Geopolitics

Executive Summary Unhappy Households Make Unhappy Voters US polarization while down is still near historic peaks. Negative sentiments are forming among households and businesses due to inflation and high gas price, which makes fiscal expansion unlikely in the near future. President Biden is running out of options to shore the Democrats’ political capital ahead of the midterm. Biden will resort to using executive orders and move on to foreign affairs as the legislative route is blocked. More actions in the international realm will inject geopolitical risks in an already volatile year. Asset Initiation Date Return Long US Health Care Vs. S&P 500 2021-06-30 13.5% Bottom Line: Higher political risk in the near term warrants a defensive posture. Feature Dear Client, This week’s report is brought to you by Jesse Kuri, Associate Editor of our US Political Strategy. Jesse provides an update of our US Political Capital Index, which enables us to quantify the Biden administration’s ability to get things done. Jesse measures precisely how far Biden’s political capital has fallen since his election in November 2020 and highlights the key indicators investors should monitor to assess whether the administration can regain effectiveness after the midterm election.  Jesse also updates our US Equity Sector Political Risk Matrix, which combines insights from our US Equity Strategist Irene Tunkel with our own assessments of whether politics will add upside or downside risk to each sector. Health care stocks are notable for facing policy risks skewed to the upside. All very best, Matt Gertken, Chief US Political Strategist Last week, the Supreme Court delivered two political shocks to the system. On June 23rd, the Supreme Court ruled that New York’s state limit on carrying guns in public violates the Second Amendment. Furthermore, on June 24th, the court delivered what was well known for almost a month: A ban on abortion by the state of Mississippi is constitutional, overturning a 49-year-old precedent set up by Roe v. Wade. Both rulings are set to aggravate the already elevated political tensions in the US. Related Report  US Political StrategyThe Supreme Court And Midterm Elections The high court rulings overshadowed a momentous bipartisan move in Congress – the passage of the first gun control bill in almost 30 years on June 24th. 15 Republican Senators and 14 Republican House Members joined their Democratic colleagues to pass the Bipartisan Safer Communities Act. This bill includes more stringent background checks for gun buyers younger than 21 years of age, more funding for mental health care programs, federal funding to encourage states to implement red flag laws to take guns away from questionable owners, and the closing of the boyfriend loophole. So, how should investors reconcile the seemingly contradictory moves in US politics: Extreme polarization and unrest punctuated by moments of bipartisanship? Investors should ignore the US gun law — and instead focus on women’s support of Biden in coming months. If women start becoming more active in voting and start approving Democrats much more than expected, then that will help Democrats marginally. But it will not likely change the outcome of the midterm, which favors Republicans heavily in the House at least. Is President Biden’s political capital too low to save his party from a political reckoning this year? Most likely the answer is yes. Biden’s Political Capital Roundup Political Polarization Chart 1Polarization: Declining But Near Peak It would be easier to push for a policy in a less divided country, as there is a consensus on what constitutes good policy among the stakeholders. But a country that is depolarizing in times of economic stress is a negative for the political capital of the government of the day, as there is a consensus that times are tough, and the acting government will be blamed for this. In June, our polarization proxy, constructed by differencing Democrats’ and Republicans’ approval of President Biden, increased. The polarization proxy increased as Democrats’ approval of Biden rose while Republicans’ approvals remained flat, relative to their respective levels in May. Also in May, our economic sentiment polarization indicator, which is the difference between the economic sentiment of Democrats and Republicans, increased from its level in April, as Republicans’ sentiment declined by 25%, while Democrats’ sentiment only fell by 7%. On the other hand, the Philadelphia Fed Partisan Conflict Index, another indicator that the US Political Strategy team tracks, declined in May. This is not surprising considering that this indicator is constructed by the Philly Fed from news headlines which had either been dominated by the war in Ukraine or by the skyrocketing inflation. The only other time that this indicator declined was during the pandemic because everyone was in agreement that the pandemic is a negative event, just like the war in Ukraine and inflation. All three indicators are below their respective levels of November 2020. While polarization declined, it is still close to its peak in 2019-2020 (Chart 1). Household Sentiment Chart 2Biden's Approval Plumbing New Lows A government with a high approval rating among households can afford to pass policies and painful reforms, as it is less likely to be punished at the ballot box if voters are happy. Unfortunately for President Biden, his approval rating is plumbing new lows; the American Rescue Plan, loose monetary policy, and external geopolitical shocks have all resulted in US inflation reading that were last seen 40 years ago. As a result, Biden was never rewarded by voters for the passage of the American Rescue Plan and the Infrastructure Investment and Jobs Act. To shore up his and the Democrats’ political capital, Biden is now attempting to strike deals with partners and adversaries in Europe, the Middle East, and China, but they are not likely to lend him or the Democrats a helping hand; and, even if deals could be reached, the damage to the Democrats’ midterm prospect has already been done, which goes beyond the pattern where the President’s party tends to suffer in the first midterm. In another sign of the souring mood among voters, the Conference Board Consumer Confidence Index declined by 2% in May on a month-over-month basis and 11% on a year-over-year basis. While the consumer confidence index is higher now than it was in November 2020, it is 17% below its peak in the summer of 2021. What would have been a comeback year for US consumer spending is going to be dampened by high energy prices and general price inflation due to external shocks (Chart 2). Business Sentiment Governments also need the support of the business community to implement policies: Negative sentiment in the business community would subdue capital spending and job growth, which would affect household sentiment and subsequently, the ability of the government to pass its agenda. In May, high-frequency business indicators pointed to business sentiment turning negative. The capex intention survey declined by 20% from April and 37% compared to May of last year. Every activity indicator from the ISM, apart from the manufacturing employment index, is below their respective levels in November 2020, when the pandemic was raging, and vaccines had not yet been rolled out (Chart 3). The small business surveys conducted by the NFIB is indicative of the underlying reasons behind negative business sentiment: Despite lower concern about regulation and taxes, business concerns over inflation and labor costs are up by 1300% and 100%, respectively, since November of 2020. Concerns over taxes and regulation have largely been allayed as the Democrats have failed to use their second chance at reconciliation, with moderate senators objecting to higher taxes. But this decline in worries over taxes and regulation have given way to concerns about inflation and labor costs, and President Biden and the Democrats are struggling to address these concerns (Chart 4). Chart 3Businesses Are Downbeat...​​​​​​ Chart 4... Due to Inflation and Labor Costs​​​​​​ Government Sector Chart 5The Purse String Will Be Tightened The government can use fiscal policy to shore up its diminishing political capital. In Q1 2022, the fiscal thrust for the federal government was -14.3% of GDP, a 27 percentage-point swing from Q1 of last year when the Biden administration passed the American Rescue Plan (Chart 5). It is unlikely that fiscal thrust would recover anytime soon considering that fiscal stimulus early in Biden’s term had contributed to the inflation that the economy is experiencing now. While the Democrats have one last chance at using reconciliation, at best they would pass a deficit neutral budget, as there is no appetite for another extravagant budget in this inflationary environment; at worst, they could be pushed by moderate Democrats towards increasing revenue through tax hikes. Hence, Biden’s political capital through the use of fiscal policy is unlikely to recover. Economic Conditions The economy is the one bright spot underpinning Biden’s political capital (Chart 6). The unemployment rate was unchanged at 3.6% in May, close to an all-time low and 3.1 percentage points below November 2020. For the first time in his term, the stock market-to-wage ratio fell in April to below the level of November 2020 – mainly due to the sell-off in the stock market. While this is positive for reducing inequality, the Fed’s attempt to cool down the economy will also affect wage growth and household wealth via the stock market. In May, policy uncertainty was still lower than what it was in November 2020, but on a month-on-month basis, uncertainty in the US increased by 12%. Personal bankruptcies in Q1 barely increased from Q4 2021, while business bankruptcies declined by 3% during the same period. Consumer loan delinquencies also remained flat at 1.6%. Financial distress levels are still significantly below their pre-pandemic level (Chart 7). Chart 6Recovery Is Going Well...​​​​​ Chart 7... And Household And Business Finances Are Improving...​​​​​​ Chart 8... But Inflation And Gas Price Overshadow the Recovery If voters weigh these indicators equally, Biden will have strong political capital underpinned by the strong economy (78% of these indicators are sending positive signals), but there are two indicators with outsized impacts on household and business sentiment: inflation and gas prices (Chart 8). Inflation is close to an all-time high, and the high inflation will force the Federal Reserve to act to raise rates which will, in turn, cool down economic activity. The latest readings of gas prices pin them at 5 dollars per gallon, a 138% increase from November 2020. The oil/energy shock is happening at a time when Americans are experiencing their first summer without restrictions since 2019. High gas prices, high inflation, and the potential for a recession may threaten the much-awaited pent-up demand. Asset Market Chart 9Stock Market Woes Add To The Negative Sentiment The equity market is also a component of political capital – while a booming stock market is not guaranteed to be a tailwind for the President as seen from the case of President Trump during the midterm of 2018, a bear market will compound the negativity that is abound in the economy. The S&P 500 is down 18% from December 2021 and the 2-year Treasury yield is up by 231 bps. The S&P 500 is only 8% above its November 2020 level and if one takes into consideration inflation since then, the S&P 500 is below its level of November 2020 (Chart 9). Our colleagues at the Emerging Markets Strategy service have estimated that the recent selloff has wiped out roughly US$12 trillion from the US equity market and US$3.5 trillion from the US bond market. Political/Constitutional Strength An immutable component of political capital is the constitutional strength of the President – majorities in the Electoral College and popular votes, and control of Congress and the Supreme Court. President Biden, unlike Presidents Bush and Trump, had majorities in both the electoral college and national popular votes. But his control of Congress was significantly weaker; in 2017 Republicans had a seat majority in the Senate and a 23-seat advantage in the House, while the Democrats a one seat advantage in the Senate, via the Vice President, and a 4-seat majority in the House at Biden’s inauguration. Furthermore, Trump started his term with an evenly split Supreme Court, which later was expanded to 5-4 once Justice Gorsuch was confirmed, while Democrats have a 3-6 disadvantage due to the passing of Justice Ginsburg in 2020. Biden’s constitutional strength is weaker than Trump’s and Obama’s. Bottom Line: Biden’s political capital had been greatly diminished and he will unlikely be able to push for his agenda through legislative means. He is also unlikely to be able to replenish his political capital anytime soon due to skyrocketing inflation, which makes fiscal policy unpalatable to the public. As the midterm closes in, Biden will be desperate to shore up his and the Democrats political capital, and as the legislative route will be unavailable, he will resort to regulatory, executive, and foreign policy actions. Investment Conclusions As a foreign energy shock is mainly responsible for high gasoline prices in the US, Biden will attempt to have a reset with oil producers in the Middle East; but this will come at the cost of diplomacy with Iran, while attempting to restart nuclear negotiations with Iran will come at the cost of further alienating oil producers and allies in the Middle East. The Democrats domestic approach which was to disparage oil producers for alleged price gouging will also inject downside risk to the energy sector. Europe and Japan will be weighed down by the global energy shock as they are both net importers of energy, unlike the US. This will affect the sales of US industrial products abroad and by extension, the US industrial sector. Geopolitical risks will depress capex spending in Europe. The consumer discretionary sector could trade sideways as inflation bites and the stock market declines, yet strong household finances – as seen by low delinquency rates and massive pent-up demand from 2 years of lockdowns – will be tailwinds for the sector. The tech and communication services sectors will benefit from near-peak polarization, yet there are regulatory challenges at home and abroad which could weigh these sectors down. Financial regulations will pick up from low levels at end-2021 due to changes at the Fed. Plus, the Democrats and regulatory agencies will not look too kindly on banks aiding companies in merging and consolidating in a market where inflation is sky-high. The increases in rents could spur action from local governments to act on housing market which may include anti-market policies such as rent control and stabilization, which will negatively impact the real estate sector. Health care is the only sector with political risks to the upside – Biden had punted on radical changes to the health care system and even if he seeks to make changes, he lacks the political capital to do so. His actions abroad will also put a floor under global geopolitical risks, ensuring the USD remains well bid, and health care tends to do well when the dollar is in a bull market.     Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

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

Executive Summary Biden Can Take Risks With Russia President Biden will make a last-ditch effort to mitigate Democratic losses in the midterm elections and the effect will be still-high policy uncertainty and erratic US behavior. Biden can take several executive actions against inflation but we do not expect them to resolve the global supply shock or to save the Democrats from a Republican takeover of Congress this fall. There is substantial risk of a direct US-Russia crisis ahead of the election that would sustain bearish sentiment. US policy remains a headwind for equities in 2022 but possibly a tailwind in 2023. A rally after the midterm is fairly likely.   Recommendation (Tactical) Initiation Date  Return Long DXY (Dollar Index) 23-FEB-22 8.8% Bottom Line: Maintain a defensive posture in the third quarter but look for opportunities to buy oversold assets with long-term macro and policy tailwinds. Feature President Biden and the Democratic Party will make a last-ditch effort in the third quarter to mitigate their large expected losses in the midterm elections. The president will concentrate on fighting inflation, which is weighing on wages, incomes, and consumer and business sentiment (Chart 1). Related Report  US Political StrategyBiden Opens The Border Biden’s frantic efforts will induce additional market volatility. The president has a few limited tools to address global energy and supply shocks that probably will not work. Inflation will remain problematic even if it slows down over the next three months as our bond strategists expect. The odds of recession have risen sharply. Our Chief Global Strategist Peter Berezin suggests that the odds are 40% – a point underscored by inversion of some parts of the yield curve and a falling leading economic indicator (Chart 2). President Biden recently met with outside economic adviser Larry Summers and concluded that a recession is “not inevitable.” Not very comforting. Chart 1Inflation's Toll Chart 2Odds Of Recession Rising Summers, who warned Biden and the Democrats not to add $1.9 trillion in spending at the beginning of 2021, has put forward research showing recession odds at 60%-70% over the next 12-24 months.1 However, BCA’s own recession checklist is still ambivalent (Table 1). BCA’s House View is now neutral on equities. Table 1BCA Recession Checklist What could change the US policy outlook? Not much. Avoiding recession, reducing inflation, mobilizing women voters, and clashing directly with Russia could mitigate some of the Democrats’ expected losses this fall, but the outcome would probably be the same. Betting markets give a 72%probability to Democrats losing control of both the House of Representatives and the Senate. Our own election models show Democrats losing 22 seats in the House and two seats in the Senate (see Appendix), reinforcing our February forecast. The implication is congressional gridlock in 2023-24. Gridlock is marginally positive for the broad US equity market beginning in Q4 2022 … but marginally negative before then. Checking Up On Our Three Key Views For 2022 Our three key views for 2022 remain intact at the halfway point of the year. : 1.   From Single-Party Rule To Gridlock: The Democrats are highly likely to lose control of the House of Representatives this fall, meaning that unified government will end with the lame duck legislative session in November and December. The Democrats’ fiscal 2022 budget reconciliation bill is less likely to pass now that midterm campaigning has begun. A fiscally expansive bill would add to inflation. A deficit-reducing bill – i.e. one with substantial tax hikes – would increase the odds of recession. Biden no longer has an interest in pushing the bill until he is reasonably sure a recession can be avoided. It is very hard to garner 218 votes in the House and 51 votes in the Senate now that Biden’s and Democrats’ popular support is melting down. Democrats are polling comparably to Republicans who lost 41 House seats in the 2018 midterms (Chart 3). Thus while it is still possible for Democrats to pass an energy security and climate change bill under Biden’s presidency, we have no conviction that they can do it before the midterm. More likely it would have to pass during the lame-duck session in the fourth quarter – or as a compromise law with a Republican Congress in 2023-24. Until 2025, at earliest, US government will be divided, which means that the post-election drop in policy uncertainty will be short-lived, as fears will emerge of breaching the debt ceiling in early 2023. Chart 3Democratic Party Troubles 2.   From Legislative To Executive Power: With the legislature stymied, Biden will resort to executive power to keep his presidency afloat. So what will he do? Fight inflation. Biden’s anti-inflation plan consists of three prongs. The first is “letting” the Fed raise interest rates, which is well under way. The Fed hiked rates by 75 basis points on June 15 and plans to raise the Fed funds rate to 3.25% or 3.5% by end of year. The second prong is passing his Build Back Better plan and the third is consolidating the fiscal deficit. But these two options are bogged down in Congress – no new belt-tightening will occur until 2023 at earliest. So Biden’s remaining options consist of administrative maneuvers and executive orders. Biden could stop collecting the federal gas tax, although the tax has not risen since 1993 and its removal will have a marginal impact (Chart 4). He has already tapped the strategic petroleum reserve, to an unprecedented degree, without preventing the surge in prices at the pump (Chart 5). Chart 4Biden To Defer Federal Gas Tax Chart 5Strategic Petroleum Reserve Already Tapped   3.   From Domestic To Foreign Policy: Part of Biden’s turn toward executive power will be a turn toward foreign policy orientation. However, before the midterm, Biden’s foreign policy will be defensive or reactive. That is, with the exception of Russia, he will attempt to placate foreign threats and mitigate the energy shock. On China, Biden is considering pulling back on some of President Trump’s extraordinary tariffs, though probably not the Section 301 tariffs related to technology theft. He has the authority to do so unilaterally just as Trump had the authority to put them on. The problem is that easing the China tariffs will have little effect on inflation, and only after the midterm, while it would weaken Biden’s political standing in the Rust Belt and undermine the US’s strategic competition with China. Tariff relief would only temporarily benefit the renminbi, if at all, given China’s need for a weak currency amid its economic slowdown (Chart 6). Hence Biden may reduce some tariffs but it will be underwhelming. Not a reliable way to bring down inflation. Chart 6Biden Can Ease China Tariffs (But Don't Bet On It) Second, Biden has proposed to ease sanctions on Iran if it will freeze its nuclear program and come back into compliance with the 2015 nuclear deal that the Trump administration rejected. But the Iranians can export oil anyway at today’s prices, they have customers in China and India, and they have immense military leverage over Iraqi production, which means they are not forced to capitulate (Chart 7). Not a reliable way to bring down inflation. Third, Biden is courting the Gulf Arab states and tinkering with easing sanctions on Venezuela and others. OPEC support is a better option than Iran/Venezuela. However, OPEC will decide when and how much support to give. The Arab states will act to prolong the global business cycle but will not base their strategy on helping Democrats win an election. Hence they may not come to the rescue as early as the third quarter (Chart 8). Chart 7Biden Can Ease Iran Sanctions (But Don't Bet On It) Chart 8Biden Casting About For Oil Providers Moreover if the Biden administration makes amends with Saudi Arabia, then Iran’s nuclear progress will steam ahead and ignite tensions in the Middle East within the year. That would vitiate the impact of increased OPEC production. Not a reliable way to bring down inflation. Biden has even sought to exempt Russia from some sanctions for the sake of reducing inflation, such as with grain exports. However, these arrangements may not last. Given Biden’s weak domestic support and given the way that the Cuban Missile Crisis helped President Kennedy to mitigate his party’s losses in 1962, Biden can afford to be confrontational and even provocative toward Russia (Chart 9). After all, Russia is already pulling levers to add to inflation. The problem is that a direct US-Russia showdown would increase inflation while heightening global risk aversion. Bottom Line: Gridlock is coming, which is marginally negative for US equities in Q3 2022 but marginally positive as early as Q4 2022 and in 2023. It is not good for equities in 2022 because of elevated uncertainty – uncertainty not so much about the election results as about the volatile and unpredictable impacts of the president’s last-ditch efforts to fight inflation. Chart 9Biden Can Take Risks With Russia Checking Up On Our Strategic Themes For The 2020s Looking beyond the short term, this year’s inflation outbreak and geopolitical events will largely reinforce our three long-term US political themes, in the following ways: 1.   Millennials/GenZ Rising: In the coming 12 months, a fall in job openings due to the economic slowdown, combined with a recovering labor participation rate, could reduce wage pressures and inflation, in accordance with the Federal Reserve’s plan for a “soft landing” (Chart 10). Of course, that is not happening yet. And conversely labor participation will fall again if recession risks materialize. So there will be a lot of noise in the short run. Over the long run, a rising dependency ratio, in the context of a growing population, has inflationary implications. It decreases the pool of savings, increases the need for public investment, and increases the cost of each prime-age worker. Today the headline labor participation rate has mostly recovered but workers over the age of 55 are failing to return to pre-pandemic levels of participation, as are young people, which will keep wage pressures up (Chart 11). Chart 10The Fed's Idea Of A Soft Landing Chart 11Generational Shift In Labor Market Thus generational change will be marginally inflationary and will have powerful political effects. An increasingly multi-ethnic and educated population will hold different opinions from previous generations. Political parties will evolve to capture these voters. Underlying the shift will be the fact that government support will be necessary for the rising share of dependents, yet fiscal discipline will be necessary to restrict inflation. The current quarrel between older and younger generations will intensify before it subsides. The Silent Generation, along with the conservative Baby Boomers, will remain the decisive voting bloc in the 2022 midterm and will seek to freeze fiscal policy. That brings us to our next theme … 2.   Peak Polarization: Political polarization has declined since the 2020 election, as we predicted. All voters dislike high inflation (Chart 12). However, polarization will remain at historically high levels at least over the short and medium term. Chart 12Everyone Loathes Inflation Chart 13Women’s Turnout Will MatterPolarization will remain high in part because of the generational divide, which is still very wide and underpins stark ideological divides. For example, a short-term driver of polarization will be abortion. The Supreme Court is likely, though not certain, to overturn the 1972 Roe v. Wade decision that guarantees nationwide access to abortion. If it does, protests and civil unrest will occur. Women turned out in droves against President Trump’s Republicans in the 2018 midterms and will do so again in 2022 (Chart 13), helping Democrats to mitigate some of their losses. Polarization will also remain high due to the electoral system and intra-party dynamics. While Democrats ensconce themselves in formal institutions, Republicans continue to transform into a populist party. So far in the Republican primary elections, candidates endorsed by former President Trump are winning the nomination at a 94% rate. Table 2 shows the outcomes in the GOP primary elections for the House of Representatives so far. A GOP House majority is likely to impeach President Biden for one or another reason, even though they will not be able to remove him from office. Table 2Polarization Will Stay Near Historic Peaks Over 2022-24 Cycle Today’s extreme polarization entails that congressional gridlock will return and that the US remains at high risk of social unrest, political violence, and domestic terrorism (Chart 14). A terrorist attack that affects critical infrastructure, high-level personnel, or the electoral system would lead to greater sociopolitical instability. Especially if violence tips the narrow political balance of one of the branches of government and has a concrete impact on national policy.2 Social unrest alone will hardly move markets but unrest that fundamentally damages US political stability is possible and would engender risk-aversion. Over the long run, however, the US will avoid a second civil war since Washington possesses the world’s most powerful military and intelligence apparatus, which is highly unlikely to be coopted or defeated by an extremist movement. The military swears allegiance to the constitution. For example, neither the military nor the political institutions (as opposed to individuals) showed any serious sign of breaking down during the January 6, 2021 insurrection. The vast majority of voters will recoil from any major incidents of terrorism or militancy. While opinion polls show non-negligible support for political violence, such polls need to be interpreted carefully (Chart 15). A recent study shows that these polls overstate public support for violence.3 Chart 14Major Risk Of Domestic Terrorism, Political Violence Chart 15Opinion Growing More Militant … Until Militancy Happens The emerging Russo-Chinese strategic challenge, combined with generational change, will force political elites to cooperate to prevent domestic insurrections, regime fracture, and foreign humiliation. Polarization will give way to a new American consensus which is largely directed at domestic stabilization and fighting the Second Cold War. 3.   Limited Big Government: The inflation outbreak has dealt a blow to arguments in favor of unlimited government, including Modern Monetary Theory. While the US rediscovered the need for “Big Government” during the deflationary 2010s, it is already starting to rediscover the need for limited government via the inflationary 2020s (Chart 16). The next Congress will reimpose some fiscal discipline – and future governments will face some checks and balances on spending due to their fear of an inflationary surge and negative consequences at the voting booth. Unless Democrats somehow retain control of Congress this fall, they will reinforce the precedent set by the Carter administration that high inflation is politically undesirable. Chart 16Inflation Outbreak Will Limit Big Government Fiscal policy will be more expansive in the coming decade than in recent decades due to structural factors. But it will still face limitations from democratic politics, i.e. gridlock. As long as polarization does not spiral out of control, the US government will not become authoritarian or autocratic and fiscal policy will not result in Big Government Socialism or No Government Anarchism. A new compromise will be found which will be Limited Big Government. Bottom Line: Generational tensions will rise and then fall – and so will political polarization. The US faces a high risk of sociopolitical instability in the short term. The 2022 midterm will become a source of uncertainty, volatility, and a still-elevated equity risk premium. After the midterm, uncertainty and risk premiums will dissipate temporarily. But avoiding a recession will become the critical factor in maintaining policy continuity and national stability through the 2024 election cycle. Investment Takeaways BCA has shifted its House View to a neutral asset allocation stance on equities relative to bonds, as noted. US Political Strategy remains defensively positioned, as midterm elections typically provide a tailwind to defensive sectors for the first three quarters of the election year. This is also true when unified governments shift to divided governments – and in that case bond yields tend to be higher than usual (Chart 17). While the inflation outbreak makes this year different from many recent midterm years, these trends have persisted. For this reason, and our Geopolitical Strategy views, we will maintain our defensive bias in the third quarter. Chart 17Stocks Flat, Bond Yields High, Until After Midterm Elections We remain overweigh health care relative to the broad market and overweight nominal Treasuries relative to inflation-protected securities. Having said that, we are putting our long US dollar (DXY) trade on downgrade watch. We do not doubt that the dollar can go higher this year but our bearish views have come to fruition both within the US and in the geopolitical space and they are now largely priced. It may soon be time to step back and reassess, especially because interest rate differentials are turning against the dollar (Chart 18). In addition China’s government will take a pro-growth turn to try to secure the economic recovery over the next 12 months. In the energy space, we expect volatility. The Biden administration is focused on fighting inflation and could pull various levers to affect the oil market, outlined above. If Biden succeeds against expectations, then the oil price would suffer a substantial setback. Moreover OPEC has an independent interest in prolonging the business cycle now that global prices have become punitive. Hence we are neutral on oil prices and booked gains on our long energy trades for the time (Chart 19). Chart 18Put US Dollar On Downgrade Watch If inflation subsides and bond yields moderate, then growth stocks should rebound against value stocks. However, we implemented this idea prematurely earlier this year and suffered for it. Therefore we remain neutral on the question of portfolio styles for now. Our cyclical plays remain the same: long cyber security stocks, defense stocks, and infrastructure stocks. We also remain long renewable energy, although for now we only recommend it as a tactical trade (Chart 20). Chart 19Energy Prices Will Be Volatile Chart 20Stick With Cyber Security, Defense, And Renewables     Matt Gertken Senior Vice President Chief US Political Strategist mattg@bcaresearch.com     Footnotes 1     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. 2     Consider the January 6 insurrection, the recent plot against Supreme Court Justice Brett Kavanaugh’s life, the gun attack on Republican Senators in 2017, and the risk of assassinations or other extremist incidents. 3    See Sean J. Westwood et al, “Current research overstates American support for political violence,” Proceedings of the National Academy of Sciences, 119:12 (2022), pnas.org. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model  Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets  

    Executive Summary At our monthly view meeting on Monday, BCA strategists voted to change the House View to a neutral asset allocation stance on equities, with a slight plurality favoring an outright underweight. The view of the Global Investment Strategy service is somewhat more constructive, as I think it is still more likely than not that the US will avoid a recession; and that if a recession does occur, it will be a fairly mild one. Nevertheless, the risks to my view have increased. I now estimate 40% odds of a recession during the next 12 months, up from 20% a month ago. In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising Bottom Line: With the S&P 500 down 27% in real terms from its highs at the time of the meeting, the view of the Global Investment Strategy service is that a modest overweight is appropriate. However, investors should refrain from adding to equity positions until more clarity emerges about the path for inflation and growth. Heading For Recession? Every month, BCA strategists hold a view meeting to discuss the most important issues driving the macroeconomy and financial markets. This month’s meeting, which was held yesterday, was especially pertinent as it comes on the heels of a substantial decline in global equities. The key issue that we grappled with was whether the Fed could achieve a proverbial soft landing or whether the US and the rest of the global economy were spiraling towards recession (if it wasn’t already there). I began the meeting by showing one of my favorite charts, a deceptively simple chart of the US unemployment rate (Chart 1). The chart makes three things clear: 1) The US unemployment rate is rarely stable; It is almost always either rising or falling; 2) Once it starts rising, it keeps rising. In fact, the US has never averted a recession when the 3-month average of the unemployment rate has risen by more than a third of a percentage point; and 3) As a mean-reverting series, the unemployment rate is most likely to start rising when it is very low. Chart 1In The Past, When Unemployment Has Started Rising In The US, It Has Kept On Rising Taken at face value, the chart paints a damning picture about the economic outlook. The US unemployment rate is near a record low, which means that it has nowhere to go but up. And once the unemployment rate starts going up, history suggests that a recession is inevitable. Five Caveats Despite this ominous implication, I did highlight five caveats. First, the observation that even a modest increase in the unemployment rate invariably heralds a recession is based on a limited sample of business cycles from the US. Across the G10, soft landings have occurred, Canada being one example (Chart 2). Second, unlike the unemployment rate, the employment-to-population ratio is still 1.1 percentage points below its pre-pandemic level, and 4.6 percentage points below where it was in April 2000. A similar, though less pronounced, pattern holds if one focuses only on the 25-to-54 age cohort (Chart 3). Chart 2G10 Economies Sometimes Manage To Avoid A Recession Amid Rising Unemployment Chart 3The Employment-To-Population Ratio Remains Below Pre-Pandemic Levels   While the number of people not working either because they are worried about the pandemic, or because they are still burning through their stimulus checks, has been trending lower, it is still fairly high in absolute terms (Chart 4). As my colleague Doug Peta discussed in his latest report, one can envision a scenario where job growth remains positive, but the unemployment rate nonetheless edges higher as more workers rejoin the labor force. Chart 4ALabor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (I) Chart 4BLabor Supply Should Increase As Covid Fears Continue To Abate And More Workers Burn Through Their Stimulus Savings (II)     Third, the job vacancy rate is extremely high today – much higher than a pre-pandemic “Beveridge Curve” would have predicted (Chart 5). This provides the labor market with a wide moat against an increase in firings. As Fed governor Christopher Waller has emphasized, the main effect of the Federal Reserve’s efforts to cool labor demand could be to push down vacancies rather than to push up unemployment. Fourth, as we have highlighted in past research, the Phillips curve is kinked at very low levels of unemployment (Chart 6). This means that a decline in unemployment from high to moderate levels may do little to spur inflation, but once the unemployment rate falls below its full employment level, then watch out! Chart 5The Fed Hopes That Its Tightening Policy Will Bring Down Job Openings More Than It Pushes Up The Unemployment Rate Chart 6The Phillips Curve Is Kinked At Very Low Levels Of Unemployment   The converse is also true, however. If a small decrease in unemployment can trigger a large increase in inflation, then a small increase in unemployment can trigger a large decrease in inflation, provided that long-term inflation expectations remain reasonably well anchored in the meantime. In other words, it is possible that the so-called “sacrifice ratio” — the amount of output that has to be sacrificed to reduce inflation — may be quite low. Fifth, and perhaps most importantly, there is a lot of variation from one recession to the next in how much unemployment rises. In general, the greater the financial and economic imbalances going into a recession, the deeper it tends to be. US household balance sheets are in reasonably good shape these days. Households are sitting on $2.2 trillion in excess savings (Chart 7). Yes, most of those savings belong to relatively well-off households. But as Chart 8 illustrates, even rich people spend well over half of their income. Chart 7Households Have Only Just Begun To Draw Down Their Accumulated Savings Chart 8Even The Rich Spend The Majority Of Their Income     The ratio of household debt-to-disposable income in the US is down by a third since its peak in 2008. Despite falling equity prices, the ratio of household net worth-to-disposable income is still up nearly 50 percentage points since the end of 2019, mainly because home prices have risen (Chart 9). As is likely to be the case in many other countries, home prices in the US will level off and quite possibly decline over the next few years. In and of itself, that may not be such a bad outcome for equity markets since lower real estate prices will cool aggregate demand, thus lowering inflation without the need for much higher interest rates. The danger, of course, is that we could see a replay of the GFC. This risk cannot be ignored but is probably quite small. The quality of mortgage lending has been very strong over the past 15 years. Moreover, unlike in 2007, when there was a large glut of homes, the homeowner vacancy rate today is at a record low. Tepid homebuilding has pushed the average age of the US residential capital stock to 31 years, the highest since 1948 (Chart 10). Chart 9The US Household Debt Burden Has Come Down Significantly Since 2008, While Net Worth Is Still Higher Than Before The Pandemic Chart 10Tight Supply Conditions In The Housing Market Argue Against A Repeat Of The GFC   A Bleaker Picture Outside The US The situation is admittedly dicier outside the US. Putin’s despotic regime continues to wage war on Ukraine. While European natural gas prices are still well below their March peak, they have recently surged as Russia has begun to throttle natural gas exports (Chart 11). The euro area manufacturing PMI clocked in a respectable 54.6 in May but is likely to drop over the coming months as higher energy prices restrain production. The only saving grace is that fiscal policy in Europe has turned more expansionary. The IMF’s April projection foresaw the structural primary budget balance easing from a surplus of 1.2% of GDP between 2014 and 2019 to a deficit of 1.2% of GDP between 2022 and 2027, the biggest swing among the major economies (Chart 12). Even the IMF’s numbers probably underestimate the fiscal easing that will transpire considering the need for Europe to invest more in energy independence and defense. Chart 11The European Economy Is Threatened By Rising Gas Prices Chart 12Euro Area Fiscal Policy Is Expected To Be More Expansionary In The Years To Come Than Before The Pandemic   The Chinese economy continues to suffer from the “triple threat” of renewed Covid lockdowns, a shift of global demand away from manufactured goods towards services, and a floundering property market. We expect the Chinese property market to ultimately succumb to the same fate that befell Japan 30 years ago. Chart 13Chinese Stocks Are Cheap Unlike Japanese stocks in the early 1990s, however, Chinese stocks are trading at fairly beaten down valuations – 10.9-times earnings and 1.4-times book for the investable index (Chart 13). With the Twentieth Party Congress slated for later this year and the population jaded by lockdowns, the political incentive to shower the economy with cash and loosen the reins on regulation will intensify. A Scenario Analysis For The S&P 500 Corralling all these moving parts is no easy matter. We would put the odds of a US recession over the next 12 months at 40%. This is double what we would have said a month ago when we tactically upgraded stocks after the S&P 500 fell below the 4,000 mark. The May CPI report was clearly a shocker, both to the Fed and the markets. The median dot in the June Summary of Economic Projections sees the Fed funds rate rising to 3.8% next year, smack dab in the middle of our once highly out-of-consensus estimate of 3.5%-to-4% for the neutral rate of interest. With interest rates potentially moving into restrictive territory next year, equity investors are right to be concerned. Yet, as noted above, if a recession does occur, it is likely to be a fairly mild one. At the time of the BCA monthly view meeting, the S&P 500 was already down 23% in nominal terms and 27% in real terms from its peak in early January. We assume that the S&P 500 will fall a further 10% in real terms over the next 12 months in a “mild recession” scenario (30% odds) and by 25% in a “deep recession” scenario (10% odds). Conversely, we assume that the S&P 500 will be 20% higher in 12 months’ time in a “no recession” scenario (60% odds). Note that even in a “no recession” scenario, the real value of the S&P 500 would still be down 12% in June 2023 from its all-time high. On a probability-weighted basis, the expected 12-month real return across all three scenarios works out to 6.5%, or 8% with dividends (Table 1). That is enough to justify a modest overweight in my view – but given the risks, just barely. Investors focused on capital preservation should consider a more conservative stance. Table 1S&P 500 Drawdowns Depending On Whether The US Will Enter A Recession And How Severe It Will Be Most of my colleagues were more cautious than me, as they generally thought that the odds of a recession were greater than 50%. They voted to shift the BCA house view to a neutral asset allocation stance on equities, with a slight plurality favoring an outright underweight (10 for underweight; 9 for neutral; and 6 for overweight). Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Global Investment Strategy View Matrix Special Trade Recommendations Current MacroQuant Model Scores  

Listen to a short summary of this report.     Executive Summary Higher Real Yields Have Weighed On Equity Valuations I had the pleasure of visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi last week. In contrast to the rest of the world, the mood in the Middle East was very positive. While high oil prices are helping, there is also a lot of optimism about ongoing structural reforms. Petrodollar flows are increasingly being steered towards private and public equities. EM assets stand to benefit the most. Producers in the region are trying to offset lost Russian output, but realistically, they will not be able to completely fill the gap in the near term. Today’s high energy prices have largely baked in this reality, as reflected in strongly backwardated futures curves. There was no consensus about how high oil prices would need to rise to trigger a global recession, although the number $150 per barrel got bandied about a lot. Given that most Middle Eastern currencies are pegged to the dollar, there was a heavy focus on Fed policy. Market estimates of the neutral rate in the US have increased rapidly towards our highly out-of-consensus view. Nevertheless, we continue to see modest upside for bond yields over a multi-year horizon. Over a shorter-term 6-to-12-month horizon, the direction of bond yields will be guided by the evolution of inflation. While US CPI inflation rose much more than expected in May, the details of the report were somewhat less worrying, as they continue to show significant supply-side distortions. Bottom Line: Inflation should come down during the remainder of the year, allowing the Fed to breathe a sigh of relief and stocks to recover some of their losses. A further spike in oil prices is a major risk to this view.   Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Chester Ntonifor, BCA Research’s Chief Foreign Exchange Strategist, discussing the outlook for gold. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the following week, on Thursday, July 7th. Best regards, Peter Berezin Chief Global Strategist Peter in Arabia I had the pleasure of visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi last week. This note summarizes my impressions and provides some commentary about recent market turmoil. The Mood in the Region is Very Positive In contrast to the rest of the world, the mood in the Middle East was upbeat. Obviously, high oil prices are a major contributor (Chart 1). Across the region, stock markets are still up for the year (Chart 2). Chart 1Oil Prices Have Shot Up Chart 2Middle Eastern Stock Markets Are Doing Relatively Well This Year   That said, I also felt that investors were encouraged by ongoing structural reforms, especially in Saudi Arabia where the Vision 2030 program is being rolled out. The program seeks to diversify the Saudi economy away from its historic reliance on petroleum exports. A number of people I spoke with cited the Saudi sovereign wealth fund’s acquisition of a majority stake in Lucid, a California-based EV startup, as the sort of bold move that would have been unthinkable a few years ago. I first visited Riyadh in May 2011 where I controversially delivered a speech entitled “The Coming Commodity Bust” (oil was $120/bbl then and copper prices were near an all-time high). The city has changed immensely since then. The number of restaurants and entertainment venues has increased exponentially. The ban on women drivers was lifted only four years ago. In that short time, it has become a common-day occurrence. Capital Flows Into and Out of the Region are Reflecting a New Geopolitical Reality In addition to high oil prices and structural reforms, geopolitical considerations are propelling significant capital inflows into the region. The freezing of Russia’s foreign exchange reserves sent a shockwave across much of the world, with a number of other EM countries wondering if “they are next.” Ironically, the Middle East has emerged as a neutral player of sorts in this multipolar world, and hence a safer destination for capital flows. On the flipside, the region’s oil exporters appear to be acting more strategically in how they allocate their petrodollar earnings. Rather than simply parking the proceeds of oil sales in overseas US dollar bank accounts, they are investing them in ways that further their economic and political goals. One clear trend is that equity allocations to both overseas public and private markets are rising. Other emerging markets stand to benefit the most from this development, especially EMs who have assets that Middle Eastern countries deem important – assets tied to food security being a prime example. Assuming that the current level of oil prices is maintained, we estimate that non-US oil exports will rise to $2.5 trillion in 2022, up from $1.5 trillion in 2021 (Chart 3). About 40% of this windfall will flow to the Middle East. That is a big slug of cash, enough to influence the direction of equity markets. Chart 3Oil Exporters Reaping The Benefits Of High Oil Prices Middle Eastern Energy Producers Will Boost Output, But Don’t Expect Any Miracles in the Short Term Russian oil production will likely fall by about 2 million bpd relative to pre-war levels over the next 12 months. To help offset the impact, OPEC has already raised production by 200,000 barrels and will almost certainly bump it up again following President Biden’s visit to the region in July (Chart 4). The decision to raise production to stave off a super spike in oil prices is not entirely altruistic. The region’s oil exporters know that excessively high oil prices could tip the global economy into recession, an outcome that would surely lead to much lower oil prices down the road. There was not much clarity on what that tipping point is, but the number $150 per barrel got bandied around a lot. Politics is also a factor. A further rise in oil prices could compel the US to make a deal with Iran, something the Saudis do not want to see happen. Still, there is a practical limit to how much more oil the Saudis and other Middle Eastern producers can bring to market in the near term. Today’s high energy prices have largely baked in this reality, as reflected in strongly backwardated futures curves (Chart 5). Chart 4Output Trends In The Major Oil Producers Chart 5Energy Prices On Both Sides Of The Atlantic Data on Saudi’s excess capacity is notoriously opaque, but I got the feeling that an extra 1-to-1.5 million bpd was the most that the Kingdom could deliver. The same constraints apply to natural gas. Qatar is investing nearly $30 billion to expand its giant North Field, which should allow gas production to rise by as much as 60%. However, it will take four years to complete the project. The share of Qatari liquefied natural gas (LNG) going to Europe has actually declined this year. About 80% of Qatar’s LNG is sold to Asian buyers under long-term contracts that cannot be easily adjusted. And even if those contracts could be rewritten, this would only bring limited benefits to Europe. For example, Germany has no terminals to accept LNG imports, although it is planning to build two. While there was plenty of sympathy to Europe’s plight in the region, there was also a sense that European governments had been cruising for a bruising by doubling down on strident anti-fossil fuel rhetoric over the past decade without doing much to end their dependence on Russian oil and gas. In that context, few in the region seemed willing to bend over backwards to help Europe. In the meantime, the US remains Europe’s best hope. US LNG shipments to Europe have tripled since last year. The US is now sending nearly three quarters of its liquefied gas to Europe. This has pushed up US natural gas prices, although they still remain a fraction of what they are in Europe. Huge Focus on the Fed Chart 6Most Of The Increase In Bond Yields Has Been In The Real Component Most Middle Eastern currencies are pegged to the dollar, and hence the region effectively imports its monetary policy from the US. Not surprisingly, clients were very focused on the Federal Reserve. Many expressed concern about the abrupt pace of rate hikes. One of our high-conviction views is that the neutral rate of interest in the US has risen as the household deleveraging cycle has ended, fiscal policy has become structurally looser, and a growing number of baby boomers have transitioned from working (and saving) to retirement (and dissaving). The markets have rapidly priced in this view over the course of 2022. The 5-year/5-year forward Treasury yield – a proxy for the neutral rate – has increased from 1.90% at the start of the year to 3.21% at present. Most of this increase in the market’s estimate of the neutral rate has occurred in the real component. The 5-year/5-year forward TIPS yield has climbed from -0.49% to 0.84%; in contrast, the implied TIPS breakeven inflation rate has risen from only 2.24% to 2.37% (Chart 6). Implications of Higher Bond Yields on Equity Prices and the Economy Chart 7Higher Real Yields Have Weighed On Equity Valuations As both theory and practice suggest, there is a strong negative correlation between real bond yields and equity valuations. Chart 7 shows that the S&P 500 forward P/E ratio has been moving broadly in line with the 5-year/5-year forward TIPS yield. The bad news is that there is still scope for bond yields to rise over the long haul. Our fair value estimate of 3.5%-to-4% for the neutral rate is about 25-to-75 basis points above current pricing. The good news is that a high neutral rate helps insulate the economy from a near-term recession. Recessions typically occur only when monetary policy turns restrictive. A few clients cited the negative Q1 GDP reading and the near-zero Q2 growth estimate in the Atlanta Fed GDPNow model as evidence that a US recession is either close at hand or has already begun (Chart 8). Chart 8Underlying US Growth Is Expected To Be Solid In Q2 We would push back against such an interpretation. In contrast to the -1.5% real GDP print, real Gross Domestic Income (GDI) rose by 2.1% in Q1. Conceptually, GDP and GDI should be equal, but since the two numbers are compiled in different ways, there can often be major statistical discrepancies. A simple average of the two suggests the US economy still grew in the first quarter. More importantly, real final sales to private domestic purchasers rose by 3.9% in Q1. This measure of economic activity – which strips out the often-noisy contributions from inventories, government expenditures, and net exports – is the best predictor of future GDP growth of any item in the national accounts (Table 1). Table 1A Good Sign: Real Final Sales To Private Domestic Purchasers Rose By 3.9% In Q1 As far as Q2 is concerned, real final sales to private domestic purchasers are tracking at 2.0% according to the Atlanta Fed model – a clear deceleration from earlier this year, but still consistent with a generally healthy economy. Growth will probably slow in the third quarter, reflecting the impact of higher gasoline prices, rising interest rates, and lower asset prices. Nevertheless, the fundamental underpinnings for the economy – low household debt, $2.2 trillion in excess savings, a dire need to boost corporate capex and homebuilding, and a strong labor market – remain in place. The odds of a recession in the next 12 months are quite low. Gauging Near-Term Inflation Dynamics A higher-than-expected neutral rate of interest implies that bond yields will probably rise from current levels over the long run. Over a shorter-term 6-to-12-month horizon, however, the direction of yields will be guided by the evolution of inflation. While the core CPI surprised on the upside in May, the details of the report were somewhat less worrying, as they continue to show significant supply-side distortions. Excluding vehicles, core goods prices rose 0.3% in May, down from a Q1 average of 0.7% (Chart 9). Recent commentary from companies such as Target suggest that goods inflation will ease further. Chart 9Goods Inflation Is Moderating, While Service Price Growth Is Elevated Stripping out energy-related services, services inflation slowed slightly to 0.6% in May from 0.7% in April. A deceleration in wage growth should help keep a lid on services inflation over the coming months (Chart 10). Chart 10A Deceleration In Wage Growth Should Help Keep Services Inflation Contained During his press conference, Fed Chair Powell described the rise in inflation expectations in the University of Michigan survey as “quite eye-catching.” Although long-term inflation expectations remain a fraction of what they were in the early 1980s, they did rise to the highest level in 14 years in June (Chart 11). Powell also noted that the Fed’s Index of Common Inflation Expectations has been edging higher. The Fed’s focus on ensuring that inflation expectations remain well anchored is understandable. That said, there is a strong correlation between the level of gasoline prices and inflation expectations (Chart 12). If gasoline prices come down from record high levels over the coming months, inflation expectations should drop.  Chart 11Consumer Long-Term Inflation Expectations Keep Rising, But Are Still Not At Historically High Levels Chart 12Lower Gasoline Prices Would Help Soothe Consumer Fears Over Inflation The Fed expects core PCE inflation to fall to 4.3% on a year-over-year basis by the end of 2022. This would require month-over-month readings of about 0.35 percentage points, which is slightly above the average of the past three months (Chart 13). Our guess is that the Fed may be highballing its near-term inflation projections in order to give itself room to “underpromise and overdeliver” on the inflation front. If so, we could see inflation estimates trimmed later this year, which would provide a more soothing backdrop for risk assets. Chart 13AUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (I) Chart 13BUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (II) Concluding Thoughts on Investment Strategy According to Bank of America, fund managers cut their equity exposure to the lowest since May 2020. Optimism on global growth fell to a record low. Meanwhile, bears outnumbered bulls by 39 percentage points in this week’s AAII poll (Chart 14). If the stock market is about to crash, it will be the most anticipated crash in history. In my experience, markets rarely do what most people expect them to do. Chart 14Sentiment Towards Equities Is Pessimistic Chart 15Global Equities Are More Attractively Valued After The Recent Sell-Off Chart 16US And European EPS Estimates Have Been Trending Higher This Year US equities are trading at 16.3-times forward earnings, with non-US stocks sporting a forward P/E ratio of 12.1 (Chart 15). Despite the decline in share prices, earnings estimates in both the US and Europe have increased since the start of the year (Chart 16). The consensus is that those estimates will fall. However, if our expectation that a recession will be averted over the next 12 months pans out, that may not happen. A sensible strategy right now is to maintain a modest overweight to stocks while being prepared to significantly raise equity exposure once clear evidence emerges that inflation has peaked. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on        LinkedIn Twitter       View Matrix Special Trade Recommendations Current MacroQuant Model Scores

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Executive Summary 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. 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 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 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 Chart 3BCyclically 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 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 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 Chart 6China: 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 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 Chart 9More 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 Chart 11China 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 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 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 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 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 Chart 17China 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' 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 Chart 2Return Of The 'Pocketbook Voter' 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 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 Chart 5Manufacturing Employment Weakening 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 Chart 7Supply Snarls Will Continue While China Struggles With Covid 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 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 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 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 Chart 12Protectionist Sentiment To Prevail Amid Midterms 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 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 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 Table A3US Political Capital Index Chart A1Presidential Election Model Chart A2Senate Election Model  Table A4House Election Model Table A5APolitical Capital: White House And Congress Table A5BPolitical Capital: Household And Business Sentiment Table A5CPolitical Capital: The Economy And Markets

Executive Summary EU Embargoes Russian Oil 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 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 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 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 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? 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 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 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 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 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 Chart 6Silver 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 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 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 Chart 10Other Measures Of Russian Geopolitical Risk Chart 11China: GeoRisk Indicator Chart 12United Kingdom: GeoRisk Indicator Chart 13Germany: GeoRisk Indicator Chart 14France: GeoRisk Indicator Chart 15Italy: GeoRisk Indicator Chart 16Canada: GeoRisk Indicator Chart 17Spain: GeoRisk Indicator Chart 18Australia: GeoRisk Indicator Chart 19Taiwan: GeoRisk Indicator Chart 20Korea: GeoRisk Indicator Chart 21Turkey: GeoRisk Indicator Chart 22South Africa: GeoRisk Indicator Chart 23Brazil: 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