Geopolitics

Highlights This week we highlight key charts for US Political Strategy themes and views in the New Year. For H1 2022, we maintain a pro-cyclical, risk-on approach. We favor industrials, energy, infrastructure, and cyclicals. Foreign supply kinks will persist due to Omicron. The US Congress will pass one more spending bill as Democrats try to save their skin ahead of the midterm election. Yet other trends are not so inflationary: Fed rate hikes, an 8% of GDP fiscal drag, and a looming return to congressional gridlock. Midterm elections usually see defensive and growth stocks outperform cyclical and value stocks. This is a risk to our view and may require adjustments later this year. Feature This week we offer our updated US Political Strategy chart pack for the new year. Inflation and stagflation are the top concerns. But the Federal Reserve is kicking into gear, with the market now expecting three-to-four interest rate hikes in 2022 alone. We doubt that will come to pass but it is possible and there is no question that a 12-month core PCE print of 4.7% is forcing the Fed to move. Since the mega-stimulus of March 2020, markets have seen a 91% rally in the S&P 500 and a 114% rally in the tech sector. Ultra-low interest rates and stay-at-home policies created a paradise for tech stocks. But the 10-year Treasury yield surged from 1.45% in December, when Omicron emerged and the Fed turned hawkish, to 1.76% today. An inflation-induced pullback and rotation out of tech stocks was to be expected and has been our most consistent sectoral view. Long-term inflation expectations have not taken off, however. Many investors see secular stagnation over the long run – and even in the short run the resilient dollar should work against inflation. Not only will the Fed wind down asset purchases by $30bn a month starting January 2022 and start hiking rates in March, but also the budget deficit is contracting, making for an 8% of GDP fiscal drag in 2022. In addition the market no longer has any confidence that Congress will pass President Biden’s “Build Back Better” plan. We still think a reconciliation bill will pass, albeit in watered down form. But ultimately the looming midterm election will paralyze Congress, as we argued in our 2022 outlook report, “Gridlock Begins Before The Midterms.” Gridlock will ensure that whatever passes only modestly expands the long-term deficit and then that fiscal taps will be turned off in 2023. In the context of Fed hikes, this should reduce fears of inflation later in 2022, though we still see inflation as a persistent long-term problem. If history is any guide, stocks and bond yields will be flattish for most of the year due to election uncertainty. The difference between this year and other midterm years is that the US consumer is in better financial shape and yet foreign supply kinks will persist due to Omicron. The takeaway is to prefer industrials, energy, small caps, and cyclicals, even though we may not maintain these recommendations for the whole year. We are hedging by staying long health care stocks. Omicron: Less Relevant At Home, More Relevant Abroad American economic growth is declining but will likely settle at or above trend (Chart 1A). Money growth, a proxy for stimulus, is also coming off its peaks while credit growth is rising moderately. The long deleveraging of the American consumer since 2008 appears to have come to an end. But it is too soon to say how aggressively Americans will lever back up and whether a new private sector “debt super cycle” will begin (Chart 1B). Chart 1AEconomic Growth Peaked, Will Slow To Trend Economic Growth Peaked, Will Slow To Trend Economic Growth Peaked, Will Slow To Trend Chart 1BEconomic Growth Peaked, Will Slow To Trend Economic Growth Peaked, Will Slow To Trend Economic Growth Peaked, Will Slow To Trend The Omicron variant of COVID-19 will have a modest negative impact early in the year. Hospitalizations are picking up in the wake of a surge in new cases following Christmas gatherings. Only 61% of Americans are fully vaccinated and only 23% have received the booster shot that is most effective against Omicron (Chart 2A & Chart 2B). Yet new deaths from the disease remain subdued and only about a fifth of those hospitalized go to the intensive care unit today. Chart 2 Chart 2BCOVID-19 Continues But Relevance Wanes COVID-19 Continues But Relevance Wanes COVID-19 Continues But Relevance Wanes Pharmaceuticals, both vaccines and anti-viral medications, are saving the day and Americans are becoming resigned to the likelihood of getting the virus at some point. Social mobility has dropped off since summer 2021 but will boom in the springtime and consumer confidence is already picking back up (Chart 3A & Chart 3B). The Biden administration is not likely to impose unpopular social restrictions during an election year unless a variant is deadlier, more contagious, and resistant to vaccines, which is not the case with Omicron. Chart 3AOmicron Not A Major Setback For Recovery Omicron Not A Major Setback For Recovery Omicron Not A Major Setback For Recovery The resilience of the US will come with persistent inflation in goods given that Omicron will still cause supply disruptions abroad. Not all countries have as effective vaccines when it comes to Omicron – if they maintain tighter social restrictions, prices of imported goods will continue to rise. The Fed cannot resolve foreign bottlenecks. While manufacturing surveys show bottlenecks easing from last year’s highs, foreign supply constraints will remain a problem throughout the year. Chart 3BOmicron Not A Major Setback For Recovery Omicron Not A Major Setback For Recovery Omicron Not A Major Setback For Recovery Buy The Rumor, Sell The News Of “Build Back Better” The Biden administration and Democratic Party are still likely to pass one last blast of fiscal spending – the “Build Back Better” budget reconciliation act, a social welfare bill. The output gap is virtually closed and the economy does not need new demand stimulus. However, the Democratic Party needs a legislative win ahead of the midterm election. Thin majorities in both chambers of Congress enable a single senator to derail the bill. But the bill’s provisions are popular among political independents and especially the Democratic Party’s base, which is lacking in enthusiasm about the election as things stand (Charts 4A & 4B). Moderate Democrats in the Senate are still negotiating: their goal is to chop the plan down to size and pass only the most popular provisions, rather than to sink the president and their own party. Chart 4 Chart 4 This means the bill’s top-line spending will be further reduced. The final size should fall from the earlier range of $2.5-$4.7 trillion to $2.3 trillion or less. Add a few tax hikes, like the minimum corporate tax, and the deficit impact will be around $600 billion (Table 1). Table 1"You’ve Gotta Pass It To See What’s In It" Chart Pack: Gridlock Now Chart Pack: Gridlock Now Ultimately we cannot have high conviction on the BBB plan because we cannot predict what a single senator will do. That is a matter of intelligence, not macro analysis. Chart 5 Chart 5 But subjectively we still give 65% odds that the Democratic Party will circle the wagons and pass the bill. The party views itself as surrounded by populism on both its right and left flanks – a failure to compromise will whet the appetites of both the Sanderistas (left-wing populists) and the Trumpists (right-wing populists) (Chart 5A). The Republicans still have a better position in the states, and the states have constitutional control of elections, so establishment Democrats are more terrified than usual of flopping in the midterm elections (Chart 5B). Otherwise the midterms – which are already likely to be bad for the Democrats – will deal a devastating blow. Republicans are recovering in party affiliation and tentatively surpassing Democrats among independent voters (Chart 6A). Biden and the Democrats lashed out at former President Trump and the Republican Party on the anniversary of the January 6, 2020 rebellion, but this tactic will not lift their popularity in polls. Their current polling is not much better than that of Republicans in 2018, when the latter suffered a bruising defeat in the midterms (Chart 6B). Chart 6ADemocrats Need A Win Before The Midterm Democrats Need A Win Before The Midterm Democrats Need A Win Before The Midterm Chart 6 Biden’s legislation would reduce the fiscal drag marginally in fiscal year 2023 but overall the budget deficit will shrink and then lie flat over 2022-24 regardless of what Congress does (Chart 7). New spending would be marginally inflationary over the long run since the budget deficit is expected to expand again beyond fiscal year 2024. Chart 7 Republicans will not be able to slash the budget until they control both Congress and the White House, but in that case they are likely to prove big spenders as in the past. Populism will persist on all sides: the political establishment will keep trying to use fiscal profligacy to peel voters away from populists, who are even more fiscally profligate. Only an inflation-induced recession will restore some fiscal discipline – and that is a way off. Ultimately the significance of the BBB bill is to verify whether establishment politicians – fiscal authorities – are capable of moderating their spending plans according to the threat of inflation, as Modern Monetary Theory maintains. Otherwise the implication is that polarization and populism will produce fiscal overshoots regardless of near-term inflation, even with the narrowest of possible majorities in Congress. The latter, a BBB fiscal overshoot, is what we expect. If it happens it will probably be received negatively by the equity market, fearing faster Fed rate hikes, and it would add credibility to long-term concerns about inflation, because it would reveal that fiscal authorities are not good at adjusting in real time. The former, a BBB failure and a halt to fiscal spending, would suggest that fiscal extravagance remains a crisis-era phenomenon and will be reined in by Congress after a crisis passes, which is probably positive for equities. It would at least suggest that fiscal authorities will adjust when the facts change. Of course, how investors respond to any legislative outcome will depend on a range of factors. But the takeaway is this: Inflation fears may or may not peak in the short run but they will persist over the long run. The Fed: Focus On The Framework In the wake of the Great Recession the Federal Reserve as an institution – both the Federal Open Market Committee and the Board of Governors – shifted in a more accommodative or dovish direction (Chart 8). The shift culminated in the review of monetary policy strategy in August 2020, which produced average inflation targeting. Chart 8 In practice the dovish policy shift is apparent in a real Fed funds rate at -4%, the lowest level since the inflationary 1970s under Fed Chair Arthur Burns. But what is more remarkable is the simultaneous surge in the budget deficit, unlike anything since World War II, and unlike anything in peacetime (Chart 9). Chart 9Inflation And Stagflation Risks Inflation And Stagflation Risks Inflation And Stagflation Risks The massive increase in federal debt, from 34% of GDP in 2000 to 75% before COVID-19 and 106% today, acts as a constraint on any future Fed hawkishness (Chart 10). A Fed chair who drives interest rates too high amid high debt levels will cause a recession and force the debt-to-GDP ratio up even higher. Yet the result of low rates is to stimulate indebtedness. While the private debt super cycle has subsided, a public debt super cycle is thriving. Chart 10A Major Check On Fed Hawkishness A Major Check On Fed Hawkishness A Major Check On Fed Hawkishness This brings us to today’s predicament. The Fed’s criteria for raising interest rates have mostly been met: 12-month core PCE inflation is running at 4.7% while the inflation breakeven rate in the Treasury market suggests that inflation is well anchored and likely to persist above the 2% inflation target for some time (Chart 11A). The economy is virtually at “maximum employment” (Table 2) – the Fed has set aside concerns about low labor force participation to focus on the collapsing unemployment rate, which is now within the range at which it will feed inflation (Chart 11B). Chart 11AThe Fed's Criteria For Liftoff The Fed's Criteria For Liftoff The Fed's Criteria For Liftoff Table 2The Fed’s Criteria For Liftoff Chart Pack: Gridlock Now Chart Pack: Gridlock Now Chart 11BThe Fed's Criteria For Liftoff The Fed's Criteria For Liftoff The Fed's Criteria For Liftoff The takeaway is that the Fed is suddenly restoring the credibility of its 2% inflation target, with headline PCE rapidly coming up on the trajectory established in the wake of the Great Recession (Chart 12), as our US bond strategist Ryan Swift has demonstrated. Chart 12Lo And Behold: Debt Monetization Generates Inflation Lo And Behold: Debt Monetization Generates Inflation Lo And Behold: Debt Monetization Generates Inflation The explosion of fiscal spending played a critical role in generating this new trajectory. The combination of monetary and fiscal accommodation has worked wonders. Assuming the BBB passes, Chairman Powell will face even greater pressure to prevent this correction of the inflation trajectory from overshooting and turning into a wage-price spiral. The unexpected risk would be if the BBB bill fails, the Fed hikes aggressively, global growth sputters, the dollar surges, and Republicans retake Congress — then Powell may yet see disinflationary challenges in his term in office. Our sense is that the BBB will pass, reinforcing Powell’s less dovish pivot, and yet the Fed’s framework will not permit too hawkish of a stance, resulting in persistent inflation risks over the long run. Three Strategic Themes In our annual strategic outlook, we highlighted three structural or strategic themes that are not beholden to the 12-month forecasting period: 1.   Rise Of Millennials And Generation Z: The sharp drop in labor force participation will gradually mend in the wake of the crisis but the aging of the population ensures that the general trend will decline over time as the dependency ratio rises (Chart 13A). Chart 13AStrategic Theme #1: Rise Of Millennials/Gen Z Strategic Theme #1: Rise Of Millennials/Gen Z Strategic Theme #1: Rise Of Millennials/Gen Z Chart 13 Politically the millennials and younger generations are gaining clout over time, although their partisan identity will also evolve as they mature and gain a greater stake in the economy and become asset owners (Chart 13B). 2.   Peak Polarization: US political polarization stands at historic highs and will likely remain so over the 2022-24 political cycle (Chart 14A). Polarization coincides with the transformation of society amid falling bond yields and technological revolution (Chart 14B). Chart 14AStrategic Theme #2: Peak Polarization Strategic Theme #2: Peak Polarization Strategic Theme #2: Peak Polarization Chart 14BStrategic Theme #2: Peak Polarization Strategic Theme #2: Peak Polarization Strategic Theme #2: Peak Polarization The pandemic era has been especially polarized due to the 2020 election and controversies over vaccination (Chart 15). Chart 15 Domestic terrorism of whatever stripe is possible (Chart 16). But any historic incidents will generate a majority opposed to political violence. Chart 16Risk Of Domestic Terrorism Risk Of Domestic Terrorism Risk Of Domestic Terrorism True, former President Trump is still likely to run on the Republican ticket, which will ensure that polarization remains elevated (Diagram 1). However, US elections hinge on structural factors, not individuals. Diagram 1GOP 2024 Is Up To Trump Chart Pack: Gridlock Now Chart Pack: Gridlock Now So far structural factors point to policy continuity: not only are Democrats still slated to retain the White House, but President Biden has coopted many of Trump’s key policies, including infrastructure, protectionism, and big budget deficits (Chart 17). If Democrats falter, Trump’s policies will be reaffirmed. The implication is that a new national policy consensus is taking shape beneath the surface. Chart 17 3.   Limited “Big Government”: Americans have been turning away from “small government” and toward “big government” since the 1990s. Voters no longer worry so much about budget discipline and instead look for the “visible hand” of government to support the economy (Charts 18A & 18B). Chart 18 Chart 18 Both domestic populism and geopolitical challenges encourage this shift. Industrial policy and domestic manufacturing are making a comeback (Table 3). Table 3Strategic Theme #3: Limited “Big Government” Chart Pack: Gridlock Now Chart Pack: Gridlock Now With extremely robust fiscal policy, the US has avoided the policy mistake of the period after the Global Financial Crisis, when premature fiscal tightening undermined the economic recovery (Chart 19). Policy uncertainty will increase as gridlock returns to Congress and fiscal policy will be frozen. But investors need not fear a slide back into deflation. The Republican Party’s populist base may prevent more Democratic social spending but they will not be able to repeal what is done.  Chart 19Even With Looming Gridlock, The US Is Far From Tightening Fiscal Policy Too Soon This Time Even With Looming Gridlock, The US Is Far From Tightening Fiscal Policy Too Soon This Time Even With Looming Gridlock, The US Is Far From Tightening Fiscal Policy Too Soon This Time Three Key Views For 2022 The key views for the 12-month period are connected with the above but of a more short-term or cyclical duration: 1.   From Single-Party Rule To Gridlock: Republicans are highly likely to win back control of the House of Representatives and likely the Senate (Charts 20A & 20B). President Biden’s approval rating suggests that Democrats could lose 40 seats in the House (Chart 21) and three in the Senate (Chart 22), whereas they only need to lose five and one to lose control. Our quantitative Senate election model shows an even split but the model’s trend favors Republicans, as does the political cycle and partisan enthusiasm (Chart 23). Chart 20 Chart 20 Chart 21 Chart 22 Chart 23 2.   From Legislative To Executive Power: Biden may still pass one more spending bill but otherwise the legislature will be frozen. Democrats will not succeed in ramming legislation through by abolishing the Senate filibuster. Biden will turn to executive decree, where he is already on track to make a historic increase in regulation, which will increase concerns among small business (Chart 24A & Chart 24B). Anti-trust laws are unlikely to be overhauled and Democrats will struggle to bring back the tough anti-trust posture of the 1900s-1950s without new legislation, meaning that Big Tech faces a bigger threat from inflation than regulation (Table 4). The green transition will continue but primarily in the form of any subsidies passed in the reconciliation bill, rather than new taxes or any carbon pricing scheme (Chart 25A & Chart 25B). Chart 24AKey View #2: From Legislative To Executive Power Key View #2: From Legislative To Executive Power Key View #2: From Legislative To Executive Power Chart 24 Table 4Key View #2: From Legislative To Executive Power Chart Pack: Gridlock Now Chart Pack: Gridlock Now Chart 25 Chart 25BGreen Energy: Subsidies But No Carbon Tax Green Energy: Subsidies But No Carbon Tax Green Energy: Subsidies But No Carbon Tax   3.   From Domestic To Foreign Policy Risks: Biden faces a slew of foreign policy and external risks that could damage the Democrats in the midterms. The surge in illegal immigration on the southern border is truly historic and will have significant policy ramifications over the long run (Chart 26A & Chart 26B). The surge in inflation will force Biden to contend with foreign policy challenges with one hand tied behind his back, since energy supply disruptions could derail his party ahead of the midterm election (Chart 27). While Biden could ease some inflationary pressure via reduced trade tariffs, protectionist impulses will prevail during an election year (Chart 28). Chart 26AKey View #3: External Risks For Biden Key View #3: External Risks For Biden Key View #3: External Risks For Biden Chart 26BKey View #3: External Risks For Biden Key View #3: External Risks For Biden Key View #3: External Risks For Biden Chart 27Foreign Policy Could Hit Prices At Pump Foreign Policy Could Hit Prices At Pump Foreign Policy Could Hit Prices At Pump Chart 28Tariff Relief In 2022? Don't Bet On It Tariff Relief In 2022? Don't Bet On It Tariff Relief In 2022? Don't Bet On It Investment Takeaways The stock market tends to be flat, with risks skewed to the downside, during midterm election years due to policy uncertainty. The same is true for bond yields (Chart 29). Chart 29Stocks And Bond Yields Trend Lower Before Midterms ... Stocks And Bond Yields Trend Lower Before Midterms ... Stocks And Bond Yields Trend Lower Before Midterms ... When united or single-party governments approach midterms, stocks tend to perform worse than for divided governments in midterm years, while bond yields tend to be a bit higher (Chart 30). This trend is supercharged in 2022 due to the inflationary effects of the pandemic. Chart 30... But United Govts See Higher Bond Yields And Weaker Stocks ... ... But United Govts See Higher Bond Yields And Weaker Stocks ... ... But United Govts See Higher Bond Yields And Weaker Stocks ... Assuming Republicans regain at least the House, the US will transition from united to divided government (gridlock). In previous such transitions, stocks tend to perform in line with the average for a midterm election year, but bond yields skew higher – reinforcing the previous point (Chart 31). Chart 31... Shift From United To Divided Govt Implies Higher Bond Yields Than Otherwise ... Shift From United To Divided Govt Implies Higher Bond Yields Than Otherwise ... Shift From United To Divided Govt Implies Higher Bond Yields Than Otherwise We will update our US Sector Political Risk Matrix to bring it better into line with our views, particularly in light of Table 5 below regarding sector relative performance during midterm election years. Normally defensives and growth stocks outperform in midterm years, Table 5ConDisc, Tech, Health Do Best During Midterms …But Waning Pandemic Makes An Exception Chart Pack: Gridlock Now Chart Pack: Gridlock Now while cyclicals and value stocks underperform, but 2022 looks to be different due to inflation. Still over the course of the year we would expect the historic trend to reassert itself. Investors should favor cyclicals even though they probably cannot outperform defensives for much longer (Chart 32A). We recommend health care stocks as a hedge given that the dollar should still be resilient this year, Fed hikes should moderate inflation expectations, and midterm policy uncertainty will eventually weigh on risk appetite (Chart 32B). Chart 32AFavor Cyclicals, Though They May Not Outperform Defensives Much Longer Favor Cyclicals, Though They May Not Outperform Defensives Much Longer Favor Cyclicals, Though They May Not Outperform Defensives Much Longer Chart 32BLong Health Care As Hedge Long Health Care As Hedge Long Health Care As Hedge Value stocks are forming a bottom relative to growth stocks, although this trend is less clear in the US, especially among US large caps, than it is abroad (Chart 33). We favor value over growth on a cyclical basis but midterm election uncertainties will pull the other way, making for a choppy bottom. Chart 33Favor Value And Small Caps, Though Bottom Formation Remains Choppy Favor Value And Small Caps, Though Bottom Formation Remains Choppy Favor Value And Small Caps, Though Bottom Formation Remains Choppy The same process is visible on a sector basis, where energy and materials continue to outperform tech (Chart 34A). We recommend staying long energy on a cyclical basis, though its outperformance against tech could abate later in 2022. Infrastructure stocks – such as building and construction materials – also continue to outperform. Since Biden’s honeymoon period ended, the outperformance is largely relative to tech rather than the S&P as a whole. We still favor infrastructure stocks as the fiscal policy theme will continue even beyond the current legislation, which will barely start to be implemented in 2022 (Chart 34B). Chart 34AFavor Energy, Materials, And Infrastructure Versus Tech Favor Energy, Materials, And Infrastructure Versus Tech Favor Energy, Materials, And Infrastructure Versus Tech Chart 34BFavor Energy, Materials, And Infrastructure Versus Tech Favor Energy, Materials, And Infrastructure Versus Tech Favor Energy, Materials, And Infrastructure Versus Tech   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Image Image Image Image Image Image Image

Highlights In this week’s report we update our Chart Pack, updating familiar charts that underscore our strategic themes and cyclical/tactical views. Social unrest in Kazakhstan points to two of our strategic themes: great power struggle and populism/nationalism. A sneak preview of our Black Swan risks for the year: Iran crisis, Russian aggression, and a massive cyber attack. Recent market moves reinforce the BCA House View that investors will rotate out of US growth stocks and into global cyclicals and value plays.  We are sticking with our current tactical and cyclical views and trades. Feature Since releasing our key views for 2022, bond yields have surged, tech shares have sold off, and social unrest has erupted in Central Asia. These developments have both structural and cyclical drivers and are broadly supportive of our investment strategy. First, a brief word about Kazakhstan. The surge in unrest this week is a new and urgent example of one of our strategic themes: populism and nationalism. Long-accumulating Kazakh nationalism is blowing up and forcing the autocratic regime to complete an unfinished political leadership transition that began three years ago. Russia is now forced to intervene militarily to maintain stability in this important satellite state. If instability is prolonged, Russia will be weakened in its high-stakes standoff against the United States and the West over Ukraine. China’s interest in Kazakhstan is also threatened by the change in political orientation there. We will provide a full report on this topic soon but for now the investment implication is to stay short Russian equities. In the rest of this report we offer our newly revised chart book for investors to consider as they gird for a year that promises to be anything but dull. The purpose of the chart book is to update a succinct series of charts that underpin our key themes and views. Many of these charts will be familiar to regular readers but here they are updated with some notable points highlighted in the text. A Waning Pandemic And Global Growth Falling To Trend The Omicron variant of COVID-19 is causing a surge of new cases and hospitalizations around the world, which will weigh on economic activity in the first quarter. However, this variant does not appear to be a game changer. While it is highly contagious, not as many people who go to the hospital end up in the intensive care unit (Chart 1). Chart 1 China is in a difficult predicament that will continue to constrict the global supply side of the economy. Chinese authorities maintain a “zero COVID” policy that emphasizes draconian social restrictions to suppress COVID cases and deaths to minimal levels (Chart 2A). Chart 2 ​​​​​ Chart 2 But Chinese-made vaccines are not as effective as western alternatives, particularly against Omicron, as discussed in our flagship Bank Credit Analyst. Hence China cannot open its economy without risking a disastrous wave of infections. When China shuts down activity, as at the Yantian port last spring, the rest of the world suffers higher costs for goods (Chart 2B). Chart 3Global Growth Will Fall Back To Trend Global Growth Will Fall Back To Trend Global Growth Will Fall Back To Trend Global economic growth is decelerating from the peaks of the extreme rebound (Chart 3). The historic fiscal stimulus of 2020 (Chart 4A) is giving way to negative fiscal thrust, or a decline in budget deficits, that will take away from growth (Chart 4B). Chart 4 Chart 4 Chart 5Inflation Will Moderate But Remain A Long-Term Risk Inflation Will Moderate But Remain A Long-Term Risk Inflation Will Moderate But Remain A Long-Term Risk Yet a recession is not the likeliest scenario since growth is expected to stabilize given the resumption of activity across the world due to an improved ability to live with the virus. The Federal Reserve is considering hiking interest rates faster than the market had expected given that the unemployment rate is collapsing and core inflation is surging. The persistence of the pandemic’s supply disruptions adds to concerns. At the same time, a wage-price spiral is not yet taking shape, as our bond strategist Ryan Swift shows. Productivity is growing faster than real wages and long-term inflation expectations remain within reasonable ranges, at least for now (Chart 5). Three Strategic Themes In our annual outlook (“2022 Key Views: The Gathering Storm”)  we revised our long-term mega themes: 1. Great Power Struggle The US’s relative decline as a share of global geopolitical power, despite a brief respite last year, is indicated in Charts 6-8. Chart 6 Chart 7 ​​​​​ Chart 7 ​​​​​ Chart 8America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) 2. Hypo-Globalization An ongoing globalization process, yet one that falls short of potential, is shown in Charts 9-10. A tentative improvement in our multi-century globalization chart is misleading – it is due to lack of data reporting by several countries, which artificially suppresses the denominator.  Chart 9Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Chart 10AFrom 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization While trade sharply rebounded from the pandemic, the global policy setting is now averse to ever-deeper dependency on international trade. Chart 10BFrom 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization ​​​​​ 3. Populism and Nationalism The post-pandemic cycle will see these structural trends reaffirmed. Charts 11-12 shows a rising Misery Index, or sum of unemployment and inflation, a source of political turmoil that will both reflect and feed these trends. Chart 11Misery Indexes Signal More Unrest, Populism, And Nationalism Misery Indexes Signal More Unrest, Populism, And Nationalism Misery Indexes Signal More Unrest, Populism, And Nationalism ​​​​​​ Chart 12EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 ​​​​​ Chart 12 highlights major markets that have local or nationwide elections in 2022-23, where policy fluctuations are already occurring with various investment implications. We are tactically bullish on South Korea and Brazil, strategically but not tactically bullish on India, and bearish on Turkey. Russia’s domestic sociopolitical problems are not all that different from Kazakhstan’s and its response may be outwardly aggressive, so we are bearish. Three Key Views For 2022 Our annual outlook also outlined three key views for this year: 1. China’s Reversion To Autocracy The government will ease policy to secure the economic recovery so that President Xi Jinping can clinch his personal rule for at a critical Communist Party personnel reshuffle this fall (Chart 13). Chart 13China Will Easy Policy Ahead Of Political Reversion To Autocracy China Will Easy Policy Ahead Of Political Reversion To Autocracy China Will Easy Policy Ahead Of Political Reversion To Autocracy A stabilization of Chinese demand in 2022 will be positive for commodities, cyclical equity sectors, and emerging markets. Chart 14 ​​​​​​ Chart 14 Policy easing will not lead to a sustainable rally in Chinese equities, as internal and external political risks remain high (Charts 14A & 14B). A “fourth Taiwan Strait Crisis”  is likely in the short run while a military conflict is not unlikely over the long run. ​​​​​​​​​​​​​​2. America’s Policy Insularity The Biden administration is focused on domestic legislation and the midterm elections, due November 8, 2022. Biden’s approval rating has deteriorated further, putting the Democrats in line for a loss of around 40 seats in the House and four seats in the Senate, judging by historic patterns (Chart 15). But our sense is that the Senate is still in play – Democrats probably will not lose four Senate seats – but they are likely to lose control of both chambers as things stand. Chart 15 However, the Democrats still have a subjective 65% chance of passing a partisan budget reconciliation bill, which would be a badly needed victory. The “Build Back Better” plan would include a minimum corporate tax and various social programs. Another round of fiscal reflation would reinforce the Federal Reserve’s less dovish pivot. Chart 16US Still At Peak Polarization US Still At Peak Polarization US Still At Peak Polarization Polarization will remain at historic peaks leading up to the election, as the Democrats will need “wedge issues” to drive enthusiasm among their popular base in the face of Republican enthusiasm. For decades polarization has correlated with falling Treasury yields and US tech sector equity outperformance (Chart 16). Midterm election years tend to see flat equity performance and falling yields, albeit with yields higher when a single party controls government, as is the case this year. 3. Petro-State Leverage Globally, commodity markets continue to tighten on the supply side. Our Commodity & Energy Strategist Bob Ryan outlines the situation admirably: The supply side is tightening in oil markets, where OPEC 2.0 producers have been unable to restore output under their agreement to return 400,000 barrels per day each month since August 2021. It is true in base metals, where the energy crisis in Europe and Asia are constricting supplies, particularly in copper. And it is true in agricultural commodities, where high natural gas prices are driving fertilizer prices higher, which will push food prices up this year. Demand for these commodities will increase as Omicron becomes the dominant COVID-19 strain, keeping consumption above production, particularly in oil. These are long-term trends. Oil and natural gas markets will probably remain tight throughout the decade, as will base metal markets. This is going to put enormous stress on the global energy transition to renewable energy over the next 10 years. The ascendance of left-of-center political parties in critical base-metal exporting states, and rising ESG initiatives, will increase costs for energy and metals producers; and global climate activism in boardrooms and courtrooms will push costs higher as well. Higher prices will be necessary to recover these cost increases. In this context, energy producers gain geopolitical leverage. Their treasuries become flush with cash and they see an opportunity to pursue foreign policy objectives. Conflicts involving oil producers are more likely when oil prices are swinging up (Chart 17). Chart 17 This trend is on display in Russia’s dispute with the West, where Europe is struggling with a surge in natural gas prices due to Russian supply constraints that weaken its resolve in the showdown over Ukraine (Chart 18, top panel). Chart 18Energy Prices: Biden's And Europe's Problem Energy Prices: Biden's And Europe's Problem Energy Prices: Biden's And Europe's Problem ​​​​​ Yet even in the energy-independent US, the Biden administration is wary of pursuing policies against Russia or Iran that would ignite a bigger spike in prices at the pump during an election year (Chart 18, bottom panel). Biden will have to attend to foreign policy this year but will be defensive. Petro-states are not immune to domestic problems, including social unrest. Many of them are poor, unequal, misgoverned, and suffering from inflation. Iran is a prime example. Yet Iran has not collapsed under sanctions so far, the world is recovering, and Tehran has the advantage in its negotiations with the US because it can stage attacks across the Middle East, including the Persian Gulf and Strait of Hormuz. Military incidents could drive oil prices into politically punitive territory. Three Black Swans For 2022 This brings us to three “Black Swans” or low-probability, high-impact events for 2022. We will publish our regular annual report on this year’s black swans soon. For now we offer a sneak preview: 1. Iran Crisis In Middle East The fear of being abandoned by the US has kept Israel from acting unilaterally so far (Chart 19A). Chart 19 ​​​​​​ Chart 19 ​​​​ But an attack is not impossible if Iran reaches “breakout” levels of highly enriched uranium – and the global impact of an attack could be catastrophic (Chart 19B). The news media have been conspicuously quiet about Iran. Taken together, this scenario is pretty much the definition of a black swan. 2. Russian Aggression Abroad There is a 50% chance that Russia will stage a limited re-invasion of Ukraine to secure its control of territory in the east or along the Black Sea coast. Chart 20Black Swan #2: Russian Aggression Abroad Black Swan #2: Russian Aggression Abroad Black Swan #2: Russian Aggression Abroad Within this risk, there is a small chance (less than 5%) that Russia would invade all of Ukraine. We do not expect this and neither do other analysts. The total conquest of Ukraine is unlikely when Russia’s domestic conditions are weak and it faces so much unrest in other parts of its sphere of influence (including Belarus and Kazakhstan). As we go to press, Russia is staging a military intervention in Kazakhstan, which could expand. Kazakhstan could create a way for Russia to avoid its self-induced pressure to take military action against Ukraine. But most likely Russia and Kazakhstan will quell the unrest, enabling Russia to sustain the threat of a partial re-invasion of Ukraine. Putin’s low approval rating often triggers new foreign adventures and financial markets are pricing higher risks (Chart 20). 3. Massive Cyber Attack Amid the pandemic and inflation surge, investors have forgotten about the huge risks facing businesses and individuals from their extreme dependency on remote work and digital services. A cyber war is also raging behind the scenes. So far it has not spilled into the physical realm. Yet Russia-based ransomware attacks in 2021 showed that vital US infrastructure is vulnerable. Cyber stocks have topped out amid the recent tech selloff (Chart 21A). But the global average cost of data breaches is skyrocketing. Governments are devoting more resources to network security and cyber-security (Chart 21B), which should be positive for earnings. Chart 21ABlack Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack ​​​​​ Chart 21BBlack Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack Black Swan #3: Massive Cyber Attack ​​​​​ Investment Takeaways The revised Geopolitical Risk Index does not show as pronounced of an uptrend as the version published last year but it is still higher than in the late 1990s (Chart 22). Our reading of all available evidence points to rising geopolitical risk – at least until the current challenge to US global supremacy leads to a new equilibrium. Chart 22 Global policy uncertainty is also rising on a secular basis and maintaining its correlation with the trade-weighted dollar, which has rebounded despite the global growth recovery and rise in inflation (Chart 23). We remain neutral on the dollar. Chart 23A Secular Rise In Global Uncertainty A Secular Rise In Global Uncertainty A Secular Rise In Global Uncertainty Gold has fallen from its peaks during the onset of the pandemic and real rates suggest it will fall further. But we hold it as a hedge against geopolitical risk as well as inflation (Chart 24). Chart 24Stay Long Gold As Hedge Against Geopolitical Crisis As Well As Inflation Stay Long Gold As Hedge Against Geopolitical Crisis As Well As Inflation Stay Long Gold As Hedge Against Geopolitical Crisis As Well As Inflation The evidence is inconclusive about whether global investors will rotate away from US assets this year. The US share of global equity capitalization is stretched. Long-dated Treasuries will eventually reflect higher inflation expectations (Chart 25). Chart 25No Substitute For The USA Yet No Substitute For The USA Yet No Substitute For The USA Yet ​​​​​ Chart 26Waiting For Rotation Waiting For Rotation Waiting For Rotation ​​​​​ US equity outperformance continues unabated and emerging market equities are still underperforming their developed peers (Chart 26). Cyclically investors should take the opposite side of these trends but not tactically. The renminbi is tentatively peaking against both the dollar and euro. As expected, China’s policymakers are shifting toward preserving economic stability (Chart 27). Stabilization may require a weaker renminbi, though producer price inflation is also a factor for the People’s Bank to consider. Chart 27Strategically Short Renminbi And Taiwanese Dollar Strategically Short Renminbi And Taiwanese Dollar Strategically Short Renminbi And Taiwanese Dollar Taiwanese stocks continue to outperform Korean stocks (to our chagrin) but they have not broken above previous peaks relative to global equities. Nor has the Taiwanese dollar broken above previous peaks versus the greenback (Chart 28). So far Taiwan has avoided the fate of semiconductor stocks, which have sold off. This situation presents a buying opportunity for semi stocks but we remain short Taiwan as a bourse because it is central to US-China strategic conflict. Chart 28Strategically Short Taiwan Strategically Short Taiwan Strategically Short Taiwan ​​​​​​ Chart 29Strategically Short Russia And EM Europe Strategically Short Russia And EM Europe Strategically Short Russia And EM Europe ​​​​​​ Chart 30Safe Havens Look Attractive Safe Havens Look Attractive Safe Havens Look Attractive Russia and eastern European assets continue to underperform developed market peers as geopolitical risks mount across the former Soviet Union (Chart 29). Russia’s negotiations with the US, NATO, and the EU in January will help us to gauge whether tensions will break out to new highs. Assuming Russia succeeds in quashing Kazakh unrest, it will be necessary for the US to offer concessions to Russia to prevent the Ukraine showdown from worsening Europe’s energy crisis. Safe havens caught a bid in early 2021 and have not yet broken down. Our geopolitical views support building up safe-haven positions (Chart 30). Presumably one should favor global cyclical equities as the pandemic wanes and global growth stabilizes. But cyclicals are struggling to outperform defensives (Chart 31A). Chart 31AFavor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization ​​​​​ Chart 31BFavor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization Favor Cyclicals On China's Stabilization ​​​​​ ​​​​​​​China’s policy easing is positive in this regard, although the new wave of fiscal-and-credit support is only just beginning and financial markets will remain skeptical until the dovish policy pivot is borne out in hard data (Chart 31B). Global value stocks have ticked up again versus growth stocks, suggesting that the choppy process of bottom formation continues (Charts 32A & 32B). Chart 32AValue’s Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks ​​​​​​ Chart 32BValue’s Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks Value's Choppy Bottom Versus Growth Stocks ​​​​​     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Dear Client, Thank you for your continued readership and support this year. This is the last European Investment Strategy report for 2021. In this piece, we review ten charts covering important aspects of the European economy and capital markets. We will resume our regular publishing schedule on January 10th, 2022. The European Investment Strategy team wishes you and your loved ones a wonderful holiday season, and a healthy, happy, and prosperous new year. Best regards, Mathieu Savary   Highlights European growth continues to face headwinds as it enters 2022. The ECB will be slow to remove more accommodation than what is implied by the end of the PEPP. Value stocks and Italian equities will enjoy a modest tailwind from rising Bund yields. The lower quality of European stocks creates a long-term headwind versus US benchmarks. The outperformance of European cyclicals relative to defensives will resume and financials will have greater upside. The relative performance of small-cap stocks will soon stabilize, but a weak euro will create a near-term risk. President Emmanuel Macron’s real contender is the center-right candidate Valerie Pécresse, not populists. Feature Chart 1: Wave Dynamics The current wave of COVID-19 infections continues to surge in Europe. As Chart 1 highlights, Austria and the Netherlands just witnessed intense waves that eclipsed those experienced earlier this year. However, these waves are already ebbing because of the containment measures implemented in recent weeks. In these two severely hit nations, hospitalization rates also increased significantly; however, they did not reach the degree experienced in France or the UK in the first half of 2021 (Chart 1, right panel). Chart 1Wave Dynamics Wave Dynamics I Wave Dynamics I Chart 1Wave Dynamics Wave Dynamics II Wave Dynamics II Europe will experience another test in the coming weeks as the highly contagious Omicron variant becomes the dominant COVID-19 strain. However, data from South Africa continues to suggest that this mutation is much less pathogenic than previous variants and will not place as much strain on the healthcare system as potential case counts would indicate. Nonetheless, it is too early to make this prognosis with great confidence. Importantly, even if a small proportion of infected people is hospitalized, a large enough a pool of infections could cause a rupture in the healthcare system. As a result, politicians will likely remain cautious until a larger share of the population receives its booster dose. Hence, Omicron still represents a near-term risk to economic activity, albeit one that will prove ephemeral. Chart 2: The Economy Is Not Out Of The Woods Yet European growth remains highly dependent on the fluctuations of the global economy because exports and capex account for a large share of the continent’s output. Consequently, global economic trends remain paramount when considering the European economic outlook. In the near-term, Europe continues to face headwinds beyond the uncertainty caused by the potential effects of the Omicron variant. Global economic activity, for instance, is likely to face some further near-term headwinds caused by the supply shock typified by elevated commodity prices and bottlenecks (Chart 2). Not only does this shock limit the ability of producers to procure important inputs, but it also increases the costs of production. Historically, this combination results in downward pressure on global manufacturing activity. Chart 2The Economy Is Not Out Of The Woods Yet The Economy Is Not Out Of The Woods Yet I The Economy Is Not Out Of The Woods Yet I Chart 2The Economy Is Not Out Of The Woods Yet The Economy Is Not Out Of The Woods Yet II The Economy Is Not Out Of The Woods Yet II The second problem remains the deceleration in the Chinese economy. Declining credit growth in China results in slower European exports, which also hurts the region’s PMI. The recent Central Economic Work Conference suggests that China is ready to inject more stimulus in its economy, which will help Europe. However, the beginning of 2022 will still witness the lagged impact of previous tightening in credit conditions on European economic indicators. Moreover, BCA’s China Investment Strategy team expects the stimulus to be modest at first and only grow in intensity later.  It is unlikely to be as credit-heavy as in the past, which also means it will be less beneficial to Europe. Chart 3: A Careful ECB Last week, the European Central Bank aggressively upgraded its inflation forecast for 2022 and announced the end of the PEPP for March, however, it will increase temporarily the APP program to EUR40bn. Moreover, President Christine Lagarde remains steadfast that the Governing Council will not raise rates in 2022. Our Central Bank Monitor points to the need for tighter policy, yet the ECB continues to adopt a cautious tone, even if the Eurozone HICP inflation has reached 4%—the highest reading in thirteen years. First, the ECB still runs the risk of dislocation in the periphery, where Italian and Spanish spreads may easily explode if monetary accommodation is removed too quickly. Second, European inflationary pressures remain significantly narrower than they are in the US (Chart 3, left panel). Our Eurozone trimmed-mean CPI continues to linger well below core CPI readings, while in the US both measures track each other closely. Third, the decline in energy prices and the ebbing transportation bottlenecks mean that odds are growing that sequential inflation will soon experience an interim peak (Chart 3, right panel). Chart 3A Careful ECB A Careful ECB I A Careful ECB I Chart 3A Careful ECB A Careful ECB II A Careful ECB II This view of the ECB implies that German yields will not rise as much as US yields next year, which BCA’s US Bond Strategy team expects to reach 2.25% by the end of 2022. Moreover, the more tepid pace of the removal of accommodation and the implicit targeting of peripheral bond markets also warrant an overweight position in Italian bonds. Spreads will be volatile, but any move upward will be self-limiting because of their role in the ECB’s reaction function. As a result, investors should continue to pocket the additional income over German paper. Chart 4: A Murky Outlook For The Euro The market continues to test EUR/USD. Any breakdown below 1.1175 is likely to prompt a pronounced down leg toward 1.07-1.08, near the pandemic lows. The euro suffers from three handicaps. First, Europe’s economic links with China are greater than those of the US with China. Consequently, the Chinese economic deceleration hurts European rates of returns more than it hurts those in the US. Second, the acceleration of US inflation is inviting investors to reprice the path of the Fed’s policy rate, which accentuates the upside pressure on the dollar. Finally, the energy crisis is ramping up anew following Germany’s suspension of the approval of the Nord Stream 2 pipeline and the buildup of Russian troops on Ukraine’s borders. Surging European natural gas prices act as a powerful headwind for EUR/USD because they accentuate stagflation risks in the Eurozone (Chart 4, left panel). While these create downside pressures on the euro, the picture is more complex. Our Intermediate-Term Timing Model shows that EUR/USD is one-sigma oversold (Chart 4, right panel). Over the past 20 years, it was more depressed only in 2010 and in early 2015. Such a reading indicates that most of the bad news is already embedded in EUR/USD and that sentiment has become massively negative. Thus, we are not chasing the euro lower, even though we will respect our stop-loss at 1.1175 if it were triggered. Instead, we will look to buy the euro at lower levels in the first quarter of 2021. Chart 4A Murky Outlook For The Euro A Murky Outlook For The Euro I A Murky Outlook For The Euro I Chart 4A Murky Outlook For The Euro A Murky Outlook For The Euro II A Murky Outlook For The Euro II Chart 5: German Yields Are Key To Value Stocks And Italian Equities The performance of European value stocks relative to that of growth stocks continues to exhibit a close relationship with the evolution of German Bund yields (Chart 5, left panel). Value stocks are less sensitive than growth stocks to higher yields because they derive a smaller proportion of their intrinsic value from long-term deferred cash flows; which suffer more from rising discount factors than near-term cash flows. Moreover, value stocks overweight financials, whose profitability increases when yields rise. The same relationship exists between the performance of Italian equities relative to the Eurozone benchmark (Chart 5, right panel). This correlation holds because of Italy’s significant value bias and its large exposure to financials. Chart 5German Yields Are Key To Value Stocks And Italian Equities German Yields Are Key To Value Stocks And Italian Equities I German Yields Are Key To Value Stocks And Italian Equities I Chart 5German Yields Are Key To Value Stocks And Italian Equities German Yields Are Key To Value Stocks And Italian Equities II German Yields Are Key To Value Stocks And Italian Equities II Based on these observations, BCA’s view that German Bund yields will rise toward 0.25% is consistent with a modest outperformance of value and Italian equities in 2022. For a more robust outperformance by value and Italian stocks, the Chinese economy will have to re-accelerate clearly and the dollar will have to fall significantly. However, these two outcomes could take more time to materialize than our bond view. Chart 6: Europe’s Quality Deficit The gyrations in the performance of European equities relative to US stocks continue to be influenced by China’s economic fluctuations. The deterioration in various measures of China’s credit impulse remains consistent with further near-term underperformance of European equities (Chart 6, left panel). Moreover, if Omicron has a significant impact on consumer behavior (via personal choices or government measures), it will once again hurt spending on services and boost the appeal of growth stocks, which Europe underrepresents. These headwinds will not be long lasting. Europe has an opportunity to outperform next year if global yields rise. However, European equity markets continue to suffer from a potent long-term disadvantage relative to those of the US. American benchmarks are composed of higher quality stocks than European ones. As a result of greater market concentration, more innovative applications of research, and the development of greater moats, US stocks generate wider profits margins than European companies and have a higher utilization of their asset base. Consequently, US shares sport significantly higher RoEs and earnings growth than European large-cap names (Chart 6, right panel). Historically, the quality factor has been one of the top performers and is an important contributor to the current strength of growth equities. Thus, even if Europe’s day in the sun arrives before the middle of 2022, it will again be a temporary phenomenon. Chart 6Europe’s Quality Deficit Europe's Quality Deficit I Europe's Quality Deficit I Chart 6Europe’s Quality Deficit Europe's Quality Deficit II Europe's Quality Deficit II Chart 7: Will the Cyclicals Outperformance Resume? For most of 2021, European cyclicals equities have not performed as well against defensive stocks as many investors hoped. In fact, the relative performance of cyclicals is broadly flat since March. Going forward, cyclicals will resume their uptrend against defensive equities and even break out of their range of the past twenty years. From a technical perspective, cyclicals have expunged many of their excesses. By the spring, European cyclicals had become prohibitively expensive compared to their defensive counterparts (Chart 7, left panel). However, their overvaluation has now passed and medium-term momentum measures are not overbought anymore, which creates a much better entry point for cyclical equities. From a fundamental perspective, cyclicals will also enjoy rising yields after being hamstrung by Treasury yields that have moved sideways for more than nine months (Chart 7, right panel). Moreover, the eventual stabilization of the Chinese economy will create an additional tailwind for these stocks. Chart 7Will The Cyclicals Outperformance Resume? Will the Cyclicals Outperformance Resume? I Will the Cyclicals Outperformance Resume? I Chart 7Will The Cyclicals Outperformance Resume? Will the Cyclicals Outperformance Resume? II Will the Cyclicals Outperformance Resume? II The biggest risk to cyclical stocks lies in inflation expectations. Ten-year CPI swaps have stopped increasing despite rising inflation. As the yield curve flattens and long-term segments of the OIS curve invert, markets register their fears that the Fed might tighten too much over the next two years. In other words, markets continue to agonize over the effect of a very low perceived terminal rate. These worries may cause the CPI swaps to decline significantly as the Fed hikes rates next year, creating a headwind for cyclicals. Chart 8: Favor Financials Financials in general and banks in particular have outperformed the European benchmark this year. This trend will persist in 2020. More than the positive impact of higher yields on the profitability of financials justifies this view. One of the key drivers supporting our optimism toward this sector is the continued improvement in the balance-sheet health of the European banking sector (Chart 8, left panel). Capital adequacy ratios remain in an uptrend and NPLs continue to be well-behaved. Meanwhile, both the governments’ liquidity support during the pandemic and the nonfinancial sector’s cash buildup over the past 18 months limit the risk that a brisk rise in insolvencies would threaten the viability of the banking system. European bank lending is also likely to remain superior to that of the post-GFC years. Consumer confidence is still sturdy, despite the recent increase in COVID cases and the tax hike created by rapidly climbing energy prices (Chart 8, right panel). Companies also benefit from an environment of low real rates and limited fiscal austerity. Unsurprisingly, capex intentions are elevated, which should support credit demand from businesses going forward. Chart 8Favor Financials Favor Financials I Favor Financials I Chart 8Favor Financials Favor Financials II Favor Financials II These factors imply that the current large discount embedded in European financials’ valuations remains excessive (even if a smaller discount is still warranted). As long as peripheral spreads do not blow out durably, financials will have scope to outperform further. Banks should also beat insurance companies. Chart 9: Small-Caps Are Nearly There Despite a sideways move followed by a 4% dip, the performance of European small-cap stocks remains in a pronounced uptrend relative to large-cap equities. The recent bout of underperformance is likely to end soon, unless a recession is around the corner. Small-cap stocks are becoming oversold (Chart 9, left panel) and will benefit from their pronounced procyclicality, especially if the recent improvement in global economic surprises continues next year. Moreover, above-trend European growth as well as an ECB that will maintain accommodative monetary conditions will combine to prevent a significant widening in European high-yield spreads, particularly once natural gas prices are turned down after the winter. This process will also help small-cap equities. The biggest risk for the European small-caps’ relative performance is the currency market. The relative performance of small-cap names is still closely correlated to the euro (Chart 9, right panel). As a result, if EUR/USD were to falter in the coming weeks, the underperformance of small-cap stocks could deepen. At the very least, small-cap stocks would languish before resuming their uptrend later in the year. Chart 9Small-Caps Are Nearly There Small-Caps Are Nearly There I Small-Caps Are Nearly There I Chart 9Small-Caps Are Nearly There Small-Caps Are Nearly There II Small-Caps Are Nearly There II Chart 10: A Risk to Macron’s Second Term The emergence of the new populist candidate Éric Zemmour has galvanized the media in recent weeks. However, he is very unlikely to pose a credible threat to French President Emmanuel Macron, unlike center-right candidate Valerie Pécresse, who just won the Les Républicains (LR) primary. In a Special Report published conjointly with our geopolitical strategists last summer, we identified the emergence of a single candidate able to unite the center-right as one of the biggest risks to Macron. As Chart 10 shows, Pécresse has made a comeback in the polls and is now expected to face Macron in the second round. According to an Elabe poll conducted after her victory in the primary, if the second round of the elections were held now, she would beat Macron. Chart 10 Chart 10 Will Pécresse manage to keep her momentum going until April 2022? First, she has to ensure the center-right remains united behind her. Up until the primaries, the center-right was divided. While she won the primary by a wide margin, her main opponent Éric Ciotti won the first round (25.6%), and Michel Barnier as well as Xavier Bertrand came close behind, with 23.9% and 22.7% respectively. Second, Pécresse must work hard to prevent voters from succumbing to the siren songs of Zemmour and Marine Le Pen, or to lean toward former Prime Minister Phillippe Edouard, a declared supporter of Macron. Investors should ignore Le Pen and Eric Zemmour. The real threat to Macron lies in Valerie Pécresse’s ability to keep the center-right united under her banner. Considering that the center-left does not represent an option and that the far-right is entangled in a tug-of-war, there is a high probability that Pécresse will reach the second round.   Footnotes Tactical Recommendations Europe In Charts Europe In Charts Cyclical Recommendations Europe In Charts Europe In Charts Structural Recommendations Europe In Charts Europe In Charts Closed Trades Currency Performance Fixed Income Performance Equity Performance

Highlights Our three strategic themes over the long run: (1) great power rivalry (2) hypo-globalization (3) populism and nationalism. The implications are inflationary over the long run. Nations that gear up for potential conflict and expand the social safety net to appease popular discontent will consume a lot of resources. Our three key views for 2022: (1) China’s reversion to autocracy (2) America’s policy insularity (3) petro-state leverage. The implications are mostly but not entirely inflationary: China will ease policy, the US will pass more stimulus, and energy supply may suffer major disruptions. Stay long gold, neutral US dollar, short renminbi, and short Taiwanese dollar. Stay tactically long global large caps and defensives. Buy aerospace/defense and cyber-security stocks. Go long Japanese and Mexican equities – both are tied to the US in an era of great power rivalry. Feature Chart 1US Resilience US Resilience US Resilience Global investors have not yet found a substitute for the United States. Despite a bout of exuberance around cyclical non-US assets at the beginning of 2021, the year draws to a close with King Dollar rallying, US equities rising to 61% of global equity capitalization, and the US 30-year Treasury yield unfazed by inflation fears (Chart 1). American outperformance is only partly explained by its handling of the lingering Covid-19 pandemic. The US population was clearly less restricted by the virus (Chart 2). But more to the point, the US stimulated its economy by 25% of GDP over the course of the crisis, while the average across major countries was 13% of GDP. Americans are still more eager to go outdoors and the government has been less stringent in preventing them (Chart 3). Chart 2 ​​​​​ Chart 3Social Restrictions Short Of Lockdown Social Restrictions Short Of Lockdown Social Restrictions Short Of Lockdown ​​​​​​ Going forward, the pandemic should decline in relevance, though it is still possible that a vaccine-resistant mutation will arise that is deadlier for younger people, causing a new round of the crisis. The rotation into assets outside the US will be cautious. Across the world, monetary and credit growth peaked and rolled over this year, after the extraordinary effusion of stimulus to offset the social lockdowns of 2020 (Chart 4). Government budget deficits started to normalize while central banks began winding down emergency lending and bond-buying. More widespread and significant policy normalization will get under way in 2022 in the face of high core inflation. Tightening will favor the US dollar, especially if global growth disappoints expectations. Chart 4Waning Monetary And Credit Stimulus Waning Monetary And Credit Stimulus Waning Monetary And Credit Stimulus Chart 5Global Growth Stabilization Global Growth Stabilization Global Growth Stabilization Global manufacturing activity fell off its peak, especially in China, where authorities tightened monetary, fiscal, and regulatory policy aggressively to prevent asset bubbles from blowing up (Chart 5). Now China is easing policy on the margin, which should shore up activity ahead of an important Communist Party reshuffle in fall 2022. The rest of the world’s manufacturing activity is expected to continue expanding in 2022, albeit less rapidly. This trend cuts against US outperformance but still faces a range of hurdles, beginning with China. In this context, we outline three geopolitical themes for the long run as well as three key views for the coming 12 months. Our title, “The Gathering Storm,” refers to the strategic challenge that China and Russia pose to the United States, which is attempting to form a balance-of-power coalition to contain these autocratic rivals. This is the central global geopolitical dynamic in 2022 and it is ultimately inflationary. Three Strategic Themes For The Long Run The international system will remain unstable in the coming years. Global multipolarity – or the existence of multiple, competing poles of political power – is the chief destabilizing factor. This is the first of our three strategic themes that will persist next year and beyond (Table 1). Our key views for 2022, discussed below, flow from these three strategic themes. Table 1Strategic Themes For 2022 And Beyond 2022 Key Views: The Gathering Storm 2022 Key Views: The Gathering Storm 1. Great Power Rivalry Multipolarity – or great power rivalry – can be illustrated by the falling share of US economic clout relative to the rest of the world, including but not limited to strategic rivals like China. The US’s decline is often exaggerated but the picture is clear if one looks at the combined geopolitical influence of the US and its closest allies to that of the EU, China, and Russia (Chart 6). Chart 6 China’s rise is the most destabilizing factor because it comes with economic, military, and technological prowess that could someday rival the US for global supremacy. China’s GDP has surpassed that of the US in purchasing power terms and will do so in nominal terms in around five years (Chart 7). Chart 7 True, China’s potential growth is slowing and Chinese financial instability will be a recurring theme. But that very fact is driving Beijing to try to convert the past 40 years of economic success into broader strategic security. Chart 8America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) America's Global Role Persists (If Lessened) ​​​​​ Since China is capable of creating an alternative political order in Asia Pacific, and ultimately globally, the United States is reacting. It is penalizing China’s economy and seeking to refurbish alliances in pursuit of a containment policy. The American reaction to the loss of influence has been unpredictable, contradictory, and occasionally belligerent. New isolationist impulses have emerged among an angry populace in reaction to gratuitous wars abroad and de-industrialization. These impulses appeared in both the Obama and Trump administrations. The Biden administration is attempting to manage these impulses while also reinforcing America’s global role. The pandemic-era stimulus has enabled the US to maintain its massive trade deficit and aggressive defense spending. But US defense spending is declining relative to the US and global economy over time, encouraging rival nations to carve out spheres of influence in their own neighborhoods (Chart 8). Russia’s overall geopolitical power has declined but it punches above its weight in military affairs and energy markets, a fact which is vividly on display in Ukraine as we go to press. The result is to exacerbate differences in the trans-Atlantic alliance between the US and the European Union, particularly Germany. The EU’s attempt to act as an independent great power is another sign of multipolarity, as well as the UK’s decision to distance itself from the continent and strengthen the Anglo-American alliance. If the US and EU do not manage their differences over how to handle Russia, China, and Iran then the trans-Atlantic relationship will weaken and great power rivalry will become even more dangerous. 2. Hypo-Globalization The second strategic theme is hypo-globalization, in which the ancient process of globalization continues but falls short of its twenty-first century potential, given advances in technology and governance that should erode geographic and national boundaries. Hypo-globalization is the opposite of the “hyper-globalization” of the 1990s-2000s, when historic barriers to the free movement of people, goods, and capital seemed to collapse overnight. Chart 9From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization From 'Hyper-Globalization' To Hypo-Globalization The volume of global trade relative to industrial production  peaked with the Great Recession in 2008-10 and has declined slowly but surely ever since (Chart 9). Many developed markets suffered the unwinding of private debt bubbles, while emerging economies suffered the unwinding of trade manufacturing. Periods of declining trade intensity – trade relative to global growth – suggest that nations are turning inward, distrustful of interdependency, and that the frictions and costs of trade are rising due to protectionism and mercantilism. Over the past two hundred years globalization intensified when a broad international peace was agreed (such as in 1815) and a leading imperial nation was capable of enforcing law and order on the seas (such as the British empire). Globalization fell back during times of “hegemonic instability,” when the peace settlement decayed while strategic and naval competition eroded the global trading system. Today a similar process is unfolding, with the 1945 peace decaying and the US facing the revival of Russia and China as regional empires capable of denying others access to their coastlines and strategic approaches (Chart 10).1 Chart 10Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Hypo-Globalization And Hegemonic Instability Chart 11Hypo-Globalization: Temporary Trade Rebound Hypo-Globalization: Temporary Trade Rebound Hypo-Globalization: Temporary Trade Rebound No doubt global trade is rebounding amid the stimulus-fueled recovery from Covid-19. But the upside for globalization will be limited by the negative geopolitical environment (Chart 11). Today governments are not behaving as if they will embark on a new era of ever-freer movement and ever-deepening international linkages. They are increasingly fearful of each other’s strategic intentions and using fiscal resources to increase economic self-sufficiency. The result is regionalization rather than globalization. Chinese and Russian attempts to revise the world order, and the US’s attempt to contain them, encourages regionalization. For example, the trade war between the US and China is morphing into a broader competition that limits cooperation to a few select areas, despite a change of administration in the United States. The further consolidation of President Xi Jinping’s strongman rule will exacerbate this dynamic of distrust and economic divorce. Emerging Asia and emerging Europe live on the fault lines of this shift from globalization to regionalism, with various risks and opportunities. Generally we are bullish EM Asia and bearish EM Europe. 3. Populism And Nationalism A third strategic theme consists of populism and nationalism, or anti-establishment political sentiment in general. These forces will flare up in various forms across the world in 2022 and beyond. Even as unemployment declines, the rise in food and fuel inflation will make it difficult for low wage earners to make ends meet. The “misery index,” which combines unemployment and inflation, spiked during the pandemic and today stands at 10.8% in the US and 11.4% in the EMU, up from 5.2% and 8.1% before the pandemic, respectively (Chart 12). Large budget deficits and trade deficits, especially in the US and UK, feed into this inflationary environment. Most of the major developed markets have elected new governments since the pandemic, with the notable exception of France and Spain. Thus they have recapitalized their political systems and allowed voters to vent some frustration. These governments now have some time to try to mitigate inflation before the next election. Hence policy continuity is not immediately in jeopardy, which reduces uncertainty for investors. By contrast, many of the emerging economies face higher inflation, weak growth, and are either coming upon elections or have undemocratic political systems. Either way the result will be a failure to address household grievances promptly. The misery index is trending upward and governments are continually forced to provide larger budget deficits to shore up growth, fanning inflation (Chart 13). Chart 12DM: Political Risk High But New Governments In Place DM: Political Risk High But New Governments In Place DM: Political Risk High But New Governments In Place ​​​​​ Chart 13EM: Political Risk High But Governments Not Recapitalized EM: Political Risk High But Governments Not Recapitalized EM: Political Risk High But Governments Not Recapitalized ​​​​​​ Chart 14EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 EM Populism/Nationalism Threatens Negative Surprises In 2022 Just as social and political unrest erupted after the Great Recession, notably in the so-called “Arab Spring,” so will new movements destabilize various emerging markets in the wake of Covid-19. Regime instability and failure can lead to big changes in policies, large waves of emigration, wars, and other risks that impact markets. The risks are especially high unless and until Chinese imports revive. Investors should be on the lookout for buying opportunities in emerging markets once the bad news is fully priced. National and local elections in Brazil, India, South Korea, the Philippines, and Turkey will serve as market catalysts, with bad news likely to precede good news (Chart 14). Bottom Line: These three themes – great power rivalry, hypo-globalization, and populism/nationalism – are inflationary in theory, though their impact will vary based on specific events. Multipolarity means that governments will boost industrial and defense spending to gear up for international competition. Hypo-globalization means countries will attempt to put growth on a more reliable domestic foundation rather than accept dependency on an unreliable international scene, thus constraining supplies from abroad. Populism and nationalism will lead to a range of unorthodox policies, such as belligerence abroad or extravagant social spending at home. Of course, the inflationary bias of these themes can be upset if they manifest in ways that harm growth and/or inflation expectations, which is possible. But the general drift will be an inflationary policy setting. Inflation may subside in 2022 only to reemerge as a risk later. Three Key Views For 2022 Within this broader context, our three key views for 2022 are as follows: 1. China’s Reversion To Autocracy As President Xi Jinping leads China further down the road of strongman rule and centralization, the country faces a historic confluence of internal and external risks. This was our top view in 2021 and the same dynamic continues in 2022. The difference is that in 2021 the risk was excessive policy tightening whereas this coming year the risk is insufficient policy easing. Chart 15China Eases Fiscal Policy To Secure Recovery In 2022 China Eases Fiscal Policy To Secure Recovery In 2022 China Eases Fiscal Policy To Secure Recovery In 2022 China’s economy is witnessing a secular slowdown, a deterioration in governance, property market turmoil, and a rise in protectionism abroad. The long decline in corporate debt growth points to the structural slowdown. Animal spirits will not improve in 2022 so government spending will be necessary to try to shore up overall growth. The Politburo signaled that it will ease fiscal policy at the Central Economic Work Conference in early December, a vindication of our 2021 view. Neither the combined fiscal-and-credit impulse nor overall activity, indicated by the Li Keqiang Index, have shown the slightest uptick yet (Chart 15). Typically it takes six-to-nine months for policy easing to translate to an improvement in real economic activity. The first half of the year may still bring economic disappointments. But policymakers are adjusting to avoid a crash. Policy will grow increasingly accommodative as necessary in the first half of 2022. The key political constraint is the Communist Party’s all-important political reshuffle, the twentieth national party congress, to be held in fall 2022 (usually October). While Xi may not want the economy to surge in 2022, he cannot afford to let it go bust. The experience of previous party congresses shows that there is often a policy-driven increase in bank loans and fixed investment. Current conditions are so negative as to ensure that the government will provide at least some support, for instance by taking a “moderately proactive approach” to infrastructure investment (Chart 16). Otherwise a collapse of confidence would weaken Xi’s faction and give the opposition faction a chance to shore up its position within the Communist Party. Chart 16China Aims For Stability, Not Rapid Growth, Ahead Of 20th National Party Congress China Aims For Stability, Not Rapid Growth, Ahead Of 20th National Party Congress China Aims For Stability, Not Rapid Growth, Ahead Of 20th National Party Congress Party congresses happen every five years but the ten-year congresses, such as in 2022, are the most important for the country’s overall political leadership. The party congresses in 1992, 2002, and 2012 were instrumental in transferring power from one leader to the next, even though the transfer of power was never formalized. Back in 2017 Xi arranged to stay in power indefinitely but now he needs to clinch the deal, lest any unforeseen threat emerge from at home or abroad. Xi’s success in converting the Communist Party from “consensus rule” to his own “personal rule” will be measurable by his success in stacking the Politburo and Politburo Standing Committee with factional allies. He will also promote his faction across the Central Committee so as to shape the next generations of party leaders and leave his imprint on policy long after his departure. The government will be extremely sensitive to any hint of dissent or resistance and will move aggressively to quash it. Investors should not be surprised to see high-level sackings of public officials or private magnates and a steady stream of scandals and revelations that gain prominence in western media. The environment is also ripe for strange and unexpected incidents that reveal political differences beneath the veneer of unity in China: defections, protests, riots, terrorist acts, or foreign interference. Most incidents will be snuffed out quickly but investors should be wary of “black swans” from China in 2022. Chinese government policies will not be business friendly in 2022 aside from piecemeal fiscal easing. Everything Beijing does will be bent around securing Xi’s supremacy at all levels. Domestic politics will take precedence over economic concerns, especially over the interests of private businesses and foreign investors, as is clear when it comes to managing financial distress in the property sector. Negative regulatory surprises and arbitrary crackdowns on various industrial sectors will continue, though Beijing will do everything in its power to prevent the property bust from triggering contagion across the economic system. This will probably work, though the dam may burst after the party congress. Relations with the US and the West will remain poor, as the democracies cannot afford to endorse what they see as Xi’s power grab, the resurrection of a Maoist cult of personality, and the betrayal of past promises of cooperation and engagement. America’s midterm election politics will not be conducive to any broad thaw in US-China relations. While China will focus on domestic politics, its foreign policy actions will still prove relatively hawkish. Clashes with neighbors may be instigated by China to warn away any interference or by neighbors to try to embarrass Xi Jinping. The South and East China Seas are still ripe for territorial disputes to flare. Border conflicts with India are also possible. Taiwan remains the epicenter of global geopolitical risk. A fourth Taiwan Strait Crisis looms as China increases its military warnings to Taiwan not to attempt anything resembling independence (Chart 17A). China may use saber-rattling, economic sanctions, cyber war, disinformation, and other “gray zone” tactics to undermine the ruling party ahead of Taiwan’s midterm elections in November 2022 and presidential elections in January 2024. A full-scale invasion cannot be ruled out but is unlikely in the short run, as China still has non-military options to try to arrange a change of policy in Taiwan. Chart 17 ​​​​​​ Chart 17BMarket-Based Risk Indicators Say China/Taiwan Risk Has Not Peaked Market-Based Risk Indicators Say China/Taiwan Risk Has Not Peaked Market-Based Risk Indicators Say China/Taiwan Risk Has Not Peaked China has not yet responded to the US’s deployment of a small number of troops in Taiwan or to recent diplomatic overtures or arms sales. It could stage a major show of force against Taiwan to help consolidate power at home. China also has an interest in demonstrating to US allies and partners that their populations and economies will suffer if they side with Washington in any contingency. Given China’s historic confluence of risks, it is too soon for global investors to load up on cheap Chinese equities. Volatility will remain high. Weak animal spirits, limited policy easing, high levels of policy uncertainty, regulatory risk, ongoing trade tensions, and geopolitical risks suggest that investors should remain on the sidelines, and that a large risk premium can persist throughout 2022. Our market-based geopolitical risk indicators for both China and Taiwan are still trending upwards (Chart 17B). Global investors should capitalize on China’s policy easing indirectly by investing in commodities, cyclical equity sectors, and select emerging markets. 2. America’s Policy Insularity Our second view for 2022 centers on the United States, which will focus on domestic politics and will thus react or overreact to the many global challenges it faces. The US faces the first midterm election after the chaotic and contested 2020 presidential election. Political polarization remains at historically high levels, meaning that social unrest could flare up again and major domestic terrorist incidents cannot be ruled out. So far the Biden administration has focused on the domestic scene: mitigating the pandemic and rebooting the economy. Biden’s signature “Build Back Better” bill, $1.75 trillion investment in social programs, has passed the House of Representatives but not the Senate. The spike in inflation has shaken moderate Democratic senators who are now delaying the bill. We expect it to pass, since tax hikes were dropped, but our conviction is low (65% subjective odds), as a single defection would derail the bill. The implication would be inflationary since it would mark a sizable increase in government spending at a time when the output gap is already virtually closed. Spending would likely be much larger than the Congressional Budget Office estimate, shown in Chart 18, because the bill contains various gimmicks and hard-to-implement expiration clauses. Equity markets may not sell if the bill fails, since more fiscal stimulus would put pressure on the Federal Reserve to hike rates faster. Chart 18 Chart 19 Whether the bill passes or fails, Biden’s legislative agenda will be frozen thereafter. He will have to resort to executive powers and foreign policy to lift his approval rating and court the median voter ahead of the midterm elections. Currently Democrats are lined up to lose the House and probably also the Senate, where a single seat would cost them their majority (Chart 19). The Senate is still in play so Biden will be averse to taking big risks. For the same reason, Biden’s foreign policy goal will be to stave off various bubbling crises. Restoring the Iranian nuclear deal was his priority but Russia has now forced its way to the top of the agenda by threatening a partial reinvasion of Ukraine. In this context Biden will not have room for maneuver with China. Congress will be hawkish on China ahead of the midterms, and Xi Jinping will be reviving autocracy, so Biden will not be able to improve relations much. Biden’s domestic policy could fuel inflation, while his domestic-focused foreign policy will embolden strategic rivals, which increases geopolitical risks. 3. Petro-State Leverage A surge in gasoline prices at the pump ahead of the election would be disastrous for a Democratic Party that is already in disarray over inflation (Chart 20). Biden has already demonstrated that he can coordinate an international release of strategic oil reserves this year. Oil and natural gas producers gain leverage when the global economy rebounds, commodity prices rise, and supply/demand balances tighten. The frequency of global conflicts, especially those involving petro-states, tend to rise and fall in line with oil prices (Chart 21). Chart 20Inflation Constrains Biden Ahead Of Midterms Inflation Constrains Biden Ahead Of Midterms Inflation Constrains Biden Ahead Of Midterms Chart 21 Both Russia and Iran are vulnerable to social unrest at home and foreign strategic pressure abroad. Both have long-running conflicts with the US and West that are heating up for fundamental reasons, such as Russia’s fear of western influence in the former Soviet Union and Iran’s nuclear program. Both countries are demanding that the US make strategic concessions to atone for the Trump administration’s aggressive policies: selling lethal weapons to Ukraine and imposing “maximum pressure” sanctions on Iran. Biden is not capable of making credible long-term agreements since he could lose office as soon as 2025 and the next president could reverse whatever he agrees. But he must try to de-escalate these conflicts or else he faces energy shortages or price shocks, which would raise the odds of stagflation ahead of the election. The path of least resistance for Biden is to lift the sanctions on Iran to prevent an escalation of the secret war in the Middle East. If this unilateral concession should convince Iran to pause its nuclear activities before achieving breakout uranium enrichment capability, then Biden would reduce the odds of a military showdown erupting across the region. Opposition Republicans would accuse him of weakness but public opinion polls show that few Americans consider Iran a major threat. The problem is that this logic held throughout 2021 and yet Biden did not ease the sanctions. Given Iran’s nuclear progress and the US’s reliance on sanctions, we see a 40% chance of a military confrontation with Iran over the coming years. With regard to Ukraine, an American failure to give concessions to Russia will probably result in a partial reinvasion of Ukraine (50% subjective odds). This in turn will force the US and EU to impose sanctions on Russia, leading to a squeeze of natural gas prices in Europe and eventually price pressures in global energy markets. If Biden grants Russia’s main demands, he will avoid a larger war or energy shock but will make the US vulnerable to future blackmail. He will also demoralize Taiwan and other US partners who lack mutual defense treaties. But he may gain Russian cooperation on Iran. If Biden gives concessions to both Russia and Iran, his party will face criticism in the midterms but it will be far less vulnerable than if an energy shock occurs. This is the path of least resistance for Biden in 2022. It means that the petro-states may lose their leverage after using it, given that risk premiums would fall on Biden’s concessions. Of course, if energy shocks happen, Europe and China will suffer more than the US, which is relatively energy independent. For this reason Brussels and Beijing will try to keep diplomacy alive as long as possible. Enforcement of US sanctions on Iran may weaken, reducing Iran’s urgency to come into compliance. Germany may prevent a hardline threat of sanctions against Russia, reducing Russia’s fear of consequences. Again, petro-states have the leverage. Therefore investors should guard against geopolitically induced energy price spikes or shocks in 2022. What if other commodity producers, such as Saudi Arabia, crank up production and sink oil prices? This could happen. Yet the Saudis prefer elevated oil prices due to the host of national challenges they face in reforming their economy. If the US eases sanctions on Iran then the Saudis may make this decision. Thus downside energy price shocks are possible too. The takeaway is energy price volatility but for the most part we see the risk as lying to the upside. Investment Takeaways Traditional geopolitical risk, which focuses on war and conflict, is measurable and has slipped since 2015, although it has not broken down from the general uptrend since 2000. We expect the secular trend to be reaffirmed and for geopolitical risk to resume its rise due to the strategic themes and key views outlined above. The correlation of geopolitical risk with financial assets is debatable – namely because some geopolitical risks push up oil and commodity prices at the expense of the dollar, while others cause a safe-haven rally into the dollar (Chart 22).  Global economic policy uncertainty is also measurable. It is in a secular uptrend since the 2008 financial crisis. Here the correlation with the US dollar and relative equity performance is stronger, which makes sense. This trend should also pick up going forward, which is at least not negative for the dollar and relative US equity performance (Chart 23). Chart 22Geopolitical Risk Will Rise, Market Impacts Variable Geopolitical Risk Will Rise, Market Impacts Variable Geopolitical Risk Will Rise, Market Impacts Variable ​​​​​​ Chart 23Economic Policy Uncertainty Will Rise, Not Bad For US Assets Economic Policy Uncertainty Will Rise, Not Bad For US Assets Economic Policy Uncertainty Will Rise, Not Bad For US Assets ​​​​​​ We are neutral on the US dollar versus the euro and recommend holding either versus the Chinese renminbi. We are short the currencies of emerging markets that suffer from great power rivalry, namely the Taiwanese dollar versus the US dollar, the Korean won versus the Japanese yen, the Russian ruble versus the Canadian dollar, and the Czech koruna versus the British pound.     We remain long gold as a hedge against both geopolitical risk and inflation. We recommend staying long global equities. Tactically we prefer large caps and defensives. Within developed markets, we favor the UK and Japan. Japan in particular will benefit from Chinese policy easing yet remains more secure from China-centered geopolitical risks than emerging Asian economies. Within emerging markets, Mexico stands to benefit from US economic strength and divorce from China. We would buy Indian equities on weakness and sell Chinese and Russian equities on strength. We remain long aerospace and defense stocks and cyber-security stocks.   -The GPS Team We Read (And Liked) … Conspiracy U: A Case Study “Crazy, worthless, stupid, made-up tales bring out the demons in susceptible, unthinking people.” Thus the author’s father, a Holocaust survivor translated from Yiddish, on conspiracy theories and the real danger they present in the world. Scott A. Shay, author and chairman of Signature Bank, whose first book was a finalist for the National Jewish Book Award, has written an intriguing new book on the topic and graciously sent it our way.2 Shay is a regular reader of BCA Research’s Geopolitical Strategy and an astute observer of international affairs. He is also a controversialist who has written essays for several of America’s most prominent newspapers. Shay’s latest, Conspiracy U, is a bracing read that we think investors will benefit from. We say this not because of its topical focus, which is too confined, but because of its broader commentary on history, epistemology, the US higher education system – and the very timely and relevant problem of conspiracy theories, which have become a prevalent concern in twenty-first century politics and society. The author and the particular angle of the book will be controversial to some readers but this very quality makes the book well-suited to the problem of the conspiracy theory, since it is not the controversial nature of conspiracy theories but their non-falsifiability that makes them specious. As the title suggests, the book is a polemical broadside. The polemic arises from Shay’s unique set of moral, intellectual, and sociopolitical commitments. This is true of all political books but this one wears its topicality on its sleeve. The term “conspiracy” in the title refers to antisemitic, anti-Israel, and anti-Zionist conspiracy theories, particularly the denial of the Holocaust, coming from tenured academics on both the right and the left wings of American politics. The “U” in the title refers to universities, namely American universities, with a particular focus on the author’s beloved alma mater, Northwestern University in Chicago, Illinois. Clearly the book is a “case study” – one could even say the prosecution of a direct and extended public criticism of Northwestern University – and the polemical perspective is grounded in Shay’s Jewish identity and personal beliefs. Equally clearly Shay makes a series of verifiable observations and arguments about conspiracy theories as a contemporary phenomenon and their presence, as well as the presence of other weak and lazy modes of thought, in “academia writ large.” This generalization of the problem is where most readers will find the value of the book. The book does not expect one to share Shay’s identity, to be a Zionist or support Zionism, or to agree with Israel’s national policies on any issue, least of all Israeli relations with Arabs and Palestinians. Shay’s approach is rigorous and clinical. He is a genuine intellectual in that he considers the gravest matters of concern from various viewpoints, including viewpoints radically different from his own, and relies on close readings of the evidence. In other words, Shay did not write the book merely to convince people that two tenured professors at Northwestern are promoting conspiracy theories. That kind of aberration is sadly to be expected and at least partially the result of the tenure system, which has advantages as well, not within the scope of the book. Rather Shay wrote it to provide a case study for how it is that conspiracy theories can manage to be adopted by those who do not realize what they are and to proliferate even in areas that should be the least hospitable – namely, public universities, which are supposed to be beacons of knowledge, science, openness, and critical thinking, but also other public institutions, including the fourth estate. Shay is meticulous with his sources and terminology. He draws on existing academic literature to set the parameters of his subject, defining conspiracy theories as “improbable hypotheses [or] intentional lies … about powerful and sinister groups conspiring to harm good people, often via a secret cabal.” The definition excludes “unwarranted criticism” and “unfair/prejudiced perspectives,” which are harmful but unavoidable. Many prejudices and false beliefs are “still falsifiable in the minds of their adherents,” which is not the case with conspiracy theories, although deep prejudices can obviously be helpful in spreading such theories. Conspiracy theories often depend on “a stunning amount of uniformity of belief and coordination of action without contingencies.” They also rely excessively on pathos, or emotion, in making their arguments, as opposed to logos (reason) and ethos (credibility, authority). Unfortunately there is no absolute, infallible distinction between conspiracy theories and other improbable theories – say, yet-to-be-confirmed theories about conspiracies that actually occurred. Conspiracy theories differ from other theories “in their relationship to facts, evidence, and logic,” which may sound obvious but is very much to the point. Again, “the key difference is the evidence and how it is evaluated.” There is no ready way to refute the fabrications, myths, and political propaganda that people believe without taking the time to assess the claims and their foundations. This requires an open mind and a grim determination to get to the bottom of rival claims about events even when they are extremely morally or politically sensitive, as is often the case with wars, political conflicts, atrocities, and genocides: Reliable historians, journalists, lawyers, and citizens must first approach the question of the cause or the identity of perpetrators and victims of an event or process with an open mind, not prejudiced to either party, and then evaluate the evidence. The diagnosis may be easy but the treatment is not – it takes time, study, and debate, and one’s interlocutors must be willing to be convinced. This problem of convincing others is critical because it is the part that is so often left out of modern political discourse. Conspiracy theories are often hateful and militant, so there is a powerful urge to censor or repress them. Openly debating with conspiracy theorists runs the risk of legitimizing or appearing to legitimize their views, providing them with a public forum, which seems to grant ethos or authority to arguments that are otherwise conspicuously lacking in it. In some countries censorship is legal, almost everywhere when violence is incited. The problem is that the act of suppression can feed the same conspiracy theories, so there is a need, in the appropriate context, to engage with and refute lies and specious arguments. Clients frequently email us to ask our view of the rise of conspiracy theories and what they entail for the global policy backdrop. We associate them with the broader breakdown in authority and decline of public trust in institutions. Shay’s book is an intervention into this topic that clients will find informative and thought-provoking, even if they disagree with the author’s staunchly pro-Israel viewpoint. It is precisely Shay’s ability to discuss and debate extremely contentious matters in a lucid and empirical manner – antisemitism, the history of Zionism, Holocaust denialism, Arab-Israeli relations, the Rwandan genocide, QAnon, the George Floyd protests, various other controversies – that enables him to defend a controversial position he holds passionately, while also demonstrating that passion alone can produce the most false and malicious arguments. As is often the case, the best parts of the book are the most personal – when Shay tells about his father’s sufferings during the Holocaust, and journey from the German concentration camps to New York City, and about Shay’s own experiences scraping enough money together to go to college at Northwestern. These sequences explain why the author felt moved to stage a public intervention against fringe ideological currents, which he shows to have gained more prominence in the university system than one might think. The book is timely, as American voters are increasingly concerned about the handling of identity, inter-group relations, history, education, and ideology in the classroom, resulting in what looks likely to become a new and ugly episode of the culture and education wars. Let us hope that Shay’s standards of intellectual freedom and moral decency prevail.   Matt Gertken, PhD Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1      The downshift in globalization today is even worse than it appears in Chart 10 because several countries have not yet produced the necessary post-pandemic data, artificially reducing the denominator and making the post-pandemic trade rebound appear more prominent than it is in reality. 2     Scott A. Shay, Conspiracy U: A Case Study (New York: Post Hill Press, 2021), 279 pages. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Appendix: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan Territory: GeoRisk Indicator Taiwan Territory: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator South Africa South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights A partial reinvasion of Ukraine cannot be ruled out. The constraints on Russia are not prohibitive, especially amid global energy shortages. On this issue, it is better to be alarmist than complacent. We would put the risk of a partial re-invasion of Ukraine as high as 50/50, albeit with an uncertain time frame over 12-36 months. The negative impact of conflict may not stay contained within Russian and eastern European markets. The US and EU are now threatening major retaliatory sanctions if Russia invades. In response Russia could reduce energy exports, exacerbating global shortages and damaging Europe’s overall economy. Investors should stay short Russian assets and overweight developed European equities over emerging European peers. Stay long gold and GBP-CZK. The dollar will be flat-to-up. Feature Chart 1Ruble Faces More Downside From Geopolitics Ruble Faces More Downside From Geopolitics Ruble Faces More Downside From Geopolitics Geopolitical tensions surrounding Russia remain unresolved and investors should continue to reduce holdings of assets exposed to any renewed conflict in Ukraine and the former Soviet Union. The ruble has dropped off its peaks since early November when strategic tensions revived (Chart 1). Presidents Joe Biden and Vladimir Putin held their second bilateral summit on a secure video link on December 7 to discuss the situation in Ukraine, where Russia has amassed 95,000-120,000 troops on the border in a major show of force. Russia also mustered troops in April and only partially drew them down after the Biden-Putin summit in Geneva where the two sides agreed to hold talks to address differences. The two presidents agreed to hold consultations regarding Ukraine. Putin accused NATO of building up Ukraine’s military and demanded “reliable, legally fixed guarantees excluding the expansion of NATO in the eastern direction and the deployment of offensive strike weapons systems in the states adjacent to Russia.”1 President Putin’s red line against Ukraine joining NATO is well known. Recently he said his red line includes the placement of western military infrastructure or missile systems in Ukraine. Biden refused to accept any limits on NATO membership in keeping with past policy. After the summit National Security Adviser Jake Sullivan said, “I will tell you clearly and directly [Biden] made no such commitments or concessions. He stands by the proposition that countries should be able to freely choose who they associate with.” 2 Biden, who had conferred with the UK, France, Germany, and Italy prior to the call, outlined the coordinated economic sanctions that would be leveled against Russia if it resorted to military force, as well as defense aid that would go to Ukraine and other eastern European countries.  Thus Putin gave an ultimatum and Biden rebuffed it – and yet the two agreed to keep talking. The Russians have since said that they will present proposals to the Americans in less than a week. Talks are better than nothing. But neither side has given concrete indication of a change in position that would de-escalate strategic tensions – instead they have both raised the stakes. Therefore investors should proceed with the strong presumption that tensions will remain elevated or escalate in the coming months. Clearing Away Misconceptions Before going further we should clear away a few misconceptions about the current situation: Ukraine has unique strategic value to Russia. Like Belarus, but unlike Central Asia, Ukraine serves as critical buffer territory protecting Moscow and the Russian core from any would-be invaders. Russia lacks firm geological borders so it protects itself by means of distance and winter. This grand strategy succeeded against King Charles XII of Sweden, Napoleon, and Hitler. The collapse of the Soviet Union left Russia shorn of much of its buffer territory. Ukraine also offers access to the Black Sea. Russia has long striven to gain access to warm-water ports. The loss of control over Ukraine resulted in a loss of access. Russia’s seizure of Crimea in 2014 only partially rectified the situation. Ukraine’s southern coastline around Crimea is the territory at risk today (Map 1). Chart It is Ukraine’s physical existence and unique strategic value – not its democratic leanings or ideological orientation – that ensures perpetual tensions with post-Soviet Russia. Russia has a strategic imperative to reassert control or at least prevent control by foreign powers. Ideological opposition may make things worse but an anti-Russian Ukrainian dictator would also face Russian coercion or aggression, perhaps even more than the current weak democracy. In fact Russia is trying to force Ukraine to revise its constitution and adopt a federal structure so as to grant greater autonomy to separatist regions Donetsk and Luhansk that Russia helped break away in 2014. But Ukraine has not relented to Moscow’s demands of political reform. It is not authoritarianism but a permanent foreclosure of Ukrainian membership in the EU and NATO that Moscow is after. Yet it is highly unlikely that Russia would try to invade and conquer all of Ukraine. Ukraine is the largest country by territory in Europe and has 255,000 active soldiers and 900,000 reserves (contra Russia’s 1 million active and 2 million reserves) who would defend their freedom and sovereignty against an invader.3 Russia would not be able to stage a full-scale invasion with the 175,000 maximum troop buildup that US intelligence is warning about. It would have to mobilize fully, dangerously neglecting other vast dimensions of its national security, and would inevitably get bogged down fighting a vicious insurgency backed by the NATO powers. It would save blood and treasure by paralyzing Ukraine’s politics and preventing it from allying with western militaries, which is what Putin is attempting to do today. Putin uses foreign adventures to strengthen his grip at home but an adventure of this nature would impose such burdens as to threaten his grip at home. A limited re-invasion of Ukraine could yield historic strategic advantages to Russia. Moscow could focus on a partial military incursion that would annex or shore up Donbass, or extend its control from Donbass to the Black Sea, conceivably all the way to the Dnieper river. This pathway would yield Russia maritime access and a buffer space to fortify Crimea. Naval warfare could also yield control of deep-water ports (Yuzhne, Odessa, Mykolaiv, Chornomorsk), control of the mouth of the Dnieper, control of the canal that supplies water to Crimea, and a means of bottling up the Ukrainian navy and preventing foreign maritime assistance. Ukraine would be further weakened and Russia would have a larger beachhead in Ukraine for future pressure tactics. Russia is not bluffing – its military buildup poses a credible threat. If there is anywhere Russia’s threats are credible, it is in taking military action against former Soviet republics like Georgia (2008) and Ukraine (2014) that have pro-western leanings yet lack the collective security of the NATO alliance. At very least, given that Russian forces did deploy in Ukraine in 2014, Russian action in Ukraine cannot be ruled out. The military balance has not changed so significantly in that time and strongly favors Russia (Chart 2). The US has provided around $2.5 billion in military aid to Ukraine since 2014, and has sent lethal weapons including Javelin anti-tank missiles and launchers since 2017-18, including $450 million worth of military aid under the Biden administration (and $300 million just authorized by Congress on December 7). NATO allies have also provided defense aid. This is part of Putin’s complaint but these new arms are not game changers that would prevent Russia from taking military action. Chart 2 Thus if the West rejects Moscow’s core demands, war is likely. This is true even if Russia would prefer to achieve its aims through political and economic rather than military means. Russia does not deem the West’s threat of sanctions as prohibitive of invasion. The West’s sanctions since 2014 have failed to change Russia’s government, strategy, or posture in Ukraine. Yes, European nations joined the US in imposing sanctions. But Germany also pursued the Nord Stream II pipeline as a means of bypassing Ukraine and working directly with Russia to preserve economic engagement and energy security. Former Chancellor Merkel forced the pipeline through despite the objections of eastern Europeans and the United States. The allies also formed the “Normandy Quartet,” excluding the US, to force Ukraine to accept the Minsk agreements on resolving the conflict. Thus the lesson of 2014-21 is not that NATO allies stood shoulder-to-shoulder in defense of Ukraine’s sovereignty and territorial integrity but rather that Germany and the EU, and the EU and the US, have major differences in interests and risk-tolerance in dealing with Russia. Russia does not face, or may think it does not face, a united front among the western powers. A partial reinvasion of Ukraine would bring the western allies together initially but probably not for long. Russia determines the timing of any new military incursion in Ukraine. Winter is not the ideal time to invade Ukraine, though it is possible. Russia could act in spring 2022, as the US has warned, but it could also act in the summer of 2023, the spring of 2024, or other times. From a strategic point of view, Russia has enjoyed a historic window of opportunity since 2001 when the US got bogged down in Afghanistan and Iraq and then the US and the EU got bogged down in economic and financial crisis. Given that the American political establishment is withdrawing from foreign quagmires, reactivating fiscal policy, bulking up the military-industrial complex, and making a dedicated effort to revitalize its global alliances, Russia may believe that its historic window is closing. Russia’s domestic fundamentals are deteriorating over time. Putin could decide it is necessary to seize strategic ground in Ukraine sooner rather than later. Bottom Line: Ukraine offers unique and irreplaceable buffer space and maritime access to Russia. Russia’s military actions in 2014 led to stalemate, such that Russia remains insecure, Ukraine remains defiant, and the West is still entertaining defense cooperation or even NATO membership with Ukraine. Yet the Crimea conflict also revealed a lack of concert among western powers exemplified by Germany’s Nord Stream II pipeline. Today Russia has the military capability to seize another slice of Ukrainian territory. Western retaliatory actions would be painful but may not be deemed prohibitive. Investors cannot rule out a partial re-invasion of Ukraine. Nord Stream Pipeline Is Not The Sole Factor Is Russia not making a show of military force merely to ensure that Nord Stream II pipeline goes into operation? Will Russia not back down if the pipeline is guaranteed? A common view in Washington and the financial industry is that Russia’s military buildup is just a bluff, i.e. Moscow’s aggressive way of demanding that Germany’s new government and the European Union approve Nord Stream. The pipeline finished construction in September but now awaits formal regulatory certification. Approval was originally expected by May 2022 but has now been delayed. The pipeline would carry 55 billion cubic meters of natural gas into Europe, about half of Russia’s current export capacity outside of Ukraine. Ukraine’s total capacity is around 150 billion cubic meters. The pipeline enables Russia and Germany to bypass Ukraine, whose conflicts with Moscow since 2004 have threatened Germany’s energy security. About 18% of EU’s total energy imports come from Russia, whilst this figure is 16% for Germany. That is about 0.5% and 0.2% of EU and German GDP, respectively. Meanwhile Russian energy exports to Germany and the EU make up 0.8% and 5.6% of GDP, respectively (Chart 3). Chart 3 The problem with this reasoning is that the US conceded Nord Stream to Russia over the summer. The US initially raised the threat of sanctions because the pipeline  strengthened Russo-German ties, diminished Ukraine’s leverage, and deprived the US of a chance to sell liquefied natural gas to Europe. But the Biden administration proved unwilling to take this aggressive approach. Secretary of State Anthony Blinken has a long history of arguing that the US should prioritize strong relations with its European allies rather than punitive measures to try to block Russian gas sales. Biden met with outgoing Chancellor Angela Merkel in July and agreed to let Nord Stream go forward. The only proviso was that Russia not “weaponize natural gas,” i.e. withhold supplies for geopolitical purposes, as it has done in the past.4 Before Russia’s military threats, Germany and the EU were expected to certify the pipeline by no later than May 2022 and an earlier certification looked possible because of Europe’s low natural gas supplies. Yet Russia, fresh off parliamentary elections, did precisely what Germany said it was not supposed to do. The pipeline was completed in September and reports of Russian limitations on natural gas supply surfaced in October. Moscow not only weaponized the gas but also mustered its army on the Ukrainian border again. Putin may have feared that the new German government, which officially took office on December 8, would change policy and refuse to certify the pipeline. He also could have feared that the US Congress would pass a Republican-backed provision that would require Biden to impose sanctions that would halt the pipeline. But these explanations are not satisfactory. First, the German government was not likely to halt Nord Stream. Quite the opposite, Berlin has pushed against all opposition to speed the pipeline into action. It only delayed the regulatory approval when Russia did the one thing that Germany had expressly prohibited, which was weaponize natural gas. Second, the US Congress was never likely to pass mandatory sanctions on Nord Stream operators. The Democrats opposed it, as it would have tied Biden’s hands, whereas presidents always retain discretion over foreign policy and national security. Even moderate Republicans opposed the measure, for the same reason. If either of these were the reason for Putin’s latest buildup, then the buildup will probably dissipate in the coming months. Putin also wants to force Ukraine to implement the Minsk agreements. But the Biden administration adopted the Minsk framework in June for the first time, which was a concession to Russia. So the latest military threats are not solely about coercing Europe to approve the pipeline or Ukraine to implement Minsk. Putin is driving at something else. Putin’s Focus On Ukraine And NATO Putin used military pressure on Ukraine’s border to force the US to accept the pipeline and the Minsk agreements. He is now using the same tactic to raise the stakes and demand that the US and its allies permanently rule out NATO membership and defense cooperation with Ukraine. Biden rejected the first demand during the summit, as mentioned. There is no way that the US or NATO will forswear any and all eastward expansion. Even on Ukraine specifically, Biden cannot give Russia a legal guarantee because it would require a 60-seat majority in the Senate (not likely). Any future president would retain prerogative over the matter anyway and Putin knows this. Moreover Ukraine is never going to join NATO. Russia would attack. And NATO members would not be unanimous (as is required for new members) because the collective defense treaty would require them to defend Ukraine. They would be signing up for a war with Russia. Still Biden is unlikely to disavow Ukrainian NATO membership because to do so would be to deny the self-determination of nations, capitulate to Russian coercion, and demoralize the Ukrainians, whom the US hopes will maintain a plucky resistance against Russian domination. It would also demoralize US allies and partners – namely Taiwan, which also lacks a formal defense treaty and would be forced to sue for peace with China in the face of American abandonment. Biden’s refusal to ban Ukraine from NATO is encapsulated in Diagram 1, an exercise in game theory that exemplifies why the risk of war should not be dismissed. Diagram 1Game Theory Suggests Russia Will Keep Applying Military Pressure Russia/Ukraine: Don’t Be Complacent Russia/Ukraine: Don’t Be Complacent Biden may give private or executive assurances on Ukraine and NATO but Putin will know that these mean nothing since Biden may be out of office as early as January 2025 and then Putin would have to renegotiate. America is not a credible negotiator because partisanship has resulted in extreme foreign policy vacillations – the next president could revoke the deal. Even after Putin is gone Russia would have to negotiate with the US to prevent the US from arming Ukraine. Hence Moscow may decide to reduce Ukraine and improve Russia’s strategic position by force of arms. This is true even if Biden forswears the NATO option, as Diagram 1 illustrates. Putin’s second demand – that the US not provide offensive weapon systems in countries adjacent to Russia – is more material. This is what the new round of talks will focus on. This new Ukraine line of talks is separate, more urgent and important, than the other bilateral dialogues on the arms race, and cyber-war. US-Russia talks on Iran are also urgent, however, and Russia’s cooperation there may be contingent on US concessions regarding Ukraine. The US may be willing to stop its defense cooperation with Ukraine but not with other allies and partners, however. It is also not clear what Putin will accept. These negotiations will have to be watched. Biden cannot make major concessions with a gun to his head. It is unclear how far the US is willing to concede on defense cooperation with countries around Russia. The US may quietly abandon Ukraine but then it would need to reinforce its other defense relationships. If Putin draws down the troops, and Biden calls a stop to defense aid to Ukraine, then a crisis may be averted. What Could Go Wrong? Economic sanctions under consideration in Washington are significant: the US could freeze bank transactions, expand restrictions on trading Russian sovereign and corporate debt, and lobby Belgium to kick Russia off the SWIFT financial messaging system. However, these sanctions may not be effective in preventing Russia from using military force. Russia has weathered US sanctions since 2014, and the smaller and weaker Iranian economy has weathered maximum pressure sanctions since 2019. Energy producers like Russia and Iran have maximum geopolitical leverage when global energy inventories draw down, as is the case today. Even in the face of Russian military aggression, the Biden administration is vacillating on sanctions targeting Russia’s energy sector that would contribute to global shortages and ultimately raise prices at the pump for voters in a midterm election year.5 Germany’s new government also hesitates to declare unambiguously that it will discontinue the Nord Stream II pipeline if Russia invades Ukraine. True, Germany signaled that the pipeline would be halted. Its energy regulator declared that the pipeline’s ownership must be unbundled, which pushes back the certification date to sometime after May 2022 – this was a geopolitical not a legalistic decision. But construction is completed, the pipeline physically exists, which will vitiate Germany’s commitment to sanctions whenever natural gas shortages occur, as is the case this winter (Chart 4). Shortages will continue to occur and Russia controls a large share of supply. Chart 4 ​​​​​​ Chart 5 It would take a catastrophe to drive Germany to restart coal and nuclear plants, so natural gas will continue to be in demand. Germany does not have liquefied natural gas import capability yet. If Europe imposes crippling sanctions on Russia, Russia could reduce energy supplies and harm Europe’s economy (Chart 5). The Russian economy and society would suffer which is one reason any military action in Ukraine would be limited in scope. Still, Moscow may believe that Germany would restrain the EU, and the EU would restrain the US, thereby preventing sanctions from being fully, uniformly, and durably implemented. Prior to Russia’s aggression, public opinion polls showed that the German public strongly supported Nord Stream. Even a majority of Green Party members supported it despite the fact that the Greens were the most critical of increasing Germany’s dependency on fossil fuels and an authoritarian petro-state. While public approval of the pipeline has surely suffered in the face of Russian aggression, a majority probably still favors the pipeline. Germany has a national consensus in support of engagement with Russia and avoiding a new cold war, given that the original Cold War cut Germany in half. For that reason invasion may only temporarily unite the western powers – it could ultimately drive a wedge between Germany and other EU members, namely in the former Soviet bloc. It would also divide the more risk-averse EU from the US in terms of how to deal with Russia. And it would weaken the Biden administration at a time when it is extremely vulnerable, exacerbating America’s internal divisions. Russian domestic patriotism would rally, at least initially. Note that Russia could miscalculate on this issue and that is one reason for high level of risk. Perhaps the West would prove far more unified and aggressive in its sanctions enforcement than it was after 2014. A falling ruble and rising inflation could cause Russian social unrest. But Russia could misread the situation. Unless the US and Europe escalate the sanctions threat massively to better deter Russia, their lack of concert is another reason for investors not to be complacent about renewed conflict. Bottom Line: The threat of sanctions may prove insufficient to deter renewed Russian aggression against Ukraine. Germany favors engagement with Russia and Europe’s energy dependency on Russia makes it vulnerable to supply disruptions. Russia has leverage given tight global energy markets, Europe’s low natural gas inventories, and US domestic political considerations ahead of the 2022 midterms. Investment Takeaways The point of this report argues that a partial re-invasion of Ukraine cannot be ruled out. Russia has the capability to reinforce de facto control of Donbas, or expand its footprint in southern Ukraine, though not to invade the whole country. The threat of economic sanctions is not yet so overwhelming as to warrant overconfident predictions of de-escalation. In this case it is better to be alarmist than complacent. Russia would want to maintain an element of surprise so the timing of any belligerence is hard to predict. For de-escalation, investors should watch for Russia to withdraw troops from the Ukrainian border, US-Russia consultations to begin promptly and proceed regularly, and for the US and allies to delay or halt defense cooperation and arms transfers to Ukraine. While global investors would quickly become de-sensitized to conflict that is entirely contained in Ukraine, the trans-Atlantic threat of major sanctions now raises the stakes and suggests that global energy shocks could negatively affect the European or global economy in the event of conflict. Any conflict could also spill outside of Ukraine’s borders, as with Malaysian Airlines flight MH17, which was shot down by Russian-backed Ukrainian separatists in July 2014. The Black Sea has seen a dangerous uptick in naval saber-rattling and that strategic situation would become permanently more dangerous if Russia seized more of coastal Ukraine. Russian military integration with Belarus is also a source of insecurity for EU and NATO members. Global financial markets have only started to price the geopolitical risk emanating from Russia. Our Russian GeoRisk Indicator has ticked up (Chart 6). But Russian equity performance relative to broad emerging markets is only arguably underperforming what is implied by Brent crude oil prices. Chart 6Market Slow To React To Ukraine Crisis - Risk To Downside For Russian Assets Market Slow To React To Ukraine Crisis - Risk To Downside For Russian Assets Market Slow To React To Ukraine Crisis - Risk To Downside For Russian Assets This relatively muted reaction suggests more downside lies ahead if we are right that strategic tensions will be flat-to-up over the coming months. Sell the RUB-USD on any strength. Stay long GBP-CZK. Tactically short Russian equities versus EM-ex-Asia (Chart 7). They are exposed to further correction as a result of escalating geopolitical risk. Chart 7Russia Falling Off Peaks Of Performance Versus EM-Ex-Asia Russia Falling Off Peaks Of Performance Versus EM-Ex-Asia Russia Falling Off Peaks Of Performance Versus EM-Ex-Asia ​​​​​​ Chart 8Developed Europe A Safer Bet Than Emerging Europe Amid Tensions Developed Europe A Safer Bet Than Emerging Europe Amid Tensions Developed Europe A Safer Bet Than Emerging Europe Amid Tensions ​​​​​​ Stick to long DM Europe versus EM Europe – our main trade this year to capture rising geopolitical risk between Russia and the West (Chart 8).     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      President of Russia, "Meeting with US President Joseph Biden," December 7, 2021, kremlin.ru.  2     White House, "Press Briefing by Press Secretary Jen Psaki and National Security Advisor Jake Sullivan, December 7, 2021," whitehouse.gov. 3     Dan Peleschuk, "Ukraine’s military poses a tougher challenge for Russia than in 2014," Politico, April 14, 2021, politico.eu.; see also Gav Don, "LONG READ: Russia looks poised to invade Ukraine, but what would an invasion actually look like?" Intellinews, November 24, 2021, intellinews.com. 4     US Department of State, "Joint Statement of the United States and Germany on Support for Ukraine, European Energy Security, and our Climate Goals," July 21, 2021, state.gov. 5     Kylie Atwood and Natasha Bertrand, "US likely to hold off for now on energy sanctions for Russia, fearing impact on global prices," CNN, December 9, 2021, cnn.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights Our theme for the year, “No Return To Normalcy,” is largely vindicated. Inflation is back! The geopolitical method still points to three long-term strategic themes: multipolarity, hypo-globalization, and populism. All are inflationary in today’s context. Our three key views for 2021 produced two hits and one miss: China sold off, oil prices held up, but the euro fell hard. Our view on Iran is still in flux. COVID-19 proved more relevant for investors than we believed, though we took some risk off the table before the Delta and Omicron variants emerged. Our biggest miss was long Korea / short Taiwan equities. Our geopolitical forecast was spot on but our trade recommendation collapsed. Our biggest hit was long India / short China equities. China’s historic confluence of internal and external risk drove investors to India, the most promising strategic EM play. Feature Every year we conduct a review of the past year’s geopolitical forecasts and investment recommendations. The intention is to hold ourselves to account, prepare for our annual outlook, and improve our analytical framework. Our three key views for 2021 were: 1.  China’s historic confluence of political and geopolitical risk = bearish view of Chinese equities; 2.  The US pivot to Asia runs through Iran = neutral-to-bullish view of oil prices; 3.  Europe wins the US election = bullish view of the euro and European equities. The first view on China was a direct hit. The second view is in flux. The third view was initially right but then turned sour. A crude way of assessing these views would be to look at equity performance relative to long-term trends: China sold off, the UAE rallied, and Europe sold off (Chart 1). Chart 1Three Key Views For 2021: Two Hits, One Miss Three Key Views For 2021: Two Hits, One Miss Three Key Views For 2021: Two Hits, One Miss This is not the whole story. We modified our views over the course of the year as new information came to light. In March we turned neutral on the US dollar, with negative implications for the euro. In June we adjusted our position on Europe overall, arguing that European political risk had bottomed and would rise going forward. In August we adjusted our position on Iran, warning of an imminent crisis due to the Biden administration’s refusal to lift sanctions and Iran’s pursuit of “breakout” uranium enrichment capacity. We stayed bearish on China throughout the year. Going forward, given that a near-term crisis is necessary to determine whether Iran will stay on a diplomatic track, we would short UAE or Saudi equities. We would expect oil to remain volatile given upside risks from geopolitics but downside risks from the new Omicron variant and China’s slowdown. China’s slowdown was also a controlling factor for the Europe view. The energy crisis and showdown with Russia can also get worse before they get better. So we prefer US assets for now and will revisit this issue in our annual strategic outlook due in the coming weeks. Before we get to the worst (and best) calls of the year, we have a few words on our analytical framework in the context of this year’s signal developments. The Geopolitical Method: Lessons From 2021 As with any method rooted in practice, the geopolitical method has many flaws. But it has the advantage of being systematic, empirical, probabilistic, and non-partisan. How do we check ourselves on the thorny problem of partisanship? First, geopolitics requires practicing empathetic analysis, i.e. striving to understand and empathize with the interests of each nation and nation-state when analyzing their behavior. For example: China: China’s ruling party believes it is necessary to have an all-powerful leader to deal with the urgent systemic risks facing the country. We refrain from criticizing single-party rule or China’s human rights record. But we do see compelling evidence that the Communist Party’s shift from consensus rule to personal rule will have a negative impact on governance and relations with the West.1 China obviously rejects foreign diplomatic and military support for Taiwan, which Beijing sees as a renegade province, and hence the odds of a war in the Taiwan Strait are high over the long run. Russia: Russia is threatening its neighbors on multiple fronts not because it is an evil empire but because of its insecurity in the face of the US and NATO, and particularly its opposition to western defense cooperation with Ukraine. Its unproductive domestic economy and vulnerability to social unrest are additional reasons to expect aggression abroad. Second, we take very seriously any complaints of bias we receive from clients. Such complaints are rare, which is encouraging. But we treat all feedback as an opportunity to improve. At the same time, the need to draw clean-cut investment conclusions for all clients will always override the political sensitivities of any subset of clients. Geopolitics is based in the idea that politics is rooted in structural forces like geography and demography, i.e. forces that limit or constrain individual actors and only change at a glacial pace. Geopolitical analysts focus on measurable and material factors rather than ever-changing opinions and ideas. It is impossible for investors today to ignore the global political environment, so the important thing is to analyze it in a cold and clinical manner. To combine this method with global macroeconomic and investment research, one must assess whether and to what extent financial markets have already priced any given policy outcome. The result will be a geopolitically informed macro conclusion, which should yield better decisions about conserving and growing wealth. This is the ideal for which we aim, even though we often fall short. Over the years our method has produced three primary strategic themes: Great Power struggle (multipolarity); hypo-globalization; and domestic populism (Table 1). Table 1Our Major Themes Point To Persistent Inflation Risk Geopolitical Report Card: 2021 Geopolitical Report Card: 2021 The macro impact of these themes will vary with events but in general they point toward a reflationary and inflationary context. They involve a larger role of government in society, new constraints on supply, demand-side stimulus, and budget indiscipline. Bottom Line: Nation-states are mobilizing, which means they will run up against resource constraints. A Return To Normalcy? Or Not? As the year draws to a close, our annual theme is vindicated: “No Return To Normalcy.”  The term “normalcy” comes from President Warren G. Harding’s election campaign in 1920. It was an appeal to an American public that yearned to move on from World War I and the Spanish influenza pandemic. A hundred years later, in December 2020, the emergence of a vaccine for COVID-19 and the election of an orthodox American president (after the unorthodox President Trump) made it look as if 2021 would witness another such return to normalcy. We foresaw this narrative and rejected it. Primarily we rejected it on geopolitical grounds – global policy will not revert to the pre-Trump status quo. We also argued that the pandemic and the gargantuan fiscal relief designed to shield the economy would have lasting consequences. Specifically they would create a more inflationary context. Chart 2No Return To Normalcy In 2021 No Return To Normalcy In 2021 No Return To Normalcy In 2021 The most obvious sign that things have not returned to normal in 2021 is the “Misery Index,” the sum of unemployment and headline inflation. Misery Indexes skyrocketed during the crisis and today stand at 10.8% in the US and 11.4% in the EMU, up from 5.2% and 8.1% in 2019, respectively (Chart 2). Unemployment rates are falling but inflation has surged to the highest levels since the 1990s. For investors to be concerned about inflation at the beginning of a new business cycle is unusual and requires explanation. It suggests that inflation will be a persistent problem going forward, as the unemployment rate falls beneath NAIRU and participation rates rise. While we expected inflation, we did not expect the political blowback to come so quickly. President Biden’s approval rating collapsed to 42.2% this fall. Approval of his handling of the economy fell even lower, to 39.6%, below President Trump’s rating at this stage. Consumer confidence has fallen by 15.1% since its post-election peak in June 2021. Republicans are automatically favored to win the House of Representatives in the 2022 midterm elections – but if the economy does not improve they will also win the Senate. Despite Biden’s unpopularity, we argued that his $550 billion bipartisan infrastructure bill and his $1.75 trillion partisan social spending bill would pass Congress. So far this view is on track, with infrastructure signed into law and the Senate looking to vote on the social bill in December (or January). These bills illustrate the strategic themes listed above: the US is reviving public investments in civil and military sectors, reducing global dependencies, and expanding its social safety net. However, large new government spending when the output gap is virtually closed will tend to be inflationary. Russia and China also have high or rising misery indexes, which underscores that political and geopolitical risks will rise rather than fall over the coming 12 months. Unemployment rates are not always reliable in authoritarian states, so the Misery Index is if anything overly optimistic regarding social and economic conditions. China is not immune to social unrest but Russia is particularly at risk. Quality of life and public trust in government have both deteriorated. Inflation will make it worse. Russians remember inflation bitterly from the ruble crisis of 1998. President Putin is already ratcheting up tensions with the West to distract from domestic woes. While we were positioned for higher inflation in 2021, we were too dismissive of the global pandemic. We expected vaccination campaigns to move faster, especially in the US, and we underrated the Delta variant as a driver of financial markets, at least relative to politics. A close look at Treasury yields, oil prices, and airline stocks shows that the evolution of the pandemic marked the key inflection points in the market this year (Chart 3). Chart 3COVID-19 Stayed Relevant In 2021 ... Now Omicron Variant Emerging COVID-19 Stayed Relevant In 2021 ... Now Omicron Variant Emerging COVID-19 Stayed Relevant In 2021 ... Now Omicron Variant Emerging Bottom Line: Tactically the market impact of the newly discovered Omicron variant of the virus should not be underrated. It is critical to find out if it is more harmful to younger people than Delta and other variants. Cyclically inflation will remain a persistent risk even if it abates somewhat in 2022. Worst Calls Of 2021 We now proceed to our main feature. As always we begin with the worst calls of the year: Chart 4Taiwan Rolled Over ... But Not Against Korea Taiwan Rolled Over ... But Not Against Korea Taiwan Rolled Over ... But Not Against Korea 1.  Long Korea / Short Taiwan. Geopolitical view correct, market view incorrect. US-China conflict is a secular trend and contains elements of all our major themes: Great Power struggle, hypo-globalization, and populism. Taiwan is the epicenter of this conflict and a war is likely over the long run. For 2021 we predicted a 5% chance of war but a 60% chance of a “fourth Taiwan Strait crisis,” i.e. a diplomatic crisis, and our contrarian short of Taiwanese equities was premised on this expectation. Investors are starting to respond to these self-evident geopolitical risks, judging by the TWD-USD exchange rate and the relative performance of Taiwanese equities, which have peaked and are lagging expectations based on global semiconductor stocks. But our choice of South Korean equities as the long end of the pair trade was very unfortunate and the trade is down by 22% (Chart 4). Korea is suffering from a long de-rating process in the face of China’s industrial slowdown and a downgrade to Korean tech sector earnings, as our Emerging Markets Strategy has highlighted. 2.  Short CNY Versus USD And EUR. Geopolitical view correct, market view incorrect. This year we argued that President Biden would be just as hawkish on China as President Trump and would not remove tariffs or export controls. We also argued that the SEC would punish US-listed China stocks and that bilateral relations would not improve despite a likely Biden-Xi summit. These views proved correct. But our neutral view on the dollar and bullish view on the euro betrayed us and the trade has lost 4% so far. The euro collapsed amid its domestic energy crisis and China’s import slowdown (Chart 5). China’s exports boomed while the People’s Bank kept the currency strong to fend off inflation. Chart 5China Tensions Sure, But Don't Fight The People's Bank China Tensions Sure, But Don't Fight The People's Bank China Tensions Sure, But Don't Fight The People's Bank Chart 6Value Surged Then Fell Back Against Growth Stocks Value Surged Then Fell Back Against Growth Stocks Value Surged Then Fell Back Against Growth Stocks 3.  Long Value Versus Growth. Geopolitical view correct, market view incorrect. We have long favored value over growth stocks, expecting that our strategic themes would lead to more muscular fiscal spending, government intervention in the economy, and a return of inflation. In 2021 we bet that rising inflation expectations and higher bond yields would favor value over growth. This was only one aspect of our larger pro-cyclical view that tech-heavy US equities would underperform their global peers and emerging markets would outpace developed markets. These expectations came true during the first part of the year when exuberance over the “reflation trade” led to a big pop in value (Chart 6). By the second quarter we had pared back our pro-cyclical leanings but we maintained value over growth, ultimately at a loss of 3.75%. The reality nowadays is that value is a byword for low quality, as our colleagues Juan Correa-Ossa and Lucas Laskey have shown. Growth stocks continue to provide investors with innovation and robust earnings amid a lingering pandemic. 4.  Long Aerospace And Defense Stocks. Geopolitical view mixed, market view incorrect. We are perennially bullish on defense stocks given our strategic themes. We expected aerospace and defense stocks to recover as vaccines spread and travel revived. We successfully played the rebound in absolute terms. But the slow pace of vaccination and the emergence of the Delta variant dealt a blow to the sector relative to the broad market. And now comes Omicron. As for defense stocks specifically, investors are downplaying Great Power struggle and worried that government defense budgets will be flat or down. Significant saber-rattling is occurring as expected in the major hotspots – the Taiwan Strait, the Persian Gulf, and Russia’s periphery – but investors do not care about saber-rattling for the sake of saber-rattling. Geopolitical tensions went nowhere so far this year and hence defense stocks floundered relative to the broad market (Chart 7). Still we would be buyers at today’s cheap valuations as we see geopolitical risk rising on a secular basis and the odds of military action are non-negligible in all three of the hotspots just mentioned. 5.  Long Safe Havens. Geopolitical view mixed, market view incorrect. Measured geopolitical risk and policy uncertainty collapsed over the second half of 2020. By early 2021 we expected it to revive on US-China, US-Russia, and US-Iran tensions. As such we expected safe-haven assets to catch a bid, especially having fallen as the global economy reopened. We stayed long gold (up 22.6% since inception, down 5.2% YTD) and at various times bought the Japanese yen and Swiss franc. Some of these trades generated positive returns but in general safe havens remained out of favor (Chart 8). As with defense stocks, we are still constructive on the yen and franc. Chart 7Market Ignored Saber-Rattling Market Ignored Saber-Rattling Market Ignored Saber-Rattling 6.  Long Developed Europe / Short Emerging Europe. Geopolitical view correct, market view incorrect. Our pessimistic view of Russia’s relations with the West, and hence of Russian currency and equities, clashed with our positive outlook on oil and commodity prices this year. To play Russian risks we favored developed European equities over their emerging peers (mainly Russian stocks). But emerging Europe has outperformed by 5% since we initiated the trade and other variations on this theme had mixed results (Chart 9). Of course, geopolitical tensions are escalating in eastern Europe we go to press. Chart 8Safe Havens Fell After US Election, Insurrection Safe Havens Fell After US Election, Insurrection Safe Havens Fell After US Election, Insurrection ​​​​​​ Chart 9Refrain From The Russia Rally Refrain From The Russia Rally Refrain From The Russia Rally We do not think investors can afford to ignore the US-Russia conflict, which has escalated over two decades. President Putin has not changed his strategy of building a sphere of influence in the former Soviet Union. The US is internally divided and distracted by a range of challenges, while it continues to lack close coordination with its European allies. Western responses to Russian aggression have failed to change Russia’s cost-benefit analysis. Thus we continue to expect market-negative surprises from Russia, whether that means a seizure of littoral territory in Ukraine, a militarization of the Belarussian border, more disruptive cyber attacks, or some other big surprise. Bottom Line: While our geopolitical forecasts generally hit the mark this year, global financial markets ignored most geopolitical risks other than China. The global recovery, inflation, and the pandemic, vaccines, variants, and social distancing remained the key dynamics. This threw many of our trades off track. However, we are sticking with some of our worst calls this year given the underlying geopolitical and economic forces motivating them beyond a 12-month time frame. Best Calls Of 2021 1.  Long India / Short China. Geopolitical view correct, market view mixed. Our number one view for 2021 was that China would suffer a historic confluence of political and geopolitical risk that would be negative for equities. This view contrasted with our bullish view on India. Prime Minister Narendra Modi had won another single-party majority in the 2019 elections and stood to benefit from the attempts of the US and other democracies to diversify away from China. We favored Indian stocks and local currency bonds – both trades saw a sharp run-up (Chart 10). Unfortunately, we took profits too soon, only netting 12% on the long India / short China equity trade. Some of our other India trades did not go so well. Going forward we expect a tactical reset given India’s tremendous performance this year. 2.  Booking Gains At Peak Biden. Geopolitical view correct, market view correct. We closed several of our reflation trades in the first quarter, when exuberance over vaccines and the Democrat’s election sweep reached extreme levels (Chart 11). We captured a 24% gain on our materials trade and a 37% gain on energy stocks. We turned a 17% profit on our BCA Infrastructure Basket relative trade. We were prompted to close these trades by dangers over Taiwan and Ukraine that soon dissipated. But we also believed that markets were priced for perfection. By the second quarter we had taken some risk off the table, which served us well throughout the middle of the year when the Delta variant struck. While global energy and materials rose to new highs later in the year, the Fed and Omicron interrupted their run. Chart 10Call Of The Year: Long India, Short China Call Of The Year: Long India, Short China Call Of The Year: Long India, Short China 3.  Long Natural Gas On Russia Risks. Geopolitical view correct, market view correct. All year we held the contrarian view that the new Nord Stream II pipeline linking Russia and Germany would become a major geopolitical flashpoint and that it was much less likely to go into operation than consensus held. Chart 11Reflation Trade' Peaked Early, Peaked Again, Then Omicron Reflation Trade' Peaked Early, Peaked Again, Then Omicron Reflation Trade' Peaked Early, Peaked Again, Then Omicron ​​​​​​ We also fully expected Russia to act aggressive in its periphery. In March we argued that while Russia probably would not re-invade Ukraine, long-term risk was substantial (and accordingly a new military standoff began in the fall) We also noted that Russia had other tools to coerce its neighbors. As a result we went long natural gas futures, following our colleagues at Commodity & Energy Strategy. While the trade returned 20%, we took profits before the European energy crisis really took off (Chart 12). 4.  The “Back To War” Trade. Geopolitical view correct, market view correct. Cyber warfare is one of the ways that the Great Powers can compete without engaging in conventional war. We have long been bullish on cyber-security stocks. However, the pandemic created a unique tactical opportunity to initiate a pair trade of long traditional defense stocks / short cyber stocks that returned 10%. It was a geopolitical variation on the “back to work” trades that characterized the revival of economic activity after pandemic lockdowns. Cyber stocks will enjoy a tailwind as long as the pandemic persists and working from home remains a major trend. But over the cyclical time frame defense stocks should rebound relative to their cyber peers, just as physical geopolitical tensions should begin to take on renewed urgency with nations scrambling for territory and resources (Chart 13). Chart 12Hold Onto The Good Ones: Long Natural Gas Hold Onto The Good Ones: Long Natural Gas Hold Onto The Good Ones: Long Natural Gas Chart 13The 'Back To War' Trade The 'Back To War' Trade The 'Back To War' Trade Chart 14Rare Earths Revived On Commodity Surge Rare Earths Revived On Commodity Surge Rare Earths Revived On Commodity Surge 5.  Long Rare Earth Metals. Geopolitical view correct, market view mixed. We have long maintained that rare earth metals would catch a bid as US-China tensions rose. The pandemic stimulus galvanized a new capex cycle with a focus on strategic goals like supply chain resilience, military-industrial upgrades, and de-carbonization that will boost demand for rare earths. Our trade made a 9% gain, despite difficulties throughout the year arising from our homemade BCA Rare Earth Basket, which proved to be an idiosyncratic instrument. Going forward we will express our view via the benchmark MVIS Rare Earth Index (Chart 14). Bottom Line: Our successful trades hinged on broad geopolitical views: China’s confluence of internal and external risk, Biden’s reflationary agenda, persistent US-Russia conflict, and India’s attractiveness relative to other emerging markets. The change in 2022 is that Biden’s legislative agenda will be spent so the market will shift from American reflation to the Fed and global concerns. If China does not stabilize its economy, more bad news will hit China-related plays and global risk assets. Honorable Mentions: For Better And For Worse Short EM “Strongmen.” Geopolitical view correct, market view mixed. We shorted the currencies of Turkey, Brazil, and the Philippines relative to benchmark EM currencies. Though we closed the trade too early, earning a paltry sum, the political analysis proved correct and the market ultimately responded in a major way (Chart 15). Upcoming elections for these countries in 2022-23 will ensure that their dysfunctional politics remain negative for investors, while other emerging market currencies continue to outperform. Chart 15Short EM 'Strongman' Leaders Short EM 'Strongman' Leaders Short EM 'Strongman' Leaders ¡Viva México! Geopolitical view correct, market view mixed. Mexico benefited from US stimulus, the USMCA trade deal, the West’s economic divorce from China, and the resumption of tourism, immigration, and remittances. In general Latin America stands aloof from the Great Power struggles afflicting emerging markets in Europe and East Asia. But Latin America’s perennial problem with domestic populism and political instability undermines US dollar returns. Mexico looks to be a notable exception. Chart 16¡Viva México! ¡Viva México! ¡Viva México! Mexico suffered the biggest opportunity cost from the West’s love affair with China over the past 40 years. Now it stands to gain from the US drive to relocate supply chains, onshore to North America, and diversify from China. Two of our Mexico trades were ill-timed this year, but favoring Mexico over other emerging markets, particularly Brazil, was fundamentally the right call (Chart 16). Bottom Line: Cyclically Mexico is an emerging market with a compelling story based on fundamentals. Tactically disfavor emerging market “strongmen” regimes. Investment Takeaways Our batting average this year was 65%. 2021 will be remembered as a transitional year in which the world tried but did not quite return to normal amid a lingering pandemic. Inflation reemerged as a major concern of consumers, governments, and central banks. Developed markets adopted proactive fiscal policy but global cyclicals faced crosswinds as China resumed its monetary, fiscal, and regulatory tightening campaign. Our bearish call on China was a direct hit. China’s political risks will persist ahead of the twentieth national party congress in fall 2022. Cyclically stay short CNY-USD and TWD-USD. Our worst market call was long Korean / short Taiwanese equities. But the world awoke to Taiwan risk and Taiwanese stocks peaked relative to global equities. Over the long run we think war is likely in the Taiwan Strait. Re-initiate long JPY-KRW as a strategic trade. Our best market call was long Indian / short Chinese equities. Tactically this trade will probably reverse but strategically we maintain the general thesis. The US and Iran failed to rejoin their nuclear deal this year as we originally expected. In August we adjusted our view to expect a short-term Persian Gulf crisis, which in turn will lead either to diplomacy or a new war path. Oil shocks and volatility should be expected over the next 12 months. Tactically go short UAE equities relative to global. European equities and the euro disappointed this year, even though we were right that Scotland would not secede from the UK, that Italian politics would not matter, and that Germany’s election would be an upset but not negative for markets. In March we turned neutral on the US dollar and in June we argued that European political risk had bottomed and would escalate going forward. We remain tactically negative on the euro, though we are cyclically constructive. We still prefer DM Europe over EM Europe due to Russian geopolitical risks. Re-initiate long CAD-RUB and long GBP-CZK as strategic trades. We are waiting for a tactical re-entry point for the following trades: long CHF-USD, CHF-GBP, GBP-EUR, short EM ‘Strongman’ currencies versus EM currencies, long US infrastructure stocks, long European industrials, and long Italian versus Spanish stocks.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1   While autocracy is agreed to be negative for governance indicators, the connection between regime type and economic growth is debatable. Suffice it to say that the determinants of total factor productivity, such as human capital, trade openness, and effectiveness of the legislature, are often difficult to sustain under autocratic or authoritarian regimes. On this point see United Nations Industrial Development Organization, "Determinants of total factor productivity: a literature review," Staff Working Paper 2 (2007). For further discussion, see Carl Henrik Knutsen, "A business case for democracy: regime type, growth, and growth volatility," Democratization 28 (2021), pp 1505-24; Ryan H. Murphy, "Governance and the dimensions of autocracy," Constitutional Political Economy 30 (2019), pp 131-48. For a skeptical view of the relationship, see Adam Przeworski and Fernando Limongi, "Political Regimes and Economic Growth," Journal of Economic Perspectives 7:3 (1993), pp 51-69.   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)