Industrials

Executive Summary Shanghai Is Extending Lockdowns Due To Exponentially Rising COVID Cases Shanghai Is Extending Lockdowns Due To Exponentially Rising COVID Cases Shanghai Is Extending Lockdowns Due To Exponentially Rising COVID Cases The economic impact of China’s struggle with another wave of COVID outbreaks is showing up in March’s PMI and high-frequency data. The highly contagious nature of the Omicron variant suggests that Shanghai’s battle against the virus spread may last longer than the market has priced in. Chinese authorities will continue playing whack-a-mole in efforts to eliminate the country’s COVID cases. The zero-COVID approach and the virus’ mutating to more contagious variants mean that the country may have to impose more frequent mobility restrictions going forward than in the past two years. Although Chinese policymakers are determined to stabilize the economy, the ongoing combat with COVID will weigh down the effectiveness of the stimulus. In relative terms, we maintain a neutral position on Chinese onshore stocks. However, downshifting corporate profits and the economic shock from lockdowns remain significant risks to the absolute performance of Chinese stocks. Bottom Line: China’s combat against the current COVID-19 outbreaks may last longer than the market has priced in. In the near term, the lockdowns will weigh down the effectiveness of the stimulus. In the second half of the year, the more contagious virus mutations and China’s sticking to zero-COVID strategy may lead to more frequent disruptions to business activity.     Chart 1China Is Bracing For The Worst COVID Outbreak Since Early 2020 China Is Bracing For The Worst COVID Outbreak Since Early 2020 China Is Bracing For The Worst COVID Outbreak Since Early 2020 China’s efforts to stabilize economic growth are facing new challenges, dampening an already fragile recovery. The current wave of COVID-19 outbreaks — the worst since early 2020 — has infected more than 100,000 (TK) people across the country, and the number of new cases is still rising at an exponential rate (Chart 1). Measures to contain the spread of the virus have led to city lockdowns, halted factory production and have dragged down the tourism and catering industries. In previous reports, we noted that it is challenging for China to reach this year’s 5.5% growth target due to downbeat private-sector sentiment and subdued demand for housing. The outlook for China’s economy is grimmer now. The highly contagious COVID virus mutations, including the emerging Omicron BA.2 variant, will make it more difficult for China to control its domestic outbreaks going forward. We do not expect that China will fundamentally change its zero-COVID policy throughout the rest of this year. Therefore, the country will probably see more frequent regional and city lockdowns this year than in the past two years.  The leadership will calibrate its handling of these lockdowns to minimize damage to the economy, and Beijing will continue stepping up its growth support policies. However, the whack-a-mole strategy to eliminate domestic COVID cases will be disruptive to business activity and dampen the effectiveness of policy easing. A One-Two Punch… Related Report  China Investment StrategyA Choppy Bottom The downside risks to China’s economy stemming from the ongoing domestic COVID outbreaks are adding to the difficulties the country is already facing due to subdued domestic demand. As we have been highlighting in our previous reports, weak private sector sentiment has been weighing down the effectiveness of authorities’ efforts to stimulate the Chinese economy. The sluggish PMI data released last week in part reflects the impact of restrictions imposed to control the latest wave of COVID-19 infections, but also highlights the bleak domestic demand conditions. Notably, the March PMI survey does not capture the full impact of the Shanghai lockdown as the data collection period ended before the restrictions went into effect on March 28. The official composite PMI fell from 51.2 to 48.8 – below the 50 boom-bust threshold and the lowest reading since February 2020. The drop reflects a slump in the manufacturing and – to a greater extent – the non-manufacturing sectors, which both fell into a contractionary territory. The manufacturing PMI slid 0.7 points to 49.5, while the non-manufacturing PMI dropped 3.2 points to 48.4 (Chart 2). The new orders sub-index of the manufacturing PMI lost nearly two percentage points and deteriorated more sharply than the production index (Chart 3). Moreover, the spread between the new orders component and new export orders – a proxy for domestic demand – ticked down in March (Chart 3, bottom panel). This indicates that weak production does not just stem from COVID-related supply-side issues, but also from poor domestic demand conditions. Chart 2Chinese PMIs Slide Into Contractionary Territory Chinese PMIs Slide Into Contractionary Territory Chinese PMIs Slide Into Contractionary Territory Chart 3Economic Shock From Lockdowns Compounds An Already Weak Domestic Demand Economic Shock From Lockdowns Compounds An Already Weak Domestic Demand Economic Shock From Lockdowns Compounds An Already Weak Domestic Demand Chart 4Auto Inventory Index Jumped To Highest Since Early 2020 Auto Inventory Index Jumped To Highest Since Early 2020 Auto Inventory Index Jumped To Highest Since Early 2020 In addition, high-frequency data from the China Automobile Dealers Association shows that the Vehicle Inventory Alert Index (VIAI) – a survey that measures destocking pressures in the automobile industry – jumped to the highest level since the first wave of COVID-19 hit China in early 2020 (Chart 4). A rising VIAI above the 50-percent threshold indicates that auto inventories are cumulating at a faster pace than demand.  Importantly, the cities and regions that have been worst hit by this round of COVID outbreaks are mostly coastal metropolises and business hubs such as Shanghai, Shenzhen and cities in Jiangsu and Zhejiang provinces. These cities and provinces represent more than 20% of China’s aggregate GDP and almost 30% of the country’s total import and export volume. As such, the negative impact on China’s overall economy from the lockdowns will be more substantive than during the previous waves. Measures to contain Shanghai’s worst-ever COVID outbreak are also disrupting operations at the world’s busiest container port, adding strains to the already overstretched global shipping industry (Chart 5). The supplier delivery times subindex of the manufacturing PMI dropped to 46.5 in March, the lowest reading since March 2020 (Chart 6). This suggests that suppliers’ delivery times have lengthened with near-term supply chain pressure, since lower readings reflect longer delivery times. Chart 5Shanghai Lockdowns Will Disrupt The Already Overstretched Global Shipping Industry Shanghai Lockdowns Will Disrupt The Already Overstretched Global Shipping Industry Shanghai Lockdowns Will Disrupt The Already Overstretched Global Shipping Industry Chart 6Chinese Suppliers' Delivery Times Have Lengthened Chinese Suppliers' Delivery Times Have Lengthened Chinese Suppliers' Delivery Times Have Lengthened Bottom Line: The economic shock from the current COVID outbreaks is compounding an already weak domestic demand in China. Since the cities and regions that are affected by this round of lockdowns are some of China’s most developed metropolitan areas, the negative impact will likely be larger than during the past two years. How Long Will The Battle Last? China’s struggle to contain the current round of domestic COVID outbreaks will likely last longer than the market has priced in. There is also a non-trivial risk that during the rest of the year, the country will need to shutter large parts of its economy more frequently to combat the spread of COVID variants, which appear to become more contagious as the mutation continues. The lockdowns in Shanghai have already been extended beyond the originally announced two-phased, eight-day restriction plan (Chart 7). The first phase of the lockdown, for which restrictions were due to be lifted on the morning of April 1, has now been extended to anywhere between 3 to 10 days. It may take Shanghai, a city of 25 million residents, between four to six weeks to bring the number of new cases down to a level that is acceptable to the authorities. Chart 7Shanghai Is Extending Its Two-Phased, Eight-Day Lockdowns Bracing For More Turbulence Bracing For More Turbulence Shenzhen, a dynamic metropolitan city bordering Hong Kong, seems to have successfully contained its COVID outbreaks after only one week of a city-wide lockdown. However, Shenzhen imposed lockdowns at an early stage of the outbreak, when both confirmed and asymptomatic case numbers in the city were in the low double digits. Shanghai, on the other hand, took more stringent measures when the number of asymptomatic cases had already reached nearly a thousand. The Omicron variant is four times more transmissible than the earlier Delta mutation, which means it will generate an explosive rise in cases and make containing the virus spread much more difficult than with Delta. In a fully susceptible (unvaccinated and uninfected) population, one person with Delta would on average infect five other people, while one person with Omicron could transmit the virus to about 20 others. As a result, despite a relatively low number of newly confirmed cases, the surging asymptomatic cases in Shanghai imply that a larger population in the city might have already been infected (Chart 8). China’s struggle with the current wave of COVID outbreaks may be an example of what lies ahead, as continuously mutating variants become more contagious and will pose fresh new challenges to China’s zero-COVID approach. The latest strain of Omicron BA.2 appears to be 40% more contagious than the original Omicron strain and is quickly spreading around the world. The number of cases has spiked across much of Europe, parts of Asia, and has begun to rise in North America (Chart 9). It took only two months from when China reported its first local Omicron BA.1 case in early January to the outbreaks of Omicron BA.2 in March. Chart 8Surging Asymptomatic Patients In Shanghai Imply More Confirmed Cases Still To Come Surging Asymptomatic Patients In Shanghai Imply More Confirmed Cases Still To Come Surging Asymptomatic Patients In Shanghai Imply More Confirmed Cases Still To Come Chart 9Covid Cases Are On The Rise Again Globally Bracing For More Turbulence Bracing For More Turbulence This presents the Chinese authorities with a difficult dilemma: impose severe mobility restrictions when domestic cases pop up, or let the virus run rampant and develop a herd immunity among much of its population. China’s leadership has recently reiterated that the country will stick to its zero-COVID strategy. The success that China has had in suppressing the virus in the past two years has left its population with little natural immunity. Moreover, while China’s overall vaccination rate is high at 85%, less than 50% of people over the age of 80 in the country are fully vaccinated. The authorities have been fine tuning their measures to control the virus spread while sticking to a zero-COVID approach. The recently calibrated measures include allowing residents to take rapid antigen tests at home, quarantining people with asymptomatic COVID cases at dedicated isolation centers rather than hospitals, and monitoring patients for shorter periods than previously required. China has also fast-tracked the approval for the importing and domestic manufacturing of Paxlovid, which is highly effective at preventing hospitalization if taken within five days of the onset of symptoms. In addition, the global production of antiviral drugs is starting to ramp up (Chart 10). Nonetheless, China will probably wait until the antiviral drugs are in sufficient supply before fundamentally relaxing its zero-COVID policy. In the meantime, while the country’s economic growth will rebound when the current wave of COVID cases subsides, disruptive outbreaks and lockdowns may become more frequent as the authorities continue to play whack-a-mole with COVID (Chart 11). As a result, business activity in China will suffer. Chart 10Production Of New COVID Drugs Is Picking Up Production Of New COVID Drugs Is Picking Up Production Of New COVID Drugs Is Picking Up Chart 11China Has The Most Stringent COVID-Control Measures Among Large Economies China Has The Most Stringent COVID-Control Measures Among Large Economies China Has The Most Stringent COVID-Control Measures Among Large Economies Bottom Line: Shanghai’s current battle with COVID outbreaks will likely continue in the coming weeks. Before China can relax its zero-COVID policy, the more contagious COVID virus mutations in the future will see Chinese authorities adopt even harsher quarantine and control measures, which will disrupt economic activity further. Investment Conclusion  Chinese stocks in both onshore and offshore markets have recovered some ground from their deeply oversold conditions in mid-March (Chart 12A). While the risk-reward profile for the A-share market warrants a neutral position in a global portfolio, in absolute terms both on- and offshore Chinese stock prices have probably not reached their bottom (Chart 12B). Chart 12AChinese Stocks Will Likely Fall Further In Q2 Chinese Stocks Will Likely Fall Further In Q2 Chinese Stocks Will Likely Fall Further In Q2 Chart 12BIn Relative Terms, Stay Neutral On Chinese Onshore Stocks In Relative Terms, Stay Neutral On Chinese Onshore Stocks In Relative Terms, Stay Neutral On Chinese Onshore Stocks The private sector’s downbeat sentiment, households’ subdued demand for housing, and the ongoing COVID-19 lockdowns pose significant near-term downside risks to China’s economy and corporate profits. February’s credit impulse shows that corporate and household demand for credit has been weakening. Without a major reversal in corporate credit and the property market, a strong business cycle recovery is unlikely in China. Moreover, the March PMI readings suggest that the lockdowns in China’s business and manufacturing hubs will have substantial negative impacts on the economy. As such, we maintain our neutral stance on Chinese onshore stocks and continue to recommend underweight Chinese offshore stocks in a global portfolio.   Jing Sima China Strategist jings@bcaresearch.com   Strategic Themes Cyclical Recommendations

Executive Summary Expansion In European Defense Expanding Military Spending Expanding Military Spending European yields have significant upside on a structural basis. European government spending will remain generous, which will boost domestic demand; meanwhile, lower global excess savings will lift the neutral rate of interest and structurally higher inflation will boost term premia. A short-term pullback in yields is nonetheless likely; however, it will not short-circuit the trend toward higher yields on a long-term basis. CYCLICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Favor European Aerospace & Defense Over European Benchmark 3/28/2022     Favor European Aerospace & Defense Over Other Industrials 3/28/2022     Bottom Line: Investors should maintain a below-benchmark duration in their European fixed-income portfolios. Higher yields driven by robust domestic demand and strong capex also boost the appeal of industrial, materials, and financials sectors. Aerospace and defense stocks are particularly appealing.     The economic impact of the war in Ukraine continues to drive the day-to-day fluctuations of the market; however, investors cannot ignore the long-term trends in the economy and markets. The direction of bond yields over the coming years is paramount among those questions. Does the recent rise in yields only reflect the current inflationary shock caused by both supply-chain impairments and commodity inflation—that is, is it finite? Or does that rise mirror structural forces and therefore have much further to run? We lean toward yields having more upside over the coming years, propelled higher by structural forces. As a result, we continue to recommend investors structurally overweight sectors that benefit from a rising yield environment, such as financials and industrials, while also favoring value over growth stocks. The defense sector is particularly attractive. Three Structural Forces Behind Higher Yields The current supply-chain disruptions and inflation crises have played a critical role in lifting European yields. However, a broader set of factors underpins our bearish bond view—namely, the lack of fiscal discipline accentuated by the consequences of the Ukrainian war, the likely move higher in the neutral rate of interest generated by lower savings, and the long-term uptrend in inflation. Profligate Governments Chart 1 The Lasting Bond Bear Market The Lasting Bond Bear Market Larger government deficits will contribute to higher European yields. Europe is not as fiscally conservative as it was before the COVID-19 crisis. Establishment politicians must fend off pressures caused by voters attracted to populist parties willing to spend more. Consequently, IMF estimates published prior to the Ukrainian war already tabulated that, for the next five years, Europe’s average structurally-adjusted budget deficit would be 2.4% of GDP wider than it was last decade (Chart 1). Chart 2Expanding Military Spending Expanding Military Spending Expanding Military Spending The Ukrainian crisis is also prompting a fiscal response that will last many years. Europe does not want to stand still in the face of the Russian threat. Today, Western Europe’s military spending amounts to 1.5% of GDP, or €170 billion. This is below NATO’s threshold of 2% of GDP. Rebuilding military capacity will take large investments. Thus, European nations are likely to move toward that target and even go beyond. Conservatively, if we assume that military spending hits 2% of GDP by the end of the decade, it will rise above €300 billion (Chart 2). Weaning Europe off Russian energy will also prevent a significant fiscal retrenchment. This effort will take two dimensions. The first initiative will be to build infrastructures to receive more LNG from the rest of the world to limit Russian intake. Constructing regasification and storage facilities as well as re-directing pipeline networks be costly and require additional CAPEX over the coming years. The second initiative will be to double-up on green initiatives to decrease the need for fossil fuel. The NGEU funds are already tackling this strategic goal. Nonetheless, the more than €100 billion reserved for renewable energy and energy preservation initiatives was only designed to kick-start hitting the EU’s CO2 emission target for 2050. Accelerating this process not only helps cutting the dependence on Russian energy, but it is also popular with voters. The path of least resistance is to invest in that sphere and to increase such investment beyond the current sums from the NGEU program. The last fiscal push is likely to be more temporary. The UN estimates that four million refugees have left Ukraine, with the vast majority settling in the EU. Accommodating that many individuals will be costly and will add to government spending across the region. Even if mostly transitory, this spending will have an important impact on activity. Larger fiscal deficits push yields higher for two reasons. Greater sovereign issuance that does not reflect a negative shock to the private sector will need to offer higher rates of returns to attract investors. Moreover, greater government spending will boost aggregate demand, which increases money demand. As a result, the price of money will be higher than otherwise, which means that interest rates will rise—as will yields. Decreasing Global Excess Savings Decreasing global excess savings will put upward pressure on the global neutral rate of interest, a phenomenon Peter Berezin recently discussed in BCA’s Global Investment Strategy service. This process will be visible in Europe as well. The US will play an important role in the process of lifting global neutral rates because the dollar remains the foundation of the global financial system. Compared to last decade, the main drag on US savings is that household deleveraging is over. As households decreased their debt load following the global financial crisis, a large absorber of global savings vanished, putting downward pressure on the price of those savings. Today, US households enjoy strong net worth equal to 620% of GDP and have resumed accumulating debt (Chart 3). Consequently, the downward trend in US total private nonfinancial debt loads has ended. The US capex cycle is likely to experience a boost as well. As Peter highlighted, the US capital stock is ageing (Chart 4). Moreover, the past five years have witnessed three events that underscore the fragility of global supply-chains: a disruptive Sino-US trade war, a pandemic, and now a military conflict. This realization is causing firms to move from a “just-in-time” approach to managing supply-chains to a “just-in-case” one. The process of building redundancies and localized supply chains will add to capex for many years, pushing up ex-ante investments relative to savings, and thus, interest rates. Chart 3US Households Are Done Deleveraging US Households Are Done Deleveraging US Households Are Done Deleveraging Chart 4An Ageing US Capital Stock An Ageing US Capital Stock An Ageing US Capital Stock China’s current account surplus is also likely to decline. For the past two decades, China has been one of the largest providers of savings to the global economy. This is a result of an annual current account surplus that first averaged $150 billion per year from 2000 to 2010 and then $180 billion from 2010 to 2020, and now stands at $316 billion. Looking ahead, China wants to use fiscal policy more aggressively to support demand, which often boosts imports without increasing exports. Also, more domestically-oriented supply chains around the world will limit the growth of Chinese exports. This combination will compress Chinese excess savings, which will place upward pressure on the global neutral rate of interest. Europe is not immune to declining savings. Over the past ten years, the Euro Area current account surplus has averaged €253 billion. Germany’s current account surplus stood at 7.4% of GDP before the pandemic. Those excess savings depressed global rates in general and European ones especially (Chart 5). As in the US, Europe’s capital stock is ageing and needs some upgrade (Chart 6). Moreover, greater government spending boosts aggregate demand. Because investment is a form of derived demand, stronger overall spending promotes capex to a greater extent. Thus, Europe’s public infrastructure push will lift private capex and curtail regional excess savings beyond the original drag from wider fiscal deficits. Additionally, the European population is getting older and will have to tap into their excess savings as they retire. This process will further diminish Europe’s current account surplus, that is, its excess savings. Chart 5Excess Savings Cap Relative Yields Excess Savings Cap Relative Yields Excess Savings Cap Relative Yields Chart 6An Ageing European Capital Stock Too An Ageing European Capital Stock Too An Ageing European Capital Stock Too Structurally Higher Inflation BCA believes that the current inflation surge is temporary and mostly reflects a mismatch between demand and supply. However, we also anticipate that, once this inflation climax dissipates, inflation will settle at a level higher than that prior to COVID-19 and will trend higher for the remainder of this decade. Labor markets will tighten going forward because policy rates remain well below neutral interest rates. Output gaps will close because of robust government spending and capex. This will keep wage growth elevated in the US and reanimate moribund salary gains in the Eurozone (Chart 7). This process, especially when combined with less efficient global supply chains and lower excess savings (which may also be thought of as deficient demand), will maintain inflation at a higher level than in the past two decades. Higher inflation will lift yields for two main reasons. First, investors will require both greater long-term inflation compensation and higher policy rates than in the past. Second, higher inflation often generates greater economic volatility and policy uncertainty, which means that today’s minimal term premia will increase over time (Chart 8). Together, these forces will create a lasting upward drift in yields. Chart 7European Wages Will Eventually Revive European Wages Will Eventually Revive European Wages Will Eventually Revive Chart 8Term Premia Won't Stay This Low Term Premia Won't Stay This Low Term Premia Won't Stay This Low Bottom Line: European yields will sport a structural uptrend for the remainder of the decade. Three forces support this assertion. First, European government spending will remain generous, supported by infrastructure and military spending. Second, global excess savings will recede as US consumer deleveraging ends, global capex rises, and the Chinese current account surplus narrows. Europe will mimic this process in response to an ageing population, greater government spending, and capex. Finally, inflation is on a structural uptrend, which will warrant higher term premia across the world. Not A Riskless View There are two main risks to this view, one in the near-term and one more structural. The near-term risk is the most pertinent for investors right now. Global yields may have embarked on a structural upward path, but a temporary pullback is becoming likely. As Chart 9 highlights, the expected twelve-month change in the US policy rate is at the upper limit of its range of the past three decades. Historically, when the discounter attains such a lofty level, a retrenchment in Treasury yields ensues, since investors have already discounted a significant degree of tightening. The same is true in Europe, where the ECB discounter is also consistent with a temporary pullback in German 10-year yields (Chart 10). Chart 9Discounters Point To A Treasury Rally... Discounters Point To A Treasury Rally... Discounters Point To A Treasury Rally... Chart 10... And A Bund Rally ... And A Bund Rally ... And A Bund Rally Chart 11A Mixed Message A Mixed Message A Mixed Message Investor positioning confirms the increasing tactical odds of a yield correction. The BCA Composite Technical Indicator for bonds is massively oversold, which often anticipates a bond rally (Chart 11). This echoes the signals from the JP Morgan surveys that highlight the very low portfolio duration of the bank’s clients. However, the BCA Bond Valuation Index suggests that bonds remain expensive. Together, these divergent messages point toward a temporary bond rally, not a permanent one. The longer-term risk is regularly highlighted by Dhaval Joshi in BCA’s Counterpoint service. Dhaval often shows that the stock of global real estate assets has hit $300 trillion or 330% of global GDP. Real estate is a highly levered asset class and global cap rates have collapsed with global bond yields. With little valuation cushion, real estate prices could become very vulnerable to higher yields. Nevertheless, real estate is also a real asset that produces an inflation hedge. Moreover, rental income follows global household income, and stronger aggregate demand will likely lift median household income especially in an environment in which globalization has reached its apex and populism remains a constant threat. Bottom Line: Global investor positioning has become stretched; therefore, a near-term pullback in yield is very likely, especially as central bank expectations have become aggressive. Nonetheless, a bond rally is unlikely to be durable in an environment in which bonds are expensive and in which growth and inflation will remain more robust than they were last decade. A greater long-term risk stems from expensive global real estate markets. However, real estate is sensitive to global economic activity and inflation, which should allow this asset class ultimately to weather higher yields. Investment Conclusions An environment in which yields rise will inflict additional damage on global bond portfolios. This is especially true in inflation-adjusted terms, since real yields stand at a paltry -0.76% in the US and -2.5% in Germany. Hence, we continue to recommend investors maintain a structural below-benchmark duration bias in their portfolios. Nonetheless, investors with enough flexibility in their investment mandate should take advantage of the expected near-term pullback in yields. Those without this flexibility should use the pullback as an opportunity to shorten their portfolio duration. Higher yields will also prevent strong multiple expansion from taking place; hence, the broad stock market will also offer paltry long-term real returns. Another implication of rising yields, especially if they reflect stronger growth and rising neutral interest rates, is to underweight growth stocks relative to value stocks (Chart 12). Growth stocks are expensive and very vulnerable to the pull on discount rates that follows rising risk-free rates. Meanwhile, stronger economic activity driven by infrastructure spending and capex will help the bottom line of industrial and material firms. Financials will also benefit. Higher yields help this sector and robust capex also boosts loan growth, which will generate a significant tailwind for banking revenues. Hence, rising yields will boost the attractiveness of banks, especially after they have become significantly cheaper because of the Ukrainian war (Chart 13). Chart 12Favor Value Over Growth Favor Value Over Growth Favor Value Over Growth Chart 13Bank Remain Attractive Bank Remain Attractive Bank Remain Attractive Related Report  European Investment StrategyFallout From Ukraine Finally, four weeks ago, we highlighted that defense stocks were particularly appealing in today’s context. The re-armament of Europe in response to secular tensions with Russia is an obvious tailwind for this sector. However, it is not the only one. A long-term theme of BCA’s Geopolitical Strategy service is the expanding multipolarity of the world.  The end of an era dominated by a single hegemon (the US) causes a rise in geopolitical instability and tensions. The resulting increase in conflict will invite a pickup in global military spending. Chart 14Defense Will Outshine The Rest Defense Will Outshine The Rest Defense Will Outshine The Rest European defense and aerospace stocks are expensive, with a forward P/E ratio approaching the top-end of their range relative to the broad market and other industrials. However, their relative earnings are also depressed following the collapse in airplane sales caused by the pandemic. Our bet on the sector is that its earnings will outperform the broad market as well as other industrials because of the global trend toward military buildup. As relative earnings recover their pandemic-induced swoon, so will relative equity prices (Chart 14). Bottom Line: Higher yields warrant a structural below-benchmark duration in European fixed-income portfolios, even if a near-term yield pullback is likely. As a corollary, value stocks will outperform growth stocks while industrials, materials, and financials will also beat a broad market whose long-term real returns will be poor. Within the industrial complex, aerospace and defense equities are particularly appealing because a global military buildup will boost their earnings prospects durably.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Executive Summary Ebbing Stagflation Fear Will Prompt Rerating Ebbing Stagflation Fear Will Prompt Rerating Ebbing Stagflation Fear Will Prompt Rerating European inflation will rise further before peaking this summer. Core CPI will reach between 2.8% and 3.2% by year-end before receding. The combination of stabilizing growth and the eventual peak in inflation will cause stagflation fears to recede. European assets have greater upside. Cyclicals, small-caps, and financials will be major beneficiaries of declining stagflation fears. The underperformance of UK small-cap stocks is nearing its end. UK large-cap equities are a tactical sell against Eurozone and Swedish shares. TACTICAL INCEPTION DATE RETURN SINCE INCEPTION (%) COMMENT EQUITIES Buy European & Swedish Equities / Sell UK Large Caps Stocks 03/21/2022     Bottom Line: Stagflation fears are near an apex as commodity inflation recedes. A peak in these fears will allow European asset prices to perform strongly over the coming quarters.     Despite a glimmer of hope that Ukraine and Russia may find a diplomatic end to the war, the reality on the ground is that the conflict has intensified. Although the hostilities are worsening and the European Central Bank (ECB) surprised the markets with its hawkish tone, European assets have begun to catch a bid. The crucial question for investors is whether this rebound constitutes a new trend or a counter-trend move? Our view about Europe is optimistic right now. The path is not a direct line upward. The recent optimism about the outcome of the Russia-Ukraine talks is premature; however, we are getting to the point when markets are becoming desensitized to the war and energy prices are losing steam. Moreover, the increasing number of statements by Chinese economic authorities pointing toward greater stimulus and support to alleviate the pain created by China’s stringent zero-COVID policy are another positive omen. Higher Inflation For Some Time European headline inflation is set to exceed 7% this summer and core CPI will increase between 2.8% and 3.2% by the end of 2022. Related Report  European Investment StrategySpring Stagflation The main force that will push inflation higher in Europe remains commodity prices. Energy inflation is extremely strong at already 32% per annum (Chart 1). It will increase further because of both the recent jump in Brent prices to EUR122/bbl on March 8 and the upsurge in natural gas prices, which were as high as EUR212/MWh on the same day before settling to EUR106/MWh last Friday. The impact of energy prices will not be limited to headline inflation and will filter through to core CPI (Chart 1, bottom panel). The average monthly percentage change in the Eurozone core CPI inflation stands at 0.25% for the past six months (compared to an average of 0.09% over the past ten years), or the period when energy-prices inflation has been the strongest. Assuming monthly inflation remains at such an elevated level, annual core CPI will hit 3.3% in the Eurozone by the end of 2022 (Chart 2). Chart 2Core CPI to Rise Further Core CPI to Rise Further Core CPI to Rise Further Chart 1Energy Inflation: Alive And Well Energy Inflation: Alive And Well Energy Inflation: Alive And Well The picture is not entirely bleak. Many forces suggest that these inflationary forces will recede before year-end in Europe. Energy prices are peaking, which is consistent with a diminishing inflationary impulse from that space. We showed two weeks ago that the massive backwardation of oil curves, the heavy bullish sentiment, and the high level of risk-reversals were consistent with a severe but transitory adjustment in the energy market. Oil markets will experience further volatility, as uncertainty around peace/ceasefire negotiations continues to evolve in Ukraine. Nonetheless, the peak in energy prices has most likely been reached. BCA’s energy strategists expect Brent to average $93/bbl in 2022 and in 2023. The potential for a decline in headline CPI after the summer is not limited to energy prices. Dramatic moves in the commodity market, from metals to agricultural resources, have made headlines. Yet, the rate of change of commodity prices is decelerating, hence, the commodity impulse to inflation is slowing sharply. As Chart 3 shows, this is a harbinger of a slowdown in European headline CPI. Related Report  European Investment StrategyFallout From Ukraine Looking beyond commodity markets, the recent deceleration in European economic activity also suggests weaker inflation in the latter half of 2022. Germany will likely suffer a recession because it already registered a negative GDP growth in Q4 2021. Q1 2022 growth will be even worse because of the country’s high exposure to both China and fossil fuel prices. More broadly, the recent deceleration in the rate of change of both the manufacturing and services PMIs is consistent with an imminent peak in the second derivative of goods and services CPI (Chart 4). Chart 3Commodity Impulse Is Peaking Commodity Impulse Is Peaking Commodity Impulse Is Peaking Chart 4Inflation's Maximum Momentum Is Now Inflation's Maximum Momentum Is Now Inflation's Maximum Momentum Is Now Underlying drivers of inflation also remain tame in Europe. European negotiated wages are only expanding at a 1.5% annual rate, which translates into unit labor costs growth of 1% (Chart 5). This contrast with the US, where wages are expanding at a 4.3% annual rate. A peak in inflation, however, does not mean that CPI readings will fall below the ECB’s 2% threshold anytime soon. The European economy continues to face supply shortages that the Ukrainian conflict exacerbates (Chart 6). Moreover, the recent wave of COVID-19 in China increases the risk of disruptions in supply chains, as highlighted by the closure of Foxconn factories in Shenzhen. Finally, inflation has yet to peak; mathematically, it will take a long time before it falls back below levels targeted by Frankfurt. Chart 5The European Labor Market Is Not Inflationary The European Labor Market Is Not Inflationary The European Labor Market Is Not Inflationary Chart 6Not Blemish-Free Not Blemish-Free Not Blemish-Free Bottom Line: European headline inflation will peak this summer, probably above 7%. Additionally, core CPI is likely to reach between 2.8% and 3.2% in the second half of 2022. As a result of a decline in the commodity impulse, inflation will decelerate afterward, but it will remain above the ECB’s 2% target for most of 2023. Hopes For Growth Two weeks ago, we wrote that Europe was facing a stagflation episode in the coming one to two quarters, but that, ultimately, economic activity will recover well. Recent evidence confirms that assessment. Chart 7A Coming Chinese Tailwind? A Coming Chinese Tailwind? A Coming Chinese Tailwind? The tone of Chinese policymakers is becoming more aggressive, in favor of supporting the economy. On March 16, Vice-Premier Liu He highlighted that Beijing was readying to support property and tech shares and that it will do more to stimulate the economy. True, this response was made in part to address the need to close cities affected by the sudden spike of Omicron cases around China. Nonetheless, the global experience with Omicron demonstrates that, as spectacular and violent the surge in cases may be, it is short-lived. Meanwhile, the impact of stimulus filters through the economy over many months. As a result, Europe will experience the impact of China’s Omicron-induced slowdown, while it also suffers from the growth-sapping effects of the Ukrainian conflict; however, it will also enjoy the positive effect on growth of a rising credit impulse over several subsequent quarters (Chart 7). Beyond China, the other themes we have discussed in recent weeks remain valid. First, European fiscal policy will become looser, as governments prepare to fight the slowdown caused by the war, while also increasing infrastructure spending to wean Europe off Russian energy. Moreover, European military spending is well below NATO’s 2% objective. This will not remain the case, as military expenditure may leap from less than EUR100bn per year to nearly EUR400bn per year over the coming decade. Second, European spending on consumer durable goods still lags well behind the trajectory of the US. With the energy drag at its apex today, consumer spending on durable goods will be able to catch up in the latter half of the year, especially with the household savings rate standing at 15% or 2.5 percentage points above its pre-COVID level. Bottom Line: European growth will be very low in the coming quarters. Germany is likely to face a technical recession as Q1 2022 data filters in. Nonetheless, Chinese stimulus, European fiscal support, pent-up demand, and a declining energy drag will allow growth to recover in the latter half of the year. As a result, we agree with the European Commission estimates that European growth will slow markedly this year. Market Implications In the context of a transitory shock to European economic activity and a coming peak in inflation, European stock prices have likely bottomed. Chart 8Depressed Sentiment To Help Beta Depressed Sentiment To Help Beta Depressed Sentiment To Help Beta Sentiment has reached levels normally linked with a durable market floor. The NAAIM Exposure Index has fallen to a point from which global markets often recover. Europe’s high beta nature increases the odds that European equities will greatly benefit in that context (Chart 8). Valuations confirm that sentiment toward European assets has reached a capitulation stage. The annual rate of change of the earnings yields in the earnings yields has hit 73%, which is consistent with a market bottom (Chart 9). More importantly, the change in European forward P/E tracks closely our European Stagflation Sentiment Proxy (ESSP), based on the difference between the Growth and Inflation Expectations’ components of the ZEW survey (Chart 10). For now, our ESSP indicates that stagflation fears in Europe have never been so widespread, but these fears will likely dissipate as energy inflation declines. This process will lift European earnings multiples. Chart 9Bad News Discounted? Bad News Discounted? Bad News Discounted? Chart 10Ebbing Stagflation Fear Will Prompt Rerating Ebbing Stagflation Fear Will Prompt Rerating Ebbing Stagflation Fear Will Prompt Rerating Earnings revisions will likely bottom soon as well. The ESSP is currently consistent with a dramatic decline in European net earnings revisions (Chart 10, bottom panel). It will take a few more weeks for lower earnings revisions to be fully reflected. However, they follow market moves and, as such, the 17% decline in the MSCI Europe Index that took place earlier this year already anticipates their fall. Consequently, as stagflation fears recede, earnings revisions will rise in tandem with equity prices. Chart 11Maximum Pressure On Corporate Spreads Maximum Pressure On Corporate Spreads Maximum Pressure On Corporate Spreads A decline in stagflation fears is also consistent with a decrease in European credit spreads in the coming months (Chart 11). This observation corroborates the analysis from the Special Report we published jointly with BCA’s Global Fixed-Income Strategy team last week.  In terms of sectoral implications, a decline in stagflation fears is often associated with a rebound in the performance of small-cap equities relative to large-cap ones (Chart 12, top panel). This reflects the greater sensitivity of small-cap equities to domestic economic conditions compared to large-cap stocks. Moreover, small-cap equities had been oversold relative to their large-cap counterparts but now, momentum is improving (Chart 12). As a result, it is time to buy these equities. Similarly, financials have suffered greatly from the recent events associated with the Ukrainian conflict. European financial institutions have not only been penalized for their modest exposure to Russia, they have also historically declined when stagflation fears are prevalent (Chart 13). This relationship reflects poor lending activity when the economy weakens, and the risk of a policy-induced recession caused by high inflation. Financials will continue their sharp rebound as stagflation fears dissipate. Chart 13Financials Have Suffered Enough Financials Have Suffered Enough Financials Have Suffered Enough Chart 12Small-Caps Time To Shine Small-Caps Time To Shine Small-Caps Time To Shine The dynamics in inflation alone are very important. As Table 1 highlights, in periods of elevated inflation over the past 20 years, financials underperform the broad market by 11.3% on average. It is also a period of pain for small-cap equities and cyclicals. Logically, exiting the current environment will offer opportunities in European cyclical equities and for financials in particular. Table 1Who Suffers From High Inflation? Is Europe Turning The Corner? Is Europe Turning The Corner? Chart 14Long Industrials & Materials / Short Energy Long Industrials & Materials / Short Energy Long Industrials & Materials / Short Energy Finally, a pair trade buying industrials and materials at the expense of energy makes sense today. Materials and industrials suffer relative to energy equities when stagflation rises, especially in periods when these fears reflect rising energy pressures (Chart 14). A reversal in relative earnings revisions in favor of materials and industrials will propel this position higher. Bottom Line: Sentiment toward European assets reached a selling climax in recent weeks. Stagflation fears in Europe have reached an apex, and their reversal will lift both multiples and earnings revisions in the subsequent quarters. Diminishing stagflation fears will also boost the appeal of European corporate credit, contributing to an easing in financial conditions. Small-cap stocks, cyclicals, and financials will reap the greatest benefits from this adjustment. Going long materials and industrials at the expense of energy stocks is an attractive pair trade. Key Risk: A Policy Mistake The view above is not without risks. The number one threat to European growth and assets is a policy mistake from the ECB. On March 10, 2022, the ECB’s policy statement and President Christine Lagarde’s press conference showed that the Governing Council (GC) will decrease asset purchases faster than anticipated. Chart 15Will The ECB Repeat It Past Mistakes? Will The ECB Repeat It Past Mistakes? Will The ECB Repeat It Past Mistakes? It is important to keep in mind the dynamics of 2011. Back then, the ECB opted to increase interest rates as European headline CPI was drifting toward 2.6% on the back of rising energy prices. According to our ESSP, the April 2011 interest rates hike took place at the greatest level of stagflation fears recorded until the current moment (Chart 15). Lured by rising inflation, the ECB ignored underlying weaknesses in European economic activity, which wreaked havoc on European financial markets and growth. If the ECB were to increase rates as growth remains soft, a similar outcome would take place. For now, the ECB’s communications continue to de-emphasize the need for rate hikes in the near term, which suggests that the GC is cognizant of the risk created by weak growth over the coming months. Waiting until next year, when activity will be stronger and the output gap will be closed, will offer the ECB a better avenue to lift rates durably. This risk warrants close monitoring of the ECB’s communication over the coming months. If headline inflation does not peak by the summer, the ECB is likely to repeat its past error, which will substantially hurt European assets. Our optimism is tempered by this threat. UK Outperformance Long In The Tooth? Last week, the Bank of England (BoE) increased the Bank Rate by 25bps to 0.75%, in a move that was widely expected. Yet, the pound fell 0.7% against the euro and gilt yields fell 6 bps. This market reaction reflected the BoE’s choice to temper its forward guidance. The central bank is now expected to increase interest rates to 2.2% next year, before they decline in 2024. The dovish projection of the BoE shows the MPC’s concerns over the impact of higher energy costs and rising National Insurance contributions on household spending. In the BoE’s opinion, the economy is very inflationary right now, but it will slow, which will mitigate the inflationary impact down the road. We share the BoE’s worries about the UK’s near-term economic outlook. The combination of higher taxes, higher interest rates, and rising energy costs will have an impact on growth. However, the rapid decline in small-cap stocks, which have massively underperformed their large cap-counterparts, already discounts considerable bad news (Chart 16). Additionally, small-cap equities relative to EPS have begun to stabilize, while relative P/E and price-to-book ratios have also corrected their overvaluations. In this context, UK small-cap equities are becoming attractive. Chart 17UK vs Eurozone: A Stagflation Bet UK vs Eurozone: A Stagflation Bet UK vs Eurozone: A Stagflation Bet Chart 16UK Small-Cap Stocks Have Purged Their Excesses UK Small-Cap Stocks Have Purged Their Excesses UK Small-Cap Stocks Have Purged Their Excesses In contrast to small-cap stocks, UK large-cap equities have greatly benefited from the global stagflation scare. The UK large-cap benchmark had the right sector mix for the current environment, overweighting defensive names as well as energy and resources. It is likely that when stagflation fears recede, UK equities will undo their outperformance (Chart 17). Technically, UK equities are massively overbought against Euro Area and Swedish stocks, both of which have been greatly impacted by stagflation fears and their pro-cyclical biases (Chart 18 & 19). An attractive tactical bet will be to sell UK large-cap stocks while buying Eurozone and Swedish equities, as energy inflation declines and as China’s stimulus boosts global industrial activity in the latter half of 2022 Bottom Line: Move to overweight UK small-cap stocks within UK equity portfolios. Go long Euro Area and Swedish equities relative to UK large-cap stocks as a tactical bet. Chart 18UK Overbought Relative To Euro Area... UK Overbought Relative To Euro Area... UK Overbought Relative To Euro Area... Chart 19… And Sweden ... And Sweden ... And Sweden   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades

Executive Summary Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​ Tectonic geopolitical trends are taking shape in Emerging Markets (EMs) today that will leave an indelible imprint on the next decade. First, EMs have gone on a relatively unnoticed public debt binge at a time when the economic prospects of the median EM citizen have deteriorated. This raises the spectre of sudden fiscal populism, aggressive foreign policy or social unrest in EMs. China, Brazil and Saudi Arabia appear most vulnerable to these risks. Second, the defense bill of major EMs could be comparable to that of the top developed countries of the world in a decade from now. Investors must brace for EMs to play a central role in the defense market and in wars, in the coming years. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. To extract most from the theme of EM militarization, we suggest a Long on European Aerospace & Defense relative to European Tech stocks.   Trade Recommendation Inception Date Return LONG EUROPEAN AEROSPACE & DEFENSE / EUROPEAN TECH EQUITIES (STRATEGIC) 2022-03-18   Bottom Line: Even as EMs are set to emerge as protagonists on the world stage, investors must prepare for these countries to exhibit sudden fiscal expansions, bouts of social unrest or a newfound propensity to initiate wars. The only way to dodge these volatility-inducing events is to leverage geopolitics to foresee these shocks. Feature Only a few weeks before Russia’s war with Ukraine broke out, a client told us that he was having trouble seeing the importance of geopolitics in investing. “It seems like geopolitics was a lot more relevant a few years back, with the European debt crisis, Brexit, and Trump. Now it does not seem to drive markets at all”, said the client. To this we gave our frequent explanation which is, “Our strategic themes of Great Power Struggle, Hypo-Globalization, and Nationalism/Populism are now embedded in the international system and responsible for an observable rise in geopolitical risk that is reshaping markets”. In particular we highlighted our pessimistic view on both Russia and Iran, which have incidentally crystallized most clearly since we had this client conversation. Related Report  Geopolitical StrategyBrazil: The Road To Elections Won't Be Paved With Good Intentions Globally key geopolitical changes are afoot with Russia at war. In the coming weeks and months, we will write extensively about the dramatic changes we see taking shape in the realm of geopolitics and investing. We underscored the dramatic geopolitical realignment taking place as Russia severs ties with the West and throws itself into China’s arms in a report titled “From Nixon-Mao To Putin-Xi”. In this Special Report we highlight two key geopolitical themes that will affect emerging markets (EMs) over the coming decade. The aim is to help investors spot these trends early, so that they can profit from these tectonic changes that are sure to spawn a new generation of winners and losers in financial markets. (For BCA Research’s in-depth views on EMs, do refer to the Emerging Markets Strategy (EMS) webpage). Trend #1: Beware The Wrath Of EMs On A Debt Binge Chart 1The Pace Of Debt Accumulation Has Accelerated In Major EMs Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Investors are generally aware of the debt build-up that has taken place in the developed world since Covid-19. The gross public debt held by the six most developed countries of the world (spanning US, Japan, Germany, UK, France and Italy) now stands at an eye-watering $60 trillion or about 140% of GDP. This debt pile is enormous in both absolute and relative terms. But at the same time, the debt simultaneously being taken on by EMs has largely gone unnoticed. The cumulative public debt held by eight major EMs today (spanning China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey) stands at $20tn i.e., about 70% of GDP. Whilst the absolute value of EM debt appears manageable, what is worrying is the pace of debt accumulation. The average public debt to GDP ratio of these EMs fell over the early 2000s but their public debt ratios have now doubled over the last decade (Chart 1). EMs have been accumulating public debt at such a rapid clip that the pace of debt expansion in EMs is substantially higher than that of the top six developed countries (Chart 1). These six DMs have a larger combined GDP than the eight EMs with which they are compared. Related Report  Geopolitical StrategyIndia's Politics: Know When To Hold 'Em, Know When To Fold 'Em (For in-depth views on China’s debt, do refer to China Investment Strategy (CIS) report here). Now developed countries taking on more debt makes logical sense for two reasons. Firstly, most developed countries are ageing, and their populations have stopped growing. So one way to prop up falling demand is to get governments to spend more using debt. Secondly, this practice seems manageable because developed country central banks have deep pockets (in the form of reserves) and their central banks are issuers of some of the safest currencies of the world. But EMs using the same formula and getting addicted to debt at an earlier stage of development is risky and could prove to be lethal in some cases. Also distinct from reasons of macroeconomics, the debt binge in EMs this time is problematic for geopolitical reasons. This Time Is Different EMs getting reliant on debt is problematic this time because their median citizen’s economic prospects have deteriorated. Growth is slowing, inflation is high, and job creation is stalling; thereby creating a problematic socio-political backdrop to the EM debt build-up. Growth Is Slowing: In the 2000s EMs could hope to grow out of their social or economic problems. The cumulative nominal GDP of eight major EMs more than quadrupled over the early 2000s but a decade later, these EMs haven not been able to grow their nominal GDP even at half the rate (Chart 2). Inflation Remains High: Despite poorer growth prospects, inflation is accelerating. Inflation was high in most major EMs in 2021 (Chart 3) i.e., even before the surge seen in 2022. Chart 2Major EM’s Growth Engine Is No Longer Humming Like A Well-Tuned Machine Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 3Despite Slower Growth, Inflation In Major EMs Remains High Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Rising Unemployment: Employment levels have improved globally from the precipice they had fallen into in 2020. But unemployment today is a far bigger problem for major EMs as compared to developed markets (Chart 4). If the economic miseries of the median EM citizen are not addressed, then they can produce disruptive sociopolitical effects that will fan market volatility. This problem of rising economic misery alongside a rapid debt build-up, can also be seen for the next tier of EMs i.e. Mexico, Indonesia, Iran, Poland, Thailand, Nigeria, Argentina, Egypt, South Africa and Vietnam. While the average public debt to GDP ratios of these EMs fell over the early 2000s, the pace of debt accumulation has almost doubled over the last decade (Chart 5). Furthermore, the growth engine in these smaller EMs is no longer humming like a well-tuned machine and inflation remains at large (Chart 5). Chart 4Unemployment - A Bigger Problem In Major EMs Today Unemployment - A Bigger Problem In Major EMs Today Unemployment - A Bigger Problem In Major EMs Today ​​​​​ Chart 5Smaller EMs Must Also Deal With Rising Debt, Alongside Slowing Growth Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 6The Debt Surge In EMs This Time, Poses Unique Challenges Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War History suggests that periods of economic tumult are frequently followed by social unrest. The eruption of the so-called Arab Spring after the Great Recession illustrated the power of this dynamic. Then following the outbreak of Covid-19 in 2020 we had highlighted that Turkey, Brazil, and South Africa are at the greatest risk of significant social unrest. We also showed that even EMs that looked stable on paper faced unrest in the post-Covid world, including China and Russia. In this report we take a decadal perspective which reveals that growth is slowing, and debt is growing in EMs. Given that EMs suffer from rising economic miseries alongside growing debt and lower political freedoms (Chart 6), it appears that some of these markets could be socio-political tinderboxes in the making. Policy Implications Of The EM Debt Surge “As it turns out, we don't 'all' have to pay our debts. Only some of us do.” – David Graeber, Debt: The First 5,000 Years (Melville House Publishing, 2011) The trifecta of fast-growing debt, slowing growth and/or low political freedoms in EMs can add to the volatility engendered by EMs as an asset class. Given the growing economic misery in EMs today, politicians will be wary of outbreaks of social unrest. To quell this unrest, they may resort broadly to fiscal expansion and/or aggressive foreign policy. Both of these policy choices can dampen market returns in EMs. Chart 7India's Performance Had Flatlined Post Mild Populist Tilt India's Performance Had Flatlined Post Mild Populist Tilt India's Performance Had Flatlined Post Mild Populist Tilt Policy Choice #1: More Fiscal Spending Despite High Debt Policymakers in some EMs may respond by de-prioritizing contentious structural reforms and prioritizing fiscal expansion. The Indian government’s decision to repeal progressive changes to farm laws in late 2021, launch a $7 billion home-building program in early 2022 and withholding hikes in retail prices of fuel, illustrates how policymakers are resorting to populism despite high public debt levels. As a result, it is no surprise that MSCI India had been underperforming MSCI EM even before the war in Ukraine broke out (Chart 7). Brazil is another EM which falls into this category, while China’s attempts to run tighter budgets have failed in the face of slowing growth. Policy Choice #2: Foreign Policy Aggression EMs may also adopt an aggressive foreign policy stance. Russia’s decision to invade Ukraine, Turkey’s interventions in several countries, and China’s increasing assertiveness in its neighboring seas and the Taiwan Strait provide examples. Wars by EMs are known to dampen returns as the experience of the Russian stock market shows. Russian stocks fell by 14% during its invasion of Georgia in 2008 and are down 40% from 24 February 2022 until March 9, 2022, i.e. when MSCI halted trading. If politicians fail to pursue either of these policies, then they run the risk of social unrest erupting due to tight fiscal policy or domestic political disputes. In fact, early signs of social discontent are already evident from large protests seen in major EMs over the last year (see Table 1). Table 1Social Unrest In Major EMs Is Already Ascendant Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Bottom Line: The last decade has seen major EMs go on a relatively unnoticed public debt binge. This is problematic because this debt surge has come at a time when economic prospects of the median EM citizen have deteriorated. Politicians will be keen to quell the resultant discontent. This raises the specter of excessive fiscal expansion, aggressive foreign policy, and/or social unrest. All three outcomes are negative from an EM volatility perspective. Trend #2: The Rise And Rise Of EM Defense Spends Great Power Rivalry is an outgrowth of the multipolar structure of international relations. This theme will drive higher defense spending globally. In this report we highlight that even after accounting for a historic rearmament in developed countries following Russia’s invasion of Ukraine, a decade from now EMs will play a key role in driving global military spends. The defense bill of the six richest developed countries of the world (the US, Japan, Germany, UK, France and Italy) will increasingly be rivaled by that of the top eight EMs (China, Taiwan, Korea, India, Brazil, Russia, Saudi Arabia and Turkey). While key developed markets like Japan and Germany in specific (and Europe more broadly) are now embarking on increasing defense spends, the unstable global backdrop will force EMs to increase their military budgets as well. The combination of these forces could mean that the top eight EM’s defense spends could be comparable to that of the top six developed markets in a decade from now i.e., by 2032 (Chart 8). This is true even though the six DMs have a larger GDP. The assumptions made while arriving at the 2032 defense spend projections include: Substantially Higher Pace Of Defense Spends For Developed Countries: To reflect the fact that Russia’s invasion of Ukraine will trigger a historical wave of armament in developed markets we assume that: (a) NATO members France, Germany and Italy (who spent about 1.5% of GDP on an average on defense spends in 2019) will ramp up defense spending to 2% of GDP by 2032, (b) US and UK i.e. NATO members who already spend substantially more than 2% of GDP on defense spends will still ‘increase’ defense spends by another 0.4% of GDP each by 2032 and finally (c) Japan which spends less than 1% of GDP on defense spends today, in a structural break from the past will increase its spending which will rise to 1.5% of GDP by 2032. China And Hence Taiwan As Well As India Will Boost Spends: To capture China’s increasingly aggressive foreign policy stance and the fact that India as well as Taiwan will be forced to respond to the Chinese threat; we assume that China increases its stated defense spends from 1.7% of GDP in 2019 to 3% by 2032. Taiwan follows in lockstep and increases its defense spends from 1.8% of GDP in 2019 to 3% by 2032. India which is experiencing a pincer movement from China to its east and Pakistan to its west will have no choice but to respond to the high and rising geopolitical risks in South Asia. The coming decade is in fact likely to see India’s focus on its naval firepower increase meaningfully as it feels the need to fend off threats in the Indo-Pacific. India currently maintains high defense spends at 2.5% of GDP and will boost this by at least 100bps to 3.5% of GDP by 2032. Defense Spending Trends For Five EMs: For the rest of the EMs (namely Russia, Saudi Arabia, South Korea and Brazil), the pace of growth in defense spending seen over 2009-19 is extrapolated to 2032. For Turkey, we assume that defense spends as a share of GDP increases to 3% of GDP by 2032. Extrapolation Of Past GDP Growth For All Countries: For all 14 countries, we extrapolate the nominal GDP growth calculated by the IMF for 2022-26 as per its last full data update, to 2032. This tectonic change in defense spending patterns has important historical roots. Back in 1900, UK and Japan i.e., the two seafaring powers were top defense spenders (Chart 9). Developed countries of the world continued to lead defense spending league tables through the twentieth century as they fought expensive world wars. Chart 8Major EM’s Defense Spends Will Be Comparable To That Of Developed Countries Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 9Back In 1900, Developed Countries Like UK And Japan Were Top Military Spenders Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 10By 2000, EMs Had Begun Spending Generously On Armament Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War But things began changing after WWII. Jaded by the world wars, developed countries began lowering their defense spending. By the early 2000s EMs had now begun spending generously on armament (Chart 10). The turn of the century saw growth in developed markets fade while EMs like China and India’s geopolitical power began rising (Chart 11). Then a commodities boom ensued, resulting in petro-states like Saudi Arabia establishing their position as a high military spender. The confluence of these factors meant that by 2020 EMs had becomes major defense spenders in both relative and absolute terms too (Chart 12). Going forward, we expect the coming renaissance in DM defense spending in the face of Russian aggression, alongside rising geopolitical aspirations of China, to exacerbate this trend of rising EM militarization. Chart 11The 21st Century Saw Developed Countries’ Geopolitical Power Ebb Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Chart 12EMs Today Are Top Military Spenders, Even In Absolute Terms Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Why Does EM Weaponizing Matter? History suggests that wars are often preceded by an increase in defense spends: Well before WWI, a perceptible increase in defense spending could be seen in Austria-Hungary, Germany, and Italy (Chart 13). These three countries would go on to be known as the Triple Alliance in WWI. Correspondingly France, Britain and Russia (i.e., countries that would constitute the Triple Entente) also ramped up military spending before WWI (Chart 14). Chart 13Well Before WWI; Austria-Hungary, Germany, And Italy Had Begun Ramping Up Defense Spends Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 14The ‘Triple Entente’ Too Had Increased Defense Spends In The Run Up To WWI Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ History tragically repeated itself a few decades later. Besides Japan (which invaded China in 1937); Germany and Italy too ramped up defense spending well before WWII broke out (Chart 15). These three countries would come to be known as the Axis Powers and initiated WWII. Notably, Britain and Russia (who would go on to counter the Axis Powers) had also been weaponizing since the mid-1930s (Chart 16). Chart 15Axis Powers Had Been Increasing Defense Spends Well Before WWII Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 16Allied Powers Too Had Been Increasing Defense Spends In The Run Up To WWII Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ Chart 17Militarily Active States Have Been Ramping Up Defense Spends Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Russia, Ukraine, Turkey and Gulf Arab states like Iraq have been involved in wars in the recent past and noticeably increased their defense budgets in the lead-up to military activity (Chart 17). Given that a rise in military spending is often a leading indicator of war and given that EMs are set to spend more on defense, it appears that significant wars are becoming more rather than less likely, which Russia’s invasion of Ukraine obviously implies. A large number of “Black Swan Risks” are clustered in the spheres of influence of Russia, China, and Iran, which are the key powers attempting to revise the US-led global order today (Map 1). Map 1Black Swan Risks Are Clustered Around China, Russia & Iran Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Distinct from major EMs, eight small countries pose meaningful risks of being involved in wars over the next. These countries are small (in terms of their nominal GDPs) but spend large sums on defense both in absolute terms (>$4 billion) and in relative terms (>4% of GDP). Incidentally all these countries are located around the Eurasian rimland and include Israel, Pakistan, Algeria, Iran, Kuwait, Oman, Ukraine and Morocco (Map 2). In fact, the combined sum of spending undertaken by these countries is so meaningful that it exceeds the defense budgets of countries like Russia and UK (Chart 18). Map 2Eight Small Countries That Spend Generously On Defense Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Chart 188 Countries Located Near The Eurasian Rimland, Spend Large Sums On Defense Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​ Bottom Line: As EM geopolitical power and aspirations rise, the defense bill of top developed countries will be challenged by the defense spending undertaken by major EMs. On one hand this change will mean that certain EMs may be at the epicenter of wars and concomitant market volatility. On the other hand, this change could spawn a new generation of winners amongst defense suppliers. Investment Conclusions In this section we highlight strategic trades that can be launched to play the two trends highlighted above. Trend #1: Beware The Wrath Of EMs On A Debt Binge Investors must prepare for EMs to witness sudden fiscal expansions, unusually aggressive foreign policy stances, and/or bouts of social unrest over the next few years. The only way to dodge these volatility-inducing events in EMs is to leverage geopolitics to foresee socio-political shocks. Using a simple method called the “Tinderbox Framework” (Table 2), we highlight that: Table 2Tinderbox Framework: Identifying Countries Most Exposed To Socio-Political Risks Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War Within the eight major EMs; China, Brazil, Russia and Saudi Arabia face elevated socio-political risks. Amongst the smaller ten EMs, these risks appear most elevated for Egypt, South Africa and Argentina. It is worth noting that Brazil, South Africa and Turkey appeared most vulnerable as per our Covid-19 Social Unrest Index that we launched in 2020. We used the tinderbox framework in the current context to fade out effects of Covid-19 and to add weight to the debt problem that is brewing in EMs. Client portfolios that are overweight on most countries that fare poorly on our “Tinderbox Framework” should consider actively hedging for volatility at the stock-specific level. To profit from ascendant geopolitical risks in China, we reiterate shorting TWD-USD and the CNY against an equal-weighted basket of Euro and USD. China’s public debt ratio is high and social pressures may be building with limited valves in place to release these pressures (Table 2). The renminbi has performed well amid the Russian war, which has weighed down the euro, but China faces a confluence of domestic and international risks that will ultimately drag on the currency, while the euro will benefit from the European Union’s awakening as a geopolitical entity in the face of the Russian military threat. Trend #2: EM’s Will Drive Wars In The 21st Century Wars are detrimental to market returns.1 Furthermore, as the history of world wars proves, even the aftermath of a war often yields poor investment outcomes as wars can be followed by recessions. It is in this context that investors must prepare for the rise of EMs as protagonists in the defense market, by leveraging geopolitics to identify EMs that are most likely to be engaged in wars. While we are not arguing that WWIII will erupt, investors must brace for proxy wars as an added source of volatility that could affect EMs as an asset class. To profit from these structural changes underway we highlight two strategic trades namely: 1.  Long Global Aerospace & Defense / Broad Market Thanks to the higher spending on defense being undertaken by major EMs, global defense spends will grow at a faster rate over the next decade as compared to the last. We hence reiterate our Buy on Global Aerospace & Defense relative to the broader market. 2.  Long European Aerospace & Defense / European Tech Up until Russia invaded Ukraine and was hit with economic sanctions, Russia was the second largest exporter of arms globally accounting for 20% global arms exports. With Russia’s ability to sell goods in the global market now impaired, the two other major suppliers of defense goods that appear best placed to tap into EM’s demand for defense goods are the US (37% share in the global defense exports market) and Europe (+25% share in the global defense exports market). Chart 19American Defense Stocks Have Outperformed, European Defense Stocks Have Underperformed Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​​ Chart 20Defense Market: Russia’s Loss Could Be Europe’s Gain Beware EMs That Borrow Too Much Or Wage War Beware EMs That Borrow Too Much Or Wage War ​​​​​ But given that (a) American aerospace & defense stocks have rallied (Chart 19) and given that (b) France, Germany, and Italy are major suppliers of defense equipment to countries that Russia used to supply defense goods to (Chart 20), we suggest a Buy on European Aerospace & Defense relative to European Tech stocks to extract more from this theme. In fact, this trade also stands to benefit from the pursuance of rearmament by major European democracies which so far have maintained lower defense spends as compared to America and UK. This view from a geopolitical perspective is echoed by our European Investment Strategy (EIS) team too who also recommend a Long on European defense stocks and a short on European tech stocks. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      Please see: Andrew Leigh et al, “What do financial markets think of war in Iraq?”, NBER Working Paper No. 9587, March 2003, nber.org.  David Le Bris, “Wars, Inflation and Stock Market Returns in France, 1870-1945”, Financial History Review 19.3 pp. 337-361, December 2012, ssrn.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

Executive Summary Copper Demand Follows GDP Copper Demand Follows GDP Copper Demand Follows GDP European copper demand will increase on the back of still-accommodative monetary policy, coupled with a loosening of COVID-19-related gathering and mobility restrictions as the virus becomes endemic. Copper demand will be supported by the EU's need to diversify natural gas supplies in favor of increased LNG import capacity over the next 10 years, which will require incremental infrastructure investment. Increasing policy stimulus in China and government measures to increase lending to metals-intensive sectors – e.g., construction and grid infrastructure – will boost global copper demand. In the US, the Biden administration is backing a $550 billion bill to fund its renewable-energy buildout, which will result in higher demand for metals and steel over the next decade. Global copper supply growth will be restrained by local politics going forward, particularly in the Americas. Bottom Line: Copper prices have been grinding higher even as China maintains its zero-tolerance COVID-19 public health policy, and markets wait out the Russia-Ukraine standoff.  We are maintaining our forecast for COMEX copper to trade to $5.00/lb this year and $6.00/lb next year.  We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to miners and traders via the XME and PICK ETFs. Feature Ever since it hit its record high in May 2021, copper prices have been range-bound, despite tight market fundamentals and record low inventories in 3Q21, which, as it happens, have not significantly rebuilt since then (Chart 1, panel 1). This can be explained by weak global macro conditions since prices peaked, which have not been especially conducive to higher copper prices, particularly in Europe and China. Activity in these two markets accounting for ~ 60% and 11% of global refined copper demand, respectively, has had a stop-start aspect that has hindered full recovery to now. Chart 1Global Copper Inventories Remain Tight Global Copper Inventories Remain Tight Global Copper Inventories Remain Tight Chart 2Copper Demand Follows GDP Copper Demand Follows GDP Copper Demand Follows GDP As GDP in these regions rises, demand for copper will rise, as Chart 2 shows. Per our modelling, refined copper demand in China, the EU and the world are highly cointegrated with Nominal GDP estimates provided by the IMF. The coefficient associated with nominal GDP in all three instances is positive. Further, running Granger Causality tests indicate that past and present values of nominal GDP explain present refined copper demand values for all three entities. These results indicate that economic growth and refined copper demand have a positive long-run relationship. China’s zero-COVID tolerance policy and the property-market crisis there have restricted economic growth, activity and hence demand for the metal used heavily in construction and manufacturing. In Europe, lockdowns due to the Omicron variant restricted activity causing supply chain disruptions, which contributed to inflation. Now, Europe is relying on immunity among large shares of its population to keep economies open, as COVID-19 becomes endemic. Germany is loosening restrictions at a slower rate than its neighbors, as COVID still has not reached endemicity (Chart 3). Europe’s top manufacturer reportedly is expected to ease restrictions and increase economic activity by March-end. Chart 3New EU COVID-19 Cases Collapse Copper Will Grind Higher Copper Will Grind Higher Natural Gas Remains Critical To Europe Apart from COVID, elevated natural gas prices have and will continue to affect economic activity in Europe. These prices will only get more volatile as fears of a Russian invasion of Ukraine increase. In the short term, we do not expect Russia to cut off all gas supplies to the EU in case of an invasion.1 However, supplies going through Ukraine likely would be cut. Coupled with the region’s precariously low natgas inventory levels, this could fuel a gas price spike (Chart 4). Higher gas prices could lead to demand destruction, if, as occurred this winter, higher power-generating costs arising from higher natgas costs makes electricity too expensive to keep industrial processes like aluminum smelters up and running. In addition, another regional bidding war could incentivize more re-routing of LNG to Europe instead of Asia. This would reduce European prices, but could force Asian markets to raise their bids. Chart 4EU's Natgas Inventories Remain Critical Copper Will Grind Higher Copper Will Grind Higher Assuming gas prices do not remain significantly higher for the rest of the year, Europe will start seeing economic activity improve, and as our European Investment Strategy notes, PMIs will bottom out by the second quarter of this year. High immunity levels are allowing European nations to relax restrictions as it becomes apparent that COVID in the continent – at least in Western Europe – appears to be reaching endemicity. Importantly for base metals generally, and copper in particular, lower natgas prices will allow smelters and refining units to remain in service as electricity prices stabilize or even fall in the EU. During the pandemic, households – primarily in DM economies – built up significant levels of excess savings, particularly in Europe. The IMF reported that households in Europe have amassed nearly 1 trillion euros more in savings vs. normal levels over the last two years than if the pandemic had never occurred.2 While the entirety of excess savings will not be released as spending, even a portion of it will spur economic activity, once supply-chain issues are ironed out when the global economy reopens. China's Copper Demand Will Revive China’s property sector crisis last year was a major drag on economic growth. The Chinese government’s efforts to stabilize this sector seem to be paying off. China’s National Bureau of Statistics reported that for January housing prices in China’s first-tier cities reversed a month-on-month decline from December. The number of cities that saw home prices fall in January also was lower compared to December. Continued improvements in the property sector in China will be bullish for copper. Once macro hurdles related to COVID and high gas prices dissipate, and China’s property market stabilizes, economic activity will increase and copper demand will rebound (Chart 5). However, a timeline for this is difficult to handicap, given China's insistence – at least for now – on maintaining a zero-covid public-health policy. The zero-covid policy has resulted in sharply lower infection rates than the rest of the world, but, because it has not been accompanied by wide distribution of mRNA vaccines, immunity in the population is low. As global macro factors become conducive for copper, investors’ focus will switch to tight fundamentals in the copper market (Chart 6). Unlike the first half of 2021, copper’s high prices will be more sustained, given COVID’s current trajectory towards endemicity globally, and relatively higher immunity rates. Chart 5China's Demand Will Rebound Copper Will Grind Higher Copper Will Grind Higher Chart 6Coppers Tight Fundamentals Will Come Into Focus Again Coppers Tight Fundamentals Will Come Into Focus Again Coppers Tight Fundamentals Will Come Into Focus Again In addition, markets will have to factor in additional demand from the US that heretofore did not exist: The Biden administration is backing a $550 billion bill to fund renewable-energy development. More such funding can be expected in coming years as the US leans into decarbonization, and competes with the likes of the EU and China for limited base metals supplies. Supply Side Difficulties Mount Local governance is becoming increasingly critical to the supply side of base metals, no moreso than in the Americas – chiefly in Chile, Peru and, of late, the US., where the Biden administration recently shut down a Minnesota mining proposal in a major win for environmental groups.3 A number of these critical commodity-producing states in the Americas have elected – or are leaning toward – left-of-center candidates, some of whom are proposing fundamental changes in the laws and regulations governing resource extraction. Gabriel Boric, Chile’s new president, takes office in March. He has largely focused his campaign on the environment, human rights, and closer ties with other Latin American countries. Boric promotes a “turquoise” foreign policy, which includes “green” policies to combat climate change, and “blue” ones to protect oceans. He is likely to commit Chile, which accounts for ~ 30% of global copper mining, to participation in the Escazú Agreement, is being positioned to span the region.4 Of greatest import to the global metals and mining markets, Boric will push for a constitutional re-write affecting taxes on copper mining, decarbonization, Chile's water crisis and the nationalization of lithium mining. Chile's new constitution is expected to be put up for a vote by the end of 2022. In Peru, which accounts for ~ 10% of global copper output, President Pedro Castillo announced at the UN General Assembly that Peru would declare a "climate emergency," and promised to reach net-zero in Peru by 2050. Civil unrest in Peru directed at mining operations is becoming more widespread, as citizens become increasingly frustrated with pollution and poverty.5 Colombia is not a major metals producer, but it is a resource-based economy leaning left. In May it will hold its general elections to Congress and Presidency. The future president will have pressure on the ratification of the Escazú Agreement, fight against illegal mining, and work on the Amazon deforestation. Presently, a left-of-center candidate, Gustavo Petro, leads the polling, according to the latest December survey by the National Consulting Center.6 Petro is promising to stop approving oil exploration contracts to restructure Colombia's economy away from hydrocarbons, and plans to accelerate the transition towards renewable energy.7 In addition, Petro is trying to gather ideological allies across Latin America and the world to fight against climate change. He hopes Chile’s president-elect Gabriel Boric will be joining this alliance.8 Caution: Downside Risks Remain Apart from the Russia-Ukraine crisis discussed above, there are more headwinds to the bullish copper view. China’s zero-covid policy will lead to reduced activity in the world’s largest producer and consumer of refined copper. This will disrupt global supply chains and, along with high energy prices, spur global inflation, prolonging slow economic growth and activity. Central bank tightening globally – led by the Federal Reserve – will increase borrowing costs, reduce manufacturing, and act as a downside risk to copper, particularly if the Fed miscalculates and lifts rates too high too soon and sparks a USD rally. Finally, while DM economies have high vaccination rates, EM states do not have the same level of immunity (Chart 7). Europe exhibits this dichotomy in immunization rates between advanced and developing countries well. While most of Western Europe appears to be nearing endemicity and reopening, Omicron is spreading quickly into Eastern Europe, where immunity is low. As long as a majority of the global population is not vaccinated, COVID-19 mutations into more virulent and transmissive variants remain a major risk. Chart 7COVID-19 Remains A Risk Copper Will Grind Higher Copper Will Grind Higher Investment Implications Copper prices have been grinding higher even as China maintains its zero-tolerance COVID-19 public-health policy, and markets wait out the Russia-Ukraine standoff (Chart 8). As large economies continue to emerge from COVID-19-related disruptions demand for base metals can be expected to increase, particularly for copper. We are maintaining our forecast for COMEX copper to trade to $5.00/lb this year and $6.00/lb next year. We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to miners and traders via the XME and PICK ETFs. Chart 8Copper Continues To Grid Higher Copper Continues To Grid Higher Copper Continues To Grid Higher   Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish The US will expand its leading position as the EU-27's and UK's top liquified natural gas (LNG) supplier this year, in our view, although Qatar will provide stiff competition (Chart 9). In January, the EIA reported half of the Europe's LNG originated in the US. For all of 2021, 26% of Europe's LNG came from the US, while 24% came from Qatar and 20% came from Russia. We expect the Russia-Ukraine military standoff, which has the potential to become a kinetic engagement, will prompt Europe to diversify its natural gas supplies away from Russia to reduce its exposure to military and geopolitical pressure on its energy supplies. This also would apply, in our estimation, to pipeline supplies of natural gas from Russia, which shipped 10.7 Bcf/d to Europe in 2021 (vs. 11.8 Bcf and 14.8 Bcf/d in 2020 and 2019, respectively. Norway supplied 10.4 Bcf/d in 2019 and 2020, rising to 11.1 Bcf/d in 2021. We also would expect additional North Sea supplies to be developed to supply Europe in the wake of the current Russia-Ukraine tensions. Base Metals: Bullish Russia’s recognition of the two breakaway states of Donetsk and Luhansk People’s Republics (DPR and LPR), elicited US sanctions targeting Russian sovereign debt and its banking sector. The possibility of sanctions on Russian nickel and aluminum exports sent both metals to multi-year highs in LME trading. Russia constitutes around 6% and 9% of global primary aluminum and nickel ore supply, respectively. Precariously low inventory levels for both nickel and aluminum are inducing high price volatility. Year-over-year, global January LME aluminum and nickel stocks are 45% and 64% lower respectively. Precious Metals: Bullish Geopolitical uncertainty due to the Russia-Ukraine crisis and Western sanctions levied on Russia has pushed gold prices to levels not seen since its last bull run last year. While gold has risen, Bitcoin – once considered to be a safe-haven asset – has fallen on this uncertainty. Over the last two years, Bitcoin has been moving more in tandem with equity markets than with other safe-haven assets, as cryptocurrency has become more popular and central banks began large asset purchase programs in response to the pandemic (Chart 10). From beginning 2018 to end-2019 the coefficient measuring daily Bitcoin prices’ correlation with the S&P 500 index was ~0.31. From beginning 2020 to present day, this value has increased to ~ 0.86. Chart 9 Copper Will Grind Higher Copper Will Grind Higher Chart 10 Bitcoin Price Aligns With Gold Price And S&P 500 INDEX Bitcoin Price Aligns With Gold Price And S&P 500 INDEX     Footnotes 1     Please see our report from February 3, 2022 entitled Long-Term EU Gas Volatility Will Increase.  It is available as ces.bcaresearch.com. 2     Please see Europe’s Consumers are Sitting on 1 Trillion Euros in Pandemic Savings published by the International Monetary Fund on February 10, 2022. 3    Please see our report from on November 25, 2021 entitled Add Local Politics To Copper Supply Risks, and Biden administration kills Antofagasta's Minnesota copper project published by reuters.com on January 26, 2022. 4    Please see Chile Turns Left: The Foreign Policy Agenda of President Gabriel Boric, published by Australian Institute of Mining Affairs on January 28, 2022. 5    Please see China's MMG faces Peru whack-a-mole as mining protests splinter, published by reuters.com on February 16, 2022. 6    Please see Six Challenges Facing Colombia in 2022, published by Global Americas on January 6, 2022. 7     Please see Gustavo Petro, who leads polls in Colombia, seeks to create an anti-oil front published by Bloomberg on January 14, 2022. 8    Please see Colombia Presidential Favorite Gustavo Petro Wants to Form a Global Anti-Oil Bloc, published by Time on January 14, 2022. Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image

Executive Summary Macroeconomic Backdrop Favors Defensive Consumer Staples Macroeconomic Backdrop Favors Defensive Consumer Staples Macroeconomic Backdrop Favors Defensive Consumer Staples Markets now expect five-to-six rate hikes in 2022  The rate of change in rates as opposed to their level has triggered the fast and furious repricing of long-duration assets.  However, rising rates are a temporary headwind to equities The repricing of the equity market came through the P/E as opposed to the “E” Demand is clearly shifting from goods to services. Supply disruptions are clearing Earnings were strong, but investors expected more We are upgrading Consumer Staples, which is a “deep” defensive sector that offers downside protection in an environment of heightened volatility and slowing economic growth   Bottom Line: While it is impossible to time the market, we believe that the worst is behind us. US equities are outright oversold, and valuations are much more reasonable. However, we recommend investors be cautious in sector selection: For now, stay away from Tech, and add to Consumer Staples to reduce portfolio volatility. Feature Performance Hit Undo 2021 January had a nasty shock in store for equity investors: At the lowest point, the S&P 500 was down 12% from its peak, and NASDAQ was down 20%, officially entering correction territory. January market moves were a partial reversal of the 2021 gains (Chart 1A), with some of the hottest investment themes, such as clean energy, fintech, and Cathie Wood's innovation ETFs hit the hardest (Chart 1B). Investors were rushing to monetize their super-charged gains before the Fed starts draining liquidity off the market. Chart 1APerformance: Sectors And Styles Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Chart 1BPerformance: Investment Themes Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Post-Mortem A post-mortem of the sell-off shows that the stocks that have pulled back most, were trading at extended valuations and had long duration, i.e., companies that are not very profitable now but expect to grow earnings at a robust pace far into the future. These companies are akin to lottery tickets – a small payment now may result in a low-probability event of a high gain in the future. Small-cap growth stocks are down 30% from their peak. Over time, the sell-off of small-cap growth has spread to other areas of the market and has hit all sectors but Energy, almost indiscriminately. Overall, the S&P 500's multiple has contracted by over 10% (Chart 1C). Chart 1CJanuary Correction Was Down To Multiple Contraction Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Valuations And Technicals Pullbacks are responsible for equity market hygiene, cleansing the market of overextended valuations, taking the froth off the names that got ahead of themselves, and offering a reset for a new leg of upward moves, fueled by inflows into oversold names and cash deployed by new market entrants. Forward multiples of the S&P 500 have come down from 21.7x to a more reasonable 19.5x (Chart 2A). Now, 8 out of the 11 sectors have a forward PE below 20x (Chart 2B). Chart 2AMultiples Have Come Down A lot From The Peak Multiples Have Come Down A lot From The Peak Multiples Have Come Down A lot From The Peak Chart 2BValuations Moderated Across All Sectors But Energy Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack By many technical metrics, such as the bull/bear ratio (Chart 2C), market breadth, and RSI, the market appears oversold. Many investors may consider this a good entry point. Chart 2CRetail Investors Have Capitulated Retail Investors Have Capitulated Retail Investors Have Capitulated Macroeconomic Backdrop Six Is The New Four This correction was triggered by a market surprised by the grave tone of Fed officials, acknowledging their concern about the intransigent, as opposed to transient, inflation. While monetary tightening has been on the cards for a while now, what a difference a month makes! In December, the market was pricing in three rate hikes in 2022, while currently, the probability of five rate hikes stands at over 90%, and of six rate hikes at over 80% (Chart 3A). The 10-year Treasury yield moved from 1.5% at the end of December to 1.87% at its January peak. It is important to note that monetary policy is still easy and it was the rate of change in rates as opposed to their level that triggered the fast and furious repricing of long-duration assets. Chart 3AInvestors Expect Five-To-Six Hikes In 2022 Investors Expect Five-To-Six Hikes In 2022 Investors Expect Five-To-Six Hikes In 2022 Is Monetary Tightening A Death Knell For US Equities? Historically, equities wobbled two-to-three months prior to the first rate hike, and then took a breather for another couple of months for the dust to settle (Chart 3B). January and now February volatility and pullbacks are textbook behavior of equities at the cusp of a new monetary regime. However, in three of the four tightening cycles since 1990, the stock market was higher a year later. The same is true for long-term rates: In all but one of the episodes of a sharp rise in the 10-year Treasury yield since 1990, the stock market rose (Table 1). Chart 3BEquities Wobble Around The First Rate Hike Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Table 1Equity Performance Around Periods Of Rising Treasury Yields Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Economic Growth: Supply (Finally) Meets Demand Of course, the best antidote to higher rates is strong economic growth. So far, everything is in order on that front, with economists projecting solid 2022 nominal GDP growth of around 7.6%. Economic growth is slowing but off high levels. At last, global supply chains are gradually unclogging, and shipping bottlenecks are starting to clear. Even automakers are now saying that auto chips are becoming more readily available. However, part of the reason that supply and demand are getting closer to each other is that demand for goods is waning, dampened by both saturation and higher costs. The latest ISM PMI reading shows that both new orders and the backlog of orders are falling (Chart 4, top panel). Prices paid have also turned, heralding that the worst of price increases may be behind us (Chart 4, bottom panel). Will this contain inflation enough to appease the Fed? Possible, but not highly likely. Chart 4Demand Is Weakening Demand Is Weakening Demand Is Weakening Earnings: Good But Not Good Enough With economic growth slowing, earnings and sales growth are also rolling over (Chart 5A). As investors are trying to decipher the state of the American economy, they are increasingly focused on corporate guidance. So far 12 companies offered positive guidance vs 28 with negative guidance. The Negative/Positive ratio for Q4-2021 currently stands at 2.3, compared to 0.8 in the prior four quarters. Price action in response to projected lower growth has been brutal. And while 78% of companies have beaten earnings expectations, this is a smaller share than during the other pandemic recovery quarters. The magnitude of the earnings surprise has also fallen (Chart 5B). Chart 5AEarnings And Sales Growth Are Slowing Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack Chart 5BThe Magnitude Of Earnings Surprises Has Fallen Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack This earnings season has also seen some of the largest moves on the back of companies’ reports. Positive surprises by Google, Microsoft, and Amazon have soothed investors' fears and led to broad-based next-day rallies, while skimpy results from PayPal and Meta, not only have sent these companies down more than 20%, erasing billions in market capitalization, but also have dragged down their nearest competitors (Square, Snap, etc.). Also, many companies are complaining about rising input and labor costs cutting into their profitability. This is hardly a surprise. According to our analysis of the NIPA accounts, in the US labor costs constitute 55% of sales. With wages rising at the fastest pace in years, their effect on corporate profitability can be meaningful (Chart 6A). To make things worse, input costs are also soaring – the latest PPI reading is 9.7%. Chart 6AMargins Are Contracting As... Chartbook: Sector Chart Pack Chartbook: Sector Chart Pack However, companies are more and more constrained in their ability to pass on their cost increases to customers, although the elasticity of demand varies across industries. Many companies can no longer afford to raise prices without suppressing demand for their products. Corporate pricing power has turned decisively lower (Chart 6B). As a result, profit margins have contracted across all sectors, except Energy. Bottom-line – earnings are good so far, but they have failed to allay investor fears of waning profitability. Chart 6B...Corporate Pricing Power Is Declining ...Corporate Pricing Power Is Declining ...Corporate Pricing Power Is Declining Sector Positioning Revenge Of The Nerds – Be Granular While we believe that equities are poised for another leg up, as economic growth remains strong and corporate earnings are decent, we recommend that investors be granular in their sector selection: Avoid areas most adversely affected by a tighter monetary regime and slowing growth. Per our previous analysis, we recommend underweighting the Technology sector on a tactical basis, but within Tech, stay overweight more defensive Software and IT Services. We also like Banks and Insurers that benefit from rising rates and prefer Value and Small over Growth. We are also constructive on Industrials, which are the primary beneficiaries of the new Capex cycle and the US industrial renaissance. Consumer Services Are Finally Rebounding In the meantime, with Omicron finally receding, consumer spending is shifting from consumer goods to services (Chart 7A). Consumers are flush with cash, and still have $2.2 trillion in their coffers. We have been overweight the Travel complex (Hotels, Restaurants, Cruises) since October. However, performance was derailed in the late fall as many consumers chose to stay at home and wait for the variant to pass. Also, many of the industries in the Travel complex have been challenged by the sheer number of staff quarantining or on sick leave. We upgraded Airlines at the beginning of January and remain optimistic about the outperformance of the Consumer Services sector. Upgrading Consumer Staples We are also upgrading Consumer Staples, which is a “deep” defensive that offers downside protection in an environment of heightened volatility and slowing economic growth (Chart 7B). Moreover, consumer confidence is down as Americans are disheartened by prices in the supermarket and at the gas station. However, demand for consumer staples is inelastic and should be inflation-proof. The sector is trading at 21x forward multiples and is expected to grow earnings at 6% over the next 12 months, bettering the S&P 500. Chart 7AWaning Demand For Goods Is Replaced By Demand For Services Waning Demand For Goods Is Replaced By Demand For Services Waning Demand For Goods Is Replaced By Demand For Services Chart 7BMacroeconomic Backdrop Favors Defensive Consumer Staples Macroeconomic Backdrop Favors Defensive Consumer Staples Macroeconomic Backdrop Favors Defensive Consumer Staples Investment Implications The market correction is still running its course, and while it is impossible to time the market, we believe that the worst is behind us. US equities are outright oversold, and valuations are much more reasonable. Rising rates are a temporary headwind. However, we recommend investors be cautious in sector selection: For now, stay away from Tech, and add to Consumer Staples to reduce portfolio volatility.   Irene Tunkel Chief Strategist, US Equity Strategy irene.tunkel@bcaresearch.com     S&P 500  Chart 8Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 9Profitability Profitability Profitability Chart 10Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 11Uses Of Cash Uses Of Cash Uses Of Cash Communication Services Chart 12Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 13Profitability Profitability Profitability Chart 14Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 15Uses Of Cash Uses Of Cash Uses Of Cash Consumer Discretionary Chart 16Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 17Profitability Profitability Profitability Chart 18Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 19Uses Of Cash Uses Of Cash Uses Of Cash Consumer Staples Chart 20Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 21Profitability Profitability Profitability Chart 22Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 23Uses Of Cash Uses Of Cash Uses Of Cash Energy Chart 24Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 25Profitability Profitability Profitability Chart 26Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 27Uses Of Cash Uses Of Cash Uses Of Cash Financials Chart 28Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 29Profitability Profitability Profitability Chart 30Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 31Uses Of Cash Uses Of Cash Uses Of Cash Health Care Chart 32Sector vs Industry Groups Sector vs Industry Groups Sector vs Industry Groups Chart 33Profitability Profitability Profitability Chart 34Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 35Uses Of Cash Uses Of Cash Uses Of Cash Industrials Chart 36Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 37Profitability Profitability Profitability Chart 38Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 39Uses Of Cash Uses Of Cash Uses Of Cash Information Technology Chart 40Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 41Profitability Profitability Profitability Chart 42Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 43Uses Of Cash Uses Of Cash Uses Of Cash Materials Chart 44Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 45Profitability Profitability Profitability Chart 46Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 47Uses Of Cash Uses Of Cash Uses Of Cash Real Estate Chart 48Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 49Profitability Profitability Profitability Chart 50Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 51Uses Of Cash Uses Of Cash Uses Of Cash Utilities Chart 52Macroeconomic Backdrop Macroeconomic Backdrop Macroeconomic Backdrop Chart 53Profitability Profitability Profitability Chart 54Valuations And Technicals Valuations And Technicals Valuations And Technicals Chart 55Uses Of Cash Uses Of Cash Uses Of Cash Recommended Allocation Footnotes

Image US defense stocks have been on a tear of late (outperforming SPX by 10% since late November), benefiting from both macro and geopolitical trends.   From a macro standpoint, the Defense industry has been neglected by investors for a while, and now trades at 15.4x forward earnings, with a 27% discount to S&P 500.  As a “value” industry, it is likely to outperform in the environment of rising rates. On a geopolitical front, there is a secular rise in geopolitical risks due to a great power rivalry, hypo-globalization, and rising nationalism across the globe. The recent rise in commodity prices also means that countries will get back to active competition over resources and territory, in the Middle East, the South China Sea, the Mediterranean, Central Asia.  As such, the US refocusing on great power competition means Democrats and Republicans both support larger defense budgets, and Biden’s Congress already confirmed this with a large 2021 defense spending bill ($780bn, an increase of 5% from the peak during Trump’s presidency). China is increasing defense spending for the same reason, attempting to carve out a sphere of influence in East Asia, secure supply chains, and deter America in the event of a conflict in China’s neighborhood such as over Taiwan. There is also a rise in defense spending among other emerging powers, such as India, which is coming into its own as a geopolitical force and expanding its military to meet the China challenge as well as the ongoing Pakistan threat. The US allied states, that were formerly dovish, such as Germany and Japan, are also ramping up their defense spending.  Bottom Line: Changing world order will inevitably bring a military buildup between major powers benefiting US defense stocks on a secular basis. The US defense industry is represented by the following companies: LMT, NOC, GD, LHX, AXON, HII. ​​​​​​​  

Dear Client, Next week there will be no regular strategy report. Instead, we will hold our quarterly webcast which will discuss the outlook for the European economy and assets in 2022. I look forward to this interaction. Best regards, Mathieu Savary   Highlights European and global yields have considerable upside over the coming year, even if inflation peaks in 2022. The post-World War II experience is instructive: massive war-time fiscal and monetary stimulus allowed for an upward re-estimation of the neutral rate as trend nominal growth improved. A similar development is likely to result in an improvement in nominal growth and the neutral rate compared to the post-GFC decade. China and a financial accident outside the US constitute the greatest risks this year to higher yields. European stocks and value stocks will benefit from this rise in yields. Cyclicals in general and industrials in particular are the European sectors most levered to higher yields. Overweight these assets. Defensives will underperform meaningfully if yields rise further. Long Sweden and the Netherlands / Short Switzerland is an appealing trade to bet on higher yields, especially if inflation peaks in 2022. Feature Last week, US Treasury yields finally reached levels that prevailed before the pandemic started. In Europe, German 10-year yields flirted with the symbolic 0% level, rising to their highest reading since May 2019. With the Fed preparing to increase interest rates in March, and global inflation remaining perky, do yields already reflect all the bearish bond news or will they continue to climb higher on a cyclical basis? Moreover, what would be the implications for equity prices of higher yields? BCA expects yields to rise further, for which German Bunds will not be an exception. This process will continue to generate volatility in stock prices, but ultimately, higher equities will prevail. Increasing yields will help European stocks and are strongly associated with an outperformance of cyclical equities. What’s Moving Yields Up? Not all yield increases are created equal. A breakdown of yields helps us understand what investors are pricing in for the future. In the US, the upside in 10-year yields mostly reflects the increase in 5-year yields. This maturity has moved back to levels that prevailed prior to the pandemic, while the 5-year/5-year forward yield remains below its spring 2021 peak (Chart 1, top panel). Moreover, these shifts mirror higher real interest rates, which are rising across maturities, while inflation expectations have been declining in recent weeks or have been flat since mid-2021 on a 5-year/5-year forward basis (Chart 1, middle and bottom panels). This breakdown confirms investors are driving yields higher because they expect more Fed tightening. However, this upgraded view of the Fed’s policy path is limited to the next few years, and long-term policy expectations approximated by the forward rates are not rising as much. In other words, markets do not expect that the Fed will be able to push up interest rates on a long-term basis. In Germany, the breakdown of the most recent shift in yield paints a different picture (Chart 2). As in the US, real yields, not inflation expectations, drove the latest bond selloff. This points toward pricing in an eventual policy tightening in Europe. However, unlike what is happening in the US, 5-year/5-year forward rates are the main force driving yields higher; investors are therefore expecting the ECB to have to follow the Fed later on. Chart 1Near-Term Tightening Is Driving Treasurys Near-Term Tightening Is Driving Treasurys Near-Term Tightening Is Driving Treasurys Chart 2longer-Term Tightening Is Driving Bunds longer-Term Tightening Is Driving Bunds longer-Term Tightening Is Driving Bunds Can the Yield Upside Continue? While BCA’s target for the 10-year Treasury yield in 2022 stands at 2.25% and the Bund yield at 0.25%, the coming two to three years should witness significantly higher yields. The period after World War II offers an interesting historical equivalent. During the War, government spending as a share of GDP exploded, lifting US gross federal debt from 52% of GDP at the dawn of the conflict to 114% at the end of 1945. However, the Fed kept a lid on interest rates during this period to help finance the war effort. T-Bill rates were pegged at 3/8th of a percent and the Fed also capped T-Bond yields at 2.5%. Chart 3The Post WWII Experience The Post WWII Experience The Post WWII Experience As a consequence of this policy effort, the Fed balance sheet increased significantly and continued to do so after the war (Chart 3). The stimulative fiscal and monetary policy, as well as the capacity constraints associated with shifting production from military goods to consumer and capital goods, contributed to an inflation spike to 20% in March 1947. Moreover, the Korean War boosted government spending between 1950 and 1953, resulting in another inflation spike to 9.5% in 1951. The Fed’s cap on yields ended after the March 1951 Treasury-Fed Accord. It was followed by the beginning of a multi-decade uptrend in bond yields, which culminated in 1981 with T-Bond yields above 15% following the inflationary surge of the 1970s. Nonetheless, the yield increase from 2.5% in 1951 to 4% at the end of the 1950s happened after the inflation peak of the Korean War. This original inflection reflected economic vigor and a normalization of the neutral rate after the trauma of the Great Depression. The current situation is not dissimilar. The neutral rate and the market-based estimates of the terminal rate of interest are still very low in the US and in Europe (Chart 4). However, the vast amount of monetary and fiscal stimulus injected in the economy has jolted a recovery. It has also caused a massive wealth transfer to households and the private sector in general that is likely to increase consumption permanently. As a result, growth in the coming decade will be stronger than it was in the past decade, in both the US and Europe. This process will allow the neutral rate to rise over time, which in turn will lift the terminal rate of interest and yields. In this context, even if inflation were to cool in 2022 because some of the supply constraints that marked 2021 dissipate, yields may continue to rise and do so for the remainder of the decade. This is also true in Europe where the household savings rate still towers near 19% of disposable income and may fall by 6% to reach its pre-pandemic levels, as the US experience presages (Chart 5). Chart 4Terminal Rates Proxies Are Too Low Terminal Rates Proxies Are Too Low Terminal Rates Proxies Are Too Low Chart 5European Savings Rate Has Downside European Savings Rate Has Downside European Savings Rate Has Downside A simple modeling exercise confirms that yields will have greater upside over the coming year. Conceptually, yields are anchored by policy rates and the terminal rate, which is somewhere above the neutral rate of interest. One of the key determinants of the nominal neutral rate is the trend growth rate of nominal GDP. While the market cannot know precisely where that growth rate stands, recent experience influences the perception of market participants. Thus, a long-term moving average of nominal GDP growth constitutes a rough proxy of this measure and will relate to investors’ assessment of the neutral rate and the terminal interest rates. Chart 6Bond Yields Are Too Low, Especially If Trend Nominal Growth Picks Up Bond Yields Are Too Low, Especially If Trend Nominal Growth Picks Up Bond Yields Are Too Low, Especially If Trend Nominal Growth Picks Up Using this approach reveals two important bearish forces for bonds. Even after accounting for the slow growth rate of both the US and Eurozone economies over the past ten years, as well as extraordinarily low policy rates, T-Notes and Bunds yields are too low (Chart 6). More importantly, if nominal GDP growth is higher this decade than next, this alone will push up the equilibrium level of yields in Advanced Economies. The upside in yields is not without risks. China is still going through a deflationary shock whereby growth is slowing. As China eases policy, Chinese yields will continue to fall, bucking the global trend (Chart 7). In recent years, Chinese yields have rarely diverged from global yields. If Chinese growth plummets from here, the divergence will not be resolved via higher Chinese yields. However, Chinese authorities do not want growth to collapse. Reports from the State Council suggest an acceleration of the implementation of major spending projects under the 14th Five-year plan and that the credit impulse is trying to bottom. Nonetheless, China remains a risk to monitor closely. The second major risk stems from the intertwined nature of the global financial system. The US economy is able to withstand higher Treasury yields, but is the rest of the world? As Chart 8 highlights, US private debt-servicing costs are low today, as a result of minimal interest rates and the decline in debt loads after the GFC. The same is not true for the G-10 outside the US, let alone EM economies. These differences suggest that the US will be much more resilient to rising yields than the rest of the world. A major financial accident outside the US would prompt a wave of risk aversion that would decrease yields around the world. Chart 7An Unusual Divergence An Unusual Divergence An Unusual Divergence Chart 8Will The Rest Of The World Withstand Higher US Yields? Will The Rest Of The World Withstand Higher US Yields? Will The Rest Of The World Withstand Higher US Yields? Bottom Line: Global yields have much greater upside for the years ahead, even if inflation slows in 2022. While BCA targets 2.25% and 0.25% for, respectively, Treasurys and Bund yields this year, the multi-year upside is much greater as neutral rates are re-adjusted upward. The change will not move in a straight line, but the trend will not be friendly for bondholders. In the near-term, the main culprits preventing higher yields are a further slowdown in China as well as a financial accident outside the US. Investment Implications The most obvious investment implication is that investors should use any pullback in yields to sell duration. As a corollary, investors should maintain an overweight stance on equities relative to bonds. The equity risk premium, especially in Europe, remains elevated, and European dividend yields stand near record highs compared to Bund yields (Chart 9). Moreover, when yields rise because of a higher neutral rate, this also means that the expected long-term growth rate of earnings is firming, which negates some of the adverse impacts on valuations of higher discount rates. Nonetheless, if inflation does not stabilize, the increase in yields could become much more painful for stocks, as the negative correlation between stock prices and bond yields would reassert itself—a possibility we described five weeks ago. A rising neutral rate and terminal rate are also associated with an outperformance of European stocks compared to the US and an outperformance of value stocks over growth stocks in Europe (Chart 10). These relationships reflect the greater procyclicality of European equities and value stocks. Chart 9A Valuation Cushion For Stocks A Valuation Cushion For Stocks A Valuation Cushion For Stocks Chart 10Higher Terminal Rates Favor Europe And Value Higher Terminal Rates Favor Europe And Value Higher Terminal Rates Favor Europe And Value Finally, we looked at the performance of European sectors based on the trend in yields. Table 1 highlights that industrials are the great winner when yields rise, which is a testament to their pro-cyclicality. They beat the market on 3-month, 6-month and 12-month horizons by 1.6%, 2.9% and 5.8%, respectively. The regularity of their benchmark-beating performance is extremely high. When yields rise, financials also see a marked improvement of their relative returns compared to their historical average returns. Surprisingly, so do European tech firms, which reflect the more hardware focus of European tech compared to the US. Table 1Rising Yields & Sector Relative Performance Implications Of Rising Yields Implications Of Rising Yields Table 2 repeats the same exercise, but, this time, we control for the slope of the yield curve, focusing on periods when the yield curve is positively sloped. Again, industrials are the star sector, but other cyclicals such as materials and consumer discretionary also stand out. European tech remains dominated by its cyclical properties, while the outperformance of financials becomes more marked. Table 2Rising Yields & Sector Relative Performance With Postive Yield Curve Slope As A Control Variable Implications Of Rising Yields Implications Of Rising Yields Table 3 looks at the behavior of sectors when yields rise and when the Euro Area PMI Manufacturing improves, which is a scenario we expect for most of 2022 once the winter passes. Industrials win more clearly than materials or consumer discretionary. The European tech sector continues to generate a very strong outperformance, while the excess return of financials firms up as well. This scenario also shows a particularly steep underperformance for all the defensive sectors. Table 3Rising Yields & Sector Relative Performance With Improving Manufacturing PMI As A Control Variable Implications Of Rising Yields Implications Of Rising Yields Table 4 completes the picture, focusing on rising yields when core CPI decelerates, another development we foresee in 2022. Once again, industrials stand out as a result of the extent and regularity of their outperformance. However, under this controlling variable, the performance of materials and consumer discretionary stocks deteriorates significantly. Financials also see a large downgrade to their relative performance. Tech performs best under these circumstances. Here, staples suffer the worst fate, closely followed by utilities and healthcare. Table 4Rising Yields & Sector Relative Performance With Falling Core CPI As A Control Variable Implications Of Rising Yields Implications Of Rising Yields Based on these observations, the highest likelihood scenario is that European cyclicals will outperform defensive equities significantly this year after a period of consolidation since last spring. A more targeted approach would be to overweight industrials and tech at the expense of staples and utilities. Geographically, investors should buy a basket of Swedish (overweight industrials) and Dutch stocks (overweight tech), while selling Swiss stocks (overweight healthcare).   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

Upgrading Airlines Upgrading Airlines Following another sell-off, S&P airlines have been regaining some altitude of late despite US Covid cases and hospitalizations rising. The surge in Omicron infections appears to be priced in. Airlines have underperformed S&P 500 by about 20% over the past 13 weeks. The market is expecting the virus story to be over soon and is slowly rotating into the beaten down industries. One of the reasons for the optimistic outlook is likely due to the fact that the Omicron variant is milder. At the same time, there are no lockdowns in the US, and Americans are learning how to live with Covid on a permanent basis. Case in point, holiday travel has exceeded the pre-pandemic peak. We are also getting closer to the point of the white-collar workers returning to the office – hope is that business travel will pick up shortly after – which will benefit airlines stocks. True, international travel still weighs on the industry as quite a few European and Asian countries have reinstituted the lockdowns, but those headwinds are likely to dissipate over the course of 2022. Bottom Line: The time is ripe to start nibbling at the S&P airlines index. ​​​​​​​

Image The latest CPI and PPI prints at 6.2% and 8.6% respectively, have surprised economists on the upside. Indeed, this level of inflation was unseen in the US for the last forty years. However, there are early signs that input costs inflation is abating, thanks to a resolution of the supply chain bottlenecks and an appreciating dollar.  A proxy for the global manufacturing input cost inflation comprises of the Baltic Dry Index, DRAM, coal, and natural gas prices, is showing signs of easing (see chart). The US dollar is putting downward pressure on the price of commodities and also acts as a natural cooler to the global economic activity, helping resolve supply-demand imbalances. Resolution of the supply chain disruptions and falling prices of inputs will offer support for the Industrials sector, which has been languishing on the back of shortages and rising PPI. This thesis supports our structural overweight of the US Industrials and the US Manufacturing Renaissance theme. The rising dollar will support more domestically oriented asset classes and sectors, such as Small Cap (overweight) and Consumer Services industry groups (overweight). Conversely, the strong dollar will become a headwind for the Technology sector which derives 58% of sales from abroad, and whose goods will become more expensive for the overseas buyers.  Resolution of the shipping delays may hinder the performance of the Transportation Industry (overweight) which was reaping huge rewards from an outsized demand for shipping.  Bottom Line: Inflation will likely head lower over the coming 3-6 months while the dollar is rising. We are monitoring the effects of these macroeconomic developments on the performance of different segments of US equities. ​​​​​​​