Global vs Domestic

Executive Summary Hopes of an imminent peace deal between Russia and Ukraine will be dashed. The conflict will worsen over the coming days. As was the case during the original Cold War, both sides will eventually forge an understanding that allows the pursuit of mutually beneficial arrangements. A stabilization in geopolitical relations, coupled with fading pandemic headwinds, should keep global growth above trend this year, helping to support corporate earnings. The era of hyperglobalization is over. While central banks will temper their plans to raise rates in the near term, increased spending on defense and energy independence will lead to higher interest rates down the road. How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis Bottom Line: The near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected.   Dear Client, Given the rapidly evolving situation in Ukraine, we are sending you our thoughts earlier than normal this week. We will continue to update you as events warrant it. Best regards, Peter Berezin Chief Global Strategist   False Dawn In the lead-up to the invasion, Vladimir Putin assumed that Ukrainian forces would fold just as quickly as US-backed Afghan forces did last summer. He also presumed that the rest of the world would reluctantly accept Russia’s takeover of Ukraine. Both assumptions appear to have been proven wrong. Even if Putin succeeds in installing a puppet government in Kyiv, a protracted insurgency is sure to follow. In the initial days of the invasion, Russian troops generally tried to avoid harming civilians, partly in the hope that Ukrainians would see the Russian military as liberators. Now that this hope has been dashed, a more brutal offensive could unfold. This would trigger even more sanctions, leading to a wider gulf between Russia and the West. It is highly doubtful that sanctions will dissuade Putin from trying to subdue Ukraine. Putin made a name for himself by staging a successful invasion of Chechnya in 1999, just three years after the Yeltsin government had suffered a major defeat there. To withdraw from Ukraine now, without having fomented a regime change in Kyiv, would be a humiliating outcome for him. In this light, BCA’s geopolitical team, led by Matt Gertken, has argued that ongoing peace talks taking place on the border of Ukraine and Belarus are unlikely to amount to much. The situation will get worse before it gets better. Market Implications It always feels a bit crass writing about finance during times like this, but as investment strategists, it is our job to do so. With that in mind, we would make the following observations: Global equities are likely to suffer another leg down in the near term as hopes of an imminent peace deal fizzle. Consequently, we are downgrading our view on global stocks from overweight to neutral on a 3-month horizon. Nimble investors with a low risk tolerance should consider going underweight equities. We are shifting our stance on US stocks from underweight to neutral on a 3-month horizon. Europe could face significant pressures from near-term disruptions to Russian gas supplies. It does not make much sense for Russia to export gas if it is effectively barred from accessing the proceeds of its sales. Central and Eastern Europe will be particularly hard hit (Chart 1). Chart 1Central and Eastern Europe Would Suffer The Most From A Russian Energy Blockade A New Cold War A New Cold War For now, we are maintaining an overweight to stocks on a 12-month horizon. While it will take a month or two, both sides will ultimately forge an understanding whereby Russia and the West continue to publicly bad-mouth each other while still pursuing mutually beneficial arrangements. Remember that during the Cold War, the Soviet Union continued to sell oil to the West. Even the Cuban Missile Crisis had only a fleeting impact on equities (Chart 2). Chart 2How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis Chart 3European Fiscal Policy Will Remain Structurally Looser Over The Coming Years A New Cold War A New Cold War Assuming that any reduction in Russian energy exports is temporary, oil prices will eventually recede. BCA’s commodities team, led by Bob Ryan, expects Brent to settle to $88/bbl by the end of 2022 (down from the current spot price of $101/bbl and close to the forward price of $87/bbl). Like oil, gold prices have upside in the near term but should edge lower once the dust settles.    Global growth should remain solidly above trend in 2022 as pandemic-related headwinds fade and fiscal policy turns more expansionary. Even before the Ukraine invasion, the structural primary budget deficit in Europe was set to swing from a small surplus to a deficit (Chart 3). The emerging new world order will lead to sizable additional military spending, as well as increased outlays towards achieving energy independence (new LNG terminals, more investment in renewables, and perhaps even some steps towards restarting nuclear power programs). China will also step up credit easing and fiscal stimulus. This will not only benefit the Chinese economy, but it will also provide some much-needed support to European exporters (Chart 4). While credit spreads are apt to widen further in the near term, corporate bonds should benefit from stronger growth later this year. US high-yield bonds are pricing in a jump in the default rate from 1.3% over the past 12 months to 4.2% over the coming year, which seems somewhat excessive (Chart 5).  Chart 4Chinese Policy Will Be A Tailwind For Growth Chinese Policy Will Be A Tailwind For Growth Chinese Policy Will Be A Tailwind For Growth Chart 5Credit Markets Are Pricing In An Excessive Default Rate Credit Markets Are Pricing In An Excessive Default Rate Credit Markets Are Pricing In An Excessive Default Rate Central banks will temper their plans to raise rates in the near term. Investors and speculators are net short duration at the moment, which could amplify any downward move in bond yields (Chart 6). However, over a multi-year horizon, recent events will lead to both higher inflation and interest rates. Larger budget deficits will sap global savings. The retreat from globalization will also put upward pressure on wages and prices. As defensive currencies, the US dollar and the Japanese yen will strengthen in the near term as the conflict in Ukraine escalates. Looking beyond the next few months, the dollar will weaken. On a purchasing power parity basis, the dollar is amongst the most expensive currencies (Chart 7). For example, relative to the euro, the dollar is 22% overvalued (Chart 8). The US trade deficit has doubled since the start of the pandemic, even as equity inflows have dipped (Chart 9). Speculators are long the greenback, which raises the risk of an eventual reversal in dollar sentiment. Chart 6Short Duration Is A Crowded Trade Short Duration Is A Crowded Trade Short Duration Is A Crowded Trade Chart 7The US Dollar Is Overvalued… A New Cold War A New Cold War   Chart 8...Especially Against The Euro A New Cold War A New Cold War The freezing of Russia’s foreign exchange reserves will encourage China to diversify away from US dollars towards hard assets such as land and infrastructure in economies where they are less likely to be seized. It will also encourage the Chinese authorities to bolster domestic demand and permit a further modest appreciation of the RMB since these two steps will reduce the current account surpluses that make foreign exchange accumulation necessary. EM currencies will benefit from this trend. Chart 9The Trade Deficit Is A Headwind For The Dollar The Trade Deficit Is A Headwind For The Dollar The Trade Deficit Is A Headwind For The Dollar In summary, the near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected. Trade Update: We closed our long Brent oil trade for a gain of 24% last week. Earlier today, we were stopped out of the trade we initiated on September 16, 2021 going long the Russian ruble and the Brazilian real. The BRL leg was up 6.2% at the time of termination while the RUB leg was down 23.1% (based on the Bloomberg RUB/USD Carry Return Index as of 4pm EST today). Peter Berezin Chief Global Strategist peterb@bcaresearch.com View Matrix A New Cold War A New Cold War Special Trade Recommendations A New Cold War A New Cold War Current MacroQuant Model Scores A New Cold War A New Cold War

Executive Summary Russian Invasion Scenarios And Likely Equity Impact Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree The Ukraine crisis is escalating as predicted. We maintain our odds: 65% limited incursion, 10% full-scale invasion, 25% diplomatic de-escalation. Russia says it will take “military-technical” measures as its demands remain unmet, while the US says an invasion is imminent. Fighting has picked up in the Donbas region. Our Ukraine decision tree highlights that the key to a last-minute diplomatic resolution is a western renunciation of defense cooperation with Ukraine after a verified Russian troop withdrawal. The opposite is occurring as we go to press. Stay long gold, defensives over cyclicals, and large caps over small caps. Stay long cyber security stocks and aerospace/defense stocks relative to the broad market. Trade Recommendation Inception Date Return LONG GOLD (STRATEGIC) 2019-12-06 27.6% Bottom Line: Our 75% subjective odds of a partial Russian re-invasion of Ukraine appear to be materializing. At the same time, we are not as optimistic about an imminent solution to the US-Iran nuclear problem. A near-term energy price spike is negative for global growth so we recommend sticking with our defensive tactical trades. Feature Chart 1Ukraine: Don't Be Complacent Ukraine: Don't Be Complacent Ukraine: Don't Be Complacent Fears about a heightened war in Ukraine fell back briefly this week before redoubling. Russian President Vladimir Putin showed a willingness to pursue diplomacy but then western officials refuted Russian claims that it was reducing troops around Ukraine. US President Biden said Russia is highly likely to invade Ukraine in the next few days. The Russian foreign ministry sent a letter reiterating Russia’s earlier threat that it will take unspecified “military-technical” actions given that its chief demands have not been met by the United States. A worsening security outlook as we go to press will push the dollar up against the euro, the euro up against the ruble, will lead to global equities falling (with US not falling as much as ex-US), and global bond yields falling (Chart 1). To assess the situation we need to weigh the signs of escalation against those of de-escalation. What were the signs of de-escalation? First, the Russian Defense Ministry claimed it is reducing troop levels near Ukraine, although NATO and the western powers have not verified any drawdown. An unspecified number of troops were said to return to their barracks in the Western and Southern Military Regions, according to Russian Defense Ministry spokesman General Igor Konashenkov. A video showed military units and hardware pulling back from Crimea. Officials claimed all troops would leave Belarus after military drills ended on February 20.1 Second, the Kremlin signaled that diplomacy has not been exhausted. In a video released to the public, Putin met with Foreign Minister Sergei Lavrov. He asked whether there was still a chance “to reach an agreement with our partners on key issues that cause our concern?” Lavrov replied, “there is always a chance.” Putin replied, “Okay.” Then, after speaking with German Chancellor Olaf Scholz in Moscow, Putin said: "We are ready to work further together. We are ready to go down the negotiations track.”2 Third, the Ukrainians are supposedly restarting efforts to implement the 2015 Russia-imposed ceasefire, under pressure from Germany and France. Ukraine’s ruling party is expected to introduce three bills to the Rada (parliament) that would result in implementing the terms of the Russian-imposed 2015 ceasefire, the so-called Minsk II Protocols. Ukraine is supposed to change its constitution to adopt a more federal system that grants autonomy to the two Russian separatist regions in the Donbas, Donetsk and Luhansk. Ukraine is also supposed to hold elections.3 The caveats to these three points are already clear: The US said Russia actually added 7,000 troops to the buildup on the Ukrainian border. Without Russia’s reducing troops, the US and its allies cannot offer major concessions. The US cannot allow itself to be blackmailed as that would encourage future hostage-taking and blackmail. Putin’s offer of talks is apparently separate from its “military-technical” response to the West’s failure to meet its three core demands on NATO. Russia’s three core demands are no further NATO enlargement, no intermediate-range missiles within threatening range, and withdrawal of NATO forces from eastern Europe to pre-1997 status. Putin reiterated that these three demands are inseparable from any negotiation and that Russia will not engage endlessly without resolution. Yet the West has consistently rejected these demands. Then came the Foreign Ministry statement pledging Russia’s military-technical response. So talks that focus on other issues – like missile defense and military transparency – are a sideshow. Ukraine is reiterating its desire to join NATO and will struggle to implement the Minsk Protocol. The Minsk format is not popular in Ukraine as it grants influence and recognition to the breakaway ethnic Russian regions. Ostensibly President Volodymyr Zelenskiy has sufficient strength in the Rada to change the constitution, given the possibility of assistance from opposition parties that oppose war or favor Russia. But passage or implementation could fail. The Russian Duma has also advised Putin to recognize the Donetsk and Luhansk People’s Republics as independent countries, which Putin is not yet ready to do, but could do if Ukraine balks, and would nullify the Minsk format.4 Of Russia’s three core demands, investors should bear in mind the following points: Ukraine is never going to join NATO. One of the thirty NATO members will veto its membership to prevent war with Russia. Therefore Russia is either making this demand knowing it will fail to justify military action, or driving at something else, such as NATO defense cooperation with Ukraine. Even if NATO membership is practically unrealistic, the US and NATO are providing Ukraine with arms and training, making it a de facto member. The quality and quantity of western defense cooperation is not sufficient to threaten Russia’s military balance so far but it could grow over time and Russia is insisting that it stop. While there is also a broader negotiation over Europe’s entire security system, immediate progress depends on whether the US and its allies stop trying to turn Ukraine into a de facto NATO ally. NATO is not going to sacrifice all of the strategic, territorial, and military-logistical gains it has made since 1997. Especially not when Russia is attempting to achieve such a dramatic pullback by military blackmail. But NATO could reduce some of the most threatening aspects of its stance if Russia reciprocates and there is more military transparency. Similarly, the US and Russia have a track record of negotiating missile defense deals so this kind of agreement is possible over time. The problem, again, hinges on whether agreement can be found over Ukraine. The opposite looks to be the case. Based on the above points, Diagram 1 provides a “Decision Tree” that outlines the various courses of action, our subjective probabilities, and the sum of the conditional probabilities for each final scenario. Diagram 1Russia-Ukraine Decision Tree, February 9, 2022 Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree We start with the view that there is a 55% chance that the status quo continues: the West will not rule out Ukraine’s right to join NATO and will not halt defense cooperation. If this is true, then the new round of talks will fail because Russia’s core security interests will not be met. However, we also give a 25% chance to the scenario in which Ukraine is effectively barred from NATO but not defense cooperation. This may be the emerging scenario, given Chancellor Scholz’s point that Ukrainian NATO membership is not on the agenda and the White House’s claim that it will not pressure states to join NATO. Basically, western leaders could provide informal assurances that Ukraine will never join. But then the matter of defense cooperation must be resolved in the next round of talks. Given that the US and others have increased arms transfers to Ukraine in recent months and years (with US providing lethal arms for the first time in 2018), it seems more likely (60/40) that they will continue with arms transfers. After all, if they halt arms, Russia can invade anyway, but Ukraine will have less ability to resist. We allot a 15% chance to a scenario in which the US and its allies halt defense cooperation, even if they officially maintain NATO’s “open door” policy. If the Russians withdraw troops in this scenario, then a lasting reduction of tensions will occur. Again, while allied defense cooperation has been limited so far, it is up to Russia whether it poses a long-term threat. Finally, we give a 5% chance that the US and NATO will bar Ukraine from membership and halt defense cooperation. This path would mark a total capitulation to Russia’s demands. So far the allies have done nothing like this. They have insisted on NATO’s open door policy and have continued to transfer arms. No one should be surprised that tensions are escalating. De-escalation could still conceivably occur if Russia verifiably withdraws troops, if Ukraine moves to implement the Minsk II protocol, and if the US and its allies pledge to halt defense cooperation with Ukraine. The first step is for Russia to reduce troops, since that enables the US and allies to make major concessions when they are not under duress. If the US and NATO guarantee they will halt defense cooperation, given that Ukraine is practically unlikely to join NATO, then Russia may not be as concerned with Ukraine’s implementation of Minsk. As we go to press, none of these conditions are falling into place. The security situation is deteriorating rapidly. Bottom Line: Russia is likely to stage a limited military intervention into Ukraine (75%). The odds of a diplomatic resolution at the last minute are the same (25%). A full-scale invasion of all of Ukraine remains unlikely (10%). Market Reaction To Re-Escalation Chart 2 highlights the global equity market response to the Russian invasion of Crimea in 2014, which should serve as the baseline for assessing the market reaction to any renewed attack today. Stocks fell and moved sideways relative to bonds for several months, cyclicals (except energy) underperformed defensives, small caps briefly rose then collapsed against large caps, and value stocks rose relative to growth stocks. The takeaway was to stay invested over the cyclical time frame, prefer large caps, and prefer value. The difference today is that cyclicals and small caps are already performing worse against defensives and large caps than in 2014, while value has vastly outstripped growth (Chart 3). The implication is that once war breaks out, cyclicals and small caps have less room to fall whereas value has limited near-term upside. Chart 2Market Response To Crimea Invasion, 2014 Market Response To Crimea Invasion, 2014 Market Response To Crimea Invasion, 2014 ​​​​​​ Chart 3Market Response 2022 Versus 2014 Market Response 2022 Versus 2014 Market Response 2022 Versus 2014 ​​​​​​ If we look closely at global equity gyrations over the past week – when the Ukraine story moved to front and center – we see that stocks are falling relative to bonds, cyclicals are flat relative to defensives, small caps are rising relative to large caps, and value is flat relative to growth but may have peaked (Chart 4). In the short term the geopolitical dynamic will move markets so we expect cyclicals, small caps, and value to underperform. Commodity prices and the energy sector are initially benefiting from tensions as expected – oil prices and energy equities spiked amid the tensions (Chart 5). But assuming war materializes, Russia will at least cut off natural gas flowing through Ukraine, cutting off about 20% of Europe’s natural gas supply and triggering a bigger price shock. Ultimately, however, this price shock will incentivize production, destroy global demand, and drive energy prices down. Chart 4Global Equities Just Woke Up To Ukraine Global Equities Just Woke Up To Ukraine Global Equities Just Woke Up To Ukraine ​​​​​​ Chart 5Global Energy Sector Just Woke Up To Ukraine Global Energy Sector Just Woke Up To Ukraine Global Energy Sector Just Woke Up To Ukraine ​​​​​ Thus we expect energy price volatility. Russia will keep shipping energy to Europe to finance its military adventures. Europe will be loath to slap sanctions on critical energy supplies, assuming Russia’s military action is limited. The Saudis may or may not increase production to prevent demand destruction – in past Russian invasions they have actually reduced production once prices started to fall. A temporary US-Iran nuclear deal could release Iranian oil to the market, though that is not what we expect in the short run (discussed below). Bottom Line: Tactically investors should favor bonds over stocks, the US dollar and US equities over global currencies and equities (especially European), defensive sectors over cyclicals, large caps over small caps, and growth over value stocks. Is Ukraine Already Priced? Not Yet. Chart 6Crisis Events And Peak-To-Trough Market Drawdown Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree The peak-to-trough equity drawdown – in geopolitical crises that are comparable to a Russian invasion of Ukraine – range from 11%-14% going back to 1931. The following research findings are derived from a list of select events, from the Japanese invasion of China to the German invasion of Poland to lesser invasions, all the way down to Russia’s seizure of Crimea in 2014. We used the S&P 500 as it is the most representative stock index over this long period of time. The fully updated and broader list of geopolitical crises can be found in Appendix 1. Geopolitical crises tend to trigger an average 10% equity decline, smaller than economic crises or major terrorist attacks (Chart 6). The biggest geopolitical shocks to the equity market occur when an event is a truly global event, as opposed to regional shocks. Interestingly Europe-only shocks have seen some of the smallest average drawdowns at around 8% (Chart 7). An expanded Ukraine war would be limited to Europe. The average equity selloff is largest, at 14%, if both the US and its allies are directly involved in the geopolitical event. But the range is 11%-14% regardless of whether the US or its allies are involved (Chart 8). Ukraine is not an official ally, which is one reason the markets will tend to play down a larger war there. However, the market is underrating the fact that Ukraine’s neighbors are NATO members and will have a powerful interest in supporting the Ukrainian militant insurgency, which could lead to unexpected conflicts that involve NATO member-state’s citizens. Chart 7Geopolitical Crises And Markets: Where Is The Crisis? Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree ​​​​​​ Chart 8Geopolitical Crises And Markets: Who Are The Players? Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree ​​​​​​ Chart 9Russian Invasion Scenarios And Likely Equity Impact Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree The Russians have as many as 150,000 troops on the border with Ukraine, according to President Biden’s latest speech. The Ukrainian active military numbers 215,000. This ratio is not at all favorable for a full-scale invasion. The Russians are contemplating a limited action directed at teaching Ukraine a lesson or encroaching further onto Ukrainian territory, especially coastal territory. History suggests that a limited incursion will produce a 10% total equity drawdown, whereas a full-scale invasion would produce 13% or more (Chart 9). Still, investors should view 11%-14% as the appropriate range for a geopolitically induced crisis. The S&P has fallen by 9% since its peak on January 3, 2022. But Russia has not invaded yet. If war breaks out, there is more downside, given high uncertainty. Markets could still be surprised by the initial force of any Russian military action. The US will impose sweeping sanctions immediately. The Europeans will modify their sanctions according to Russia’s actions, a key source of uncertainty. If a diplomatic resolution is confirmed – with Russia withdrawing troops and the US and its allies cutting defense cooperation with Ukraine – then the market may continue to rally. However, there are other reasons to be cautious: especially inflation and monetary policy normalization, with the Federal Reserve potentially lifting rates by 50 basis points in March. Bottom Line: Stocks can fall further given that investors do not yet know the magnitude of the Russian military action or the US and European sanctions response. However, a buying opportunity is around the corner once this significant source of global uncertainty is clarified. New Iran Deal Is Neither Guaranteed Nor Durable A short note is necessary on the situation with Iran, another major risk this year, which falls under our third 2022 key view: oil-producing states gain geopolitical leverage. The implication is that the Iran risk will not be resolved quickly or easily. The global economy could suffer a double whammy of energy supply shock from Ukraine and energy supply risk in the Middle East this year. The US-Russia showdown is connected to the US-Iran nuclear negotiation. Russia took Crimea in 2014 in part because it saw an opportunity to exact a price from the United States, which sought Russia’s assistance in negotiating the 2015 nuclear deal with Iran. Today a similar dynamic is playing out, in which Russian diplomats cooperate on Iranian talks while encroaching on Ukraine. The Russians do not have an interest in Iran achieving a deliverable nuclear weapon and thus will offer some limited cooperation to this end. Their pound of flesh is Ukraine. According to media reports, the Iranian negotiations have seen some positive developments over the past month. US interest in rejoining the 2015 deal: The Biden administration has an interest in preventing Iran from reaching “breakout” levels of uranium enrichment and triggering a conflict in the region that would drive up oil prices ahead of the midterm election. It is going to be hard for Biden to remove sanctions in the context of Russian aggression but it is likely he would do it if the Iranians recommit to complying with the 2015 restrictions on their nuclear program. Iranian interest in rejoining the 2015 deal: The Iranians have an interest in convincing President Biden to remove sanctions to improve their economy and reduce the risk of social unrest. They are demanding the removal of all sanctions, not only those levied by President Trump. They also know that rejoining the 2015 deal itself is not so bad, since it starts expiring in 2025 and does not limit their missile production or support of militant proxies in the region. However, note that the Iranian regime has suppressed domestic instability since Trump’s “maximum pressure” sanctions, and the economy is improving on oil prices, so the threat of social unrest is not forcing Iran to accept a deal today. Also note that Iran is making demands that cannot be met: Iranian Foreign Minister Hossein Amirabdollahian is asking the US to provide guarantees that the US will not renege on the deal again, for example if the Republicans return to the White House in 2025. President Biden cannot provide these guarantees. The voting margins are too thin for a “political statement,” promising that the US will not renege on a deal, to pass Congress. While House Speaker Nancy Pelosi might be willing to provide such a statement to the Iranians, Senate Majority Leader Chuck Schumer probably will not – he opposed the originally 2015 deal. Even if Congress gave Iran guarantees, the fact remains that the GOP could win the White House in 2025, so the current, hawkish Iranian leadership cannot be satisfied on this front. Furthermore, even if Biden pulls back sanctions and Iran complies with the 2015 deal for a brief reprieve, Iran’s underlying interest is to obtain a deliverable nuclear weapon to achieve regime survival in the future. Iran faces a clear distinction between Ukraine, which gave up nukes and is now being dismembered (like Libya and Iraq), and North Korea, which now has a deliverable nuclear arsenal and commands respect from the US on the national stage. Moreover if the Republicans take back power in 2025, Iran will want to have achieved or be close to achieving a deliverable nuclear weapon. The Biden administration is weak at home and facing a crisis with Russia, which may present a window of opportunity for Iran to make a dash for the nuclear deterrent. Still, we acknowledge the short-term risk to our pessimistic view: It is possible that Iran will rejoin the deal to gain sanctions relief. In this case about 1-1.2 million barrels per day of Iranian crude will hit the global market. The implication, depending on the size of the energy shock, is that Brent crude prices will fall back to the $80 per barrel average that our Commodity & Energy Strategy expects. We also agree with our Commodity & Energy Strategist that global oil production will pick up in the face of supply risks that threaten to destroy demand. Bottom Line: We doubt Iran will rejoin the 2015 nuclear deal quickly. We expect energy prices to continue spiking in the short term due to Ukraine and any setbacks in the Iran negotiations. Yet we also expect oil producers around the world to increase production, which will sow the seeds for an oil price drop. Our tactical trade recommendations rest on falling oil prices and bond yields in the short run. Investment Takeaways Stay long gold. Stay long global defensive equity sectors over cyclicals. Favor global large caps over small caps. Stay long cyber security stocks and aerospace/defense stocks relative to the broad market. Stay long Japanese industrials relative to German and long yen. Stay long British stocks relative to other developed markets excluding the US, and long GBP-CZK. Favor Latin American equities within emerging markets, namely Mexican stocks and Brazilian financials relative to Indian stocks.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      See "Russia Announces Troop Withdrawal," Russia Today, February 15, 2022, rt.com; "Ukraine crisis: Russian claim of troop withdrawal false, says US," BBC, February 17, 2022, bbc.com. 2     David M. Herszenhorn, “On stage at the Kremlin: Putin and Lavrov’s de-escalation dance,” Politico, February 14, 2022, politico.eu. 3     "Scholz says Zelensky promised to submit bills on Donbass to Contact Group," Tass, February 15, 2022, tass.com; "Scholz in Kyiv confirms Germany won’t arm Ukraine, stays mum on Nord Stream 2," February 15, 2022, euromaidanpress.com. 4     "Kiev makes no secret Minsk-2 is not on its agenda — Russian Foreign Ministry," Tass, February 17, 2022, tass.com; Felix Light, "Russian Parliament Backs Plan To Recognize Breakaway Ukrainian Regions," Moscow Times, February 15, 2022, themoscowtimes.com. Appendix 1: Geopolitical Events And Equity Market Impact Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Executive Summary The Pandemic-Led Surge In E-Commerce Spending Is Reverting Back To Trend The Pandemic-Led Surge In E-Commerce Spending Is Reverting Back To Trend The Pandemic-Led Surge In E-Commerce Spending Is Reverting Back To Trend Rising interest rates and a cooling in pandemic-related tech spending will cap the upside for technology shares over the remainder of 2022. Looking further out, US big tech companies are likely to suffer from heightened competition in increasingly saturated markets. Concerns about big tech’s excessive market power, cavalier attitudes towards personal data, proclivity for censoring non-establishment opinions, and the deleterious impact of social media on teenage mental health are all fueling a public backlash. Investors should expect increased regulation and antitrust enforcement of big tech companies in the years ahead. Bottom Line: The hegemony of today’s US-based big tech companies is coming to an end. While we do not expect tech stocks to decline in absolute terms in 2022, they will lag the S&P 500. Given tech’s heavy representation in the US, investors should underweight the US in a global equity portfolio. Sinking Ark Tech stocks have had a tough ride since the start of the year. So far in 2022, the NASDAQ Composite has fallen 9.3% compared to 5.5% for the S&P 500. The ARK Innovation ETF, Cathie Wood’s collection of “disruptor” companies, has dropped -22%, and is now down -53% from its peak last year (Chart 1). We expect tech shares to lag the market during the remainder of 2022. The pandemic was a boon for many tech companies. Generous stimulus payments and stay-at-home policies led to a surge in e-commerce spending (Chart 2). As economies continue to reopen, many tech companies could face an air pocket in demand for their goods and services.  Chart 1Tech Stocks: Rough Start to 2022 Tech Stocks: Rough Start to 2022 Tech Stocks: Rough Start to 2022 Chart 2The Pandemic-Led Surge In E-Commerce Spending Is Reverting Back To Trend The Pandemic-Led Surge In E-Commerce Spending Is Reverting Back To Trend The Pandemic-Led Surge In E-Commerce Spending Is Reverting Back To Trend   Despite some softening of late, retail sales remain well above their pre-pandemic trendline (Chart 3). If Amazon’s still-rosy projections are any guide, a further slowdown in goods spending is something that the analyst community is not fully discounting (Chart 4). Chart 3US Retail Spending Is Above Trend US Retail Spending Is Above Trend US Retail Spending Is Above Trend Chart 4Amazon Sales Estimates May Be Too Optimistic Amazon Sales Estimates May Be Too Optimistic Amazon Sales Estimates May Be Too Optimistic Rate Hikes Will Disproportionately Hit Tech Chart 5Long Rates Anticipate The Movements In Short Rates Long Rates Anticipate The Movements In Short Rates Long Rates Anticipate The Movements In Short Rates US rate expectations continued to move up this week, egged on by St. Louis Fed President James Bullard’s statement earlier today declaring that he favors raising interest rates by a full percentage point by the start of July. The market is now pricing in six rate hikes by the end of the year.  Historically, bond yields have increased starting about four months before the first rate hike and over the period in which the Fed is raising rates (Chart 5). While we do not think the Fed will need to deliver more tightening this year than what is already discounted, we do think that investors will eventually be forced to revise up their expectations of the neutral rate to between 3%-and-4%. As Chart 6 shows, the market expects the Fed to stop raising rates when they reach 2%, which we regard as unrealistic. Chart 6The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% The Disruptor Delusion The Disruptor Delusion An increase in the market’s estimate of the neutral rate will push up bond yields. Unlike banks, tech tends to underperform in a rising yield environment (Chart 7). Priced For Perfection? Higher bond yields and a reversion-to-trend in tech spending would be less of a problem for technology shares if valuations were cheap. They are not, however. The Nasdaq Composite still trades at 29-times forward earnings compared to 20-times forward earnings for the broader S&P 500 (Chart 8). Chart 8Tech Shares Are No Bargain Tech Shares Are No Bargain Tech Shares Are No Bargain Chart 7Rising Bond Yields Will Help Bank Stocks But Hurt Tech Shares Rising Bond Yields Will Help Bank Stocks But Hurt Tech Shares Rising Bond Yields Will Help Bank Stocks But Hurt Tech Shares Tech investors would argue that such a hefty valuation premium is warranted given the tech sector’s superior growth prospects. Underlying this argument is the assumption that just because tech spending will grow more quickly than the rest of the economy, this will necessarily translate into above-average earnings growth and outsized returns for publicly-listed tech companies. But is that really the case? Over short horizons of a few years, there is a decent correlation between relative industry growth and relative equity returns (Chart 9). However, that relationship evaporates over very long-term horizons (Chart 10). In fact, since 1970, the best-performing equity sector has been tobacco, hardly a paragon of technological innovation (Chart 11). Chart 9Stocks In Industries That Experience A Burst Of Output Growth Do Tend To Outperform Other Stocks … The Disruptor Delusion The Disruptor Delusion Chart 10… But Over The Long Haul, Companies In Fast- Growing Industries Do Not Outperform Their Peers The Disruptor Delusion The Disruptor Delusion Chart 11Tobacco Industry Returns Have Smoked All Others The Disruptor Delusion The Disruptor Delusion What Goes Around Comes Around Table 1History Shows Leaders Can Become Laggards The Disruptor Delusion The Disruptor Delusion Tech stock enthusiasts tend to forget that the disruptors themselves can be disrupted. History is littered with tech companies that failed to keep up with a changing world: RCA, Kodak, Polaroid, Atari, Commodore, Novell, Digital, Sinclair, Wang, Iomega, Corel, Netscape, AltaVista, AOL, Myspace, Compaq, Sun, Lucent, 3Com, Nokia, Palm, and RIM were all major players in their respective industries, only to fade into oblivion. Table 1 shows that all but one of the ten biggest tech names in the S&P 500 IT index in 2000 underperformed the broader market by a substantial degree over the subsequent ten years. Today, the incentive for startups to emerge has never been stronger. Venture capital funds are flush with cash. Tech profit margins are near record highs, making challenging the incumbents an increasingly enticing goal. About one-third of the outperformance of US tech stocks since 1996 can be explained by rising relative profit margins, with faster sales growth and relative P/E multiple expansion explaining 45% and 23% of the remainder, respectively (Chart 12). Chart 12Decomposing Tech Outperformance The Disruptor Delusion The Disruptor Delusion Meta’s Malaise Chart 13Unlike Economists, Facebook Just Ain't Cool No More The Disruptor Delusion The Disruptor Delusion Which of today’s tech titans could join the “has been club”?  As we flagged in August, Meta is certainly a possibility. In its disastrous quarterly earnings report, the company revealed that globally, the number of Facebook users is shrinking for the first time ever. While this came as a surprise to many investors, the writing has been on the wall for a long time. According to Piper Sandler’s survey of teen preferences conducted late last year, only 27% of teenagers used Facebook, down from 94% in 2012 (Chart 13). Meta has been fortunate in that many Facebook users have migrated to Instagram, a social media platform it acquired in 2012. Unfortunately, the latest data suggests that even Instagram usage is starting to slow as more young people flock to TikTok. Google Also Vulnerable Unlike Meta, Alphabet crushed earnings estimates. However, the similarities between the two companies may be greater than most investors are willing to admit. Like Facebook, Google’s profits almost entirely come from ad spending. According to eMarketer, Google garnered 44% of digital ad spending in 2021 while Facebook took in 23%. Digital advertising accounted for 63% of all ad spending in 2021, up from 58% in 2020 and 51% in 2019. While there may be scope for digital ads to take further market share,  eventually, growth in digital ad spending will converge with overall consumption growth, which in the US is likely to average no more than 2% in real terms over time. Monopoly Power Another important similarity between Meta and Alphabet is that both companies are increasingly coming under scrutiny from politicians and regulators. The antitrust case brought against Alphabet by 14 US states contains a litany of allegations of unfair practices. After an initial failed attempt, the Federal Trade Commission’s antitrust suit against Meta is also moving forward. Privacy Matters In addition, the way big tech companies handle private data is raising some hackles. In its annual report filed earlier this month, Meta warned that it would need to shut down Facebook and Instagram in Europe unless regulators drew up new privacy regulations. This came on top of Meta’s disclosure that it will lose $10 billion this year after Apple introduced pop-ups on the iPhone’s operating system asking users if they wanted to be tracked by apps.  Turn Off That Phone! Another looming worry revolves around the corrosive impact of excessive social media usage on mental health. Academic studies have shown that adolescents who use Facebook and Instagram frequently feel greater anxiety and unease than those who do not. The share of students reporting high levels of loneliness more than doubled in both the US and abroad over the past decade, a trend that predates the pandemic (Chart 14). In 2020, the last year for which comprehensive data is available, one-quarter of US girls between the ages of 12 and 17 reported experiencing a major depressive episode, up from 12% in 2011 (Chart 15). Chart 15The Rise In Depression Rates Coincided With Increased Social Media Usage The Disruptor Delusion The Disruptor Delusion Chart 14Alone In The Crowd The Disruptor Delusion The Disruptor Delusion     Backlash Public contempt for tech companies is fueling a political backlash. According to a Gallup poll conducted last year, only 34% of Americans held a favorable view of tech companies such as Amazon, Facebook, and Google, down from 46% in 2019; 45% had an unfavorable opinion, up from 33% in 2019 (Chart 16). Chart 16Americans Do Not Hold Tech Companies In High Regard The Disruptor Delusion The Disruptor Delusion The shift in public sentiment over the past two years has been entirely driven by Independent and Republican voters, many of whom feel that tech companies are unfairly censoring their opinions (Table 2). The same poll revealed that the majority of Americans – including the majority of Republicans – now favor increased regulation of tech companies.  Table 2American Views On Big Tech The Disruptor Delusion The Disruptor Delusion Investment Conclusions Chart 17Value Stocks Are Cheap Value Stocks Are Cheap Value Stocks Are Cheap Considering that global growth is likely to remain above-trend this year, we do not expect tech stocks to decline in absolute terms. A flattish, though volatile, trajectory is the most plausible outcome. In relative terms, however, tech stocks will underperform. Despite having outperformed tech-heavy growth stocks by 14% since last November, value stocks remain exceptionally cheap by historic standards (Chart 17). Tech stocks are overrepresented in the US. Thus, if tech continues to underperform, it stands to reason that non-US equities will outperform their US peers over the coming years.    Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix The Disruptor Delusion The Disruptor Delusion Special Trade Recommendations Current MacroQuant Model Scores The Disruptor Delusion The Disruptor Delusion

Executive Summary Brazil: Are Political & Macro Risks Priced-In? Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Presidential elections are due in Brazil on October 2, 2022. While the left-of-center former President Lula da Silva will likely win, the road to his victory will not be as smooth as markets expect. Incumbent President Jair Bolsonaro will make every effort to cling to power, including fiscal populism and attacks on Brazil’s institutions. These moves may roil Brazil’s equity markets as they may provide a fillip to Bolsonaro’s popularity. Bolsonaro’s institutional attacks have triggered down moves in the market before and any fiscal expansion may worry investors as it could prove to be sticky. We urge investors to take-on only selective tactical exposure in Brazil. Equities appear cheap but political and macro risks abound. To play the rally yet stave-off political risk in Brazil, we suggest a tactical pair trade: Long Brazil Financials / Short India. Tactical Recommendation Inception Date Long Brazil Financials / Short India 2022-02-10   Bottom Line: On a tactical timeframe we suggest only selective exposure to Brazil given the latent political and macro risks. On a strategic timeframe, we are neutral on Brazil given that its growth potential coexists with high debt and low proclivity to structural reform. Feature Chart 1Brazil Underperformed Through 2020-21, Is Cheap Today Brazil Underperformed Through 2020-21, Is Cheap Today Brazil Underperformed Through 2020-21, Is Cheap Today Brazil’s equity markets underperformed relative to emerging markets (EMs) for a second consecutive year in 2021 (Chart 1). But thanks to this correction, Brazilian equities now appear cheap (Chart 1). With Brazil looking cheap, China easing policy, and Lula’s return likely, is now a good time to buy into Brazil? We recommend taking on only selective exposure to Brazil on a tactical horizon for now. Brazil in our view may present a near-term value trap as markets are under-pricing political and economic risks. Lula Set For Phoenix-Like Return Luiz Inácio Lula da Silva (or popularly Lula) of the Worker’s Party (PT) appears all set to reclaim the country’s presidency in the fall of 2022. The main risk that Lula’s presidency may bring is a degree of fiscal expansion. Despite this markets may ultimately welcome his victory at the presidential elections as Lula is in alignment with the median voter, is expected to be better for Brazil’s institutions, will institute a superior pandemic-control strategy, and may also undertake badly needed structural reforms in the early part of his tenure. Despite these points we urge investors to limit exposure to Brazil for now and turn bullish only once the market corrects further. Whilst far-right President Jair Bolsonaro managed to join a political party (i.e., the center-right Liberal Party) late last year, he is yet to secure something more central to winning elections i.e., a high degree of popularity. To boost his low popularity ratings (Chart 2), we expect Bolsonaro to leverage two planks: populism and authoritarianism. These measures will bump up Bolsonaro’s popularity enough to shake up Brazil’s markets with renewed uncertainty, but not enough to win him the presidency. Chart 2Lula Is Ahead But His Lead Has Narrowed Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Lula is a clear favorite to win. After spending more than a year in jail on corruption charges, Lula is back in the fray and has maintained a lead on Bolsonaro for the first round of polling (Chart 2). Even if a second-round run-off election were to take place, Lula would prevail over Bolsonaro or other key candidates (Chart 3). By contrast, Bolsonaro’s lower popularity means that in a run-off situation he stands a chance only if pitted against center-right candidates like Sergio Moro (his former justice minister) or João Doria (i.e., the center-right Governor of São Paulo) (Chart 4). Chart 3Lula Leads Run-Off Vote Against All Potential Candidates Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 4In A Run-Off, Bolso Stands Best Chance Of Winning If Pitted Against Moro Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ What has driven the swing to the left in Brazil? After the pandemic and some stagflation, Brazil’s median voter’s priorities have changed. In specific: Brazil’s median voter’s top concerns in 2018 were centered around improving law and order (Chart 5). A right-of-center candidate with concrete law-and-order credentials like Bolsonaro was well placed to tap into this public demand. Chart 5In 2018-19, Law And Order Issues Dominated Voters’ Concerns Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Now, however, Brazil’s voters’ top concerns are focused around improving the economy and controlling the pandemic, where Bolsonaro’s record is dismal (Chart 6). Given this change of priorities, a left-of-center candidate with a solid economic record like Lula is best placed to address voters’ concerns. Lula had the fortune to preside over a global commodity bull market and Brazilian economic boom in the early 2000s (Chart 7). Regarding pandemic control, almost any challenger would be better positioned than Bolsonaro, who initially dismissed Covid-19 as “a little flu” and lacked the will or ability to set up a stable public health policy. Chart 6In 2022, Median Voter Cares Most About Economic Issues, Pandemic-Control Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 7Lula’s Presidency Overlapped With An Economic Boom Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ A left-of-center candidate like Lula, or even Ciro Gomes (Chart 8), is more in step with the median voter today for two key reasons: Inflation Surge, Few Jobs: Inflation has surged, and the increase is higher than that seen under the previous President Michael Temer (Chart 7). Transportation, food, and housing costs have all taken a toll on voter’s pocketbooks (Chart 9). The cost of electricity has also shot up. For 46% of Brazilian families, expenditure on power and natural gas is eating into more than half of their monthly income, according to Ipec. Chart 8Left-Of-Center Candidates Stand A Better Chance In Brazil In 2022 Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 9Under Bolso Inflation Has Surged Across Key Categories Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​ Distinct from inflation, unemployment too has been high under Bolsonaro (Chart 10). Chart 10Unemployment Too Has Surged Under Bolsonaro Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 11Brazil’s Per Capita Income Growth Has Lagged That Of Peers Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 12Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Stagnant Incomes: Despite a strong post-pandemic fiscal stimulus, GDP growth in Brazil has been low (Chart 7). In a country that is structurally plagued with high inequalities, the slow growth in Brazil’s per capita income (Chart 11) under a right-wing administration is bound to trigger a leftward shift. It is against this backdrop of rising economic miseries (Chart 12) that Latin America’s largest economy is seeing its ideological pendulum swing leftwards. This phenomenon has played out before too - most notably when Lula first assumed power as the president of Brazil in 2002. Brazil’s GDP growth was low, inflation was high and per capita incomes had almost halved under the presidency of Fernando Henrique Cardoso (or popularly FHC) over 1995-2002. This economic backdrop played a key role in Lula’s landslide win in 2002. Brazil’s political differences are rooted in regional as well as socioeconomic disparities. In the 2018 presidential elections, left-of-center candidates like Fernando Haddad generated greatest traction in the economically backward northeastern region of Brazil. On the other hand, Bolsonaro enjoyed higher traction in the relatively well-off regions in southern and northern Brazil (Maps 1 & 2). Now Bolsonaro has faltered under the pandemic and Lula can reunite the dissatisfied parts of the electorate with his northeastern base. Map 1Brazil’s South, Mid-West And North Supported Bolso In 2018 Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Map 2Left-Of-Center 2018 Presidential Candidate Haddad Had Greatest Traction In Regions With Low Incomes Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Bottom Line: The stage appears set for Lula’s return to Brazil’s presidency. But will the road be smooth? We think not. Investors should gird for downside risks that Brazilian markets must contend with as President Bolsonaro fights back. Brace For Bolso’s Fightback The road to Bolsonaro’s likely loss will be paved with market volatility and potentially a correction. Interest rates have surged in Brazil as its central bank combats inflation (Chart 13). Even as BCB’s actions will lend some stability to the Brazilian Real (Chart 13), political events over the course of 2022 will spook foreign investors. Bolsonaro will leverage two planks in a desperate attempt to retain control: Plank #1: Populism Brazil’s financial markets experienced a major correction in the second half of 2021. This was partially driven by the fact that Brazilian legislators approved a rule that allows the government to breach its federal spending cap. Given Bolsonaro’s low popularity ratings today and given that his fiscal stance has been restrained off late, Bolsonaro could well drive another bout of fiscal expansion in the run up to October 2022. Such a move will bump up his popularity but at the same time worry markets given Brazil’s elevated debt levels (Chart 14). Bolsonaro can technically pass these changes in the Brazilian national assembly given that in both houses the government along with the confidence and supply parties has more than 50% of seats. Chart 13Brazil’s Central Bank Has Hiked Rates Aggressively Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Chart 14Brazil Is One Of The Most Indebted Emerging Markets Today Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​​ Plank #2: Institutional Attacks To rally his supporters, the former army captain could also sow seeds of doubt in Brazil’s judiciary and electoral process. Given the strong support that Bolsonaro enjoys amongst conservatives, he may even mobilize supporters to stage acts of political violence in the run up to the elections. Bolsonaro could make more dramatic attempts to stay in power than former US President Trump, whose rebellion on Capitol Hill did not go as far as it could have gone to attempt to seize power for the outgoing president. Last but not the least, there is a possibility that the Brazilian judiciary presents an unexpected roadblock to Lula’s candidacy. Given the unpredictable path of Brazil’s judicial decisions, investors should be prepared for at least some kind of official impediments to Lula’s rise. Even if Lula is ultimately allowed to run, any ruling that casts doubt on his candidacy or corruption-related track record will upset financial markets. Global financial markets rallied through the Trump rebellion on January 6 last year. But US institutions, however flawed, are more stable than Brazil’s. Brazil only emerged from military dictatorship in 1985. Bolsonaro has fired up elements of the populace that are nostalgic for that period, as we discuss below. Bottom Line: Brazil’s equities look cheap today, but political risks have not fully run their course. President Bolsonaro may launch his fightback soon, which could drive another down-leg in Brazil’s markets. His institutional attacks have triggered down moves before and any potential fiscal expansion that Bolsonaro pursues may worry investors, as this expansion could stick under the subsequent administration. In addition, there is a chance that civil-military relations undergo high strain in the run-up to or immediately after Brazil’s elections. Is A Self-Coup By Bolso Possible? “One uncomfortable fact of the dictatorship is that its most brutal period of repression overlapped with what Milton Friedman called an economic miracle.… Brazil’s economy, nineteenth largest in the world before the coup, grew into the eighth largest. Jobs abounded and the regime then was actually popular.” – Alex Cuadros, Brazillionaires: Wealth, Power, Decadence, and Hope in an American Country (Spiegel & Grau, 2016) It is extremely difficult for President Bolsonaro to win the support of a majority of the electorate. But given his open admiration for Brazil’s dictatorship, is a self-coup possible in 2022? The next nine months will be tumultuous. A coup attempt could occur. However, we allocate a low probability to a successful self-coup because: Bolsonaro’s Popularity Is Too Low: Even dictators need to have some popular appeal. Bolsonaro has lost too much support (Chart 15), he never had full control of any major institutions (including the military), and few institutional players will risk their credibility for his sake. If he somehow clung to power, his subsequent administration would face overwhelming popular resistance. Chart 15Bolsonaro’s Low Approval Ratings - A Liability Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Bolsonaro’s Economy Is Too Weak: The dictatorship in Brazil managed to hold power for more than two decades partially because this period of authoritarianism was accompanied by a degree of economic well-being. Currently the public is shifting to the left because low growth and high inflation have dented the median voter’s purchasing power. The weak economy would make an authoritarian government unsustainable from the start. Lack Of American Support: Some military personnel may be supportive of a coup and several retired military officers are occupying civilian positions in the Brazilian federal government, thanks to Bolsonaro. So why can’t Brazil slip right back into a military dictatorship led by Bolsonaro, say if the election results are narrow and hotly contested? The coup d'état in Brazil in 1964 was a success to a large extent because this regime-change was supported by America. Back then communism was a threat to the US and Washington was keen to displace left-leaning heads of states in Latin America, such as Brazilian President João Goulart. But America’s strategic concerns have now changed. America today is attempting to coalesce an axis of democracies and the Biden administration has no incentive whatsoever to muddy its credentials by supporting dictatorship in Latin America’s largest country. Even aside from ideology, any such action would encourage fearful governments in the region to seek support from America’s foreign rivals, thus inviting the kind of foreign intervention that the US most wants to prevent in Latin America. The Brazilian Military Has Not Been Suppressed Or Sidelined: History suggests that coups are often triggered by a drop in the military’s importance in a country. However, the military’s power in Brazil has remained meaningful through the twenty-first century. Brazil has maintained steady military spends at around 1.5% of GDP over the last two decades. Thus, top leaders of Brazil’s military have no reason to feel aggrieved or disempowered. Having said that, it is not impossible that an extreme faction of junior officers might try to pull off a fantastical plot, even if they have little hope of succeeding, which is why we highlight that markets can be rudely awakened by the road to Brazil’s election this year. In Turkey in July 2016, an unsuccessful coup attempt caused Turkish equities to decline by 9% over a four-day period. Bottom Line: Investors must gird for the very real possibility of civil-military relations undergoing high degrees of strain in Brazil, particularly if a contested election occurs. While Bolsonaro’s supporters and disaffected elements of the Brazilian military could resist a smooth transition of power away from Bolsonaro, the transition will eventually take place because two powerful constituencies – Brazil’s median voter and America – will not support a coup in Brazil. Will Lula Be Good For Brazil’s Markets? Looking over Bolsonaro’s presidency, from a market-perspective, some policy measures were good, some were bad, and some were downright ugly. In specific: The Good: Pension Reforms And Independent Monetary Policy In Bolsonaro’s first year in power, he delivered pension sector reforms. The law increased the minimum retirement age and also increased workers’ pension contributions thereby resulting in meaningful fiscal savings. Bolsonaro passed a law to formalise the BCB’s autonomy and the BCB has been able to pursue a relatively independent monetary policy. BCB has now lifted the benchmark Selic rate by 725bps over 2021 thereby making it one of the most hawkish central banks amongst EMs (Chart 13). This is in sharp contrast to the situation in EMs like Turkey where the central bank cut rates owing to the influence of a populist head of state. The Bad: Poor Free Market Credentials And Fiscal Expansion In early 2021, President Bolsonaro fired the head of Petrobras (the state-owned energy champion) reportedly for raising fuel prices. Bolsonaro then picked a former army general (with no relevant work experience) to head the company. Although Bolsonaro positioned himself as a supporter of privatization in the run up to his presidency, he failed to follow through. Another area where the far-right leader has disappointed markets is with respect to Brazil’s debt levels. Under his presidency, a constitutional amendment to raise a key government spending cap was passed. Shortly afterwards came the creation of the massive welfare program Auxílio Brasil. Bolsonaro embraced fiscal populism to try to save his presidency after the pandemic. Consequently Brazil’s public debt to GDP ratio ballooned from 86% in 2018 to a peak of 99% in 2020. The Ugly: Poor Pandemic Response And Institutional Attacks The darkest hour of Bolsonaro’s presidency came on September 7, 2021, i.e., Brazil’s Independence Day. During rallies with his supporters, Bolsonaro levelled attacks on the Brazilian judiciary and sowed seeds of doubt in Brazil’s electoral process. More concretely, the greatest failing of the Bolsonaro administration has been its lax response to the pandemic. Bolsonaro delayed preventive measures, and this has meant that Brazil was one of the worst hit major economies of the world. The pandemic has claimed more than 630,000 lives in Brazil i.e., the second highest in the world. In relative terms too, Brazil has experienced a high death rate of about 2,960 per million which is even higher than the US rate of 2,720 per million. President Bolsonaro’s poor handling of the pandemic will cost the President in terms of votes in 2022 as the highest Covid-19-related death rates were seen in Southern Brazil (Map 3) i.e., a region that had voted in large numbers for Bolsonaro in 2018 (see Map 1 above). Map 3The Pandemic Has Had A Devastating Impact In Brazil’s South, Mid-West And North Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Given this backdrop, a Lula presidency will be welcomed by global financial markets, potentially for three reasons: Superior Pandemic-Control: An administration headed by Lula will bring in a more scientific and cohesive pandemic-control strategy thereby saving lives and benefiting the economy. Alignment With Institutions: Lula will act in alignment with Brazil’s institutions. He stands to benefit from the existing electoral system, the civil bureaucracy, academia, and the media. He may have rougher relations with the judiciary and parts of the military, but he is a known quantity and not likely to attempt to be a Hugo Chavez. Possibility Of Some Structural Reform: Given Brazil’s unstable debt dynamics, and the “lost decade” of economic malaise in the 2010s, there is a chance that Lula could pursue some structural reforms. Lula is more popular than his Worker’s Party, which is still tainted by corruption, so his strength in Congress will not be known until after the election. But Brazilian parties tend to coalesce around the president and Lula has experience in managing the legislative process. The probability of Lula pushing through some bit of structural reform will be the greatest in 2021. Back in 2019, it is worth recounting that only 4% of the Brazilian public supported pension reforms. Despite this Bolsonaro managed the passage of painful pension reforms in 2019 because market pressure forced the parties to cooperate. Faced with inflation and low growth, Lula may be forced to push through some piecemeal structural financial sector and economic reforms. However, if commodity prices and financial markets are cheering his election, he may spend his initial political capital on policies closer to his base of support, which means that a market riot may be necessary to force action on structural reforms. This dynamic will have to be monitored in the aftermath of the election. Assuming Lula does pursue some structural reforms while he has the political capital, and therefore that his first year is positive for financial markets, there is a reason to be positive on Brazil selectively on a tactical basis. However, electoral compulsions could cause Lula to pursue left-wing populism, fiscal expansion, and to resist privatization over the remaining three years of his presidency. Given Brazil’s already elevated debt levels (Chart 14), such a policy tilt would be market negative. It is against this backdrop that we expect a pro-Lula market rally to falter after the initial excitement. Bottom Line: Once the power transition is complete, a relief rally may follow as markets factor in the prospects of institutional stability and possibly a dash of structural reform in the first year of Lula’s presidency. But given Brazil’s elevated inequalities, even a pro-Lula rally will eventually fade as the administration will be constrained to switch back to the old ways and pursue an expansionary fiscal policy when elections loom. Investment Conclusions Brazil Presents A Value Trap, Fraught with Politico-Economic Risks From a strategic perspective, we are neutral on Brazil. A decade of bad news has been priced in but there is not yet a clear and sustainable trajectory to improve the country’s productivity. History suggests that both left-wing and right-wing presidents are often forced to backtrack on structural reforms and resort to cash-handouts in the run up to elections. This tends to add to Brazil’s high debt levels, prevents the domestic growth engine from revving up, and adds to inflation. Low growth and high inflation then set the wheels rolling for another bout of fiscal expansion (Chart 16). Chart 16The Vicious Politico-Economic Cycle That Brazil Is Trapped In Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Exceptions to this politico-economic cycle occur when a commodity boom is underway or if China, which is Brazil’s key client state, is booming. China today buys a third of Brazil’s exports (Chart 17) and is Brazil’s largest export market. The other reason we remain circumspect about Brazil’s strategic prospects is because of the secular slowdown underway in China. China is not in a position today to recreate the commodity and trade boom that buoyed Lula during his first presidency. China’s policy easing is a tactical boon at best, which can coincide with a Lula relief rally, but afterwards investors will be left with Chinese deleveraging and Brazilian populism. Political Risks Are High, Selective Tactical Exposure Brazil Will Be Optimal We urge investors to buy into Brazilian assets only selectively, even as Brazilian equities appear cheap (Chart 18). Political risks and economic risks such as low growth in GDP and earnings (Chart 19) could contribute to another correction and/or volatility in Brazilian equities. Chart 17China Buys A Third Of Brazil’s Exports Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions ​​​​​ ​​​​​Chart 18Brazil: Are Political & Macro Risks Priced-In? Brazil: The Road To Elections Won't Be Paved With Good Intentions Brazil: The Road To Elections Won't Be Paved With Good Intentions Chart 19Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag China’s policy easing is an important macro factor playing to Brazil’s benefit. As we highlighted in our “China Geopolitical Outlook 2022,” Beijing is focused on ensuring stability over the next 12 months. But history suggests that Brazil’s corporate earnings respond to a pick-up in China’s total social financing with a lag of more than six months (Chart 19). Thus, even from a purely macro perspective it may make sense to turn bullish on Brazil after the election turmoil concludes. Given that politically sensitive sectors account for an unusually high proportion of Brazil’s market capitalization (Chart 18), and given the political risks in the offing for Brazil, we suggest taking-on selective exposure in Brazil. To play the rally yet mitigate political risks (that can be higher for capital-heavy sectors), we suggest a pair trade: Long Brazil Financials / Short India. We remain positive on India on a strategic horizon. However, in view of India approaching the business-end of its five-year election cycle, when policy risks tend to become elevated, we reiterate our tactical sell on India. India currently trades at a 81% premium to MSCI EM on a forward P-E ratio basis versus its two year average of 56%. A Quick Note On The Nascent EM Rally Investors should gradually look more favorably on emerging markets, but tactical caution is warranted. MSCI EM and MSCI World are down YTD 1.1% and 4.6% respectively. Despite the dip, we are not yet turning bullish on EM as a whole, owing to both geopolitical and macroeconomic factors. Global geopolitical risks in the new year are high. We recently upgraded the odds of Russia re-invading Ukraine from 50% to 75%. Besides EM Europe, we also see high and underrated geopolitical risks in the Middle East in the short run. Both the Russia and Iran conflicts raise a non-negligible risk of energy shocks that undermine global growth. Once these hurdles are cleared, we will turn more positive toward risky assets. Macroeconomically, the current EM rally can be sustained only if China delivers a substantial stimulus, and the US dollar continues to weaken. The former is likely, as we have argued, but the dollar looks to be resilient and it will take several months before China’s credit impulse rebounds. Hence conditions for a sustainable EM rally do not yet exist. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights The selloff in equities since the start of the year marks a long overdue correction rather than the start of a bear market. Stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory. BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. While valuations in the US remain stretched, they are much more favorable abroad. Investors should overweight non-US markets, value stocks, and small caps in 2022. Go long homebuilders versus the S&P 500. US homebuilders are trading at only 6.5-times forward earnings and will benefit from tight housing supply conditions and a moderation in input costs. FAQ On Recent Market Action The selloff in stocks since the start of the year has garnered a lot of attention. In this week’s report, we address some of the key questions clients are asking.   Q: What do you see as the main reasons for the equity selloff? A: At the start of the year, the S&P 500 had gone 61 straight weeks without experiencing a 6% drawdown, the third longest stretch over the past two decades. Stocks were ripe for a pullback. The backup in bond yields provided a catalyst for the sellers to come out. Not surprisingly, growth stocks fell hardest, as they are most vulnerable to changes in the long-term discount rate. At last count, the S&P 500 Growth index was down 13.7% YTD, compared to 4.1% for the Value index. Our research has found that stocks often suffer a period of indigestion when bond yields rise suddenly, but usually bounce back as long as yields do not move into economically restrictive territory (Table 1). BCA’s bond strategists expect the 10-year yield to rise to 2%-to-2.25% by the end of the year, which is well below the level that could trigger a recession. Table 1As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Should Recover A Correction Not A Bear Market A Correction Not A Bear Market Historically, equity bear markets have coincided with recessions (Chart 1). Corrections can occur outside of recessionary periods, but for stocks to go down and stay down, corporate earnings need to fall. That almost never happens unless there is a major economic downturn (Chart 2). In fact, the only time in the last 50 years the US stock market fell by more than 20% outside of a recessionary environment was in October 1987. Chart 1Recessions And Bear Markets Tend To Go Hand In Hand Recessions And Bear Markets Tend To Go Hand In Hand Recessions And Bear Markets Tend To Go Hand In Hand Chart 2Business Cycles Drive Earnings Business Cycles Drive Earnings Business Cycles Drive Earnings Chart 3The Bull-Bear Ratio Is Below Its Pandemic Lows The Bull-Bear Ratio Is Below Its Pandemic Lows The Bull-Bear Ratio Is Below Its Pandemic Lows It is impossible to know when this correction will end. However, considering that the bull-bear spread in this week’s AAII survey fell below the trough reached both in March 2020 and December 2018, our guess is that it will be sooner rather than later (Chart 3). With global growth likely to remain solid, equity prices should rise. Q: What gives you confidence that growth will hold up? A: Households are sitting on a lot of excess savings – $2.3 trillion in the US and a similar amount abroad. That is a lot of dry powder. Banks are also actively looking to expand credit, as the recent easing in lending standards demonstrates (Chart 4). Leading indicators of capital spending are at buoyant levels (Chart 5). Chart 4US Banks Are Easing Lending Standards US Banks Are Easing Lending Standards US Banks Are Easing Lending Standards Chart 5The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright The Outlook For US Capex Is Bright It is striking how well the global economy has handled the Omicron wave. While service PMIs have come down, manufacturing PMIs have remained firm. In fact, the euro area manufacturing PMI reached 59 in January versus expectations of 57.5. It was the strongest manufacturing print for the region since August. The manufacturing PMI also ticked up slightly in Japan. The China Caixin/Markit PMI and the official PMI published by the National Bureau of Statistics also ticked higher. After dipping below zero last August, the Citi global economic surprise index has swung back into positive territory (Chart 6). Chart 6The Omicron Wave Did Not Drag Down The Global Economy The Omicron Wave Did Not Drag Down The Global Economy The Omicron Wave Did Not Drag Down The Global Economy Markets are also not pricing in much of a growth slowdown (Chart 7). Growth-sensitive industrial stocks have outperformed the overall index by 1.1% in the US so far this year. EM equities have outperformed the global benchmark by 5.9%. The Bloomberg Commodity Spot index has risen 7.2%. Credit spreads have barely increased. Chart 7Markets Are Not Discounting Much Of A Growth Slowdown Markets Are Not Discounting Much Of A Growth Slowdown Markets Are Not Discounting Much Of A Growth Slowdown   Q: What is your early read on the earnings season? A: Nothing spectacular, but certainly not bad enough to justify the steep drop in equity prices. According to Refinitiv, of the 145 S&P 500 companies that have reported Q4 earnings, 79% have beat analyst expectations while 19% reported earnings below expectations. Usually, 66% of companies report earnings above analyst estimates, while 20% miss expectations. In aggregate, the reported earnings are coming in 3.2% above estimates, slightly lower than the historic average of 4.1%. Guidance has been lackluster. However, outside of a few tech names like Netflix, earnings disappointments have generally been driven by higher-than-expected expenses, rather than weaker sales. Overall EPS estimates for 2022 have climbed 0.4% in the US and by 1.1% in foreign markets since the start of the year (Chart 8).   Q: To the extent that the Fed is trying to engineer tighter financial conditions, doesn’t this imply that stocks must continue falling? A: That would be true if the Fed really did want to tighten financial conditions, either via lower stock prices, a stronger dollar, higher bond yields, or wider credit spreads. However, we do not think that this is what the Fed wants. Despite all the chatter about inflation, the 5-year/5-year forward TIPS breakeven inflation rate has fallen to 2.05%, which is 25 basis points below the bottom end of the Fed’s comfort zone (Chart 9).1 Chart 8Earnings Expectations Have Not Been Revised Lower Earnings Expectations Have Not Been Revised Lower Earnings Expectations Have Not Been Revised Lower Chart 9Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Market-Based Long-Term Inflation Expectations Are Below The Fed's Comfort Zone Chart 10The Terminal Fed Funds Rate Seen At 2%-2.5% The Terminal Fed Funds Rate Seen At 2%-2.5% The Terminal Fed Funds Rate Seen At 2%-2.5% Chart 11The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% The Market Thinks The Fed Will Not Be Able To Lift Rates Above 2% Remember that the Fed’s estimate of the neutral rate, R*, is very low. The Fed thinks it will only be able to raise rates to 2.5% during this tightening cycle, which would barely bring real rates into positive territory (Chart 10). The market does not think the Fed will be able to raise rates to even 2% (Chart 11). The last thing the Fed wants to do is inadvertently invert the yield curve. In the past, an inverted yield curve has reliably predicted a recession (Chart 12). Chart 12A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) A Yield Curve Inversion Usually Signals The End Of A Business Cycle (And Can Even Predict A Pandemic) The Fed is about to start raising rates and shrinking its balance sheet not because it wants to slow growth, but because it wants to maintain its credibility. While the Fed will never admit it, it is very much attuned to the direction in which the political winds are blowing. The rise in inflation, and the Fed’s failure to predict it, has been embarrassing for the FOMC. Doing nothing is no longer an option. However, doing “something” does not necessarily imply having to raise rates more than the market is already discounting. Contrary to the consensus view that the Fed has turned hawkish, we think that the main takeaway from this week’s FOMC meeting is that Jay Powell, aka Nimble Jay, wants more flexibility in how the Fed conducts monetary policy. This makes perfect sense, as layer upon layer of forward guidance merely served to confuse market participants while unnecessarily tying the Fed’s hands.   Q: How confident are you that inflation will fall without a meaningful tightening in financial conditions? A: If we are talking about a horizon of 2-to-3 years, not very confident. As we discussed two weeks ago in a report entitled The New Neutral, the interest rate consistent with stable inflation and full employment is substantially higher than either the Fed believes or the market is pricing in. This means that the Fed is likely to keep rates too low for too long. However, if we are talking about a 12-month horizon, there is a high probability that inflation will fall dramatically, even if monetary policy stays very accommodative. Today’s inflation is largely driven by rising durable goods prices. Durables are the one category of the CPI basket where prices usually fall over time, so this is not a sustainable source of inflation (Chart 13). As demand shifts back from goods to services and supply bottlenecks abate, durable goods inflation will wane. Chart 14 shows that the price indices for a number of prominent categories of goods – including new and used vehicles, furniture and furnishings, building supplies, and IT equipment – are well above their trendlines. Not only is inflation in these categories likely to fall, but it is apt to turn negative, as the absolute level of prices reverts back to trend. This will put significant downward pressure on inflation. Chart 13Durable Goods Prices Are The Main Driver Of Inflation Durable Goods Prices Are The Main Driver Of Inflation Durable Goods Prices Are The Main Driver Of Inflation Chart 14Some Of These Prices Will Fall Outright Some Of These Prices Will Fall Outright Some Of These Prices Will Fall Outright Chart 15Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Granted, service inflation will accelerate this year as the labor market continues to tighten. However, rising service inflation is unlikely to offset falling goods inflation. While wage growth has accelerated, wage pressures have been concentrated at the bottom end of the wage distribution (Chart 15). According to the Census Household Pulse Survey, a record 8.75 million workers – many of them in relatively low-paid service jobs – were not working in the second week of January due to pandemic-related reasons (Chart 16). As the Omicron wave fades, most of these workers will re-enter the labor force. This should help boost labor participation among low-wage workers, which has recovered much less than for higher paid workers (Chart 17).   Chart 16The Pandemic Is Still Affecting Labor Supply The Pandemic Is Still Affecting Labor Supply The Pandemic Is Still Affecting Labor Supply Chart 17Employment In Low-Wage Industries Has Not Fully Recovered Employment In Low-Wage Industries Has Not Fully Recovered Employment In Low-Wage Industries Has Not Fully Recovered Q: Tensions between Ukraine and Russia have risen to a fever pitch. Could this destabilize global markets? Chart 18Valuations Matter For Long-Term Returns Valuations Matter For Long-Term Returns Valuations Matter For Long-Term Returns A: In a note published earlier today, Matt Gertken, BCA’s Chief Geopolitical Strategist, increased his odds that Russia will invade Ukraine from 50% to 75%. However, of that 75% war risk, he gives only 10% odds to Russia invading and conquering all of Ukraine. A much more likely scenario is one where Russia invades Donbas and perhaps a few other regions in Eastern or Southern Ukraine where there are large Russian-speaking populations and/or valuable coastal territory. While such a limited incursion would still invite sanctions from the West, Matt does not think that Russia will retaliate by cutting off oil and natural gas exports to Europe. Not only would such a retaliation deprive Russia of its main source of export earnings, but it could lead to a hostile response from countries such as Germany which so far have pushed for a more measured approach than the US has championed.   Q: Valuations are still very stretched. Even if the conflict in Ukraine does not spiral out of control and the goldilocks macroeconomic scenario of above-trend global growth and falling inflation comes to pass, hasn’t much of the good news already been discounted? A: US stocks are quite pricey. Both the Shiller PE ratio and households’ allocations to equities point to near-zero total returns for stocks over a 10-year horizon (Chart 18). That said, valuations are not a useful timing tool. The business cycle, rather than valuations, tends to dictate the path of stocks over medium-term horizons of 6-to-12 months (Chart 19). Chart 19AThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (I) Chart 19BThe Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) The Business Cycle Drives The Stock Market Over Medium-Term Horizons (II) Moreover, stocks are not expensive everywhere. While US equities trade at 20.8-times forward earnings, non-US stocks trade at a more respectable 14.1-times. The valuation gap is even more extreme based on other measures such as normalized earnings, price-to-book, and price-to-sales (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) In terms of equity styles, both small caps and value stocks trade at a substantial discount to large caps and growth stocks (Chart 21). We recommend that investors overweight these cheaper areas of the market in 2022. Trade Recommendation: Go Long US Homebuilders Versus The S&P 500 US homebuilder stocks have fallen by 19.4% since December 10th. Beyond the general market malaise, worries about rising mortgage rates and soaring input costs have weighed on the sector. Yet, current valuations more than adequately discount these risks. The sector trades at 6.5-times forward earnings, a steep discount to the S&P 500. Whereas demand for new homes is near record high levels according to the National Association of Home Builders (NAHB) survey, the homeowner vacancy rate is at a multi-decade low. The supply of recently completed new homes is half of what it was on the eve of the pandemic (Chart 22). With demand continuing to outstrip supply, home prices will maintain their upward trend. As building material prices stabilize and worries about an overly aggressive Fed recede, homebuilder stocks will rally. Chart 21Value Stocks And Small Caps Are Cheap Value Stocks And Small Caps Are Cheap Value Stocks And Small Caps Are Cheap Chart 22US Homebuilders Looking Attractive US Homebuilders Looking Attractive US Homebuilders Looking Attractive Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. Global Investment Strategy View Matrix A Correction Not A Bear Market A Correction Not A Bear Market Special Trade Recommendations Current MacroQuant Model Scores A Correction Not A Bear Market A Correction Not A Bear Market

Highlights Our top five “black swan” risks for 2022: Social unrest in China; Russian invasion of all of Ukraine; unilateral Israeli strikes on Iran; a cyber attack that goes kinetic; and a failure of OPEC 2.0. Too early to buy the dip on Russian assets: President Biden says Putin will probably “move in” and re-invade Ukraine, Russian embassy staff have been evacuating Ukraine, the US and UK have been providing more arms to Ukraine, and the US is warning of a semiconductor embargo against Russia. Talks resume in Geneva on Friday. Tactically investors should take some risk off the table, especially if linked to Russia and Europe.  Stay short the Russian ruble and EM Europe; stay short the Chinese renminbi and Taiwanese dollar; stay long cyber security stocks; and be prepared for oil volatility. Convert tactical long equity trades to relative trades: long large caps versus small caps, long defensives versus cyclicals, and long Japanese industrials versus German industrials. Feature Chart 1Recession Probability And Yield Curve Recession Probability And Yield Curve Recession Probability And Yield Curve The 2/10-year yield curve is flattening and now stands at 79 bps, while the implied probability of a recession over the next 12 months troughed at 5.9% in April 2021, and as of December 2021 stood at 7.7% (Chart 1). Apparently stagflation and recession are too high of a probability to constitute a “black swan” risk for this year. Black swans are not only high impact but also low probability. In this year’s annual “Five Black Swan” report, the last of our 2022 outlook series, we concentrate on impactful but unlikely events. These black swans emerge directly from the existing themes and trends in our research – they are not plucked at random. The key regions are highlighted in Map 1. Chart Black Swan #1: Major Social Unrest Erupts In China China’s financial problems are front and center risks for investors this year. They qualify as a “Gray Rhino” rather than “Black Swan” risk.1 It is entirely probable that China’s financial and property sector distress will negatively impact Chinese and global financial markets in 2022. What investors are not expecting is an eruption of social unrest in China that fouls up the twentieth national party congress this fall and calls into question the Communist Party’s official narrative that it is handling the pandemic and the underlying economic transition smoothly. Social unrest is a major risk around the world in the face of the new bout of inflation. Most of the democracies have already changed governments since the pandemic began, recapitalizing their political systems, but major emerging markets – Russia, India, Turkey, Brazil – have not done so. They have seen steep losses of popular support for both political leaders and ruling parties. There is little opinion polling from China and people who are surveyed cannot speak openly. It is possible that the government’s support has risen given its minimization of deaths from the pandemic. But it is also possible that it has not. Beijing’s policies over the past few years have had a negative impact on the country’s business elite and foreign relations. There are disgruntled factions within China, though the current administration has a tight grip over the main organs of power. Since President Xi is trying to clinch his personal rule this fall, sending China down a path of autocracy that proved disastrous under Chairman Mao Zedong, it is possible he will face surprise resistance. China’s economic growth is decelerating, clocking in at a 4.0% quarter-on-quarter growth rate at the end of last year. While authorities are easing policy to secure the recovery, there is a danger of insufficient support. Private sentiment will remain gloomy, as reflected by weak money velocity and a low propensity to spend among both businesses and households (Chart 2). The government will continue to be repressive in the lead up to the political reshuffle. At least for the first half of the year the economy will remain troubled. Structurally China is ripe for social unrest. It suffers from high income inequality and low social mobility, comparable to the US and Brazil, which are both struggling with political upheaval (Chart 3). Chart 2China's Private Sector Still Depressed China's Private Sector Still Depressed China's Private Sector Still Depressed ​​​​​ Chart 3 ​​​​​​ In addition China is keeping a stranglehold over Covid-19. This “Zero Covid” policy minimizes deaths but suppresses economic activity. Strict policy has also left the population with a very low level of natural immunity and the new Omicron variant is even more contagious than other variants. Hence the regime is highly likely to double down to prevent an explosive outbreak. The service side of the economy will continue to suffer if strict lockdowns are maintained, exacerbating household and business financial difficulties (Chart 4). Yet in other countries around the world, government decisions to return to lockdowns have sparked unrest. Chart 4Zero Covid Policy: Not Sustainable Beyond 2022 Zero Covid Policy: Not Sustainable Beyond 2022 Zero Covid Policy: Not Sustainable Beyond 2022 China’s “Misery Index” (unemployment plus inflation) is rising sharply. While misery is ostensibly lower than that of other emerging markets, China’s unemployment data is widely known to be unreliable. If we take a worst-case scenario, looking at youth unemployment and fuel prices, misery is a lot higher (Chart 5). The youth, who are having the hardest time finding jobs, are also the most likely to protest if conditions become intolerable (Chart 6). Of course, if social unrest is limited to students, it will lack support among the wider populace. But it is inflation, not youth activism, that is the reason for China’s authorities to be concerned, as inflation is a generalized problem that affects workers as well as students. Chart 5China's Misery Index Is Higher Than It Looks China's Misery Index Is Higher Than It Looks China's Misery Index Is Higher Than It Looks ​​​​​ Chart 6China's Troubled Youth China's Troubled Youth China's Troubled Youth Why would protesters stick their necks out knowing that the Communist Party will react ferociously to any sign of instability during President Xi Jinping’s political reshuffle? True, mainland Chinese do not have the propensity to political activism that flared up in protests in Hong Kong in recent years. Also the police state will move rapidly to repress any unrest. Yet the entire focus of Xi Jinping’s administration, since 2012, has been the restoration of political legitimacy and prevention of popular discontent. Xi has cracked down on corruption, pollution, housing prices, education prices, and has announced his “Common Prosperity” agenda to placate the low and middle classes.2 The regime has also cracked down on the media, social media, civil society, and ideological dissent to prevent political opposition from taking root. If the government were not concerned about social instability, it would not have been adopting these policies. Disease, often accompanied by famines or riots, has played a role in the downfall of six out of ten dynasties, so Beijing will not be taking risks for granted (Table 1). Table 1Disease And Downfall Of Chinese Dynasties Five Black Swans For 2022 Five Black Swans For 2022 Social instability would have a major impact as it would affect China’s stability and global investor sentiment toward China. Western democracies would penalize China for violations of human rights, leaving China even more isolated. Bottom Line: Investors should stay short the renminbi and neutral Chinese equities. Foreign investors should steer clear of Chinese bonds in the event of US sanctions. After the party congress this fall there will be an opportunity to reassess whether Xi Jinping will “let a hundred flowers bloom,” thus improving the internal and external political and investment environment, but this is not at all clear today. Black Swan #2: Russia Invades All (Not Just Part) Of Ukraine US-Russia relations are on the verge of total collapse and Russian equities have sold off, in line with our bearish recommendations in reports over the past two years. Russia’s threat of re-invading Ukraine is credible. Western nations are still wishy-washy about the counter-threat of economic sanctions, judging by German Chancellor Olaf Scholz’s latest comments, and none are claiming they will go to war to defend Ukraine.3 Russia is looking to remove the threat of Ukraine integrating militarily and economically with the West. The US and UK are providing Ukraine with defense weaponry even as Russia specifically demands that they cease to do so. President Putin may choose short-term economic pain for long-term security gain. The consensus view is that if Russia does invade, it will undertake a limited invasion. But what if Russia invades all of Ukraine? To be clear, a full invasion is unlikely because it would be far more difficult and costly for Russia. It would go against Putin’s strategy of calculated risk and limited conflict. Table 2 compares Russia and Ukraine in size and strength, alongside a comparison of the US and Iraq in 2002. This is not a bad comparison given that Ukraine’s and Iraq’s land area and active military personnel are comparable. Table 2Russia-Ukraine Balance Of Power 2022 Compared To US-Iraq 2002 Five Black Swans For 2022 Five Black Swans For 2022 Russia would be biting off a much bigger challenge than the US did. Ukraine’s prime age population is 2.5 times larger than Iraq’s in 2002, and its military expenditure is three times bigger. The US GDP and military spending were 150 and 250 times bigger than Iraq’s, while Russia’s GDP and military spending are about ten times bigger than Ukraine’s today. Iraq was not vital to American national security, whereas Ukraine is vital to Russia; Russia has more at stake and is willing to take greater risks. But Ukraine is in better shape to resist Russian occupation than Iraq was to resist American. The point is that the US invasion went smoothly at first, then got bogged down in insurgency, and ultimately backfired both in political and geopolitical terms. Russia would be undertaking a massive expense of blood and treasure that seems out of proportion with its goal, which is to neutralize Ukraine’s potential to become a western defense ally and host of “military infrastructure.” However, there are drawbacks to partial invasion. The remainder of the Ukrainian state would be unified and mobilized, capable of integrating with the western world, and willing to support a permanent insurgency against Russian troops in eastern Ukraine. Russia has forces in Belarus, Crimea, and the Black Sea, as well as on Ukraine’s eastern border, giving rise to fears that Russia could attempt a three-pronged invasion of the whole country. In short, it is conceivable that Russian leaders could make the Soviet mistake of overreaching in the military aims, or that a war in eastern Ukraine could inadvertently expand into the west. If Russia tries to conquer all of Ukraine, the global impact will be massive. A war of this size on the European continent for the first time since World War II would shake governments and populations to their bones. The borders with Poland, Romania, the Baltic states, Slovakia, Hungary, Finland and the Black Sea area would become militarized (Map 2). Chart NATO actions to secure its members and fortify their borders would exacerbate tensions with Russia and fan fears of a wider war. Trade flows would become subject to commerce destruction, affecting even neutral nations, including in the Black Sea. Energy supplies would tighten further, sending Russia and probably Europe into recession. The disruption to business and travel across eastern Europe would be deep and lasting, not only due to sanctions but also due to a deep risk-aversion that would affect foreign investors in the former Soviet Union and former Warsaw Pact. Germany would be forced to quit sitting on the fence, as it would be pressured by the US and the rest of Europe to stand shoulder to shoulder in the face of such aggression. Finland and Sweden would be much more likely to join NATO, exacerbating Russia’s security fears. Russia would suffer a drastic loss of trade, resulting in recession, and its currency collapse would feed inflation (Chart 7). Chart 7Inflation Poses Long-Term Threat To Putin Regime Inflation Poses Long-Term Threat To Putin Regime Inflation Poses Long-Term Threat To Putin Regime Ultimately the consequences would be negative for the Putin regime and Russia as a result of recession and international isolation. But in the short run the Russian people would rally around the flag and support a war designed to prevent NATO from stationing missiles on their doorstep. And their isolation would not be total, as they would strengthen ties with China and conduct trade via proxy states in the former Soviet Union. Bottom Line: A full-scale invasion of all of Ukraine is highly unlikely because it would be so costly for Russia in military, economic, and political terms. But the probability is not zero, especially because a partial re-invasion could lead to a larger war. While global investors would react in a moderate risk-off matter to a limited war in eastern Ukraine, a full-scale war would trigger a massive global flight to safety as it would call into question the entire post-WWII peace regime in Europe. Black Swan #3: Israel Attacks Iran The “bull market in Iran tensions” continues as there is not yet a replacement for the 2015 nuclear deal that the US abrogated. Our 2022 forecast that the UAE would get caught in the crossfire was confirmed on January 17 when Iran-backed Houthi rebels expanded their range of operations and struck Abu Dhabi (Map 3). The secret war is escalating and US-led diplomacy is faltering. Chart Iran is not going to give up its nuclear program. North Korea achieved nuclear arms and greater military security and is now developing first and second strike capabilities. Meanwhile Ukraine, which faces another Russian invasion, exemplifies what happens to regimes that give up nuclear arms (as do Libya and Iraq). Iran appears to be choosing the North Korean route. While we cannot rule out a minor agreement between President Biden and Iranian President Ebrahim Raisi, we can rule out a substantial deal that halts Iran’s nuclear and missile progress. Here’s why: Any day now Iran could reach nuclear “breakout capacity,” with enough highly enriched uranium to construct a nuclear device (Table 3).4 Table 3Iran’s Violations Of 2015 Nuclear Deal Since US Exit Five Black Swans For 2022 Five Black Swans For 2022 Within Iran’s government, the foreign policy doves have been humiliated and kicked out of office while the hawks are fully in control. No meaningful agreement can be reached before 2024 because of the risk that the US will change ruling parties again and renege on any promises. Iran is highly incentivized to make rapid progress on its nuclear program now. The US will not be able to lead the P5+1 coalition to force Iran to halt its program because of its ongoing struggles with Russia and China. China is striking long-term cooperation deals with Iran. Israel has a well-established record of taking unilateral action, specifically against regional nuclear programs, known as the “Begin Doctrine.”5 Israel’s threats are credible on this front, although Iran is a much greater operational challenge than Iraq or Syria. Iran’s timeline from nuclear breakout to deliverable nuclear weapon is 12-24 months.6 Iran’s missile program is advanced. Missile programs cannot be monitored as easily as nuclear activity, so foreign powers base the threshold on nuclear capability rather than missile capability. Iran had a strong incentive to move slowly on its nuclear and missile programs in earlier years, to prevent US and Israeli military interference. But as it approaches breakout capacity it has an incentive to accelerate its tempo to a mad dash to achieve nuclear weaponization before the US or Israel can stop it. Now that time may have come. The Biden administration is afraid of higher oil prices and Israeli domestic politics are more divided and risk-averse than before. And yet Iran’s window might close in 2025, as the US could turn aggressive again depending on the outcome of the 2024 election. Hence Iran has an incentive to make its dash now. The US and Israel will restate their red lines against Iranian nuclear weaponization and brandish their military options this year. But the Biden administration will be risk-averse since it does not want to instigate an oil shock in an election year. Israel is more likely than the US to react quickly and forcefully since it is in greatest danger if Iran surprises the world with rapid weaponization. Here are the known constraints on unilateral Israeli military action: Limited Israeli military capability: Israel would have to commit a large number of aircraft, leaving its home front exposed, and even with US “bunker buster” bombs it may not penetrate the underground Fordow nuclear facility.7 Limited Israeli domestic support: The Israeli public is divided on whether to attack Iran. The post-Netanyahu government recently came around to endorsing the US’s attempt to renegotiate the nuclear deal. Limited US support: Washington opposes Israeli unilateralism that could entangle the US into a war. Israel cannot afford to alienate the US, which is its primary security guarantor. Iranian instability: The Iranian regime is under economic distress due to “maximum pressure” sanctions. It is vulnerable to social unrest, not least because of its large youth population. These constraints have been vitiated in various ways, which is why we raise this Israeli unilateralism as a black swan risk: Where there’s a will, there’s a way: If Israel believes its existence will be threatened, it will be willing to take much greater operational risks. It has already shown some ability to set back Iran's centrifuge program beyond the expected.8 Israeli opinion will harden if Iran breaks out: If Iran reaches nuclear breakout or tests a nuclear device, Israeli opinion will harden in favor of military strikes. Prime Minister Naftali Bennett has an incentive to take hawkish actions before he hands the reins of government over to a partner in his ruling coalition as part of a power-sharing agreement. The ruling coalition is so weak that a collapse cannot be ruled out. US opposition could weaken: Biden will have to explore military options if talks fail and Iran reaches nuclear breakout capacity. Once the midterms are over, Israel may have even more freedom to act, while a gridlocked Biden may be looking to shift his focus to foreign policy. Iranian stability: Iran’s social instability has not resulted in massive unrest or regime fracture despite years of western sanctions and a global recession/pandemic. Yet now energy prices are rising and Iran has less reason to believe sanction regimes will be watertight. From Israeli’s point of view, even regime change in Iran would not remove the nuclear threat once nuclear weapons are obtained. Finally, while Israel cannot guarantee that military strikes would successfully cripple Iran’s nuclear program and prevent weaponization, Israel cannot afford not to try. It would be a worse outcome to stand idly by while Iran gets a nuclear weapon than to attack and fail to set that program back. Hence the likeliest outcome over the long run is that Iran pursues a nuclear weapon and Israel attacks to try to stop it, even if that attack is likely to fail (Diagram 1). Diagram 1Game Theory: Will Israel Attack Iran? Five Black Swans For 2022 Five Black Swans For 2022 Bottom Line: A unilateral Israeli strike is unlikely but would have a massive impact, as 21% of global oil and 26% of natural gas flows through the Strait of Hormuz, and conflict could disrupt regional energy production and/or block passage through the strait itself. Black Swan #4: Cyber Attacks Spill Into Real World Investors are very aware of cyber security risks – it holds a respectable though not commanding position in the ranks of likely crisis events (Table 4). Our concern is that a cyber attack could spill over into the real world, impairing critical infrastructure, supply chains, and/or prompting military retaliation. Table 4Cyber Events Underrated In Consensus View Of Global Risks Five Black Swans For 2022 Five Black Swans For 2022 Russian attacks on US critical infrastructure by means of ransomware gangs disrupted a US fuel pipeline, meat-packing plant, and other critical infrastructure in 2021. Since then the two countries have engaged in negotiations over cyber security. The Russian Federal Security Bureau has cracked down on one of the most prominent gangs, REvil, in a sign that the US and Russia are still negotiating despite the showdown over Ukraine.9 Yet a re-invasion of Ukraine would shatter any hope of cooperation in the cyber realm or elsewhere. Russia is already using cyberattacks against Ukraine and these activities could expand to Ukraine’s partners if the military conflict expands. Should the US and EU impose sweeping sanctions that damage Russia’s economy, Russia could retaliate, not only by tightening energy supply but also by cyber attacks. Any NATO partners or allies would be vulnerable, though some states will be more reactive than others. Interference in the French election, for example, would be incendiary. The key question is: if Russia strikes NATO states with damaging cyber attacks, at what point would it trigger Article V, the mutual defense clause? There are no established codes of conduct or red lines in cyber space, so the world will have to learn each nation’s limits via confrontation and retaliation. Similar cyber risks could emerge from other conflicts. China is probably not ready to invade Taiwan but it has an interest in imposing economic costs on the island ahead of this fall’s midterm elections. Taiwan’s critical role in the semiconductor supply chain means that disruptions to production would have a global impact. Israel and the US have already used cyber capabilities to attack Iran and set back its nuclear program. These capabilities will be necessary as Iran approaches breakout capacity. Yet Iran could retaliate in a way that disrupts oil supplies. North Korea began a new cycle of provocations last September, accelerated missile tests over the past four months, and is dissatisfied with the unfinished diplomatic business of the Trump administration. In the wake of the last global crisis, 2010, it staged multiple military attacks against South Korea. South Korea may be vulnerable due to its presidential elections in May. The semiconductor or electronics supply chain could be interrupted here as well as in Taiwan. Bottom Line: There is no code of conduct in cyber space. As geopolitical tensions rise, and nations test the limits of their cyber capabilities, there is potential for critical infrastructure to be impaired. This could exacerbate supply chain kinks or provoke kinetic responses from victim nations. Black Swan #5: OPEC 2.0 Falls Apart The basis of the OPEC 2.0 cartel is Russian cooperation with Saudi Arabia to control oil supply and manage the forward price curve. Backwardation, when short-term prices are higher than long-term, is ideal for these countries since they fear that long-term prices will fall. In a world where Moscow and Riyadh both face competition from US shale producers as well as the green energy revolution, cooperation makes sense. Yet the two sides do not trust each other. Cooperation broke down both in 2014 and 2020, sending oil prices plunging. Falling global demand ignited a scramble for market share. Interestingly, Russian military invasions have signaled peak oil price in 1979, 2008, and 2014. Russia, like other petro-states, has greater room for maneuver when oil revenues are pouring in. But high prices also incentivize production, disincentivize cartel discipline, and trigger reductions in global demand (Chart 8). Chart 8Russian Invasions And Oil Price Crashes Russian Invasions And Oil Price Crashes Russian Invasions And Oil Price Crashes Broadly speaking, Saudi oil production rose modestly during times of Russian military adventures, while overall OPEC production was flat or down, and Russian/Soviet production went up (Chart 9). Chart 9Saudi And OPEC Oil Production During Russian Military Adventures Saudi And OPEC Oil Production During Russian Military Adventures Saudi And OPEC Oil Production During Russian Military Adventures Since 2020, we have held that OPEC 2.0 would continue operating but that the biggest risk would come in the form of a renewed US-Iran nuclear deal that freed up Iranian oil exports. In 2014, the Saudis increased production in the face of the US shale threat as well as the Iranian threat. This scenario is still possible in 2022 but it has become a low-probability outcome. Even aside from the Iran dynamic, there is some probability that Russo-Saudi cooperation breaks down as global growth decelerates and new oil supply comes online. Bottom Line: The world’s inflation expectations are elevated and closely linked to oil prices. Yet oil prices hinge on an uneasy political agreement between Russia and Saudi Arabia that has fallen apart twice before. If Russia invades Ukraine, or if US withdraws sanctions on Iran, for example, then Saudi Arabia could make a bid to expand its market share and trigger price declines in the process. Two Bonus Black Swans: Turkey And Venezuela Turkey lashes out: Our Turkish Political Capital Index shows deterioration for President Recep Erdogan’s political capital across a range of variables (Table 5). With geopolitical pressures increasing, and domestic politics heating up ahead of the 2023 elections, Erdogan’s behavior will become even more erratic. His foreign policy could become aggressive, keeping the lira under pressure and/or weighing on European assets. Table 5Turkey: Erdogan’s Political Capital Wearing Thin Five Black Swans For 2022 Five Black Swans For 2022 Venezuela’s Maduro falls from power: Venezuelan regime changes often follow from military coups. These coups do not only happen when oil prices collapse – sometimes the army officers wait to be sure prices have recovered. Coup-throwers want strong oil revenues to support their new rule. An unexpected change of regimes would affect the oil market due to this country’s giant reserves. Bottom Line: Turkey’s political instability could result in foreign aggression, while Venezuela’s regime could collapse despite the oil price recovery. Investment Takeaways We are booking profits on our tactical long trades on large caps and defensive sectors. We will convert these to relative trades: long large caps over small caps, and long defensives over cyclicals. We also recommend converting our tactical long Japan trade into long Japanese industrials / short German industrials equities. If US-Russia diplomacy averts a war we will reconsider.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      “Gray Rhino” is a term coined by author Michele Wucker to describe large and probable risks that people neglect or avoid. For more, see thegrayrhino.com. 2     Xi Jinping recently characterized the “common prosperity” agenda as follows: “China has made it clear that we strive for more visible and substantive progress in the well-rounded development of individuals and the common prosperity of the entire population. We are working hard on all fronts to deliver this goal. The common prosperity we desire is not egalitarianism. To use an analogy, we will first make the pie bigger, and then divide it properly through reasonable institutional arrangements. As a rising tide lifts all boats, everyone will get a fair share from development, and development gains will benefit all our people in a more substantial and equitable way.” See World Economic Forum, “President Xi Jinping’s message to The Davos Agenda in full,” January 17, 2022, weforum.org. 3     Chancellor Scholz, when asked whether Germany would avoid using the Nord Stream II pipeline if Russia re-invaded Ukraine, said, "it is clear that there will be a high cost and that all this will have to be discussed if there is a military intervention against Ukraine.” He was speaking with NATO Secretary-General Jens Stoltenberg. See Hans Von Der Burchard, “Scholz: Germany will discuss Nord Stream 2 penalties if Russia attacks Ukraine,” Politico, January 18, 2022, politico.eu. 4     For the Begin Doctrine, see Meir Y. Soloveichik, “The Miracle of Osirak,” Commentary, April 2021, commentary.org. 5     The estimate of 12-24 months to mount a nuclear warhead on a missile has been cited by various credible sources, including David Albright and Sarah Burkhard, “Highlights of Iran’s Perilous Pursuit of Nuclear Weapons,” Institute for Science and International Security, August 24, 2021, isis-online.org, and Eric Brewer and Nicholas L. Miller, “A Redline for Iran?” Foreign Affairs, December 23, 2021, foreignaffairs.com. 6     See Edieal J. Pinker, Joseph Szmerekovsky, and Vera Tilson, “Technical Note – Managing a Secret Project,” Operations Research, February 5, 2013, pubsonline.informs.org, as well as “What Can Game Theory Tell Us About Iran’s Nuclear Intentions?” Yale Insights, March 17, 2015, insights.som.yale.edu.  7     See Josef Joffe, “Increasingly Isolated, Israel Must Rely On Nuclear Deterrence,” Strategika 35 (September 2016), Hoover Institution, hoover.org. 8     The sabotage of the Iran Centrifuge Assembly Center at the Natanz nuclear facility in July 2020 “set back Iran’s centrifuge program significantly and continues to do so,” according to David Albright, Sarah Burkhard, and John Hannah, “Iran’s Natanz Tunnel Complex: Deeper, Larger Than Expected,” Institute for Science and International Security, January 13, 2022, isis-online.org. For a recent positive case regarding Israel’s capabilities, see Mitchell Bard, “Military Options Against Iran,” Jewish Virtual Library, American-Israeli Cooperative Enterprise, January 2022, jewishvirtuallibrary.org.  9     For the FSB and REvil, see Chris Galford, “Russian FSB arrests members of REvil ransomware gang following attacks on U.S. infrastructure,” Homeland Preparedness News, January 18, 2022, homelandprepnews.com. For the Colonial Pipeline and JBS attacks, and other ransomware attacks, see Jonathan W. Welburn and Quentin E. Hodgson, “How the United States Can Deter Ransomware Attacks,” RAND Blog, August 9, 2021, rand.org. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

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)

Highlights Global equities are poised to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Non-US markets are likely to outperform. We examine the four pillars that have historically underpinned stock market performance. Pillar 1: Technically, the outlook for equities is modestly bullish, as investor sentiment is nowhere near as optimistic as it usually gets near market tops. Pillar 2: The outlook for economic growth and corporate earnings is modestly bullish as well. While global growth is slowing, it will remain solidly above trend in 2022. Pillar 3: Monetary and financial conditions are neutral. The Fed and a number of other central banks are set to raise rates and begin unwinding asset purchases this year. However, monetary policy will remain highly accommodative well into 2023. Pillar 4: Valuations are bearish in the US and neutral elsewhere. Investors should avoid tech stocks in 2022, focusing instead on banks and deep cyclicals, which are more attractively priced. The Bedrock For Equities In assessing the outlook for the stock market, our research has focused on four pillars: 1) Sentiment and other technical factors, which are most pertinent for stocks over short-term horizons of about three months; 2) cyclical fluctuations in economic growth and corporate earnings, which tend to dictate the path for stocks over medium-term horizons of about 12 months; 3) monetary and financial conditions, which are also most relevant over medium-term horizons; and finally 4) valuations, which tend to drive stocks over the long run. In this report, we examine all four pillars, concluding that global equities are likely to deliver mid-to-high single-digit returns this year, with the outlook turning bleaker in 2023 and beyond. Pillar 1: Sentiment And Other Technical Factors (Modestly Bullish)   Chart 1US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern US Equities: Breadth Is A Concern Scaling The Wall Of Worry Stocks started the year on a high note, before tumbling on Wednesday following the release of the Fed minutes. Market breadth going into the year was quite poor. Even as the S&P 500 hit a record high on Tuesday, only 57% of NYSE stocks and 38% of NASDAQ stocks were trading above their 200-day moving averages compared to over 90% at the start of 2021 (Chart 1). The US stock market had become increasingly supported by a handful of mega-cap tech stocks, a potentially dangerous situation in an environment where bond yields are rising and stay-at-home restrictions are apt to ease (more on this later). That said, market tops often occur when sentiment reaches euphoric levels. That was not the case going into 2022 and it is certainly not the case after this week's sell-off. The number of bears exceeded the number of bulls in the AAII survey this week and in six of the past seven weeks (Chart 2). The share of financial advisors registering a bullish bias declined by 25 percentage points over the course of 2021 in the Investors Intelligence poll. Option pricing is far from complacent. The VIX stands at 19.6, above its post-GFC median of 16.7.  According to the Minneapolis Fed’s market-based probabilities model, the market was discounting a slightly negative 12-month return for the S&P 500 as of end-2021, with a 3.6 percentage-point larger chance of a 20% decline in the index than a 20% increase (Chart 3). Chart 3Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Option Pricing Is Not Pointing To Elevated Complacency Chart 2Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Sentiment Is Not Exceptionally Bullish, Despite The S&P 500 Trading Close To All-Time Highs Equities do best when sentiment is bearish but improving (Chart 4). With bulls in short supply, stocks can continue to climb the proverbial wall of worry.   Whither The January Effect? Historically, stocks have fared better between October and April than between May and September (Chart 5). One caveat is that the January effect, which often saw stocks rally at the start of the year, has disappeared. In fact, the S&P 500 has fallen in January by an average annualized rate of 5.2% since 2000 (Table 1). Other less well-known calendar effects – such as the tendency for stocks to underperform on Mondays but outperform on the first trading day of each month – have persisted, however. Chart 4 Chart 5 Table 1Calendar Effects The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Bottom Line: January trading may be choppy, but stocks should rise over the next few months as more bears join the bullish camp. Last year’s losers are likely to outperform last year’s winners. Pillar 2: Economic Growth And Corporate Earnings (Modestly Bullish)   Economic Growth And Earnings: Joined At The Hip The business cycle is the most important driver of stocks over medium-term horizons of about 12 months. The reason is evident in Chart 6: Corporate earnings tend to track key business cycle indicators such as the ISM manufacturing index, industrial production, business sales, and global trade. Chart 6The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons The Business Cycle Is The Most Important Driver Of Stocks Over Medium-Term Horizons Chart 7PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth PMIs Signaling Above-Trend Growth Global growth peaked in 2021 but should stay solidly above trend in 2022. Both the service and manufacturing PMIs remain in expansionary territory (Chart 7). The forward-looking new orders component of the ISM exceeded 60 for the second straight month in December. The Bloomberg consensus is for real GDP to rise by 3.9% in the G7 in 2022, well above the OECD’s estimate of trend G7 growth of 1.4% (Chart 8). Global earnings are expected to increase by 7.1%, rising 7.5% in the US and 6.7% abroad (Chart 9). Our sense is that both economic growth and earnings will surprise to the upside in 2022. Chart 9Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Analysts Expect Single-Digit Earnings Growth Chart 8 Plenty Of Pent-Up Demand For Both Consumer And Capital Goods US households are sitting on $2.3 trillion in excess savings (Chart 10). Around half of these savings will be spent over the next few years, helping to drive demand. Households in the other major advanced economies have also buttressed their balance sheets. Chart 10Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand Plenty Of Pent-Up Demand After two decades of subdued corporate investment, capital goods orders have soared. This bodes well for capex in 2022. Inventories remain at rock-bottom levels, which implies that output will need to exceed spending for the foreseeable future (Chart 11). On the residential housing side, both the US homeowner vacancy rate and the inventory of homes for sale are near multi-decade lows. Building permits are 11% above pre-pandemic levels (Chart 12). Chart 11Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Business Investment Should Be Strong In 2022 Chart 12Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Residential Construction Will Remain Well Supported Chart 13China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed China's Credit Impulse Has Bottomed Chinese Growth To Rebound, Europe To Benefit From Lower Natural Gas Prices Chinese credit growth decelerated last year. However, the 6-month credit impulse has bottomed, and the 12-month impulse is sure to follow (Chart 13). Chinese coal prices have collapsed following the government’s decision to instruct 170 mines to expand capacity (Chart 14). China generates 63% of its electricity from coal. Lower energy prices and increased stimulus should support Chinese industrial activity in 2022. Like China, Europe will benefit from lower energy costs. Natural gas prices have fallen by nearly 50% from their peak on December 21st. A shrinking energy bill will support the euro (Chart 15). Chart 14Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Coal Prices Are Renormalizing In China Chart 15A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro A Shrinking Energy Bill Will Support The Euro Chart 16 Omicron Or Omicold? While the Omicron wave has led to an unprecedented spike in new cases across many countries, the economic fallout will be limited. The new variant is more contagious but significantly less lethal than previous ones. In South Africa, it blew through the population without triggering a major increase in mortality (Chart 16). Preliminary data suggest that exposure to Omicron confers at least partial immunity against Delta. The general tendency is for viral strains to become less lethal over time. After all, a virus that kills its host also kills itself. Given that Omicron is crowding out more dangerous strains such as Delta, any future variant is likely to emanate from Omicron; and odds are this new variant will be even milder than Omicron. Meanwhile, new antiviral drugs are starting to hit the market. Pfizer claims that its new drug, Paxlovid, cuts the risk of hospitalization by almost 90% if taken within five days from the onset of symptoms. Bottom Line: While global growth has peaked and the pandemic remains a risk, growth should stay well above trend in the major economies in 2022, fueling further gains in corporate earnings and equity prices.   Pillar 3: Monetary And Financial Factors (Neutral)   Chart 17The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months The Overall Stance Of Monetary Policy Will Not Return To Pre-Pandemic Levels For At Least Another 12 Months Tighter But Not Tight Monetary and financial factors help govern the direction of equity prices both because they influence economic growth and also because they affect the earnings multiple at which stocks trade. There is little doubt that a number of central banks, including the Federal Reserve, are looking to dial back monetary stimulus. However, there is a big difference between tighter monetary policy and tight policy. Even if the FOMC were to raise rates three times in 2022, as the market is currently discounting, the fed funds rate would still be half of what it was on the eve of the pandemic (Chart 17). Likewise, even if the Fed were to allow maturing assets to run off in the middle of this year, as the minutes of the December FOMC meeting suggest is likely, the size of the Fed’s balance sheet will probably not return to pre-pandemic levels until the second half of this decade.   A Higher Neutral Rate We have argued in the past that the neutral rate of interest in the US is higher than widely believed. This implies that the overall stance of monetary policy remains exceptionally stimulative. Historically, stocks have shrugged off rising bond yields, as long as yields did not increase to prohibitively high levels (Table 2). Table 2As Long As Bond Yields Don’t Rise Into Restrictive Territory, Stocks Will Recover The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market If the neutral rate ends up being higher than the Fed supposes, the danger is that monetary policy will stay too loose for too long. The question is one of timing. The good news is that inflation should recede in the US in 2022, as supply-chain bottlenecks ease and spending shifts back from goods to services. The bad news is that the respite from inflation will not last. As discussed in Section II of our recently-published 2022 Strategy Outlook, inflation will resume its upward trajectory in mid-2023 on the back of a tightening labor market and a budding price-wage spiral. This second inflationary wave could force the Fed to turn much more aggressive, spelling the end of the equity bull market. Bottom Line: While the Fed is gearing up to raise rates and trim the size of its balance sheet, monetary policy in the US and in other major economies will remain highly accommodative in 2022. US policy could turn more restrictive in 2023 as a second wave of inflation forces a more aggressive response from the Fed.   Pillar 4: Valuations (Bearish In The US; Neutral Elsewhere)   US Stocks Are Looking Pricey… While valuations are a poor timing tool in the short run, they are an excellent forecaster of stock prices in the long run. Chart 18 shows that the Shiller PE ratio has reliably predicted the 10-year return on equities. Today, the Shiller PE is consistent with total real returns of close to zero over the next decade. Chart 18 Investors’ allocation to stocks has also predicted the direction of equity prices (Chart 19). According to the Federal Reserve, US households held a record high 41% of their financial assets in equities as of the third quarter of 2021. If history is any guide, this would also correspond to near-zero long-term returns on stocks. Chart 19Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II) Valuations Matter For Long-Term Returns (II)   … But There Is More Value Abroad Valuations outside the US are more reasonable. Whereas US stocks trade at a Shiller PE ratio of 37, non-US stocks trade at 20-times their 10-year average earnings. Other valuation measures such as price-to-book, price-to-sales, and dividend yield tell a similar story (Chart 20). Chart 20AUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (I) Chart 20BUS Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) US Stocks Are Trading At A Significant Premium To Their Non-US Peers (II) Cyclicals And Banks Overrepresented Abroad Our preferred sector skew for 2022 favors non-US equities. Increased capital spending in developed economies and incremental Chinese stimulus should boost industrial stocks and other deep cyclicals, which are overrepresented outside the US (Table 3). Banks are also heavily weighted in overseas markets; they should also do well in response to faster-than-expected growth and rising bond yields (Chart 21). Table 3Deep Cyclicals And Financials Are Overrepresented Outside The US The Four Pillars Of The Stock Market The Four Pillars Of The Stock Market Chart 21Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Rising Bond Yields Will Help Bank Shares Bottom Line: Valuations are more appealing outside the US, and with deep cyclicals and banks set to outperform tech over the coming months, overseas markets are the place to be in 2022. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Global Investment Strategy View Matrix Image Special Trade Recommendations Image Current MacroQuant Model Scores Image

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 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)