Geopolitics

Executive Summary Autocracy Hurts Productivity Autocracy Hurts Productivity Autocracy Hurts Productivity Over the next six-to-18 months, the Xi Jinping administration will “let 100 flowers bloom” – i.e., relax a range of government policies to secure China’s economic recovery from the pandemic. The first signs of this policy are already apparent via monetary and fiscal easing and looser regulation of Big Tech. However, investors should treat any risk-on rally in Chinese stocks with skepticism over the long run. Political risk and policy uncertainty will remain high until after Xi consolidates power this fall. Xi is highly likely to remain in office but uncertainty over other personnel – and future national policy – will be substantial. Next year China’s policy trajectory will become clearer. But global investors should avoid mistaking temporary improvements for a change of Xi’s strategy or China’s grand strategy. Beijing is driven by instability and insecurity to challenge the US-led world order. The result will be continued economic divorce and potentially military conflicts in the coming decade. Russia’s reversion to autocracy led to falling productivity and poor equity returns. China is also reverting to autocratic government as a solution to its domestic challenges. Western investors should limit long-term exposure to China and prefer markets that benefit from China’s recovery, such as in Southeast Asia and Latin America. Image Bottom Line: The geopolitical risk premium in Chinese equities will stay high in 2022, fall in 2023, but then rise again as global investors learn that China in the Xi Jinping era is fundamentally unstable and insecure. Feature Chart 1Market Cheers China's Hints At Policy Easing Market Cheers China's Hints At Policy Easing Market Cheers China's Hints At Policy Easing In 1957, after nearly a decade at the helm of the People’s Republic of China, Chairman Mao Zedong initiated the “Hundred Flowers Campaign.” The campaign allowed a degree of political freedom to try to encourage new ideas and debate among China’s intellectuals. The country’s innovative forces had suffered from decades of foreign invasion, civil war, and repression. Within three years, Mao reversed course, reimposed ideological discipline, and punished those who had criticized the party.  It turned out that the new communist regime could not maintain political control while allowing liberalization in the social and economic spheres.1 This episode is useful to bear in mind in 2022 as General Secretary Xi Jinping restores autocratic government in China. In the coming year, Xi will ease a range of policies to promote economic growth and innovation. Already his administration is relaxing some regulatory pressure on Big Tech. Global financial markets are cheering this apparent policy improvement (Chart 1). In effect, Xi is preparing to let 100 flowers bloom. However, China’s economic trajectory remains gloomy over the long run – not least because the US and China lack a strategic basis for re-engagement. Chinese Leaders Fear Foreign Encroachments Mao’s predicament was not only one of ideology and historical circumstance. It was also one of China’s geopolitics. Chinese governments have always struggled to establish domestic control, extend that control over far-flung buffer territories, and impose limits on foreign encroachments. Mao reversed his brief attempt at liberalization because he could not feel secure in his person or his regime. In 1959, the Chinese economy remained backward. The state faced challenges in administration and in buffer spaces like Tibet and Taiwan. The American military loomed large, despite the stalemate and ceasefire on the Korean peninsula in 1952. Russia was turning against Stalinism, while Hungary was revolting against the Soviet Union. Mao feared that the free exchange of ideas would do more to undermine national unity than it would to promote industrialization and technological progress. The 100 flowers that bloomed – intellectuals criticizing government policy – revealed themselves to be insufficiently loyal. They could be culled, strengthening the regime. However, what followed was a failed economic program and nationwide famine. Fast forward to today, when circumstances have changed but the Chinese state faces the same geopolitical insecurities. Xi Jinping, like all Chinese rulers, is struggling to maintain domestic stability and territorial integrity while regulating foreign influence. Although the People’s Republic is not as vulnerable as it was in Mao’s time, it is increasingly vulnerable – namely, to a historic downshift in potential economic growth and a rise in international tensions (Chart 2). The Xi administration has repeatedly shown that it views the US alliance system, US-led global monetary and financial system, and western liberal ideology as threats that need to be counteracted. Chart 2China: Less Stable, Less Secure China: Less Stable, Less Secure China: Less Stable, Less Secure In addition, Russia’s difficulties invading Ukraine suggest that China faces an enormous challenge in attempting to carve out its own sphere of influence without shattering its economic stability. Hence Beijing needs to slow the pace of confrontation with the West while pursuing the same strategic aims. Xi Stays, But Policy Uncertainty Still High In 2022  2022 is a critical political juncture for China. Xi was supposed to step down and hand the baton to a successor chosen by his predecessor Hu Jintao. Instead he has spent the past decade arranging to remain in power until at least 2032. He took a big stride toward this goal at the nineteenth national party congress in 2017, when he assumed the title of “core leader” of the Communist Party and removed term limits from its constitution. This year’s Omicron outbreak and abrupt economic slowdown have raised speculation about whether Xi’s position is secure. Some of this speculation is wild – but China is far less stable than it appears. Structurally, inequality is high, social mobility is low, and growth is slowing, forcing the new middle class to compromise its aspirations. Cyclically, unemployment is rising and the Misery Index is higher than it appears if one focuses on youth employment and fuel inflation (Chart 3). The risk of sociopolitical upheaval is underrated among global investors. Chart 3AStructurally China Is Vulnerable To Social Unrest Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. Chart 3BCyclically China Is Vulnerable To Social Unrest Cyclically China Is Vulnerable To Social Unrest Cyclically China Is Vulnerable To Social Unrest Yet even assuming that social unrest and political dissent flare up, Xi is highly likely to clinch another five-to-ten years in power. Consider the following points: The top leaders control personnel decisions. The national party congress is often called an “election,” but that is a misnomer. The Communist Party’s top posts will be ratified, not elected. The Politburo and Politburo Standing Committee select the members of the Central Committee; the national party congress convenes to ratify these new members. The Central Committee then ratifies the line-up of the new Politburo and Politburo Standing Committee, which is orchestrated by Xi along with the existing Politburo Standing Committee (Diagram 1). Xi is the most important figure in deciding the new leadership. Diagram 1Mechanics Of The Chinese Communist Party’s National Congress Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. There is no history of surprise votes. The party congress ratifies approximately 90% of the candidates put forward. Outcomes closely conform to predictions of external analysts, meaning that the leadership selection is not a spontaneous, grassroots process but rather a mechanical, elite-driven process with minimal influence from low-level party members, not to mention the population at large.2  The party and state control the levers of power: The Communist Party has control over the military, state bureaucracy, and “commanding heights” of the economy. This includes domestic security forces, energy, communications, transportation, and the financial system. Whoever controls the Communist Party and central government exerts heavy influence over provincial governments and non-government institutions. The state bureaucracy is not in a position to oppose the party leadership. Xi has conducted a decade-long political purge (“anti-corruption campaign”). Upon coming to power in 2012, Xi initiated a neo-Maoist campaign to re-centralize power in his own person, in the Communist Party, and in the central government. He has purged foreign influence along with rivals in the party, state, military, business, civil society, and Big Tech. He personally controls the military, the police, the paramilitary forces, the intelligence and security agencies, and the top Communist Party organs. There may be opposition but it is not organized or capable. Chart 4China: Big Tech Gets Relief ... For Now China: Big Tech Gets Relief ... For Now China: Big Tech Gets Relief ... For Now There are no serious alternatives to Xi’s leadership. Xi is widely recognized within China as the “core” of the fifth generation of Chinese leaders. The other leaders and their factions have been repressed. Xi imprisoned his top rivals, Bo Xilai and Zhou Yongkang, a decade ago. He has since neutralized their followers and the factions of previous leaders Hu Jintao and Jiang Zemin. Premier Li Keqiang has never exercised any influence and will retire at the end of this year. None of the ousted figures have reemerged to challenge Xi, but potential rivals have been imprisoned or disciplined, as have prominent figures that pose no direct political threat, such as tech entrepreneur Jack Ma (Chart 4).  Additional high-level sackings are likely before the party congress. China’s reversion to autocracy grew from Communist Party elites, not Xi alone. China’s slowing potential GDP growth and changing economic model raise an existential threat to the Communist Party over the long run. The party recognized its potential loss of legitimacy back in 2012, the year Xi was slated to take the helm. The solution was to concentrate power in the center, promoting Maoist nostalgia and strongman rule. In essence, the party needed a new Mao; Xi was all too willing to play the part. Hence Xi’s current position does not rest on his personal maneuvers alone. The party has invested heavily in Xi and will continue to do so. Characteristics of the political elite underpin the autocratic shift. Statistics on the evolving character traits of Politburo members show the trend toward leaders that are more rural, more bureaucratic, and more ideologically orthodox, i.e. more nationalist and communist (Chart 5). This trend underpins the party’s behavior and Xi’s personal rule. Chart 5China: From Technocracy To Autocracy Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. Chart 6China: De-Industrialization Undermines Stability China: De-Industrialization Undermines Stability China: De-Industrialization Undermines Stability Xi has guarded his left flank. By cornering the hard left of the political spectrum Xi has positioned himself as the champion of poor people, workers, farmers, soldiers, and common folk. This is the political base of the Communist Party, as opposed to the rich coastal elites and westernizing capitalists, who stand to suffer from Xi’s policies. Ultimately de-industrialization – e.g. the sharp decline in manufacturing and construction sectors (Chart 6) – poses a major challenge to this narrative. But social unrest will be repressed and will not overturn Xi or the regime anytime soon. Xi still retains political capital. After centuries of instability, Chinese households are averse to upheaval, civil war, and chaos. They support the current regime because it has stabilized China and made it prosperous. Of course, relative to the Hu Jintao era, Xi’s policies have produced slower growth and productivity and a tarnished international image (Chart 7). But they have not yet led to massive instability that would alienate the people in general. If Chinese citizens look abroad, they see that Xi has already outlasted US Presidents Obama and Trump, is likely to outlast Biden, and that US politics are in turmoil. The same goes for Europe, Japan, and Russia – Xi’s leadership does not suffer by comparison.  Chart 7China’s Declining International Image Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. External actors are neither willing nor able to topple Xi. Any outside attempt to interfere with China’s leadership or political system would be unwarranted and would provoke an aggressive response. The US is internally divided and has not developed a consistent China policy. This year the Biden administration has its hands full with midterm elections, Russia, and Iran, where it must also accept the current leadership as a fact of life. It has no ability to prevent Xi’s power consolidation, though it will impose punitive economic measures. Japan and other US allies have an interest in undermining Xi’s administration, but they follow the US’s lead in foreign policy. They also lack influence over the political rotation within the Communist Party. The Europeans will keep their distance but will not try to antagonize China given their more pressing conflict with Russia. Russia needs China more than ever and will lend material support in the form of cheaper and more secure natural resources. North Korean and Iranian nuclear provocations will help Xi stay under the radar.  There is no reason to expect a new leader to take over in China. The Xi administration’s strategy, revealed over the past ten years, will remain intact for another five-to-ten years at least. The real question at the party congress is whether Xi will be forced to name a successor or compromise with the opposing faction on the personnel of the Politburo and Politburo Standing Committee. But even that remains to be seen – and either way he will remain the paramount leader. Bottom Line: Xi Jinping has the political capability to cement another five-to-ten years in power. Opposing factions have been weakened over the past decade by Xi’s domestic political purge and clash with the United States. China is ripe for social unrest and political dissent but these will be repressed as China goes further down the path of autocracy. Foreign powers have little influence over the process. Policy Uncertainty Falls In 2023 … Only To Rise Again What will Xi Jinping do once he consolidates power? Xi’s administration has weighed heavily on China’s economy, foreign relations, and financial markets. The situation has worsened dramatically this year as the economy struggles with “A Trifecta Of Economic Woes” – namely a rampant pandemic, waning demand for exports, and a faltering housing market (Chart 8). In response the administration is now easing a range of policies to stabilize expectations and try to meet the 5.5% annual growth target. The money impulse, and potentially the credit impulse, is turning less negative, heralding an eventual upturn in industrial activity and import volumes in 2023. These measures will give a boost to Chinese and global growth, although stimulus measures are losing effectiveness over time (Chart 9).  Chart 8China's Trifecta Of Economic Woes China's Trifecta Of Economic Woes China's Trifecta Of Economic Woes Chart 9More Stimulus, But Less Effectiveness More Stimulus, But Less Effectiveness More Stimulus, But Less Effectiveness This pro-growth policy pivot will continue through the year and into next year. After all, if Xi is going to stay in power, he does not want to bequeath himself a financial crisis or recession at the start of his third term. Still, investors should treat any rally in Chinese equity markets with skepticism. First, political risk and uncertainty will remain elevated until Xi completes his power grab, as China is highly susceptible to surprises and negative political incidents this year (Chart 10). For example, if social unrest emerges and is repressed, then the West will impose sanctions. If China increases its support of Russia, Iran, or North Korea, then the US will impose sanctions.     Chart 10China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 Chart 11China Needs To Court Europe China Needs To Court Europe China Needs To Court Europe The regime will be extremely vigilant and overreact to any threats this year, real or perceived. Political objectives will remain paramount, above the economy and financial markets, and that means new economic policy initiatives will not be reliable. Investors cannot be confident about the country’s policy direction until the leadership rotation is complete and new policy guidance is revealed, particularly in December 2022 and March 2023. Second, after consolidating power, investors should interpret Xi’s policy shift as “letting 100 flowers bloom,” i.e., a temporary relaxation that aims to reboot the economy but does not change the country’s long-term policy trajectory. Economic reopening is inevitable after the pandemic response is downgraded – which is a political determination. Xi will also be forced to reduce foreign tensions for the sake of the economy, particularly by courting Europe, which is three times larger than Russia as a market (Chart 11). However, China’s declining labor force and high debt levels prevent its periodic credit stimulus from generating as much economic output as in the past. And the administration will not ultimately pursue liberal structural reforms and a more open economy. That is the path toward foreign encroachment – and regime insecurity. The US’s sanctions on Russia have shown the consequences of deep dependency on the West. China will continue diversifying away from the US. And, as we will see, the US cannot provide credible promises that it will reduce tensions. US-China: Re-Engagement Will Fail The Biden administration is focused on fighting inflation ahead of the midterm elections. But its confrontation with Russia – and likely failure to freeze Iran’s nuclear program – increases rather than decreases oil supply constraints. Hence some administration officials and outside observers argue that the administration should pursue a strategic re-engagement with China.3  Theoretically a US-China détente would buy both countries time to deal with their domestic politics by providing some international stability. Improved US-China relations could also isolate Russia and hasten a resolution to the war in Ukraine, potentially reducing commodity price pressures. In essence, a US-China détente would reprise President Richard Nixon’s outreach to China in 1972, benefiting both countries at the expense of Russia.4  This kind of Kissinger 2.0 maneuver could happen but there are good reasons to think it will not, or if it does that it will fall apart in one or two years. In 1972, China had nowhere near the capacity to deny the US access to the Asia Pacific region, expel US influence from neighboring countries, reconquer Taiwan, or project power elsewhere. Today, China is increasingly gaining these abilities. In fact it is the only power in the world capable of rivaling the US in both economic and military terms over the long run (Chart 12). Secretary of State Antony Blinken recently outlined the Biden administration’s China policy and declared that China poses “the most serious long-term challenge” to the US despite Russian aggression.5  Chart 12US-China Competition Sows Distrust, Drives Economic Divorce Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. While another decade of US engagement with China would benefit the US economy, it would be far more beneficial to China. Crucially, it would be beneficial in a strategic sense, not just an economic one. It could provide just the room for maneuver that China needs – at this critical juncture in its development – to achieve technological and productivity breakthroughs and escape the middle-income trap. Another ten-year reprieve from direct American competition would set China up to challenge the US on the global stage. That would be far too high of a strategic price for America to pay for a ceasefire in Ukraine. Ukraine has limited strategic value for the US and it does not steer US grand strategy, which aims to prevent regional empires from taking shape. In fact Washington is deliberately escalating and prolonging the war in Ukraine to drain Russia’s resources. Ending the war would do Russia a strategic favor, while re-engaging with China would do China a strategic favor. So why would the defense and intelligence community advise the Biden administration to pursue Kissinger 2.0? Chart 13US Unlikely To Revoke Trump Tariffs US Unlikely To Revoke Trump Tariffs US Unlikely To Revoke Trump Tariffs Biden could still pursue some degree of détente with China, namely by repealing President Trump’s trade tariffs, in order to relieve price pressures ahead of the midterm election. Yet even here the case is deeply flawed. Trump’s tariffs on China did not trigger the current inflationary bout. That was the combined Trump-Biden fiscal stimulus and Covid-era supply constraints. US import prices are rising faster from the rest of the world than they are from China (Chart 13). Tariff relief would not change China’s Zero Covid policy, which is the current driver of price spikes from China. And while lifting tariffs on China would not reduce inflation enough to attract voters, it would cost Biden some political credit among voters in swing states like Pennsylvania, and across the US, where China’s image has plummeted in the wake of Covid-19 (Chart 14).   Chart 14US Political Consensus Remains Hawkish On China Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. If Biden did pursue détente, would China be able to reciprocate and offer trade concessions? Xi has the authority to do so but he is unlikely to make major trade concessions prior to the party congress. Economic self-sufficiency and resistance to American pressure have become pillars of his support. Promises will not ease inflation for US voters in November and Xi has no incentive to make binding concessions because the next US administration could intensify the trade war regardless.  Bottom Line: The US has no long-term interest, and a limited short-term interest, in easing pressure on China’s economy. Continued US pressure, combined with China’s internal difficulties, will reinforce Xi Jinping’s shift toward nationalism and hawkish foreign policy. Hence there is little basis for a substantial US-China re-engagement that improves the global macroeconomic environment over the coming years. Investment Takeaways Chart 15Autocracy Hurts Productivity Autocracy Hurts Productivity Autocracy Hurts Productivity Xi Jinping will clinch another five-to-ten years in power this fall. To stabilize the economy, he will “let 100 flowers bloom” and ease monetary, fiscal, regulatory, and social policy at home. He will also court the West, especially Europe, for the sake of economic growth. However, he will not go so far as to compromise his ultimate aims: self-sufficiency at home and a sphere of influence abroad. The result will be a relapse into conflict with the West within a year or two. Ultimately a closed Chinese economy in conflict with the West will result in lower productivity, a weaker currency, a high geopolitical risk premium, and low equity returns – just as it did for Russia (Chart 15). Any short-term improvement in China’s low equity multiples will ultimately be capped. Over the long run, western investors should hedge against Chinese geopolitical risk by preferring markets that benefit from China’s periodic stimulus yet do not suffer from the break-up of the US-China and EU-Russia economic relationships, such as key markets in Latin America and Southeast Asia (Charts 16 & 17). Chart 16China Stimulus Creates Opportunity For … Latin America China Stimulus Creates Opportunity For ... Latin America China Stimulus Creates Opportunity For ... Latin America Chart 17China Stimulus Creates Opportunity For … Southeast Asia China Stimulus Creates Opportunity For ... Southeast Asia China Stimulus Creates Opportunity For ... Southeast Asia     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1     Modern scholarship has shown that Mao intended to entrap the opposition through the 100 Flowers Campaign. For a harrowing account of this episode, see Jung Chang and Jon Halliday, Mao: The Unknown Story (New York: Anchor Books, 2006), pp. 409-17. 2     “At least 8% of CPC Central Committee nominees voted off,” Xinhua, October 24, 2017, english.www.gov.cn. 3    Christopher Condon, “Yellen Says Biden Team Is Looking To ‘Reconfigure’ China Tariffs,” June 8, 2022, www.bloomberg.com. 4       Niall Ferguson, “Dust Off That Dirty Word Détente And Engage With China,” Bloomberg, June 5, 2022, www.bloomberg.com. 5    See Antony J Blinken, Secretary of State, “The Administration’s Approach to the People’s Republic of China,” George Washington University, Washington D.C., May 26, 2022, state.gov. Additionally, see President Joe Biden’s third assertion of US willingness to defend Taiwan against China, in a joint press conference with Japan’s Prime Minister Kishida Fumio, “Remarks by President Biden and Prime Minister Kishida Fumio of Japan in Joint Press Conference,” Akasaka Palace, Tokyo, Japan, May 23, 2022, whitehouse.gov.

Executive Summary Return Of The 'Pocketbook Voter' Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign President Biden’s pledge to fight inflation ahead of the midterm elections got a boost with the Gulf Arab states pledging to increase oil production in July and August. Yet OPEC’s action should not be overrated. The Saudis are not clearly bailing out Biden … at least not yet. Biden’s other inflation-fighting tools are also limited. The Fed will hike rates, which will weigh on inflation, at least in the short run. A short-term moderation in inflation will cause big shifts in financial markets. It will not save the midterms for Democrats, but gridlock is disinflationary so the effect is the same. Inflation risks will persist over the long run.   Recommendation (Cyclical) Inception Level Inception Date Return Small Vs. Large Cap Energy 0.6485 26-JAN-22 14.2% Oil And Gas Transportation And Storage Vs. S&P 500 0.0527 30-MAR-22 16.5% Bottom Line: Expect inflation to moderate in the short run. Oil prices will be volatile. Book a 14% profit on small cap versus large cap energy stocks and a 16.5% profit on the oil and gas transportation sub-sector relative to the broad market. Feature President Biden kicked off the summer – and the midterm election campaign – by defending his record thus far and pledging a three-pronged strategy to fight inflation. His options are limited but he received a boost from OPEC right off the bat. The bottom line is that disinflationary pressures are emerging. These include congressional gridlock, which is likely to return in January 2023. Biden’s policies will not save his party from a defeat in the midterms but moderating inflation will have huge investment consequences. Biden’s Three-Pronged Plan Consumer confidence is hurting while inflation eats away at real wage growth for Americans (Chart 1). Confidence is 14% higher than when Biden took office but 17.5% lower than when it peaked in June 2021. The latest survey from the Conference Board showed another decrease in May. This is foul weather for a ruling party that already stands to suffer a major check on its power when voters go to the polls in the fall. Biden’s approval rating is likely to stabilize but only at the current low level of 41.4%. Voters are focusing on the economy more than other issues like health care, the environment, or foreign affairs (Chart 2). Chart 1Consumer Confidence And Real Wages Tumble Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Chart 2Return Of The 'Pocketbook Voter' Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign In the Wall Street Journal Biden laid out his party’s election pitch.1 First, he argued that the US economy is transitioning from rapid recovery to stable growth – i.e. that it is not going into recession. That would be good, but a recession is possible and the slowdown is politically deadly: Household Savings: Aggregate household savings have risen from $1Tn in 2019 to $3.9Tn today, which Biden cited as evidence of improving financial security. The problem is that inequality skews the picture and the average American is unlikely to feel secure. Low and middle income earners have depleted their savings or seen only a small increase (Chart 3). The Biden administration failed to improve inequality as promised while the uneven economic recovery means that lower-paid Americans do not have as much ability to buffer spending as the aggregate savings imply. They will be unhappy in November. Chart 3Normal Households No Longer Flush With Savings Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Jobs And Wages: Biden highlighted the role of his economic stimulus in lowering unemployment and argued that Americans have better paying jobs. But inflation has eroded real wages and incomes, as highlighted in Chart 1 above. Business Investment: Biden argued that business investment is brisk. But sentiment is turning. New orders of core capital goods have rolled over and capex intentions are falling (Chart 4). Manufacturing Comeback: Biden also touted the US manufacturing comeback, claiming that factory jobs are growing at fastest rate in 30 years. But again the tide is shifting against him, with the employment component of manufacturing purchasing manager indexes now signaling contraction (Chart 5). Biden, like Presidents Trump and Obama, has invested heavily in the “Buy America” re-industrialization narrative, so this trend is threatening. Chart 4Business Investment Setback Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Chart 5Manufacturing Employment Weakening Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign A recession may indeed be avoided but the risk will not go away in time for the election. A recent study showed that at today’s extremely high level of inflation and extremely low level of unemployment, the odds of recession range from 60%-70% over the next 12-24 months.2 Second, Biden promised voters that he will fight inflation with all the powers of the White House. He laid out a three-pronged approach. However, his options are fairly limited and voters will not change their minds easily over the next five months: The Fed will hike rates: Biden argued that it is the Fed’s job to fight inflation and he will not interfere with rate hikes. While Biden offered admirable verbal support for an independent and non-partisan central bank, the truth is that real interest rates have not been this low since the highly politicized Fed chairmanship of Arthur Burns (Chart 6). While Biden has no reason to discourage rate hikes at the moment, he may change his tune as rates rise, growth slows, and the presidential election approaches. So may Powell, but by then it may be too late. In short, the Fed will hike, which will weigh on inflation, but it will not help Biden win voters this fall or avoid a recession by 2024. Congress will expand capacity: Biden argued that the bipartisan infrastructure bill that he signed into law and his other legislative proposals will boost the supply side of the economy. We are moderately optimistic about Congress’s ability to pass a party-line reconciliation bill that provides subsidies for the energy sector. This could pass under the consensus-building rubric of fighting Russia and climate change at the same time. But this measure, along with Biden’s Housing Supply Action Plan, child care and elderly care subsidies, and other proposals often look more like demand-side stimulus than supply-side reforms. They would fan inflation by increasing government spending and budget deficits. Moreover the administration cannot fix broken supply chains while China remains subject to strict Covid-19 lockdowns (Chart 7). In short, Congress may pass a reconciliation bill but it would be mildly stimulating for the economy (i.e. inflationary) and none of the supply-side improvements would reduce inflation in time for the midterms. Chart 6Biden Doesn't Need To Interfere With The Fed Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Chart 7Supply Snarls Will Continue While China Struggles With Covid Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign The budget deficit will fall: Biden argued that budget consolidation will reduce inflation, pointing to this year’s estimated $1.7 trillion drop in the budget deficit and arguing that the deficit is falling lower than pre-pandemic levels. He also argued that robust tax revenues from the economic recovery justified his previous fiscal stimulus (the American Rescue Plan Act). However, the budget is merely normalizing from extreme pandemic heights – there have obviously not been any long-term fiscal reforms (Chart 8). If Congress passes a reconciliation bill then Biden may succeed at passing a minimum corporate tax, which would mark an important success. But while the fiscal drag is negative for inflation, it is also negative for the economy this year and for Biden’s party in the midterms, and long-term budget trends are inflationary. Chart 8No Sign Of Budget Control Over Long Run – Budget Deficits Are Inflationary Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign The takeaway is that the Fed’s actions are disinflationary. Congress may or may not pass a climate bill before the election, but if it does, the budget deficit will be the same or larger and the economy will be the same or slightly stimulated. In brief Biden’s anti-inflation plan is to avoid interfering at the Fed. Extremely low unemployment will not save Biden and the Democrats this election season, any more than it saved Trump and the Republicans in 2018 (Chart 9). The Fed will rein in inflation at least in the short run. The election will lead to gridlock, which will freeze fiscal policy. Bottom Line: Inflation expectations will moderate but not because of any supply-side reform or fiscal consolidation coming from the Biden administration this year. Chart 9Low Unemployment Will Not Save Democrats Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Will Biden Ease Russian Energy Tensions? No. Biden’s other avenues for reducing inflation – not addressed in his editorial – lie in the foreign policy realm. The Biden administration is turning toward foreign policy as gridlock settles over Capitol Hill. Biden’s foreign policy will be insular, reactive, and focused on the midterm elections. Could Biden facilitate ceasefire talks in Ukraine so as to ease energy pressures stemming from Russia? The short answer is no. Biden imposed an oil embargo on Russia and ultimately agreed to the EU’s embargo. Biden can afford to run large risks with Russia this year because a larger confrontation or crisis with Russia would not hurt the Democrats in the midterm elections. Indeed the best hope for the Democrats is to recreate the 1962 congressional election, when John F. Kennedy stared down Soviet leader Nikita Krushchev in the Cuban Missile Crisis in October just before the election. Kennedy’s Democrats lost four seats in the House, gained four in the Senate, and kept control of both. Biden’s approval rating is nowhere near Kennedy’s but his party’s outlook is bad enough that he may be willing to run the risk of a crisis that could lead to a favorable rally-around-the-flag effect in the fall (Chart 10). Biden’s clearance this week of the highly mobile artillery rocket system for Ukraine – despite the risk that Ukrainians would launch attacks into Russian territory – underscores this point. Bottom Line: Biden will not ease tensions with Russia ahead of the midterm to try to reduce energy prices. Chart 10Biden Can Risk A Bigger Russia Crisis Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Will Biden Lower China Tariffs? No. What about China – will Biden ease the Trump administration’s tariffs on China to reduce inflation before the midterm election? Treasury Secretary Janet Yellen has repeatedly signaled support for this idea. The Trump administration marked a historic increase in US tariffs and the Biden administration has so far offered relief only for US allies (Chart 11). Again the short answer is no. Protectionist sentiment will prevail during midterm election season and US voters have turned decisively unfavorable toward China in recent years (Chart 12). The China tariffs have not been the driver for US inflation so tariff relief would bring minimal price relief while exacting a high political cost of making Biden look weak, wishy-washy on his pro-democracy values, and (according to Republicans) corrupt. Biden would be offering unilateral benefits to China without gaining Chinese trade concessions. Chart 11Biden Keeps Trump's Tariffs On China Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Chart 12Protectionist Sentiment To Prevail Amid Midterms Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Recently the Biden administration gave some indications of where it stands on China policy. Biden visited US allies in Asia Pacific and provoked China over the Taiwan Strait. Secretary of State Antony Blinken unveiled the administration’s comprehensive China policy and declared that the US would remain focused on China as the “most serious long-term challenge” despite Russia’s open belligerence in Europe.3 On paper, US-China trade relations do not look that bad. While China is falling short of its Phase One trade deal import promises, the truth is that a global recession intervened – and those promises were made under duress when the US slapped sweeping sanctions on Chinese exports. The commodity trade is booming, as is to be expected amid global energy shortages (Chart 13). The problem is that neither the US nor China has the domestic political capital to offer structural concessions in the short run, while both sides are girding for a century-long power struggle over the long run. Supply insecurity will result in the commodity trade suffering as a vast global substitution effect takes place. This is due to Russia’s energy breakup with Europe, growing Russia-China trade linkages, and ongoing US-China tensions. Global trade and US-China trade are set to slow, while China’s surge in energy imports from the US will abate for reasons of state security. Chart 13US-China Trade Faces Strategic Limits Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Bottom Line: No reduction in US tariffs on China is likely. Any reduction will have minimal macroeconomic effects and will be replaced by other punitive measures, given the underlying strategic competition and protectionist election politics. Meanwhile China’s “Zero Covid” policy will weigh on trade ties and sustain price pressures in the short run, as mentioned. Will Biden Lift Iran Sanctions? Probably Not. What about the Middle East? Can Biden convince the core OPEC states to pump more oil in lieu of Russian production? Or can Biden lift sanctions on Iran to undercut soaring gasoline prices? On this front Biden received welcome news on June 2 when Gulf Arab states promised to increase production by 638,000 barrels per day in July and August, up from an expected 430,000. At the same time news broke that Biden will visit Saudi Arabia, including potentially Crown Prince Mohammed bin Salman (MBS), and other Gulf partners sometime in June. There is not yet a clear understanding between Biden and MBS but it is possible that one will develop. The trigger for OPEC’s declaration is the EU oil embargo on Russia. EU is finalizing an embargo on 90% of oil imports – everything except the oil flowing through the Southern Druzhba pipeline to land-locked eastern European states. The embargo will impair Russian energy production: it could fall by as much as 2-3 million barrels per day, distribution interruptions will occur as Russia transitions to Asian buyers, and Russia’s long-term production capacity could be damaged. The result could be a destabilizing price spike. While the core OPEC states have just enough spare capacity to cover that gap in theory (Chart 14), they will not want to commit all spare capacity at once. Chart 14OPEC Spare Capacity Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign There is still a lot of uncertainty about how rapidly the embargo will be enforced, how much Russian production will suffer, whether the OPEC states will meet these new production increases (all except Saudi have been falling short), and what will be the OPEC policy beyond August. But for now it is clear that the Gulf Arab states are helping the US and EU by signaling some extra supplies at a critical time. The Gulf Arabs benefit from high oil prices and have previously ignored the G7’s pleas to increase production. But they also need to prolong the business cycle – a cycle-killing price shock from Russia is not in their interest. They are interested in keeping up revenues, maintaining domestic stability, and maintaining their position as the gatekeepers of the global oil supply and price. Secondarily, they are interested in maintaining close relations with the US, which guarantees their national security. OPEC supply easing at this juncture is obviously beneficial to Biden ahead of the US midterm election in November. But there is not yet an understanding on this front because the US is also negotiating to rejoin the 2015 nuclear agreement with Iran, which Saudi Arabia and the Gulf states oppose. Biden’s trip to the Gulf suggests that nothing is settled yet. The OPEC production increase is not proof alone that the US is breaking off talks with Iran. If the Gulf states thought the US were going to strike a deal with Iran, they might produce more oil to preempt the deal and grab more market share, which is what they did in 2014 in advance of the original 2015 US-Iran nuclear deal. The Saudis do not want US shale producers and Iranian exporters to form an unholy alliance that steals market share and compromises Saudi security. Still, we expect the US-Iran deal to fall apart. The Biden administration does not have a unified international coalition to enforce sanctions on Iran. Nor does it have the political capital or longevity to give Iran credible security guarantees that would convince it to freeze its nuclear program. Recent events support our view. The UN atomic watchdog says that Iran’s stockpile of highly enriched uranium has risen by 30% in three months. Meanwhile the US seized an Iranian tanker off Greece, Iran seized two Greek tankers, and Greece warned about dangers to shipping in the Persian Gulf. To develop a better understanding between Biden and MBS, the US needs to assure the Saudis that it will not renew the deal with Iran. The Saudis will not provide oil at Biden’s whim but they may provide if they have satisfaction that the US will scrap the deal, or otherwise compensate them, such as through increased defense assistance (which Biden threatened to cut off when he entered office). Investors should expect OPEC to fall short of its current promises – and yet to try to provide the minimum production increases necessary to prevent a destabilizing oil spike. OPEC’s interest is to make a windfall for as long as possible, which means not killing the cycle out of greed. This policy could be positive for oil prices after the immediate downward price adjustment. But for now investors should merely expect oil volatility as the EU’s embargo enforcement, Russian retaliation, Russian oil production, OPEC implementation, and US sanctions on Iran are all up in the air. A successful US-Iran deal would deepen the drop in oil prices. But odds are 60/40 that that deal will fail, leading to an escalation of tensions in the Middle East. Biden will have to underscore the US’s red line against Iranian nuclear weaponization. Oil supply disruptions will increase in frequency across the region. Bottom Line: OPEC has given Biden’s anti-inflation campaign a boost but it is too soon to declare that oil prices will substantially abate. The US-Iran deal will likely fail, increasing Middle Eastern instability and supply risks. Investment Takeaways Given that we expect continued volatility in the oil space, we are booking a 14% gain on our long small cap energy versus large cap energy trade. We are also booking a 16.5% gain on our overweight position in the oil and gas transportation and storage sub-sector. We will revisit these trades in future reports. Overall we maintain a defensive portfolio strategy. Biden’s anti-inflation campaign is meeting with some success in the Middle East but the US confrontation with Russia and the likely failure of US-Iran talks suggests that price spikes can still kill more demand and lead to further growth upsets.   Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com   Footnotes 1     See Joseph R. Biden, Jr, “Joe Biden: My Plan for Fighting Inflation,” Wall Street Journal, May 30, 2022, wsj.com.  2     See Lawrence H. Summers and Alex Domash, “History Suggests a High Chance of Recession over the Next 24 Months,” Harvard Kennedy School, March 15, 2022, www.hks.harvard.edu.  3    See Antony J. Blinken, “The Administration’s Approach to the People’s Republic of China,” US Department of State, May 26, 2022, state.gov.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Table A3US Political Capital Index Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Chart A1Presidential Election Model Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Chart A2Senate Election Model Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign  Table A4House Election Model Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Table A5APolitical Capital: White House And Congress Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Table A5BPolitical Capital: Household And Business Sentiment Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign Table A5CPolitical Capital: The Economy And Markets Biden's Anti-Inflation Campaign Biden's Anti-Inflation Campaign

Executive Summary EU Embargoes Russian Oil Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) The EU imposed an embargo on 90% of Russian oil imports, which will provoke retaliation. Russia will squeeze Europe’s economy ahead of critical negotiations over the coming 6-12 months. Russian gains on the battlefield in Ukraine point to a ceasefire later, but not yet – and Russia will need to retaliate against NATO enlargement. The Middle East and North Africa face instability and oil disruptions due to US-Iran tensions and Russian interference. China’s autocratic shift is occurring amid an economic slowdown and pandemic. Social unrest and internal tensions will flare. China will export uncertainty and stagflation.  Inflation is causing disparate effects in South Asia – instability in Pakistan and Sri Lanka, and fiscal populism in India.   Asset Initiation Date Return Long Brazilian Financials / Indian Equities (Closed) Feb 10/22 22.5%  Bottom Line: Markets still face three geopolitical hurdles: Russian retaliation; Middle Eastern instability; Chinese uncertainty. Feature Global equities bounced back 6.1% from their trough on May 12 as investors cheered hints of weakening inflation and questioned the bearish consensus. BCA’s Global Investment Strategy correctly called the equity bounce. However, as BCA’s Geopolitical Strategy service, we see several sources of additional bad news. Throughout the Ukraine conflict we have highlighted two fundamental factors to ascertain regarding the ongoing macroeconomic impact: Will the war cut off the Russia-EU energy trade? Will the war broaden beyond Ukraine? Chart 1Russian-Exposed Assets Will Suffer More Russian-Exposed Assets Will Suffer More Russian-Exposed Assets Will Suffer More In this report we update our views on these two critical questions. The takeaway is that the geopolitical outlook is still flashing red. The US dollar will remain strong and currencies exposed to Russia and geopolitical risk will remain weak (Chart 1). In addition, China’s politics will continue to produce uncertainty and negative surprises this year. Taken together, investors should remain defensive for now but be ready to turn positive when the market clears the hurdles we identify. The fate of the business cycle hangs in the balance.  Energy Ties Eroding … Russia Will Retaliate Over Oil Embargo Chart 2AEU Embargoes Russian Oil Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Europe is diversifying from Russian oil and natural gas. The European Union adopted a partial oil embargo on Russia that will cut oil imports by 90% by the end of 2022. It also removed Sberbank from the SWIFT banking communications network and slapped sanctions on companies that insure shipments of Russian crude. The sanctions will cut off all of Europe’s seaborne oil imports from Russia as well as major pipeline imports, except the Southern Druzhba pipeline. The EU made an exception for landlocked eastern European countries heavily dependent on Russian pipeline imports – namely Hungary, Slovakia, the Czech Republic, and Bulgaria (Chart 2A).  Focus on the big picture. Germany changed its national policy to reduce Russian energy dependency for the sake of national security. From Chancellors Willy Brandt to Angela Merkel, Germany pursued energy cooperation and economic engagement as a means of lowering the risk of war with Russia. Ostpolitik worked in the Cold War, so when Russia seized Crimea in 2014, Merkel built the Nord Stream 2 pipeline. But Merkel’s policy failed to persuade Russia that economic cooperation is better than military confrontation – rather it emboldened President Putin, who viewed Europe as divided and corruptible. Chart 2BRussia Squeezes EU’s Natural Gas Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Russia’s regime is insecure and feels threatened by the US and NATO. Russia believed that if it invaded Ukraine, the Europeans would maintain energy relations for the sake of preserving overall strategic stability. Instead Germany and other European states began to view Russia as irrational and aggressive and hence a threat to their long-term security. They imposed a coal ban, now an oil ban the end of this year, and a natural gas ban by the end of 2027, all formalized under the recently announced RePowerEU program. Russia retaliated by declaring it would reduce natural gas exports to the Netherlands and probably Denmark, after having already cut off Finland, Poland, and Bulgaria (Chart 2B). As a pretext Russia points to its arbitrary March demand that states pay for gas in rubles rather than in currencies written in contracts. This ruble payment scheme is being enforced on a country-by-country basis against those Russia deems “unfriendly,” i.e. those that join NATO, adopt new sanctions, provide massive assistance to Ukraine, or are otherwise adverse. Chart 3Russia Actively Cutting Gas Flows Russia Actively Cutting Gas Flows Russia Actively Cutting Gas Flows Russia and Ukraine are already reducing natural gas exports through the Ukraine and Turkstream pipelines while the Yamal pipeline has been empty since May – and it is only a matter of time before flows begin to fall in the Nord Stream 1 pipeline to Germany (Chart 3). German government and industry are preparing to ration natural gas (to prioritize household needs) and revive 15 coal plants if necessary. Europe is attempting to rebuild stockpiles for the coming winter, when Russian willingness and capability to squeeze natural gas flows will reach a peak. The big picture is demonstrated by game theory in Diagram 1. The optimal situation for both Russia and the EU is to maintain energy exports for as long as possible, so that Russia has revenues to wage its war and Europe avoids a recession while transitioning away from Russian supplies (bottom right quadrant, each side receives four points). The problem is that this solution is not an equilibrium because either side can suffer a sudden shock if the other side betrays the tacit agreement and stops buying or selling (bottom left and top right quadrants). Diagram 1EU-Russia Standoff: What Does Game Theory Say? Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) The equilibrium – the decision sets in which both Russia and the EU are guaranteed to lose the least – is a situation in which both states reduce energy trade immediately. Europe needs to cut off the revenues that fuel the Russian war machine while Russia needs to punish and deter Europe now while it still has massive energy leverage (top left quadrant, circled). Once Europe diversifies away, Russia loses its leverage. If Europe does not diversify immediately, Russia can punish it severely by cutting off energy before it is prepared.   Russian energy weaponization is especially useful ahead of any ceasefire talks in Ukraine. Russia aims for Ukrainian military neutrality and a permanently weakened Ukrainian state. To that end it is seizing territory for the Luhansk and Donetsk People’s Republics, seizing the southern coastline and strategic buffer around Crimea, and controlling the mouth of the Dnieper river so that Ukraine is forever hobbled (Map 1). Once it achieves these aims it will want to settle a ceasefire that legitimizes its conquests. But Ukraine will wish to continue the fight. Map 1Russian Invasion Of Ukraine, 2022 Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Russia will need leverage over Europe to convince the EU to lean on Ukraine to agree to a ceasefire. Something similar occurred in 2014-15 when Russia collaborated with Germany and France to foist the Minsk Protocols onto Ukraine. If Russia keeps energy flowing to EU, the EU not only gets a smooth energy transition away from Russia but also gets to keep assisting Ukraine’s military effort. Whereas if Russia imposes pain on the EU ahead of ceasefire talks, the EU has greater interest in settling a ceasefire. Finally, given Russia’s difficulties on the battlefield, its loss of European patronage, and potential NATO enlargement on its borders, Moscow is highly likely to open a “new front” in its conflict with the West. Josef Stalin, for example, encouraged Kim Il Sung to invade South Korea in 1950. Today Russia’s options lie in the Middle East and North Africa – the regions where Europe turns for energy alternatives. Not only Libya and Algeria – which are both inherently fertile ground for Russia to sow instability –  but also Iran and the broader Middle East, where a tenuous geopolitical balance is already eroding due to a lack of strategic understanding between the US and Iran. Russia’s capabilities are limited but it likely retains enough influence to ignite existing powder kegs in these areas.   Bottom Line: Investors still face a few hurdles from the Ukraine war. First, the EU’s expanding energy embargo and Russian retaliation. Second, instability in the Middle East and North Africa. Hence energy price pressures will remain elevated in the short term and kill more demand, thus pushing the EU and the rest of the world toward stagflation or even recession. War Contained To Ukraine So Far … But Russia To Retaliate Over NATO Enlargement At present Russia is waging a full-scale assault on eastern and southern Ukraine, where about half of Donetsk awaits a decision (Map 2). If Russia emerges victorious over Donetsk in the summer or fall then it can declare victory and start negotiating a ceasefire. This timeline assumes that its economic circumstances are sufficiently straitened to prevent a campaign to the Moldovan border.1   Map 2Russia May Declare Victory If It Conquers The Rest Of Donetsk Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) There are still ways for the Ukraine war to spill over into neighboring areas. For example, the Black Sea is effectively a Russian lake at the moment, which prevents Ukrainian grain from reaching global markets where food prices are soaring. Eventually the western maritime powers will need to attempt to restore freedom of navigation. However, Russia is imposing a blockade on Ukraine, has more at stake there than other powers, and can take greater risks. The US and its allies will continue to provide Ukraine with targeting information against Russian ships but this assistance could eventually provoke a larger naval conflict. Separately, the US has agreed to provide Ukraine with the M142 High Mobility Artillery Rocket System (HIMARS), which could lead to attacks on Russian territory that would prompt a ferocious Russian reaction. Even assuming that the Ukraine war remains contained, Russia’s strategic conflict with the US and the West will remain unresolved and Moscow will be eager to save face. Russian retaliation will occur not only on account of European energy diversification but also on account of NATO enlargement. Finland and Sweden are attempting to join NATO and as such the West is directly repudiating the Putin regime’s chief strategic demand for 22 years. Finland shares an 830 mile border with Russia, adding insult to injury. The result will be another round of larger military tensions that go beyond Ukraine and prolong this year’s geopolitical risk and uncertainty. Russia’s initial response to Finland’s and Sweden’s joint application to NATO was to dismiss the threat they pose while drawing a new red line. Rather than forbidding NATO enlargement, Russia now demands that no NATO forces be deployed to these two states. This demand, which Putin and other officials expressed, may or may not amount to a genuine Russian policy change. Russia’s initial responses should be taken with a grain of salt because Turkey is temporarily blocking Finland’s and Sweden’s applications, so Russia has no need to respond to NATO enlargement yet. But the true test will come when and if the West satisfies Turkey’s grievances and Turkey moves to admit the new members. If enlargement becomes inevitable, Russia will respond. Russia will feel that its national security is fundamentally jeopardized by Sweden overturning two centuries of neutrality and Finland reversing the policy of “Finlandization” that went so far in preventing conflict during the Cold War. Chart 4Military Balances Stacking Up Against Russia Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Russia’s military options are limited. Russia has little ability to expand the war and fight on multiple fronts judging by the army’s recent performance in Ukraine and the Red Army’s performance in the Winter War of 1939. This point can be illustrated by taking the military balance of Russia and its most immediate adversaries, which add up to about half of Russian military strength even apart from NATO (Chart 4). Russian armed forces already demonstrated some pragmatism in April by withdrawing from Kyiv and focusing on more achievable war aims. Unless President Putin turns utterly reckless and the Russian state fails to restrain him, Russia will opt for defensive measures and strategic deterrence rather than a military offensive in the Baltics. Hence Russia’s military response will come in the form of threats rather than outright belligerence. However, these threats will probably include military and nuclear actions that will raise alarm bells across Europe and the United States. President Dmitri Medvedev has already warned of the permanent deployment of nuclear missiles in the Kaliningrad exclave.2 This statement points to only the most symbolic option of a range of options that will increase deterrence and elevate the fear of war. Otherwise Russia’s retaliation will consist of squeezing global energy supply, as discussed above, including by opening a new front in the Middle East and North Africa. Instability should be expected as a way of constraining Europe and distracting America. Higher energy prices may or may not convince the EU to negotiate better terms with Russia but they will sow divisions within and among the allies. Ultimately Russia is highly unlikely to sacrifice its credibility by failing to retaliate for the combination of energy embargo and NATO enlargement on its borders. Since its military options are becoming constrained (at least its rational ones), its economic and asymmetrical options will grow in importance. The result will be additional energy supply constraints. Bottom Line: Even assuming that the war does not spread beyond Ukraine – likely but not certain – global financial markets face at least one more period of military escalation with Russia. This will likely include significant energy cutoffs and saber-rattling – even nuclear threats – over NATO enlargement.   China’s Political Situation Has Not Normalized China continues to suffer from a historic confluence of internal and external political risk that will cause negative surprises for investors. Temporary improvements in government policy or investor sentiment – centered on a relaxation of “Zero Covid” lockdowns in major cities and a more dovish regulatory tone against the tech giants – will likely be frustrated, at least until after a more dovish government stance can be confirmed in the wake of the twentieth national party congress in October or November this year. At that event, Chinese President Xi Jinping is likely to clinch another ten years in power and complete the transformation of China’s governance from single-party rule to single-person rule. This reversion to autocracy will generate additional market-negative developments this year. It has already embedded a permanently higher risk premium in Chinese financial assets because it increases the odds of policy mistakes, international aggression, and ultimately succession crisis. The most successful Asian states chose to democratize and expand free markets and capitalism when they reached a similar point of economic development and faced the associated sociopolitical challenges. But China is choosing the opposite path for the sake of national security. Investors have seen the decay of Russia’s economy under Putin’s autocracy and would be remiss not to upgrade the odds of similarly negative outcomes in China over the long run as a result of Xi’s autocracy, despite the many differences between the two countries. China’s situation is more difficult than that of the democratic Asian states because of its reviving strategic rivalry with the United States. US Secretary of State Antony Blinken recently unveiled President Biden’s comprehensive China policy. He affirmed that the administration views China as the US’s top strategic competitor over the long run, despite the heightened confrontation with Russia.3 The Biden administration has not eased the Trump administration’s tariffs or punitive measures on China. It is unlikely to do so during a midterm election year when protectionist dynamics prevail – especially given that the Xi administration will be in the process of reestablishing autocracy, and possibly repressing social unrest, at the very moment Americans go to the polls. Re-engagement with China is also prohibited because China is strengthening its strategic bonds with Russia. President Biden has repeatedly implied that the US would defend Taiwan in any conflict with China. These statements are presented as gaffes or mistakes but they are in fact in keeping with historical US military actions threatening counter-attack during the three historic Taiwan Strait crises. The White House quickly walks back these comments to reassure China that the US does not support Taiwanese independence or intend to trigger a war with China. The result is that the US is using Biden’s gaffe-prone personality to reemphasize the hard edge (rather than the soft edge) of the US’s policy of “strategic ambiguity” on Taiwan. US policy is still ambiguous but ambiguity includes the possibility that a president might order military action to defend Taiwan. US attempts to increase deterrence and avoid a Ukraine scenario are threatening for China, which will view the US as altering the status quo and penalizing China for Russia’s actions. Beijing resumed overflights of Taiwan’s air defense identification zone in the wake of Biden’s remarks as well as the decision of the US to send Senator Tammy Duckworth to Taiwan to discuss deeper economic and defense ties. Consider the positioning of US aircraft carrier strike groups as an indicator of the high level of strategic tensions. On January 18, 2022, as Russia amassed military forces on the Ukrainian border – and the US and NATO rejected its strategic demands – the US had only one publicly acknowledged  aircraft carrier in the Mediterranean (the USS Harry Truman) whereas it had at least five US carriers in East Asia. On February 24, the day of Russia’s invasion of Ukraine, the US had at least four of these carriers in Asia. Even today the US has at least four carriers in the Pacific compared to at least two in Europe – one of which, notably, is in the Baltics to deter Russia from attacking Finland and Sweden (Map 3). The US is warning China not to take advantage of the Ukraine war by staging a surprise attack on Taiwan. Map 3Amid Ukraine War, US Deters China From Attacking Taiwan Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Of course, strategic tensions are perennial, whereas what investors are most concerned about is whether China can secure its economic recovery. The latest data are still disappointing. Credit growth continues to falter as the private sector struggles with a deteriorating demographic and macroeconomic outlook (Chart 5). The credit impulse has entered positive territory, when local government bonds are included, reflecting government stimulus efforts. But it is still negative when excluding local governments. And even the positive measure is unimpressive, having ticked back down in April (Chart 6). Chart 5Credit Growth Falters Amid Economic Transition Credit Growth Falters Amid Economic Transition Credit Growth Falters Amid Economic Transition Chart 6Silver Lining: Credit Impulse Less Negative Silver Lining: Credit Impulse Less Negative Silver Lining: Credit Impulse Less Negative Bottom Line: Further monetary and fiscal easing will come in China, a source of good news for global investors next year if coupled with a broader policy shift in favor of business, but the effects will be mixed this year due to Covid policy and domestic politics. Taken together with a European energy crunch and Middle Eastern oil supply disruptions, China’s stimulus is not a catalyst for a sustainable global equity market rally this year. South Asia: Inflation Hammers Sri Lanka And Pakistan Since 2020 we have argued that the global pandemic would result in a new wave of supply pressures and global social unrest. High inflation is blazing a trail of destruction in emerging markets, notably in South Asia, where per capita incomes are low and political institutions often fragile. Chart 7South Asia: Surging Inflation Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Sri Lanka has been worst affected (Chart 7). Inflation surged to an eye-watering 34% in April  and is expected to rise further. Surging inflation has affected Sri Lanka disproportionately because its macroeconomic and political fundamentals were weak to begin with. The tourism-dependent Sri Lankan economy suffered a body blow from terrorist attacks in 2019 and the pandemic in 2020-21. Then 2022 saw a power struggle between Sri Lanka’s President Gotabaya Rajapaksa and members of the national assembly including Prime Minister (PM) Mahinda Rajapaksa. The crisis hit a crescendo when the country defaulted on external debt obligations last month. These events weigh on Sri Lanka’s ability to transition from a long civil war (1983-2009) to a path of sustained economic development. While the political crisis has seemingly stabilized following the appointment of new Prime Minister Ranil Wickremesinghe, we remain bearish on a strategic time horizon. This is mainly because the new PM is unlikely to bring about structural solutions for Sri Lanka’s broken economy. Moreover, Sri Lanka holds more than $50 billion of foreign debt, or 62% of GDP. Another country that has been dealing with political instability alongside high inflation in South Asia is Pakistan, where inflation hit a three-year high in April (see Chart 7 above). The latest twist in Pakistan’s never-ending cycle of political uncertainty comes from the ousted Prime Minister Imran Khan. The former PM, who commands an unusual popular support group due to his fame as a cricketer prior to entering politics, is demanding fresh elections and otherwise threatening to hold mass protests. Pakistan’s new coalition government and Prime Minister Shehbaz Sharif, who came to power amid parliamentary intrigues, are refusing elections and ultimatums. From a structural perspective Pakistan is characterized by a weak economy and an unusually influential military. Now it faces high inflation and rising food prices – indeed it is one of the countries that is most dangerously exposed to the Russia-Ukraine war as it depends on these two for over 70% of its grain imports. Bottom Line: MSCI Sri Lanka has underperformed the MSCI EM index by 58.3% this year to date. Pakistan has underperformed the same index by 41.6% over the same period. Against this backdrop, we remain strategic sellers of both bourses. Instability in these countries is also one  of the factors behind our strategic assessment of India as a country with a growing domestic policy consensus. South Asia: India’s Fiscal Populism And Geopolitics Inflation is less rampant in India, although still troublesome. Consumer prices nearly jumped to an 8-year high in April (see Chart 7). With a loaded state election calendar due over the next 12-18 months, the jump in inflation naturally triggered a series of mitigating policy responses. Ban On Wheat Exports: India produces 14% of the world’s wheat and 11% of grains, and exports 5% and 7%, respectively. India’s exports could make a large profit in the context of global shortages. But Prime Minister Narendra Modi is entering into the political end of the business cycle, with key state elections due that will have an impact on the ruling party’s political standing two years before the next federal election. He fears political vulnerability if exports continue amid price pressures at home. The emphasis on food security is typical but also bespeaks a lack of commitment to economic reform. Chart 8India's Real Interest Rates Fall India's Real Interest Rates Fall India's Real Interest Rates Fall Surprise Rate Hikes: The Reserve Bank of India (RBI) increased the policy repo rate by 40 basis points at an unscheduled meeting on May 4, thereby implementing its first rate hike since August 2018. With real rates in India lower than those in China or Brazil (Chart 8), the RBI will be forced to expedite its planned rate hikes through 2022. Tax Cuts On Fuel: India’s central government also announced steep cuts in excise duty on fuel. This is another populist measure that reduces political pressures but fails to encourage the private sector to adjust.  These measures will help rein in inflation but the rate hikes will weigh on economic growth while the tax cuts will add to India’s fiscal deficit. Indeed, India is resorting to fiscal populism with key state elections looming. Geopolitical risk is less of a concern for India – indeed the Ukraine war has strengthened its bargaining position. In the short run, India benefits from the ability to buy arms and especially cheap oil from Russia while the EU imposes an embargo. But over the long run its economy and security can be strengthened by greater interest from the US and its allies, recently highlighted by the fourth meeting of the Quadrilateral Security Dialogue (Quad) and the launch of the US’s Indo-Pacific Economic Framework (IPEF). These initiatives are modest but they highlight the US’s need to replace China with India and ASEAN over time, a trend that no US administration can reverse now because of the emerging Russo-Chinese strategic alliance. At the same time, the Quad underscores India’s maritime interests and hence the security benefits India can gain from aligning its economy and navy with the other democracies. Bottom Line: Fiscal populism in the context of high commodity prices is negative for Indian equities. However, our views on Russia, the Middle East, and China all point to a sharper short-term spike in commodity prices that ultimately drives the world economy deeper into stagflation or recession. Therefore we are booking a 22.5% profit on our tactical decision to go long Brazilian financials relative to Indian equities.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Chart 9Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Chart 10Other Measures Of Russian Geopolitical Risk Other Measures Of Russian Geopolitical Risk Other Measures Of Russian Geopolitical Risk Chart 11China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator Chart 12United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator Chart 13Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator Chart 14France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator Chart 15Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Chart 16Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Chart 17Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Chart 18Australia: GeoRisk Indicator Australia: GeoRisk Indicator Australia: GeoRisk Indicator Chart 19Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Chart 20Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Chart 21Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Chart 22South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Chart 23Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator   Footnotes 1     Recent diplomatic flaps between core European leaders and Ukrainian President Volodymyr Zelensky reflect Ukraine’s fear that Europe will negotiate a “separate peace” with Russia, i.e. accept Russian territorial conquests in exchange for economic relief. 2     Dmitri Medvedev explicitly states ‘there can be no more talk of any nuclear-free status for the Baltic - the balance must be restored’ in warning Finland and Sweden joining NATO. Medvedev is suggesting that nuclear weapons will be placed in this area where Russia has its Kaliningrad exclave sandwiched between Poland and Lithuania. Guy Faulconbridge, ‘Russia warns of nuclear, hypersonic deployment if Sweden and Finland join NATO’, April 14, 2022, Reuters. 3    See Antony J Blinken, Secretary of State, ‘The Administration’s Approach to the People’s Republic of China’, The George Washington University, Washington D.C., May 26, 2022, state.gov. Additionally, see President Joe Biden’s remarks on China and getting involved military to defend Taiwan in a joint press conference with Japan’s Prime Minister Kishida Fumio. ‘Remarks by President Biden and Prime Minister Kishida Fumio of Japan in Joint Press Conference’, Akasaka Palace, Tokyo, Japan, May 23, 2022, whitehouse.gov.   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar

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

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

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

Executive Summary EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply The EU's failed foreign policy – premised on ever-deeper engagement with the Soviet Union and, after it collapsed, Russia – will drive its hot mess of an energy policy for years. In the short term, the EU's REPowerEU scheme proposed last week to fund the decoupling from Russia will lift its green-house gas (GHG) emissions, if the sale of €20 billion of EU Emission Trading System (ETS) allowances goes forward. Markets traded lower over the week, to make room for the higher ETS pollution-permit supply. This could increase the volume of allowances sales needed to reach the €20 billion target. Another €10 billion investment in natgas pipelines also will be funded. Longer-term, the acceleration of the EU's renewable-power build-out via so-called Projects of Common Interest (PCI) will get an €800 billion boost, with another round of funding to be proposed for early next year. EU funding will lift base metals and steel prices – raising the cost of the renewables build-out – and keep fossil-fuels well bid.   Bottom Line: The REPowerEU scheme will increase volatility in the EU's ETS market, and add significant new demand to base metals and fossil-fuel markets. The propensity of EU policymakers to interfere in its ETS market makes it unattractive. We remain long the S&P GSCI index, and the COMT, XOP, XME and PICK ETFs expecting higher base metals, oil and gas prices. Tactically, we are getting long 4Q22 Brent calls struck at $120/bbl, anticipating an EU embargo of Russian oil imports. Feature Over the past three decades, foreign policy for the EU largely was set by Germany, the organization's most powerful economy. Successive generations of German politicians championed the idea that the West could bring the former Soviet Union – and later Russia – into the modern world of global trade through Ostpolitik, which had, at its core, a belief in the power of trade to effect political and economic change.1 This change-through-trade policy survived the Cold War, the collapse of the Soviet Union and rise of Russia from its ashes. It also survived Russia's first invasion of Ukraine in 2014. Indeed, following that invasion, Russia marked the completion of its Nord Stream 2 (NS2) natural gas pipeline – running parallel to NS1 – in September of last year. If NS2 were up and running now, it would have increased Russian gas flows into the EU and its revenue flows.2 As our Geopolitical Strategists noted, Germany even got the Biden administration to agree in summer 2021 to set aside any sanctions so that Germany could operate NS2 with Russia. Related Report  Commodity & Energy StrategyDie Cast By EU: Inflation, Recession Risks Rise Yet Russia did not share the German commitment to economic engagement within a US-led liberal international order. Russia's second invasion of Ukraine in February was a bridge too far, and catalyzed the EU's response, again led by Germany, to de-couple from Russia in the energy sector. The EU's reversal of a failed foreign policy, which produced its dependence on Russian energy, leaves it with a hot mess of an energy policy that is evolving rapidly. In its wake, volatility in the EU carbon-trading market has ensued, along with the promise of an accelerated doubling-down on renewable-energy generation. Higher Emissions, Lower Emissions Prices Last week, the EU proposed its REPowerEU scheme, which is meant to enable the decoupling of the EU from Russian energy dependence by funding hundreds-of-billions-of-euros in new energy investments over coming years.3 Chart 1EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply EU Surprises Carbon Market With Increased CO2 Emission Allowance Supply In a history heavily laden with paradox, this new scheme will lift the EU's green-house gas (GHG) emissions – including CO2 – if the sale of €20 billion of EU Emission Trading System (ETS) allowances goes forward.4 So, in the breach, the EU is willing to significantly relax its environmental goals – the E in ESG – to begin undoing its failed foreign policy. Markets already are making room for this increased ETS pollution-permit supply, which, as allowances prices weaken, will require additional supplies to reach the €20 billion target (Chart 1). This will lead to higher coal and fossil fuel usage during Germany's hot-mess de-coupling with Russia. In addition to raising funds by selling pollution permits, the EU will invest another €10 billion in natgas pipelines. This will help counter the likely loss of Russian gas when it embargoes Russian oil imports, but will take time (a few years) to actually put in the ground.5 The additional pipe would address one of the EU's weakest energy links: the lack of pipeline capacity to transport liquified natural gas (LNG) inland once it arrives in Europe. Europe pushed hard to re-load natgas inventories ahead of the coming winter season, and appears to have made progress in this regard (Chart 2). Europe was a strong bid for LNG in the first four months of this year, according to Refinitiv reporting.6 LNG imports were up 58% over the first four months of this year, totaling 45.3mm MT. This kept European natgas prices elevated vs. Asia (Chart 3). Chart 2Europe Re-Loads Storage One Hot Mess: EU Energy Policy One Hot Mess: EU Energy Policy Chart 3Europe Outbids Asia For LNG One Hot Mess: EU Energy Policy One Hot Mess: EU Energy Policy The back-and-forth between the Asian and European markets will continue for the rest of this year, particularly going into the Northern Hemisphere's summer, when demand for natgas in Asia, in particular, will remain strong. REPowerEU Will Boost Base Metals Demand Longer term, the EU's REPowerEU proposal, if approved, will accelerate the EU's renewable-power build-out via so-called Projects of Common Interest (PCI). The proposal contains €800 billion to support new renewable-energy proposals, with another round of funding proposed for early next year.   The doubling down by the EU on renewables will lift base metals and steel prices as soon as the REPowerEU program starts funding investments in renewable technology and short-term projects like pipeline buildouts (maybe sooner as hedges are placed). Given the tightness already apparent in the base metals markets, this will raise the price of critical materials – copper, aluminum, steel – and will, in the process, keep fossil-fuels well bid: large capital projects do not get done without a lot of diesel and gasoline being consumed.7  The EU is not alone in its desire to accelerate renewables investment: The US is funding a similar build-out, as is China, which will be accelerating its infrastructure and renewables investments. The constraint on all of these programs to build out renewables is low capex in base metals (Chart 4), and oil and gas (Chart 5). This has kept the level of supply from quickly responding to increased demand, which keeps these markets in sharp backwardations. Market tightness in metals and energy will be compounded by stronger bids from the three largest economic centers in the world – the EU, US and China.Chart 4Weak Capex Holds Base Metals Supply Growth Down … One Hot Mess: EU Energy Policy One Hot Mess: EU Energy Policy Investment Implications Chart 5… And Oil + Gas Supply Growth One Hot Mess: EU Energy Policy One Hot Mess: EU Energy Policy The EU's REPowerEU scheme is not a done deal, but we give it high odds of being adopted. It will increase volatility in the EU's ETS market, and add significant new demand to base metals and fossil-fuel markets. In terms of where to take risk, now that this proposal has been floated, we would avoid getting long carbon permits traded on the EU's ETS carbon market, given the propensity of policymakers to meddle excessively, which, in and of itself, is a risk that is difficult – if not impossible – to forecast. However, we do continue to favor being long the S&P GSCI index, and the COMT, XOP, XME and PICK ETFs expecting higher base metals, oil and gas prices. On a tactical basis, we are getting long 4Q22 Brent calls struck at $120/bbl at tonight's close, anticipating an EU embargo of Russian oil imports. 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 US officials involved in negotiations to restore the Iran nuclear deal appear to be signaling US interests could be served by agreeing such a deal.8 Allowing Iran back into the market as a bona fide oil exporter would return ~ 1mm b/d or more to global crude markets by year-end.  This would partly reverse the higher prices we expect in the wake of an EU to embargo Russian oil imports this week.  Presently, oil markets are rallying as the necessity for Russia to shut in oil production post-embargo is discounted (Chart 6).9 That said, a deal to allow Iran back into export markets would dampen the move we expect in the wake of an EU embargo. The market will remain tight after a US-Iran deal, but this might be attractive to the Biden administration as mid-terms approach, and to the EU, as it also would reduce the funds available for Russia to wage war on Ukraine.  On a tactical basis, we are getting long 4Q22 Brent calls struck at $120/bbl at tonight's close, anticipating the EU embargo.  We will close this position out if the US and Iran reinstate the Joint Comprehensive Plan of Action (JCPOA), which would allow Iran to resume oil exports.   Precious Metals: Bullish The World Platinum Investment Council (WPIC) projects a 2022 surplus of 627 koz, slightly lower than the previous forecast of 657k oz for this period. This year, strong automotive demand is expected to be offset by reductions in jewellery and industrial demand. Car manufacturers’ switch from Russian palladium to platinum – as they self-sanction – will bullish for platinum. Russia accounts for ~40% of global palladium mined output. The organization predicts lower mine supply caused primarily by supply-chain bottlenecks and COVID-19 restrictions. Nornickel, one of the world’s largest platinum miners is expected to reduce mined output on the back of supply-chain disruptions due to Russian sanctions.    Base Metals: Bullish Iron ore prices rose on the wider than anticipated cut in China’s benchmark interest rate for mortgages on May 20th (Chart 7). The upcoming easing of lockdowns in Shanghai will further boost iron ore prices, as markets expect Chinese economic activity to pick up. However, if China sticks to its zero-COVID policy, lockdowns will continue to occur in different cities and regions. BCA’s Emerging Markets Strategy expects these ‘rolling lockdowns’ to last at least until the end of this year. This will affect manufacturing and steel production, primary iron ore demand drivers. Iron ore’s reliance on China’s economic health means price of the industrial metal will not meaningfully rise this year, barring a supply shortfall. Chart 6 Brent Prices Going Up Brent Prices Going Up Chart 7 BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI) GOING DOWN     Footnotes 1     Please see The Former Chancellor Who Became Putin’s Man in Germany, published by the New York Times 23 April 2022.  This is an excellent precis of the history of German-Russian trade vis-à-vis the career of former German chancellor Gerhard Schröder, who held the office from 1998 – 2005.  The deep energy relationship with Russia began in the late 1960s under the chancellorship of Willy Brandt.  As much as 55% of Germany's gas needs were supplied by Russia prior to its invasion of Ukraine 24 February 2022.  Now its Russian gas imports are closer to 20%; Germany and the EU are scrambling to eliminate any and all energy trade with Russia, beginning with reducing gas imports by two-thirds this year, and likely embargoing all oil imports by year-end. 2     Russia completes Nord Stream 2 construction, gas flows yet to start, published by reuters.com 10 September 2021. 3    Please see REPowerEU: A plan to rapidly reduce dependence on Russian fossil fuels and fast forward the green transition* published by the European Commission 18 May 2022.  Energy accounted for 62% of the EU's Russian imports in 2021, just under €100 billion worth of gas (40%), oil (27%) and coal (46%), according to the European Commission's tally in In focus: Reducing the EU’s dependence on imported fossil fuels published 20 April 2022.  In 2011, energy accounted for 77% of the EU's imports from Russia. 4    Please see Felix K. Chang's report Legacy of Ostpolitik: Germany's Russia Policy and Energy Security published by the Foreign Policy Research Institute in May 2014.  This includes a summary of the paradoxical nature of Germany's Ostpolitik policy following Russia's first invasion of Ukraine. 5    Please see German economy minister expects EU embargo on Russian oil 'within days' -ZDF, published by reuters.com 23 May 2022. 6    Please see LNG momentum swinging back to Asia as Europe demand eases: Russell published by reuters.com on 24 May 2022. 7     Please see Tight Commodity Markets: Persistently High Inflation, which we published 24 March 2022.  It is available at ces.bcaresearch.com. 8    Please see Analysis: Subtle shift in U.S. rhetoric suggests new Iran approach published by reuters.com 24 May 2022, and German economy minister expects EU embargo on Russian oil 'within days' -ZDF, published by reuters.com 23 May 2022. 9    Please see Oil, Natgas Prices Set To Surge, which we published last week. Investment Views and Themes Recommendations Strategic Recommendations Trades Closed in 2022 Summary of Closed Trades

Executive Summary Villains Still Lurking Villains Still Lurking Villains Still Lurking European assets and the euro already discount a significant worsening of Europe’s economic outlook. If the global economic situation were to stabilize, then European assets would be a buy at current levels. However, there remain very large risks lurking over the outlook. First, a further deterioration in energy flows between Russia and the EU is a major threat to the European economic outlook. Second, the ECB delivering the seven rate hikes priced in the June 2023 Euribor contract would be painful for the European economy. Third, further selloff in the US equity market could translate into more pain for European equities. And fourth, the weakness in the Chinese economy and aggressive monetary tightening in the broader EM space outside China are additional risks. These risks loom large enough, so that investors should avoid bottom-fishing the market. Wait until greater clarity emerges or valuations improve further. Bottom Line: Don’t be a hero. European assets and the euro are probably in the process of bottoming. However, the probability of a very significant additional decline is large enough that investors should continue to emphasize capital preservation over return maximization. Also, continue to favor defensives over cyclical assets.      After declining nearly 8% since its January 2021 peak, the euro is down another 7% so far this year. Meanwhile, the Dow Jones Euro STOXX 50, which has plunged 17% since its January 5, 2022 apex, or 22% in US dollar terms, trades at 11.2 times 2023 earnings estimates. At these valuations, European assets already discount a major growth slump in Europe. Is it time to buy European assets, to favor cyclicals versus defensives, and to buy the euro? At face value, the answer is “yes,” but uncertainty abounds, which means that capital preservation remains paramount. As a result, we recommend investors avoid bottom-fishing European assets. They should wait for a safer entry point, rather than trying to pick through the market trough. Plenty Of Risks Four main risks cast a long shadow on the performance of European assets: The evolution of the energy crisis, the potential for an ECB policy mistake, the threat of a worsening US selloff, and the instability in EM. The Energy Crisis It’s official: Sweden and Finland are applying to join NATO. Turkey’s objection will create delays in the process, but it will not stop it. Turkey needs protection against Russia, and it needs help to support the lira. Turkey’s acquiescence, therefore, will be bought. What is genuinely surprising is Russia’s silence. President Putin threatened to flex Russia’s military muscles if Sweden and Finland were to abandon their neutrality. Yet, he now has “no problem” with their bid to join the alliance. We are skeptical, especially as the EU is aiming to ban Russian oil imports by the end of the year. Based on these observations, we continue to see a further deterioration in energy flows between Russia and the EU as a major threat to the European economic outlook. It is far from a guaranteed outcome, but its probability is elevated enough (more than 30%) and so impactful that any investment strategy must account for it. Chart 1Rebuilding Nat Gas Stocks Is A Must Don’t Be A Hero Don’t Be A Hero Chart 2Low-Income Households Are At Risk Don’t Be A Hero Don’t Be A Hero Moreover, European nations continue to pay a premium for their energy and are trying to rebuild their natural gas inventory ahead of winter (Chart 1). Thus, the energy market continues to carry a significant recession risk for the Eurozone. Lower-income households already spend a substantial portion of their income on utilities and transportation costs, and their consumption is highly sensitive to the evolution of energy prices (Chart 2). A Policy Mistake We consider a rate hike in July a policy mistake, but it would be a true error if the ECB ratified the pricing currently embedded in the €STR curve (Chart 3). Why would a rate hike constitute a policy mistake? The EU’s inflation spike is not a reflection of strong domestic demand. It reflects foreign factors over which the ECB has no control. Energy prices drive European inflation and are passing-through to core CPI (Chart 4). Yet, wage growth remains tepid at 2.6%. Hiking rates will not bring about the additional energy supply Europe needs to tame inflation. Chart 3Too Far Too Fast Too Far Too Fast Too Far Too Fast Chart 4European Inflation Is Energy inflation European Inflation Is Energy inflation European Inflation Is Energy inflation Chart 5The US Is Lifting Prices Around The World The US Is Lifting Prices Around The World The US Is Lifting Prices Around The World Even the analysis of the ECB is conflicted. On May 11, Executive Board Member Isabel Schnabel highlighted the need for an imminent interest rate hike, yet she also underscored the global nature of the current inflation outbreak. Goods prices in Europe not only reflect higher input costs, but they also bear the imprint of the excess demand in the US, which is lifting the price of goods prices around the world (Chart 5). However, an ECB rate hike will do little to tame US demand for manufactured goods. In the monetary policy realm, only aggressive tightening by the Fed will have the desired effect, which will trickle down to lower European inflation. Thus, European interest rate hikes will accentuate consumption weaknesses already visible across the region more than they will slow inflation. While a few rate hikes will not have a major impact, the seven rate hikes priced in the June 2023 Euribor contract would be disastrous as long as Europe is hamstrung by the current relative price shock. We remain long this contract. Worsening US Equity Selloff Investors seem to be waking up to the reality that US consumers are facing the same difficult predicament as European consumers: rising energy and food prices and contracting real incomes. The recent earnings call by Walmart was a shock that caused an 8% drubbing for consumer staples and a 7% fall in consumer discretionary equities. Until US inflation clearly peaks, investors will have to evaluate how much deeper the pain for consumers may run. Moreover, since consumers have begun to cut their discretionary spending in response to strained budgets, the ability of firms to pass on rising input costs is dwindling. Hence, investors will have to handicap the risks to margins as well. Chart 6Fed Put Not Exercised Fed Put Not Exercised Fed Put Not Exercised US inflation also impacts the Fed’s outlook. Until inflation has decelerated for a few months, the Fed will remain comfortable with tighter financial conditions. This means that the strike price of the so-called Fed put is inversely proportional to inflation, especially since FCIs are far from tight (Chart 6). As a result, inflation or energy prices must soften before the Fed can begin to send comforting signals to the market. Chart 7Where Walmart Goes, So Does The Market? Where Walmart Goes, So Does The Market? Where Walmart Goes, So Does The Market? The US market has cheapened significantly, and a floor should be close; but the risks remain considerable. A very smart investor with whom we regularly chat highlighted that we have not yet seen a full-fledged liquidation. Only once energy stocks have also been purged will the necessary condition for a bottom be met (since only then will all the speculative activity have been cleared). In fact, the recent poor performance of Walmart highlights the risk that the S&P 500 could suffer one last down leg to 3500, since over the past 12 years, WMT often leads the SPX (Chart 7). Another 300 points decline in the US benchmark could translate into significant selling pressure in the Euro STOXX, because it sports an elevated beta. EM Instability EM are still facing ample risks, which could easily dislodge the prospects of European firms servicing these economies. As a result, EM constitute another major threat for European equities. Chart 8Less COVID In Shanghai and Jilin Less COVID In Shanghai and Jilin Less COVID In Shanghai and Jilin The outlook for China remains fraught with risks. National COVID cases are declining as a result of the collapse in cases in the Shanghai and Jilin provinces (Chart 8). However, Omicron is spreading around the nation, with broadening lockdowns in Beijing and Tianjin. The one certainty is that the Chinese Communist Party remains wedded to its zero-COVID policy. Considering the size of the country and how contagious the various Omicron variants are, rolling lockdowns and their deleterious impact on activity are here to stay. China therefore remains a source of downside risk for global goods demand. Unemployment is surging, and the PMIs are extremely weak, suggesting a contraction in GDP is coming. Moreover, households continue to deleverage (Chart 9). The CNY’s weakness confirms the risks to earnings growth in Europe, and the yield spread between China and the US points to further downside in the RMB (Chart 10, top panel). Interestingly, the weakness of the yen could also drag the CNY lower because of competitive pressures. Chester Ntonifor, BCA’s Chief Foreign Exchange strategist recommends investors sell CNY/JPY. Historically, a depreciating CNY/JPY portends weakness in European stock prices (Chart 10, bottom panel). Chart 9Chinese Growth Problems Chinese Growth Problems Chinese Growth Problems Chart 10A Weaker CNY Augurs Poorly For European Stocks A Weaker CNY Augurs Poorly For European Stocks A Weaker CNY Augurs Poorly For European Stocks The broader EM space outside of China is also a source of risk. EM countries are tightening monetary policy, which is slowing economic activity in nations already exposed to declining Chinese imports. Additionally, as Arthur Budaghyan shows, the strength in the dollar is tightening EM financial conditions and invites further increases in EM policy rates because of the inflationary impact of depreciating currencies.  An additional tightening in EM financial conditions in response to this toxic mix will invite greater downside for European equities (Chart 11). Bottom Line: European equities already reflect enough of a valuation cushion to compensate for a significant slowdown in European growth. However, ample risks to global growth still lurk in the background. If these risks materialize, European stocks could selloff another 15% or so. Moreover, the overvaluation of cyclical stocks relative to defensive ones has now been purged, but China’s economic weakness remains a major handicap (Chart 12). Consequently, don’t be hero: avoid bottom-fishing European assets, especially cyclical ones. Chart 11Brewing EM Troubles Brewing EM Troubles Brewing EM Troubles Chart 12Cyclicals At Risk From China Cyclicals At Risk From China Cyclicals At Risk From China Is it Time to Buy the Euro? After falling below 1.04, EUR/USD has rebounded to 1.055. Is it time to buy the euro? The euro now embeds a large discount that reflects fears of a recession and stagflation in the Eurozone. A purchasing power parity model developed by BCA’s Foreign Exchange Strategy team that accounts for the differences in consumption baskets in Europe and the US shows that EUR/USD is trading at its deepest discount to fair value since 2001. Moreover, BCA’s Intermediate-term timing model, which is based on an augmented interest rate parity framework, confirms that EUR/USD is cheap. Additionally, BCA’s Intermediate-Term Technical Indicator is massively oversold (Chart 13). For the euro to bottom durably, the dollar needs to reverse its rally. The combination of net speculative positions on the DXY and BCA’s Dollar Capitulation Index point to elevated chances of an imminent peak (Chart 14). Chart 13The Euro's Large Risk Premium The Euro's Large Risk Premium The Euro's Large Risk Premium Chart 14The Over Extended Dollar The Over Extended Dollar The Over Extended Dollar Despite this backdrop, three of the aforementioned risks to European stocks translate into threats to the euro: A Russian energy embargo would cause a much more severe European recession. Two weeks ago, we highlighted a Bundesbank study which showed that such a cutoff would curtail German growth by 5% point for 2022.  We also highlighted that this shock would cause a temporary but significant increase in inflation. This combination would be poisonous for the euro, and it carries a roughly 30% probability. A policy mistake in the Euro Area would cause a period of significant spread widening in the periphery. Such shocks often prompt a widening in the breakup risk-premium for the euro. This risk premium pushes EUR/USD lower. Chart 15Chinese Assets Matter To The Euro Chinese Assets Matter To The Euro Chinese Assets Matter To The Euro Chinese growth problems often hurt the euro as well as European stocks. A fall in the Chinese stock-to-bond ratio often leads to a weaker EUR/USD, since both variables are correlated to Chinese economic activity. Additionally, a depreciating CNY is also synonymous with a softer euro because a declining renminbi hurts European exporters (Chart 15). Further weaknesses in the S&P 500 no longer guarantee a fall in EUR/USD. Investors are worried about the US equity outlook because they are extrapolating the impact on consumers of rising energy and food prices. They are applying the template of what is going on in Europe to US households, which means that they are pricing in a convergence of US growth toward European growth (barring the three additional shocks highlighted in the bullet points above). Related Report  European Investment StrategyIs UK Stagflation Priced In? Bottom Line: From a technical and valuation perspective, the rebound in the euro that began this week could last longer. However, several exceptional risks could prevent this bounce from morphing into a durable rally. The significant odds of a Russian energy embargo stand at the top of the list of concerns, but so does the possibility of a policy mistake in Europe as well China’s problems. Thus, even if the euro is bottoming, don’t be a hero and wait on a safer entry point to focus on capital preservation. In fact, BCA’s Foreign Strategy team is now selling EUR/JPY. Within a European context, a short GBP/CHF position is attractive as a portfolio hedge. The Swiss National Bank seems more tolerant of a higher CHF as a vehicle to tame growing inflationary pressures, while the UK faces significant risks.    Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations