% in 2020 (Chart 8). His favorability has suffered since the January 6 events but not as much as one might think. Among Republicans, Trump’s favorability remains largely unperturbed (Chart 9). While the vast majority of these voters are law-abiding, the decision to raid Trump’s home, and any future decision to press criminal charges, will drastically increase the risk of radicalization on the fringes. Chart 8Trump’s Share Of Popular Vote Chart 9Trump’s Popular Support Post-2020 It does not take a social scientist to recognize the potential for an increase in political violence if the federal government is perceived as using the arm of the law to prevent a popular candidate from contesting past or future elections. The risk of political violence cannot be dismissed because the US is a particularly well-armed country. There were 120 civilian-held firearms per 100 persons in the United States as of 2017. By contrast, the nearest country is France, with only 20 firearms per 100 persons (Chart 10). That does not mean that a major incident of violence will necessarily stem from the right wing. Only five years ago an extremist left-wing gunman tried to assassinate a whole group of Republican lawmakers while they were playing baseball. Earlier this year the Department Homeland Security warned about violent reactions to the Supreme Court’s overturning of the Roe v. Wade decision on abortion.5 If and when a major incident of political violence occurs, the public reaction will be a powerful rejection of violence across the political spectrum. For example, President Bill Clinton’s administration benefited from the Oklahoma City bombing in 1995 (Chart 11). Much will depend on the nature of the attack and which faction is most able to capitalize on its victimization. Chart 10Right To Bear Arms Shall Not Be Infringed Chart 11OKC Bombing Spurred Rally Round The Flag Ultimately instability will generate a popular consensus opposed to political violence and supportive of law and order, just as it did in previous periods of American upheaval. The future policy consensus will be “federalist” in orientation due to America’s geopolitics: there will be an increasing need to unify the states to achieve other strategic imperatives like prosperity and national security. We call this theme “Limited Big Government.” This re-centralization process will involve the federal government intervening to stabilize the society. It is not obvious which political party will first capture this consensus. It depends on the nature and timing of any crisis events and the cyclical rotation of parties. Bottom Line: The US is a heavily armed country that is currently prone to social and political instability. The risk of political violence and domestic terrorism of whatever stripe is already very high. In addition, a substantial portion of the country’s right-wing faction believes that the 2020 election was stolen, that the January 6 rebellion was justified, and that the federal government is now abusing its law enforcement powers to prevent a candidate from running in 2024. Domestic terrorism risk will increase.   Implications For The 2024 Election Federal agencies were well aware of the risk of a domestic backlash when they decided to raid Mar-a-Lago. Investigators may or may not produce ironclad evidence of wrongdoing by Trump, but polarization will continue to be the overriding dynamic in the short run. It is unlikely that any evidence will convince the different parties to change their opinions of Trump.    Assuming Republicans retake the House of Representatives this fall, they will likely impeach Biden, though they will lack the votes in the Senate to remove him from office. US domestic policy will be effectively paralyzed as the partisan conflict continues. The 2024 election will be required to settle the Trump saga and the future direction of US national policy. Trump’s legal troubles could be a blessing or a curse for the Republican Party in the 2024 cycle: If Trump is disqualified or put in jail, then he will become a political martyr for his populist base, motivating Republican voter turnout. At the same time, the Republican Party establishment will gain the advantage of nominating a more favorable candidate who will be eligible to hold the presidency for eight years. Republicans would benefit. If Trump is not disqualified, then he will be even more incentivized to run for the Republican nomination to avoid legal prosecution. In that case he will hinder Republican appeal among moderate and independent voters – leaving them vulnerable to a party split or third-party challenge. Even if he wins, he will only be eligible for the presidency for four years, limiting his party’s prospects. Republicans would suffer. The takeaway from the above is that Trump’s interests continue to be at odds with the interests of the Republican Party elite. If the Democrats aggressively prosecute Trump and try to put him behind bars, they will in fact help unify and motivate the Republican Party opposition. Two further conclusions can be drawn: First, because of the January 6 incident and the political fallout, any future attempt by protesters or rioters to storm a major federal power center will likely be met with overwhelming force rather than accommodation. If that occurs, and state violence is seen as partisan, then the party that uses force will suffer in public opinion. As with domestic terrorism, a major crisis is likely to occur. But it will ultimately be conducive to a new national policy consensus.  Second, US domestic instability will incentivize foreign powers to take advantage of US distraction to pursue their national interests aggressively in their own region. At the same time, the US government will also pursue a reactive foreign policy to attempt to divide the opposition and suppress domestic dissent. Therefore US domestic political instability increases global geopolitical instability.   Market Response Will Be Volatility What are the investment ramifications of the above? US corporate earnings are heavily insulated from political crises that do not affect either US policy or the structure of the government and economy. Volatility sometimes pops briefly during domestic terrorist events but not in a way that affects the investment outlook (Chart 12). Investors should bear this in mind since another crisis event is coming. True, if the Mar-a-Lago raid affects the midterm election – and hence the composition of the US government in 2023-24 – then financial markets will respond to some extent. However, investors can safely ignore this risk because the stagflationary economy will be the chief factor in the midterms and already favors the opposition party. For the same reason it remains highly likely that Republicans will retake the House of Representatives, producing legislative gridlock in 2023. The result is disinflationary in the short run, though inflation will be a persistent problem over the long run. If Democrats somehow retain control of both houses of Congress, i.e. the “Blue sweep risk,” then investors would see a substantial change in the policy outlook, as Democrats would have a second chance to raise taxes and social spending. But the odds of a blue sweep are low. Our House election model implies that Democrats will lose 22 seats when they only need to lose a net of five seats to lose control. Our Senate model gives 47.5% chance of Democrats retaining control, too close to call at this point (Appendix). The odds of another blue sweep are only 20% according to online betting market PredictIt. Chart 12Market Historically Ignores Domestic Terrorism US political instability has, if anything, supported the US dollar and US equity and bond outperformance for many years. The more unstable the US, the more unstable the world. Indeed, because of the US’s geopolitical position, the US often exports domestic instability to the rest of the world. That is the situation today as the Biden administration’s domestic-focused, reactive foreign policy exacerbates the conflicts with Russia and China. The Biden administration is willing to escalate strategic tensions with both China and Russia in the lead-up to the midterm elections – and this tendency will likely become the Biden Doctrine, lasting into 2024. Investors should remain defensively positioned, and overweight US assets, at least until the midterm election is over.     Matt Gertken Senior Vice President Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1     Read the warrant behind FBI search of Trump’s Mar-a-Lago,” PBS, August 12, 2022, pbs.org. 2     See Katarzyna Jasko et al, “A comparison of political violence by left-wing, right-wing, and Islamist extremists in the United States and the world,” PNAS [Proceedings of the National Academy of Sciences of the United States of America] 119:30 (2022), July 18, 2022, pnas.org. See also Herbert McClosky and Dennis Chong, “Similarities and Differences between Left-Wing and Right-Wing Radicals,” British Journal of Political Science 15:3 (1985), pp. 329-63, jstor.org.  3    See Jessica Lee, “Did Obama Get Caught ‘Spying’ on Trump’s 2016 Campaign?” Snopes, September 29, 2020, snopes.com. See also Wall Street Journal Editorial Board, “Trump Really Was Spied On,” February 14, 2022, wsj.com. 4    See Department of Homeland Security, “Strategic Intelligence Assessment and Data on Domestic Terrorism,” July 11, 2022, dhs.gov; Christopher Wray, “Worldwide Threats to the Homeland,” Federal Bureau of Investigation, September 17, 2020, fbi.gov. See also Ryan Lucas, “FBI, Homeland Security warn about threats to law enforcement after Trump search,” NPR, August 15, 2022, npr.org. 5    See Stef W. Kight, “DHS memo: Violent extremism ‘likely’ in wake of Roe v. Wade decision,” Axios, June 24, 2022, axios.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix