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Executive Summary Our negative view on the summer rally is coming to fruition, with equities falling back on the negative geopolitical, macro, and monetary environment. China is easing policy ahead of its full return to autocratic government this fall. Yet the Fourth Taiwan Strait Crisis has only just begun. Tensions can still deal nasty surprises to global investors. It is essential to verify that relations will thaw after the US midterm and Chinese party congress is critical. Russia continues to tighten energy supply as predicted. Ukraine’s counter-offensive is pushing back the time frame of a ceasefire deeper into next year. Putin may declare victory and quit while he is ahead – but Russia will not be forced to halt its invasion until commodity prices fall significantly. Sweden’s election will not interfere with its NATO bid; Australia’s new government will not re-engage with China; Malaysia’s election will be a positive catalyst; South Africa’s political risks are reawakening; Brazil’s risks are peaking; Turkey remains a leading candidate for a negative “black swan” event. China’s Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk Asset Initiation Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 17.4% Bottom Line: Investors should stay defensive in the short run until recession risks and geopolitical tensions abate. Feature Last week we visited clients across South Africa and discussed a broad range of global macro and geopolitical issues. In this month’s GeoRisk Update we relate some of the key points in the context of our market-based quantitative risk indicators. While we were traveling, US-Iran negotiations reached a critical phase. A deal is said to be “closer” but we remain pessimistic (we still give 40/60 odds of a deal). The important point for investors is that the supply side of global oil markets will remain tight even if a deal is somehow agreed, whereas it will get much tighter if a deal is not agreed. China’s rollout of 1 trillion yuan ($146 billion) in new fiscal stimulus and rate cuts (5 bps cut to 1-year Loan Prime Rate and 15 bps cut to 5-year LPR) is positive on the demand side and supports our key view in our 2022 annual outlook that China would ease policy ahead of the twentieth national party congress. However, it is still the case that China is not providing enough stimulus to generate a new cyclical rally. Second quarter US GDP growth was revised slightly upwards but was still negative. Russia tightened control of European energy, as expected, increasing the odds of a European recession. Europeans are getting squeezed by rising energy prices, rising interest rates, and weak external demand. China Eases Policy Ahead Of Return To Autocracy China is facing acute political risk in the short term but it is also delivering more stimulus to try to stabilize the economy ahead of the twentieth national party congress this fall (Chart 1). The People’s Bank of China cut the benchmark lending rate by (1-year LPR) by 5 basis points, while authorities unveiled fiscal spending worth 1 trillion renminbi. Chart 1China's Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk China's Confluence Of Domestic And Foreign Political Risk After the party congress, the regime is likely to “let 100 flowers bloom,” i.e. continue with a broad-based policy easing to secure the recovery from the Covid-19 shock. This will include loosening social restrictions and aggressive regulations against industrial sectors like the tech sector. It should also include some diplomatic improvements, especially with Europe. But it is only a short term (12-month) trend, not a long-term theme. Related Report  Geopolitical StrategyRoulette With A Five-Shooter China’s return to autocratic government under General Secretary Xi Jinping is a new, negative, structural factor and is nearly complete. Xi is highly likely to secure another decade in power and promote his faction of Communist Party stalwarts and national security hawks. The period around the party congress will be uncertain and dangerous. The exact makeup of the next Politburo could bring some surprises but there is very little chance that Xi and his faction will fail to consolidate power. The nomination of an heir-apparent is possible but of limited significance since Xi will not step down anytime soon or in a regular, predictable manner. Larger stimulus combined with power consolidation could spur greater risk appetite around the world, as it would portend a stabilization of growth and policy continuity. However, China’s underlying problems are structural. The manufacturing and property bust can be delayed but not reversed. China’s foreign policy will continue to get more aggressive due to domestic vulnerability, prompting foreign protectionism, export controls, sanctions, saber-rattling, and the potential for military conflict. Bottom Line: Investors should use any rally in Chinese assets over the coming 12 months as an opportunity to sell and reduce exposure to China’s historic confluence of political and geopolitical risk. Fourth Taiwan Strait Crisis Only Beginning The Fourth Taiwan Strait Crisis has only just begun. The previous three crises ranged from four to nine months in duration. The current crisis cannot possibly abate until November at earliest. Taiwan’s political risk will stay high and we would not buy any relief rally until there is a firm basis for believing tensions have fallen (Chart 2). Chart 2Taiwan: The Fourth Taiwan Strait Crisis Taiwan: The Fourth Taiwan Strait Crisis Taiwan: The Fourth Taiwan Strait Crisis If this year’s crisis were driven by US and Chinese domestic politics – the US midterm election and China’s party congress – then both Presidents Biden and Xi Jinping would already have achieved what they want and could proceed to de-escalate tensions by the end of the year – i.e. before somebody really gets hurt. The two leaders could hold a bilateral summit in Asia in November and agree to uphold the one China policy and status quo in the Taiwan Strait. We have given a 40% chance to this scenario, though we would still remain pessimistic about the long-term outlook for Taiwan. But if this year’s crisis is driven by a change in US and Chinese strategic thinking as a result of Russia’s invasion of Ukraine and China’s rising domestic instability, then there will not be a quick resolution on Taiwan. The crisis would grow next year, increasing the risk of aggression or miscalculation. We have given a 60% probability to this scenario, of which full-scale war comprises 20 percentage points. Bottom Line: Our geopolitical risk indicator for Taiwan spiked and Taiwanese equities rolled over relative to global equities as we expected. However, our oldest trade to capture the high long-term risk of a war in the strait – long Korea / short Taiwan – has performed badly despite the crisis. South Korea: China Stimulus A Boon But Not Geopolitics US-China rivalry – and the thawing of Asia’s once-frozen conflicts – is also manifest on the Korean peninsula, where the limited détente between the US and North Korea negotiated by President Donald Trump and Kim Jong Un has fallen apart. South Korea’s situation is not as risky as Taiwan’s but it is nevertheless less stable than it appears (Chart 3). Chart 3South Korea: Lower Geopolitical Risk Than Taiwan South Korea: Lower Geopolitical Risk Than Taiwan South Korea: Lower Geopolitical Risk Than Taiwan South Korea resumed its full-scale joint military exercise with the US, the Ulchi Freedom Shield, from August 22 to September 1. The drills involve amphibious operations and a carrier strike group. Full-scale drills were scaled down or cancelled under the Trump and Moon Jae-In administrations with the hopes of facilitating diplomacy and reducing tensions on the peninsula. North Korea was to discontinue ballistic missile tests and threats to the United States. But after the 2020 election neither Washington nor Pyongyang considered itself bound by this agreement. This year the US went forward with Ulchi Freedom even though regional tensions were sky-high because of House Speaker Nancy Pelosi’s visit to Taiwan and the De-Militarized Zone in Korea. The US is flagging its regional interests and power bases. North Korea is increasing the frequency of missile tests this year and is likely to conduct an eighth nuclear test. On August 17, it fired two cruise missiles towards the Yellow Sea. Pyongyang does not want to be ignored amid so many other geopolitical crises. It is emboldened by the fact that Russia and China will not be voting with the US for another round of sanctions at the United Nations Security Council due to the war in Ukraine and tensions over Taiwan. On August 11, South Korea responded to China’s insistence that the new government should abide by the “Three No’s,” i.e. three negatives that the Moon administration allegedly promised China: no additional deployments of the US’s Terminal High-Altitude Area Defense (THAAD) system, no Korean integration into US-led missile defense, and no trilateral military alliance with the US and Japan. Korea’s Foreign Minister Park Jin told reporters upon his return from China that the three no’s were “neither an agreement nor a promise.” South Korea’s new and conservative President Yoon Suk-yeol is unpopular and gridlocked at home but he is using the opportunity to reassert Korean national interests, including the US military alliance. Tension with the North and cold relations with China are coming at a time when the economy is slowing down. Korean GDP grew by 0.7% in Q2 2022 on a quarter-on-quarter basis, supported by household and government spending, while exports and investments shrank. Roughly a quarter of Korean exports go to China, its biggest trading partner. Korean exports to China have suffered due to China’s economic woes but cold relations could bring new economic sanctions, as China has hit South Korea before over THAAD. With the Yoon administration planning to bring the fiscal deficit back to below 3% of GDP next year, and a broader backdrop of weak Chinese and global demand, it is hard to find bright corners in the Korean economy in the near term. With Yoon’s basement level approval rating, he will resort to foreign policy to try to revive his political capital. Saber rattling and tough talk with North Korea and China will increase tensions in an already hot region – geopolitical risk is bound to stay high on the back of the Taiwan crisis. Bottom Line: On a relative basis, due to the ironclad US security guarantee, South Korea is safer than Taiwan. Investors wanting exposure to Chinese economic stimulus, electric vehicles, and semiconductors should go long South Korea. But some volatility is likely because the North’s eighth nuclear test will occur in the context of high and rising regional tensions. Australia: Stimulus Is Positive But No “Thaw” With China Australia is blessed with strong geopolitical fundamentals but it is seeing a drop in national security and economic security due to the deterioration of China relations. Domestic political turmoil is one of the consequences (Chart 4). Most recently Australia has been roiled by the revelation that former Prime Minister Scott Morrison secretly ran five ministries during the pandemic: the ministries of Home, Treasury, Finance, Resources, and Health. Chart 4Australian Geopolitical Risk Limited Australian Geopolitical Risk Limited Australian Geopolitical Risk Limited After an investigation and review by the Solicitor General Stephen Donaghue, Morrison’s action was determined to be legal, although highly inappropriate and inconsistent with the principles of responsible governance. Morrison’s appointments to these ministries were approved by the Governor General but the announcement or publication of appointments has always been the prerogative of the government of the day. One might think that this investigation is merely politically motivated but the Solicitor General is an apolitical position unlike the Attorney General, and Donaghue had been serving with Morrison, guiding him about the constitutionality of a vaccine mandate during the pandemic. The new Labor Party government of Prime Minister Anthony Albanese has vowed to be more transparent and will seek to enshrine a transparency measure into the law. Its political capital will improve, which is helpful for its ability to achieve its chief election promises. With the change of the government, it was hoped that there would be a thaw in the Australia-China relationship. China is Australia’s largest export destination and it erected boycotts against certain Australian exports in 2020 in response to Prime Minister Morrison’s inquiry into the origin of Covid-19. Hence Australia’s new defense minister, Richard Marles, met with his Chinese counterpart, General Wei Fenghe, on the sideline of the Shangri-La Dialogue in Singapore in June, which rekindled the hope that a thaw might happen. Yet a thaw is unlikely for strategic reasons, as highlighted by the Fourth Taiwan Strait Crisis, the Biden administration’s retention of former President Trump’s tariffs, and Australia’s fears of China’s rising influence in the Pacific Islands. The US and Australia are preparing for a long-term policy of containing China’s ambitions. A few days after his election, Prime Minister Albanese flew to Tokyo to attend a meeting of the Quadrilateral Security Dialogue (the Quad), sending a signal that there will be policy continuity with respect to Australian foreign policy. On May 26, Chinese fighter jets flew closely to an Australian surveillance plane on its routine operation and released aluminum chaffs that were ingested by the P8’s engines. An Australian warship, the HMAS Parramatta, was tracked by a People’s Liberation Army nuclear power submarine and multiple aircrafts on its way back from Vietnam, Korea, and Japan as part of its regional presence deployment in June. Currently Australia is hosting the Pitch-Black military exercise, with 17 countries participating. This exercise will last for three weeks – focusing on air defense and aerial refueling. It will also see the German air force with 13 military aircrafts deployed to the Indo-Pacific region for the very first time. They will be stopping in Japan after the exercise. As Australia’s policy towards China is unlikely to change, geopolitical risk will remain elevated. On the economic front, Australia’s misery index is at the highest point since 2000, with an unemployment rate at 3% and inflation at 6%. GDP growth in the first quarter was 0.8% compared to 3.6% in Q4 2021, propped up by government and household consumption while investment and exports contracted. The good news for the government is that it is inheriting this negative backdrop and can benefit from cyclical improvements in the next few years. Since the Labor government lacks a single-party majority in the Senate (where it must rely on the Greens and independents), it will be difficult for the government to raise new taxes. So far, Albanese has indicated that the budget to be tabled in October will focus on pre-election promises, which includes childcare, healthcare, and energy reforms. At worst, Australian government spending will stay flat, but it is unlikely to shrink considering Labor’s narrow control of the House of Representatives. Australian equities have not outperformed those of developed market peers despite high industrial metal prices. The stock market’s weak performance is attributable to the stumbling Chinese economy (Chart 5). Australian exports to China in June are still down 14% from June of last year. Chinese economic woes will be a headwind to Aussie growth and equity markets until next year, when Chinese stimulus efforts reach their full effect. Chart 5Australian Equities Have Yet to Benefit from Industrial Metal Prices Australian Equities Have Yet to Benefit from Industrial Metal Prices Australian Equities Have Yet to Benefit from Industrial Metal Prices On the other hand, the value of Australian natural gas and oil exports in June grew by 118% and 211% respectively (Chart 6), compared to June of last year. Chart 6Geopolitics: A Boon and Bane to Aussie Growth Geopolitics: A Boon and Bane to Aussie Growth Geopolitics: A Boon and Bane to Aussie Growth ​​​​​ Bottom Line: As China will continue stimulating the economy and global energy markets will remain tight, investors should look for opportunities in Aussie energy and materials stocks. Malaysia Closes A Chapter … And Opens A Better One? Rarely do we get to revisit our positive outlook on Malaysia – a Southeast Asian state with an ability to capitalize on the US break-up with China. On August 23, the embattled ex-prime minister of Malaysia, Najib Razak, lost his final appeal at the Federal Court in Putrajaya after being found guilty in 2020 for abuse of power, criminal breach of trust, and money laundering tied to Malaysia’s sovereign wealth fund, 1MDB. The high court instructed that he serves his 12-years prison sentence immediately, becoming the first prime minister to be imprisoned in the country’s 60-years plus of history. Political risk has weighed on the Malaysian economy for almost a decade starting with the contentious 2013 general election, which saw the collapse of non-Malay voter support for the ruling party. Then came the 2015 Wall Street Journal bombshell about 1MDB, and then the 2018 general election that resulted in Malaysia’s first change of government since independence. The pandemic also led to political crisis in 2020. Each crisis resulted in a successive weakening of animal spirits and ever lower investments, resulting in Malaysia’s loss of competitiveness (Chart 7). Malaysia’s cheap currency was unable to increase its competitiveness, due to the low investments in the economy, and reflected higher political risks in the country (Chart 8). Chart 7Political Risk Undermines Competitiveness Political Risk Undermines Competitiveness Political Risk Undermines Competitiveness ​​​​​​ Chart 8Cheap Currency Reflects Political Risk Cheap Currency Reflects Political Risk Cheap Currency Reflects Political Risk ​​​​​​ Nonetheless this entire saga has proved that Malaysia’s legal system is independent and that its political system is capable of holding policymakers accountable. The next general election will come in a matter of months and recent state elections bodes well for the institutional ruling party, the United Malay National Organization (UMNO), and its coalition, Barisan Nasional. The coalition is managing to claw back support from the Malay and non-Malay voters. The opposition had the bad luck of ruling during the pandemic and its rocky aftermath, which has helped to rehabilitate the traditional ruling party. We have long seen Malaysia as a potential opportunity. But we would advise investors to wait until the new election is held and a new government takes power before buying Malaysian equities. With the conclusion of its decade-long 1MDB saga, we would turn more bullish if the next election produces a sizeable and enduring majority, if the use of racial and sectarian rhetoric tones down, and if the governing coalition pursues pro-competitiveness policies. Bottom Line: Structurally, Malaysia is one of the largest exporters of semiconductors and will benefit from the US’s shift away from China and attempt to reconstruct supply chains so they run through the economies of allies and partners. Russia: Escalating To De-Escalate? Russia increased the number of active military personnel in a move that points to an escalation of the conflict with Ukraine and the West, even as Ukraine wages a counter-offensive against Russia in Crimea and elsewhere. The time frame for a ceasefire has been pushed further into next year. As long as the war escalates, European energy relief will be elusive. Our risk indicators will rise again (Chart 9). Chart 9Russia: Geopolitical Risk To Rise Again, Ceasefire Pushed Back Into Next Year Russia: Geopolitical Risk To Rise Again, Ceasefire Pushed Back Into Next Year Russia: Geopolitical Risk To Rise Again, Ceasefire Pushed Back Into Next Year Ukraine will not be able to drive Russians out of territory in which they are entrenched. It would need a coalition of western powers willing to go on the offense, which will not happen. Russia is also threatening to cut off the Zaporizhzhia nuclear power plant, ostensibly removing one-fifth of Ukraine’s electricity. Once the Ukrainian counter-offensive grinds to a halt, a stalemate will ensue, incentivizing ceasefire talks – but not until then. The Europeans will have to support Ukraine now but will become less and less inclined to extend the war as they get hit with recession. Russia says it is prepared for a long war but that kind of rhetoric is necessary for propaganda purposes. The truth is that Russia does not have great success with offensive wars. Russia usually suffers social instability in the aftermath. The best indicator for the duration of the war is probably the global oil price: If it collapses for any reason then Russia’s war machine will fall short of funds and the Kremlin will probably have to accept a ceasefire. This what happened in 2014-15 with the Minsk Protocols. Putin will presumably try to quit while he is ahead, i.e. complete the conquest and shift to ceasefire talks, while commodity prices are still supportive and Europe is economically weak. If commodity prices fall, Russia’s treasury dries up while Europe regains strength. So while military setbacks can delay a ceasefire, Russia should be seen as starting to move in that direction. The deal negotiated with Turkey and the United Nations to ship some grain from Odessa is not reliable in the short run but does show the potential for future negotiations. However, a high conviction on the timing is not warranted. Also, the US and Russia could enter a standoff over the US role in the war, or NATO enlargement, at any moment, especially ahead of the US midterm election. Bottom Line: Ukraine’s counteroffensive and Russia’s tightening of natural gas exports increases the risk to global stability and economic growth in the short run, even if it is a case of “escalating tensions in order to de-escalate” later when ceasefire talks begin. Italy: Election Means Pragmatism Toward Russia Italy’s election is the first large crack in the European wall as a result of Russia’s cutoff of energy. The party best positioned for the election – the right-wing, anti-establishment party called the Brothers of Italy – will have to focus on rebooting Italy’s economy once in power. This will require pragmatism toward Russian and its natural gas. Regardless of whether a right-wing coalition obtains a majority or the parliament is hung, Italian political risk will stay high in the short run (Chart 10). Chart 10Italy: Election Brings Uncertainty, Then Economic Stimulus Italy: Election Brings Uncertainty, Then Economic Stimulus Italy: Election Brings Uncertainty, Then Economic Stimulus Although the center-left Democratic Party (PD) is narrowing the gap with the Brothers of Italy in voting intentions, it is struggling to put together an effective front against the right-wing bloc. After its alliance with the centrist Azione party and +Europa party broke down, PD’s chance of winning has become even slimmer. Even if the alliance revives, the center-left bloc still falls short of the conservative parties. Together, the right-wing parties account for just 33% of voting intentions (Democrats at 23%, Greens and Left Alliance at 3%, Azione and +Europa at 7%). By contrast, the right-wing bloc has a significant lead, with 46% of the votes (Brothers of Italy at 24%, Lega at 14%, Forza Italia at 8%). They also have the advantage of anti-incumbency sentiment amid a negative economic backdrop. Unless some sudden surprises occur, a right-wing victory is expected, with Giorgia Meloni becoming the first female prime minister in Italy’s history. This has been our base case scenario for the past several months. But what does a right-wing government mean for the financial markets? In an early election manifesto published in recent weeks, the conservative alliance pledged full adhesion to EU solidarity and dropped their previous euroskepticism. This helps them get elected and is positive for investors. However, there are also clouds on the horizon: In the same manifesto, the right-wing parties pledged to lower taxes for families and firms, increase welfare, and crack down on immigration. These programs will add to Italy’s huge debt pile and eventually lead to conflicts with the ECB and other EU institutions. In the manifesto, they stated that if elected, they would seek to amend conditions of Italy’s entitlement to the EU Recovery Fund, as the Russia-Ukraine war has changed the context and priorities significantly. This could potentially put the EU’s grants and cheap loans at risk. Under the Draghi government, Italy has secured about 67 billion euros of EU funds. According to the schedule, Italy will receive a further 19 billion Euros recovery funds in the second half of 2022, if it meets previously agreed upon targets. The new government will try to accept the funds and then make any controversial policy changes. On Russia, the conservative parties claimed that Italy would not be the weak link within EU. They pledged respect for NATO commitments, including increasing defense spending. Both Meloni and her Brothers of Italy have endorsed sending weapons to support Ukraine. Still, we think that due to Italy’s historical link with Russia and the need to secure energy supplies, the new government would be more pragmatic toward Russia. On China, Meloni has stressed that Italy will look to limit China’s economic expansion if the right-wing alliance wins. She stated that “Russia is louder at present and China is quieter, but [China’s] penetration is reaching everywhere.” China will want to use diplomacy to curb this kind of thinking in Europe. Meloni also stated that she would not seek to pursue the Belt and Road Initiative pact that Italy signed with China in 2019. In short, we stand firm on our recommendation of underweighting Italian assets at least until a new government is formed. Europe Gets Its Arm Twisted Further The United Kingdom is going through a severe energy, water, and inflation crisis – on top of the long backlog at the National Health Service – as it stumbles through the aftermath of Covid-19 and Brexit. The Conservative Party’s leadership contest is a distraction – political risk will not subside after it is resolved. The new Tory leader will lack a direct popular mandate but the party will want to avoid an early election in the current economic context, creating instability. The looming attempt at a second Scottish independence referendum will also keep risks high, as the outcome this time may be too close to call (Chart 11). Chart 11UK: Tory Leaders A Sideshow, Risks Will Stay High UK: Tory Leaders A Sideshow, Risks Will Stay High UK: Tory Leaders A Sideshow, Risks Will Stay High Germany saw Russia halt natural gas flows through Nord Stream 1 as the great energy cutoff continues. As we have argued since April, Russia’s purpose is to pressure the European economies so that they are more conducive to a ceasefire in Ukraine. Germany will evolve quickly and will improve its energy security faster than many skeptics expect but it cannot do it in a single year. The ruling coalition is also fragile, even though elections are not due anytime soon (Chart 12). Chart 12Germany: Geopolitical Risk Still Rising Germany: Geopolitical Risk Still Rising Germany: Geopolitical Risk Still Rising France’s political risk will also remain high (Chart 13), as domestic politics will be reckless while President Emmanuel Macron and his allies only control 43% of the National Assembly in the aftermath of this year’s election (Chart 14). Chart 13France: Lower Geopolitical Risk Than Germany France: Lower Geopolitical Risk Than Germany France: Lower Geopolitical Risk Than Germany Chart 14Macron Will Focus On Foreign Policy Odds And Ends (A GeoRisk Update) Odds And Ends (A GeoRisk Update) Spain is likely to see its coalition destabilized and early elections, much like Italy this year (Chart 15). Chart 15Spain: Early Elections Likely Spain: Early Elections Likely Spain: Early Elections Likely Sweden, along with Finland, will be joining NATO, which became clear back in April. In this sense it is at the center of Russia’s conflict with the West over NATO enlargement, so we should take a quick look at the Swedish general election on September 11. Currently the left-wing and right-wing blocs are neck and neck in the polls. While the current Social Democrat-led government may well fall from power, Sweden’s new pursuit of NATO membership is unlikely to change. The right-wing parties in Sweden are in favor of joining NATO. The two parties that oppose NATO membership are the left-wing Green and Left Party. The Social Democrats were pro-neutrality until the invasion of Ukraine and since May have spearheaded Swedish accession to NATO. The pro-neutrality bloc currently holds 43 seats in the 349-seats Riksdag. It has a supply-and-confidence arrangement with the current government and is currently polling at 13%. If it was willing and able to derail Sweden’s NATO bid, it would already have happened. So the general election in Sweden is unlikely to stop Sweden from joining. However, Russia does not want Sweden to join and the entire pre- and post-election period is ripe for “black swan” risks and negative surprises. One thing that could change with the election is Sweden’s immigration policy. The Social Democrats are pro-immigration (albeit pro-integration), while the right-wing bloc is less so. Sweden has received a great many asylum seekers since the Syrian refugee crisis in 2015 and will be receiving more from Ukraine and Russia (Chart 16). Chart 16Asylum Seekers to Surpass 2015 Refugee Crisis Asylum Seekers to Surpass 2015 Refugee Crisis Asylum Seekers to Surpass 2015 Refugee Crisis Our Foreign Exchange Strategist Chester Ntonifor points out that the increase in asylum seekers could augment Swedish labor force and increase its potential growth in the long run, while in the short run it could increase demand in the domestic economy. But an increase in demand could also exacerbate inflation in Sweden, especially considering how much the Riksbank is behind the curve vis-à-vis the ECB. Our European Investment Strategy recommends shorting EUR/SEK as Sweden is less vulnerable to Russian energy sanctions. Sweden produces most of its energy from renewable sources. Relative to Europe, Canada faces a much more benign political and geopolitical environment (Chart 17). However, within its own context, it will continue to see more contentious domestic politics as interest rates rise on a society with high household debt and property prices. The post-Covid-19 period will undermine the Justin Trudeau government over time, though it is not facing an election anytime soon. Canada continues to benefit from North America’s geopolitical advantage, though quarrels with China will continue, including over Taiwan, and should be taken seriously. Aside from any China shocks we expect Canadian equities to continue to outperform most global bourses. Chart 17Canada: Low Geopolitical Risk But Not Happy Canada: Low Geopolitical Risk But Not Happy Canada: Low Geopolitical Risk But Not Happy South Africa: The Calm Before The Storm South Africa’s economy remains in a low growth trap, which is contributing to rising political risk (Chart 18). Electricity shortages continue to dampen economic activity. Other structural issues like 33.9% unemployment, worsening social imbalances, and a split in the ruling party threaten to cause negative policy surprises. Chart 18South Africa: Institutional Ruling Party At Risk South Africa: Institutional Ruling Party At Risk South Africa: Institutional Ruling Party At Risk The South African economy has failed to translate growth outcomes into meaningful economic development, leaving low-income households (the median voter) increasingly disenfranchised, burdened, and constrained. Last year’s civil unrest was fueled by economic hardships that persist today. Without a significant and consistent bump to growth, social and political risks will continue to rise. Low-income households remain largely state dependent. Fiscal austerity has already begun to unwind, well before the 2024 election, in a bid to shore up support and quell rising social pressures (Chart 19). Chart 19South Africa: Fiscal Easing Ahead Of 2024 Vote South Africa: Fiscal Easing Ahead Of 2024 Vote South Africa: Fiscal Easing Ahead Of 2024 Vote The fact that the social scene is relatively quiet for now should not be seen as a sign of underlying stability. For example, two of the largest trade unions led a nationwide labor strike last week – while we visited clients in the country! – but failed to “shut down” the country as advertised. Labor union constituents noted the ANC’s economic failures, demanded immediate economic reform, and advocated for a universal basic income grant. This action blew over but the election cycle is only just beginning. Looking forward to the election, President Cyril Ramaphosa’s ANC is still viewed more favorably than the faction led by ex-President Jacob Zuma, but Ramaphosa has suffered from corruption allegations recently that have detracted attention from his anti-corruption and reform agenda and highlighted the party’s shortcomings once again. The ANC’s true political rival, the far-left Economic Freedom Fighters (EFF), have so far failed to capitalize on the weak economic backdrop. The EFF is struggling with leadership battles, thus failing to attract as many soured ANC voters as otherwise possible. If the Economic Freedom Fighters refocus and install new leadership, namely a leader that better reflects the tribal composition of the country, the party will become a greater threat to the ANC. But the overall macro backdrop is a powerful headwind for the ANC’s ability to retain a parliamentary majority. Global macro tailwinds that supported local assets in the first half of the year are experiencing volatility due to China’s sluggish growth and now stimulus efforts. Cooling metals prices and slowing global growth have weighed on the rand and local equity returns. But now China is enacting more stimulus. China is South Africa’s largest trading partner, so the decision to ease policy is positive for next year, even though China’s underlying structural impediments will return in subsequent years. This makes it hard to predict whether South Africa’s economic context will be stable in the lead-up to the 2024 election. As long as China can at least stabilize in the post-pandemic environment in 2023, the ANC will not face as negative of a macro environment in 2024 as would otherwise be the case. Investors will need to watch the risk of political influence on the central bank. Recently the ANC resolved to nationalize the central bank. Nationalization is mostly about official ownership but a change in the bank’s mandate was also discussed. However, to change the bank’s mandate from an inflation target to an unemployment target, the ANC would need to change the constitution. Constitutional change requires a two-thirds vote in parliament, a margin the ANC does not hold. Constitutional change will become increasingly difficult if the ANC sheds more support in the 2024 general election, as expected. Bottom Line: Stay neutral on South Africa until global and Chinese growth stabilize. Political risk is rising ahead of the 2024 election but it is not necessarily at a tipping point. Brazil And Turkey: Election Uncertainty Prevails We conclude with two brief points on Brazil and Turkey, which both face important elections – Brazil immediately and Turkey by June 2023. Both countries have experienced different forms of instability as emerging middle classes face economic disappointment, which has led to political challenges to liberal democracy. Brazil – President Jair Bolsonaro’s popular support is rallying into the election, as expected, but it would require a large unexpected shift to knock former President Lula da Silva off course for re-election this October (Chart 20). Brazil’s first round vote will be held on October 2. If Lula falls short of the 50% majority threshold, then a second round will be held on October 30. Bolsonaro faces an uphill battle because his general popularity is weak – his support among prospective voters stands at 35% compared to Lula at 44% today and Lula at 47% when he left office in 2010. Meanwhile the macroeconomic backdrop has worsened over the course of his four-year term. Bolsonaro will contest the election if it is close so Brazil could face significant upheaval in the short run. Chart 20Brazil: Risk Will Peak Around The Election Brazil: Risk Will Peak Around The Election Brazil: Risk Will Peak Around The Election Turkey – President Recep Erdogan’s approval rating has fallen to 41%, while his disapproval has risen to 54%. It is a wonder his ratings did not collapse sooner given that the misery index is reaching 88%, with headline inflation at 78%. Having altered the constitution to take on greater presidential powers, Erdogan will do whatever it takes to stay in power, but the tide of public opinion is shifting and his Justice and Development Party is suffering from 21 years in power. Erdogan could interfere with NATO enlargement, the EU, Syria and refugees, Greece and Cyprus, North Africa and Libya, or Israel in a way that causes negative surprises for Turkish or even global investors. Turkey will be a source of “black swan” risks at least until after the general election slated for June 2023 (Chart 21). Chart 21Turkey: A Source Of 'Black Swans' Turkey: A Source Of 'Black Swans' Turkey: A Source Of 'Black Swans' We will revisit each these markets in greater detail soon. Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com ​​​​​​​Yushu Ma Research Analyst yushu.ma@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Geopolitical Calendar

Executive Summary Italy’s right-wing alliance, led by Brothers of Italy, will likely outperform in  the upcoming election. The new government will prioritize the economy, posing a risk to the EU’s united front against Russia. It is conducive to an eventual ceasefire, which is marginally positive for risk assets in 2023. We recommend investors underweight Italian assets on a tactical basis. China’s political risks will remain elevated until Xi consolidates power this fall, positive news will come after, if at all. Geopolitical risk in the Taiwan Strait will remain high and persistent until China and the US reach a new understanding. Separately, we are booking a 9% gain on our long US equities relative to UAE equities trade. Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Tactical Recommendation Inception Date Return LONG US / UAE EQUITIES (CLOSED) 2022-03-11 9.0% Bottom Line: Italy’s political turmoil suggests a more pragmatic policy toward Russia going forward. Europe’s energy cutoff will also motivate governments to negotiate with Russia. Feature In this report we update our GeoRisk Indicators, with a special focus on Italy’s newest political turmoil. Italy Over the past several months, we have argued that Italy was a source of political risk within the European Union and that the market underestimated the probability of an early Italian election. In the past two weeks, this forecast has become a reality (Chart 1). Chart 1Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator The grand coalition under Prime Minister Mario Draghi had fulfilled its two main purposes – to distribute EU recovery funds and secure an establishment politician in the Italian presidency. At the same time, headline inflation hit 8.5% in June, the highest since 1986, even as the Italian and global economy slowed down, Italian government bonds sold off, and Russia induced an energy crisis. The stagflationary economic environment is biting hard and the different coalition members are looking to their individual interests ahead of election season. On July 14, Giuseppe Conte, the former prime minister, pulled its populist Five Star Movement (M5S) out of Mario Draghi’s national unity government, triggering a new round of political turmoil in Italy. Draghi’s first resignation was rejected by Italian President Mattarella later that day. However, on July 21, the League and Forza Italia also defected from the grand coalition. After Draghi’s plan of reviving the coalition collapsed, President Mattarella accepted his resignation and called for a snap election to be held on September 25, ten months ahead of the original schedule. Based on the latest public opinion polls, right-wing political parties are well-positioned for the upcoming election. The far-right Brothers of Italy is now the front runner in the election race and is expected to win around 23% of the votes. Another far-right party, the League, is the third most popular party, with nearly 15% support despite a drop in support during its time within the grand coalition. In addition, the center-right Forza Italia receives 8.5% of the support. Together, the right-wing conservative bloc amounts to 46.5% of voting intentions. There is still positive momentum for Brothers of Italy to harvest more support given that they are the flag-bearer for anti-incumbent sentiment amid the stagflationary economy. By contrast, the left-wing parties – the Democrats, the Left, and the Greens – only command about 27%. The possibility of an extended left-wing coalition, even with the inclusion of the M5S, is looking slim. On July 25, Enrico Letta, the leader of the Democratic Party, publicly expressed his anger against party leader Giuseppe Conte and ruled out any electoral pact with the M5S because of the recent political chaos they caused. He stressed that the Democratic Party would seek ties with parties that had remained loyal to Draghi’s national unity. However, there are not many parties left for the Democrats to partner with. Apart from the Left and the Greens, the Democrats’ best chance would be the center-left Action Party and Italia Viva, which is led by Matteo Renzi, who served as the secretary of the Democratic Party from 2013 to 2018. However, these four parties are small and will not enable the Democrats to form a government. Courting M5S is the Democrats’ only chance to set up an alternative to the right-wing bloc, but that will require the election to force the two parties together. Related Report  Geopolitical StrategyLe Pen And Other Hurdles (GeoRisk Update) The Democratic Party was the biggest supporter of Draghi’s government, while the Brothers of Italy were the sole major opposition. Thus the September 25 election will be a race between these two major parties. Both are expected to outperform current polling, as they will attract the most supporters from each side. The other right-wing parties, Forza Italia and the League, will at least perform in line with their polling, while the other left-wing parties will underperform. In the meantime, M5S’ popularity will continue to decline – the party is bruised over its role in Draghi’s coalition and divided over how to respond to the Ukraine war. Foreign policy is a major factor in this election. Italy has the highest share of citizens in the Eurozone who support solving the Russia-Ukraine conflict through peaceful dialogue (52% versus the Eurozone average of 35%). Italy has long maintained pragmatic relations with Russia, including the Putin administration, as it imported 40% of its natural gas from there prior to 2022. The EU is struggling to maintain a united front against Russia, and war policy will be a key focal point among the different parties. Draghi and the Democratic Party are the strongest supporters of the EU’s oil embargo on Russia and decision to send arms to support Ukraine. On the other side, the right-wing Forza Italia and the League have been more equivocal due to their traditional friendship with Russia. What’s more important is the stance of the Brothers of Italy on Russia, as it is the largest party now and will probably lead a right-wing government after the election. On July 27, the three right-wing parties struck a deal to officially form an alliance in the upcoming election and whichever party wins the most votes would determine the next prime minister if the alliance wins. This deal puts Giorgia Meloni, the leader of Brothers of Italy, one step closer to becoming Italy’s first female PM. Giorgia Meloni, unlike her right-wing peers, has endorsed Draghi’s hawkish stance towards Russia. Recently, she stressed that Italy would keep sending arms to Ukraine if her party forms a government after the election. However, Meloni’s speech could be a tactical move to win the election more than an unshakeable policy position. First, like the other two right-wing parties, the Brothers of Italy have had close connections with Russia. After the 2018 Russian presidential election, Meloni congratulated Putin and claimed his victory was “the unequivocal will of Russians.” In addition, she is close to Prime Minister Viktor Orban of Hungary and National Rally leader Marine Le Pen of France, both of whom have criticized the EU’s decision to provide military support to Kyiv. Hence her sharp change of stance this year seems calculated to avoid accusations of being pro-Russian. But that does not preclude a more pragmatic approach to Russia once in office. Second, Meloni has compromised other far-right positions to broaden her voter base. She has reversed the party’s original anti-EU stance and claimed it does not seek to leave the EU, as most European anti-establishment parties have had to do in order to make themselves electable. Being the only female in the election race, Meloni also pledged to protect women’s access to safe abortions in Italy, also a softer stance than before. Even if the Brothers of Italy distance themselves from some unpopular right-wing positions, including on Ukraine, they probably cannot form a government on their own. They will need to court Forza Italia and the League. These two parties prefer a more pragmatic approach to Russia and a peaceful resolution to the war. Thus while it will be hard to find a middle ground on the issue of Ukraine, the election will likely prevent Italy from taking a more confrontational stance toward Russia. It will probably do the opposite. Consider the context in which the next Italian government will operate. Russia declared on July 25 that it will further reduce natural gas supplies to Europe through Nord Stream 1, as we expected, bringing pipeline flows to 20% of its full capacity.  Energy prices will go up even as European economic activity and industry will suffer greater strains. If Meloni is elected as the new prime minister this September, she will have to keep talking tough on Russia while simultaneously seeking a solution to soaring energy prices and economic crisis. This solution will be diplomacy – unless Russia seeks to expand its invasion all the way to Moldova. A right-wing victory is the most likely outcome based on opinion polling, the negative cyclical economy, and the underlying structural factors supporting populism in Italy that we have monitored for years. Such a coalition will not be pro-Russian but it will be pragmatic and focused on salvaging Italy’s economy, which means it will be highly inclined toward diplomacy. If Russia halts its military advance – does not attempt to conquer southwestern Ukraine to Moldova – then this point will be greatly reinforced. Italy will become a new veto player within the European Union when it comes to any major new sanctions on Russia. While Europeans will continue diversifying their energy mix away from Russia, it will be much harder for the EU to implement a natural gas embargo in the coming years if Italy as well as Hungary oppose it. Even if we are wrong, and the Democratic Party or other left-wing parties surprise to the upside in the election, the new coalition will most likely have to focus on mitigating the economic crisis and thus pursuing diplomacy with Russia. That is, as long as Russia pushes for a ceasefire after it achieves its military aims in Donetsk, the last holdout within the south-southeastern territories Russia is trying to conquer. Bottom Line: Due to persistent political uncertainty, we recommend investors underweight Italian stocks and bonds at least until a new government takes shape, which could take months even after the election. However, government bonds will remain vulnerable if a right-wing coalition assumes power, since it will pursue loose fiscal policies and will eschew structural reforms. Overall Italy’s early elections will lead to a new government that is focused on short-term economic growth, likely including pragmatism toward Russia. From an investment point of view that will not be a negative development, though much depends on whether Russia expands its invasion or declares victory after Donetsk. Russia Market-based measures of Russian geopolitical risk are rebounding after subsiding from peak levels hit during the invasion of Ukraine in February (Chart 2). Chart 2Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia’s continued tightening of natural gas supplies (and food exports) this week is precisely what we predicted would happen despite a wave of wishful thinking from investors over the past month. The optimists claimed that Russia would resume Nord Stream 1 pipeline flows after a regular “maintenance” period. They also said that Canada’s cooperation in resolving some “technical” issues around turbines would stabilize natural gas supply. The truth is that Russia is seeking to achieve its war aims in Ukraine. Until it has achieved its aims, it will use a range of leverage, including tightening food and energy supplies. Most likely Russia will halt the advance after completing the conquest of the Donbas region and land-bridge to Crimea. Then it will seek to legitimize its conquests through a ceasefire agreement. However, it could launch a new phase of the war to try to take Odessa and Transniestria, which would cement European resolve, even in Italy, and trigger a new round of sanctions. Bottom Line: Russia faces a fork in the road once it completes the conquest of Donetsk. Most likely it will declare victory and start pushing for a ceasefire late this year or early next year. Movement toward a ceasefire would reduce geopolitical risk for global financial markets in 2023. But there is still a substantial risk that Russia could expand the invasion to eastern Moldova, which would escalate the overarching Russia-West conflict and sustain the high level of geopolitical risk for markets. China Chinese political and geopolitical risk will continue to rise and the bounce in Chinese relative equity performance is faltering as we expected (Chart 3). Chart 3China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator China’s leaders will hold their secretive annual meeting at Beidaihe in August ahead of the critical Communist Party national congress this fall. General Secretary Xi Jinping is attempting to cement himself as the paramount leader in China, comparable to Chairman Mao Zedong, transforming China’s governance from that of single-party rule to single-person rule. The reversion to autocratic government is coinciding with a historic economic slowdown consisting of cyclical factors (weak domestic demand, weakening foreign demand, draconian Covid-19 restrictions) and structural factors (labor force contraction, property sector bust, social change and unrest). Both Xi and US President Biden face major domestic political challenges in the coming months with the party congress and the US midterm election. Hence they are holding talks to try to stabilize relations. But we do not think they will succeed. China cannot reject Russia’s strategic overture, while the US cannot afford to re-engage with a China that is partnering with Russia in a challenge to the liberal-democratic world order. In addition, US policies are erratic and the US cannot credibly promise China that it will not pursue a containment strategy even if China offers trade concessions. Bottom Line: China-related political and geopolitical risks will remain very high until at least after the twentieth party congress. At that point we expect President Xi to loosen a range of policies to stabilize the economy and foreign trade relations. These policies may bring positive news in 2023, though China’s biggest macroeconomic and geopolitical problems remain structural in nature and we remain underweight Chinese assets. Taiwan For many years we have warned of a “fourth Taiwan Strait crisis” due to the unsustainable geopolitical situation between China, Taiwan, and the United States. After the war in Ukraine we argued that the US would try to boost its strategic deterrence around Taiwan, since it failed to deter Russia from invading Ukraine, but that the increased commitment to Taiwan would in fact provoke China (Chart 4). Chart 4Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Until the US and China reach a new understanding over Taiwan, we argued that the region would be susceptible to rising tensions and crisis points that would send investors fleeing from risky assets, especially risky regional assets. It is possible that we have arrived at this crisis now, with House Speaker Nancy Pelosi making preparations to visit Taiwan, China pledging “forceful” countermeasures if she does, President Biden suggesting that the US military thinks Pelosi should not visit, and Biden and Xi preparing for a phone conversation. In essence China is giving an ultimatum and setting a new bar, and a very low bar, for taking some kind of action on Taiwan, i.e. the mere visit of a US House speaker, which has happened before (House Speaker Newt Gingrich in 1997). China’s purpose is to lay the groundwork for preventing the US from upgrading Taiwan relations in any more substantial way, whether political or military. If the Biden administration calls off the Pelosi visit, then American relations with Taiwan will have been curtailed, at least for this administration. If Biden goes forward with the visit, then Beijing will need to respond with an aggressive show of force to prevent any future president from repeating the exercise or building on it. And if this show threatens US personnel or security, a full-blown diplomatic or military crisis could ensue. While we doubt it would lead to full-scale war, it could lead to a frightening confrontation. Biden may want to stabilize relations with China, since he is primarily focused on countering Russia, but his options are limited. China cannot save him from inflation but it can solidify the public perception that he is weak. Hence he is more likely to maintain his administration’s hawkish approach. Biden’s approval rating is 38% and his party faces a drubbing in the midterm elections. A confrontation with Russia, China, Iran, or anyone else would likely help his party by producing a public rally around the flag. Any unilateral concessions will merely strengthen Xi’s power consolidation at the party congress, which is detrimental to US interests. Only if the Biden administration pursues a dovish policy of re-engagement that is subsequently confirmed by the 2024 presidential election will there be potential for a substantial US-China economic re-engagement. We are pessimistic. Bottom Line: Taiwan-related geopolitical risk will rise in the short run. If there is a new US-China understanding over Taiwan, then regional and global geopolitical risk will decline over the medium term. But we remain short Taiwanese assets. Investment Takeaways Investors should remain defensively positioned until the US midterm election ends with congressional gridlock; the Chinese party congress is over and Xi Jinping launches a broad pro-growth policy; and Russia starts pushing for a ceasefire in Ukraine. We also expect that markets will need to get over new, unexpected oil supply shocks arising from the failure of US-Iran nuclear negotiations, which remains off the radar and therefore a source of negative surprises. Any US-Iran nuclear deal would be a major positive surprise that postpones this risk for a few years. Having said that, we are booking a 9% gain on our long US versus UAE equity trade for technical reasons. Democrats have reached a deal to pass a budget reconciliation bill in an effort to mitigate midterm election losses. This development reinforces the 65% odds of passage that we have maintained for this bill’s passage in our US Political Strategy reports since last year.   Yushu Ma Research Analyst yushu.ma@bcaresearch.com Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Appendix UK Chart 5UK: GeoRisk Indicator United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator Germany Chart 6Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator France Chart 7France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator Spain Chart 8Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Canada Chart 9Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Australia Chart 10Australia: GeoRisk Indicator Australia: GeoRisk Indicator Australia: GeoRisk Indicator Korea Chart 11Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Brazil Chart 12Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey Chart 13Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator South Africa Chart 14South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades Geopolitical Calendar

Executive Summary The ECB finally exited negative interest rates last week. In exchange for higher rates, the doves received an ambitious anti-fragmentation tool, the TPI. The ECB deposit rate is likely to reach between 1% and 1.5% by the summer of 2023. The ECB’s number one problem remains the widely different neutral rates across the Eurozone’s largest economies. Our r-star estimates suggest that the German neutral rate is significantly above that of Spain, Italy, and even France. This divergence in r-star means that the TPI will be activated, but its presence alone is not enough to tame the peripheral bond markets when the ECB hikes rates. While the near-term remains fraught with risks, BTPs are increasingly attractive for long-term investors. The TPI also creates a bullish long-term backdrop for the euro. Many R-Star In The European Sky ECB Policy: One Size Doesn’t Fit All ECB Policy: One Size Doesn’t Fit All Bottom Line: Diverging neutral rates across the Eurozone’s main economies will impair the ECB’s ability to normalize interest rates over the next twelve months without also activating the new anti-fragmentation tool, the TPI. BTPs have become attractive for long-term rather than short-term investors.   Last week, the European Central Bank (ECB) increased interest rates by 50bps, the first hike in eleven years and the third time in its history that it has tightened policy by such a large increment. In exchange for this abrupt end to negative interest rates, the doves on the Governing Council (GC) extracted the creation of the Transmission Protection Instrument (TPI), a new facility designed to limit fragmentation risk on sovereign bond yields in the Eurozone. These two moves raise three key questions: Will the ECB continue to increase rates this aggressively in the coming months? Have peripheral spreads peaked? Will the threat of TPI buying be enough to put a ceiling on spreads, or will the ECB actually need to activate the program in the coming months? To answer these questions, we evaluate where r-star (the neutral real rate of interest) stands in the four largest Euro Area economies. While there is scope for the ECB to push policy rates higher, the wide differences in r-star across European nations indicate that the TPI will need to be activated to stabilize peripheral bond markets, most importantly, Italian government debt. This makes BTPs attractive for long-term investors, although near-term volatility will remain elevated as the markets test the ECB’s resolve. What Happened? Related Report  European Investment StrategyLooking Beyond Europe’s Inflation Peak In terms of interest rates, the most important conclusion from last’s week policy meeting was that forward guidance has been abandoned. The ECB is now fully data dependent, and each policy meeting will be a live one. Another rate hike is certain for the September meeting, ranging from 25bps to potentially 75bps if the ECB wishes to further “front-load” tightening. The single guiding principle will be the outlook for inflation.   ​​​​​​​ Chart 1Incoming Inflation Peak Incoming Inflation Peak Incoming Inflation Peak We do expect inflation to peak soon in the Eurozone, mostly because of the decline in the commodity impulse and slowing food inflation (Chart 1).  Additionally, the one-month impulse of our Trimmed-Mean CPI is weakening. However, as of June, headline and core inflation stand at 8.6% and 3.7%, respectively. Inflation is unlikely to slow enough by the September meeting to prompt the ECB to forecast inflation falling below its 2% target by 2024.  In this context, our base case remains that the GC will opt for a 50bps hike in September. Beyond September, we expect the ECB to revert to 25bps rate hikes and the policy rate to settle between 1% and 1.5% by the summer of 2023, which is broadly in line with the current pricing of the €STR curve (Chart 2). We are somewhat less hawkish than the market for the month of October, because we expect inflation to roll over this fall. Moreover, the European economy continues to decelerate, as highlighted by the declines in the ZEW growth expectations and the PMIs (Chart 3). This deceleration will allow the ECB to revise down its inflation outlook over time. Chart 2Appropriate Pricing Appropriate Pricing Appropriate Pricing Chart 3Growth Is Slowing Growth Is Slowing Growth Is Slowing The announcement of the TPI was the other crucial development from the last ECB meeting. The TPI was unanimously supported. In addition, its asset purchases will be unlimited, and the GC will have much discretion with respect to its implementation. These are three important features that give it ample credibility. However, the program has yet to be activated. Chart 4PEPP Reinvestment Doing Little PEPP Reinvestment Doing Little PEPP Reinvestment Doing Little We do not share the optimism of the GC members who believe that the TPI’s existence alone will narrow peripheral spreads without the ECB having to purchase a single bond. The market will have to figure out what the GC deems as “unwarranted” and “disorderly” moves, especially in a context in which the Draghi government has collapsed and Italy’s commitment to reform will be challenged exactly as interest rates begin to rise. Moreover, the flexible re-investment of PEPP redemptions has not prevented BTP/Bund spreads from widening (Chart 4). As a result, we expect the market to test the ECB’s resolve over the coming weeks, which is likely to result in volatility and wider spreads until the TPI is activated. Bottom Line: Last week’s ECB meeting was a seminal moment. The ECB not only abandoned eight years of negative rates in one go, but it also implemented an ambitious program that aims to restrict peripheral spreads, albeit with some near-term volatility. European policy rates are set to rise to between 1% and 1.5% by the summer of 2023. In Search Of A Neutral Rate During Thursday’s press conference, President Christine Lagarde refused to respond to a question about the neutral rate of interest in Europe. We have sympathy for her predicament. The ECB’s biggest problem is that there is not one neutral interest rate for the entire euro area, but nineteen individual neutral rates for each Eurozone country, with wild differences among them.1  The differences between the neutral rates across the Eurozone are the key factor limiting how far and how fast the ECB may increase rates. It is also the main reason why the ECB resorts to an alphabet soup of non-interest rate policy measures (APP, PEPP, LTRO and, now, TPI) to maintain appropriate monetary conditions across the bloc. But exactly how wide are the differences between the neutral rates? To answer this question, we expand on the methodology developed by Holston, Laubach and Williams (HLW) from the San Francisco Fed  to estimate the neutral real interest rate – or “r-star” - in Germany, France, Italy, and Spain. These are the four largest economies in the Euro Area, accounting for 70% of its GDP. Specifically, we run regressions between the real interest rates in those countries versus trend GDP growth and current account balances, which approximates the savings-investment balance. Mimicking the HLW methodology, the inflation expectations used to extract real interest rates from nominal short rates reflect an adaptative framework whereby inflation expectations are a function of the ten-year moving average core CPI. Our methodology produces estimates of r-star that range from 0% in Germany, to -0.8% in Italy, or a GDP-weighted average of -0.3% for the Eurozone (Table 1). When incorporating last week’s ECB rate hike, Europe’s real deposit rate falls to -1.2% if we use the smoothing procedure from HLW to compute inflation expectations, or -3.7% if we use current core CPI. In either case, policy remains accommodative for everyone. Table 1Many R-Star In The European Sky ECB Policy: One Size Doesn’t Fit All ECB Policy: One Size Doesn’t Fit All We also ran a second set of estimates for r-star, which includes total nonfinancial debt-to-GDP. The logic reflects the notion that adverse debt dynamics was a key force behind the 2011/12 European sovereign debt crisis, which obligated the ECB to reverse course after pushing up the repo rate twice in 2011. Moreover, heavy debt loads not only constrain the ability of various countries to withstand higher rates, but they are also linked to misallocated capital and are therefore likely to depress trend GDP growth over time compared to countries with lighter debt loads. This adjustment changes the picture considerably. While Germany’s real neutral rate of interest remains around 0%, those of Italy and Spain plunge to -1.8% and -2.4%, respectively. France has also experienced a large decline in its r-star to -2.1% in response to the heavy debt load carried by its private and public sectors. Using this method, the GDP-weighted Euro Area r-star falls to -1.4% (Table 1). So which version of the model is more accurate? We believe the most realistic estimate for r-star in each of the four countries is the simple average of both the unadjusted and the debt-adjusted r-star. This implies that the inflation-adjusted neutral rate is close 0% in Germany, -1.2% in France, -1.2% in Spain and -1.3% in Italy (Table 1). Are those results consistent with reality? A country-by-country evaluation suggests that this ranking is correct. To arrive at this judgment, we evaluated each country based on the following four dimensions: Private sector debt accumulation since 2010. If policy is particularly easy for one country, the private sector will be incentivized to take on debt at a more rapid pace than if monetary conditions were tighter. House price appreciation since 2010. Housing is the part of the economy most sensitive to monetary conditions. Larger real estate price gains will materialize in economies where monetary policy is particularly loose. Profit growth since 2010. Easy monetary policy will subsidize corporate profitability, either through faster domestic activity or a cheaper exchange rate (or both). Unemployment rate. The unemployment rate is a crude measure of slack in the economy. An easier policy setting in one country will reduce the unemployment rate compared to a country where policy rates are high relative to r-star. Germany Chart 5Loosest Monetary Conditions In Germany Loosest Monetary Conditions In Germany Loosest Monetary Conditions In Germany Germany exhibits all the evidence of monetary policy being much more accommodative for that country than the other four countries, for the following reasons: Since 2010, German private debt has been expanding much faster than the average of the four countries (Chart 5, top panel). Germany is experiencing the fastest house price appreciation (Chart 5, second panel). Germany’s profits have grown much faster (Chart 5, third panel). Germany’s unemployment rate stands at only 3%, compared to an average rate of 8% for the four nations together (Chart 5, bottom panel). France Chart 6French Monetary Conditions Are Tighter French Monetary Conditions Are Tighter French Monetary Conditions Are Tighter France is a mixed bag. Monetary policy has been easy for France, but the French economy lags Germany on three of the four aforementioned dimensions: Since 2010, French private debt is growing at the fastest pace of the four economies studied, outpacing even that of Germany (Chart 6, top panel). While French house prices have grown slightly faster than the average of the four nations, they lagged German real estate prices (Chart 6, second panel). While French profits have also bested the average of the four nations, they nonetheless trail German profits (Chart 6, third panel). France’s unemployment rate is in line with the average of the four countries under observation (Chart 6, bottom panel). Spain For most of the period following 2010, Spain has suffered from the scars of the disastrous deleveraging that was required in the wake of the sovereign debt crisis. Its trend growth collapsed, and the ECB’s common policy was never as accommodative as it was for its northern neighbors. However, in recent years, the Spanish economy seems to be catching up, a result of the impact of previous structural reforms and the improved competitiveness brought about by collapsing real unit labor costs: Chart 7Spain Still Grapples With Problems Spain Still Grapples With Problems Spain Still Grapples With Problems Since 2010, Spanish private debt has contracted by 20% compared to a 33% expansion for the European average (Chart 7, top panel). Spanish real estate prices have also lagged far behind those of the other countries put together (Chart 7, second panel). However, since 2015, Spanish house prices have begun to recover, and they are now moving at the same pace as the Euro Area average. Spanish profit growth remains weak compared to the average of the four countries studied in this report (Chart 7, third panel). The Spanish unemployment continues to tower at 13%, well above the average of the four largest Euro Area economies (Chart 7, bottom panel). Italy Italy has a similar profile to that of Spain. While its worst performance is solidly in the rear-view mirror, the recent period of easy monetary policy has allowed for some recovery. Nonetheless, Italy still lags far behind other Eurozone countries, which suggests that policy in Italy is not nearly as accommodative as in the rest of the Eurozone. Chart 8Italy Shows Little Improvements Italy Shows Little Improvements Italy Shows Little Improvements Burdened by very large nonperforming loans, the Italian banking sector has been unable to provide adequate credit to the Italian private sector, which already had a limited appetite for debt. As a result, since 2010, Italian private credit has lagged far behind the European average (Chart 8, top panel). Italian real estate prices have not recovered meaningfully from their contraction between 2011 and 2019. Consequently, Italian housing prices lag substantially behind the average of the largest Euro Area countries (Chart 8, second panel). Italian profits remain weak (Chart 8, third panel). While not as elevated as the Spanish unemployment rate, at 8%, Italy’s rate is comparable to the four-country average (Chart 8, bottom panel). Generalizations These observations about individual countries confirm that Germany’s r-star is significantly higher than those of Spain and Italy. When compared to France, the German r-star is also higher, but the gap is much narrower than that between Germany and the two southern nations. The recent ECB Euro Area Bank Lending Survey confirms that France’s r-star is well below that of Germany. French lending standards are tightening as fast as those in Italy (Chart 9). In effect, France’s heavy private sector debt load is proving to be a burden as the ECB begins to tighten policy, which implies a lower French r-star. Chart 9Lending Standard Are Tightening Most In France And Italy ECB Policy: One Size Doesn’t Fit All ECB Policy: One Size Doesn’t Fit All ​​​​​​​ Bottom Line: Among the four largest economies in the Eurozone, a modeling exercise based on the HWL approach reveals that there is a large gap in neutral real interest rates, with Germany on one side around 0%, and Italy, Spain, and even France on the other side with r-star estimates ranging between -1.2% and -1.3%. A survey of current economic activity in these four nations confirms the results from the modeling exercise. Investment Implications The main consequence of the differing r-star across the Eurozone is that the ECB will need to remain an active player in the sovereign bond market. The German, Dutch, and Baltic economies are overheating, and policy needs to be tightened. This means that the ECB will continue to hike rates over the coming months. However, it cannot raise rates much more before they become problematic in Italy, Spain, and even France. Thus, the ECB will activate the TPI in the coming months in order to ease monetary conditions in those economies relative to the stronger group by limiting policy-induced increases in bond yields. In fact, using the r-star estimates adjusted for the debt-to-GDP ratios, the ECB would need to absorb roughly 30% of the Italian total debt to bring Italy’s r-star closer to Germany’s levels. This will not happen, which means that in the foreseeable future, Italy will not be able to withstand the levels of interest rate needed to cool down the German economy. Nonetheless, the TPI can help the ECB in fine-tuning monetary conditions across the Eurozone as it hikes policy rates. For now, Italian bonds are likely to remain volatile until the TPI is activated, especially considering the political situation in Italy, where the outlook for structural reform seems compromised by political uncertainty. This volatility will result in the activation of the TPI before year-end. Once the TPI is activated, BTP/Bund spreads are likely to move back toward 100bps, the level historically consistent with the ECB’s involvement in the sovereign debt market during the APP/PEPP era. The activation of the TPI will also be a positive development for the European corporate bond market, especially investment grade bonds. In last week’s post-conference press release, the ECB revealed that the TPI will also be able to buy private issuer securities. Thus, the ECB is likely to return as a potential buyer in this market. Moreover, investment grade bonds already price in a European recession and therefore offer a large value cushion with 12-month breakeven spreads trading in their 79th historical percentile (Chart 10). We especially like European investment grade corporate bonds relative to US ones on a USD-hedged basis. Relative valuations are in favor of Europe, and the ECB is not tightening policy as much as the Fed. Related Report  European Investment StrategyTo Parity And Beyond The euro will ultimately benefit from the activation of the TPI. The narrowing of both sovereign and corporate spreads resulting from the program represents a very bullish development for EUR/USD (Chart 11), especially because the ECB will likely sterilize the bonds purchased under the program (i.e. the ECB’s balance sheet will not expand because of the TPI). The TPI will also allow the ECB to deliver higher interest rates, which further supports the euro. Nonetheless, we continue to see substantial (roughly 20%) odds of a break below parity in the near-term, especially if wider BTP-Bund spreads in the coming three months are the key catalyst behind the TPI’s activation.  Chart 10Eurozone IG Debt Is Attractive Eurozone IG Debt Is Attractive Eurozone IG Debt Is Attractive Chart 11The TPI Will Help The Euro, Eventually The TPI Will Help The Euro, Eventually The TPI Will Help The Euro, Eventually Finally, last week’s policy development is unlikely to affect the absolute performance of European stocks. European equities remain mostly impacted by the fluctuations in global stock prices and the shifting probability of a recession in Europe this winter in response to the evolving energy crisis on the continent. European equities are inexpensive, and the probability of a recession is declining as a result of the resumption of natural gas flows from Russia. Crucially, the broadening trend toward coal utilization this winter and the growing list of deals that Europe is striking to secure non-Russian gas supplies suggest the impact of Russian cutoffs this winter could be more limited than once feared. Moreover, we expect European governments to hose their economies with stimulus if a crisis does emerge, which would both limit the depth of the crisis and prompt a rapid rebound in activity once winter ends. However, the inattention of the ECB to recession risks suggests that European equities could lag US equities in the near term. Bottom Line: The differences in r-star across Europe mean that the ECB will be forced to activate the TPI before year-end in order to hike interest rates further. Practically, this means that medium- to long-term investors should overweight Italian bonds at the current level of spreads. Short-term investors should remain on the sidelines; the political situation in Italy is still dangerous, and speculators are likely to test the ECB’s resolve. This also means that the euro is attractive as a long-term play, but it still carries large left-tail risk in the near term. While investors should favor European investment-grade bonds in USD-hedged terms relative to the US, European equities are likely to continue to suffer headwinds compared to US stocks.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com   Footnotes   1     In fact, it will soon be 20 r-star since Croatia will join the euro on January 1, 2023.

Executive Summary China's Unemployment Questions From The Road Questions From The Road Over the past week we have been visiting clients along the US west coast. In this report we hit some of the highlights from the most important and frequently asked questions. Xi Jinping is seizing absolute power just as the country’s decades-long property boom turns to bust. He will stimulate the economy but Chinese stimulus is less effective than it used to be. The US and Israel are underscoring their red line against Iranian nuclear weaponization. If Iran does not freeze its nuclear program, the Middle East will begin to unravel again. The UK’s domestic instability is returning, with Scotland threatening to leave the union. Brexit, the pandemic, and inflation make a Scottish referendum a more serious risk than in the past. Shinzo Abe’s assassination makes him a martyr for a vision of Japan as a “normal country” – i.e. one that is not pacifist but capable of defending itself. Japan’s rearmament, like Germany’s, points to the decline of the WWII peace settlement and the return of great power competition. Bottom Line: Investors need a new global balance to be achieved through US diplomacy with Russia, China, and Iran. That is not forthcoming, as the chief nations face instability at home and a stagflationary global economy. Feature The world is becoming less stable as stagflation combines with great power competition. Global uncertainty is through the roof. From a macroeconomic perspective, investors need to know whether central banks can whip inflation without triggering a recession. From a geopolitical perspective, investors need to know whether Russia’s conflict with the West will expand, whether US-China and US-Iran tensions will escalate in a damaging way, and whether domestic political rotations in the US and China this fall will lead to more stable and productive economies. China: What Will Happen At The Communist Party Reshuffle? General Secretary Xi Jinping will cement another five-to-10 years in power while promoting members of his faction into key positions on the Politburo and Politburo Standing Committee. By December Xi will roll out a pro-growth strategy for 2023 and the government will signal that it will start relaxing Covid-19 restrictions. But China’s structural problems ensure that this good news for global growth will only have a fleeting effect. China’s governance is shifting from single-party rule to single-person rule. It is also shifting from commercially focused decentralization to national security focused centralization. Xi has concentrated power in himself, in the party, and in Beijing at the expense of political opponents, the private economy, and outlying regions like Hong Kong, the South China Sea, and Xinjiang. The subordination of Taiwan is the next major project, ensuring that China will ally with Russia and that the US and China cannot repair or deepen their economic partnership. Related Report  Geopolitical StrategyWill China Let 100 Flowers Bloom? Only Briefly. Xi and the Communist Party began centralizing political power and economic control shortly after the Great Recession. At that time it became clear that a painful transition away from export manufacturing and close relations with the United States was necessary. The transition would jeopardize China’s long-term economic, social, political, and geopolitical stability. The Communist Party believed it needed to revive strongman leadership (autocracy) rather than pursuing greater liberalization that would ultimately increase the odds of political revolution (democratization). The Xi administration has struggled to manage the country’s vast debt bubble, given that total debt standing has surged to 287% of GDP. The global pandemic forced the government to launch another large stimulus package, which it then attempted to contain. Corporate and household deleveraging ensued. The property and infrastructure boom of the past three decades has stalled, as the regime has imposed liquidity and capital requirements on banks and property developers to try to avoid a financial crisis. Regulatory tightening occurred in other sectors to try to steer investment into government-approved sectors and reduce the odds of technological advancement fanning social dissent. China’s draconian “zero Covid” policy sought to limit the disease’s toll, improve China’s economic self-reliance, and eliminate the threat of social protest during the year of the twentieth party congress. But it also slammed the brakes on growth. China is highly vulnerable to social instability for both structural and cyclical reasons. Chinese social unrest was our number one “Black Swan” for this year and it is now starting to take shape in the form of angry mortgage owners across the country refusing to make mortgage payments on houses that were pre-purchased but not yet built and delivered (Chart 1). Chart 1China: Mortgage Payment Boycott Questions From The Road Questions From The Road The mortgage payment boycott is important because it is stemming from the outstanding economic and financial imbalance – the property sector – and because it is a form of cross-regional social organization, which the Communist Party will disapprove. There are other social protests emerging, including low-level bank runs, which must be monitored very closely. Local authorities will act quickly to stop the spread of the mortgage boycott. But unhappy homeowners will be a persistent problem due to the decline of the property sector and industry. China’s property sector looks uncomfortably like the American property sector ahead of the 2006-08 bust. Prices for existing homes are falling while new house prices are on the verge of falling (Chart 2). While mortgages only make up 15% of bank assets, and household debt is only 62% of GDP, households are no longer taking on new debt (Chart 3). Chart 2China's Falling Property Prices China's Falling Property Prices China's Falling Property Prices ​​​​​​ Chart 3China's Property Crisis China's Property Crisis China's Property Crisis ​​​​​​ Chart 4China's Unemployment China's Unemployment China's Unemployment Most likely China’s property sector is entering the bust phase that we have long expected – if not, then the reason will be a rapid and aggressive move by authorities to expand monetary and fiscal stimulus and loosen economic restrictions. That process of broad-based easing – “letting 100 flowers bloom” – will not fully get under way until after the party congress, say in December. Unemployment is rising across China as the economy slows, another point of comparison with the United States ahead of the 2008 property collapse (Chart 4). Unemployment is a manipulated statistic so real conditions are likely worse. There is no more important indicator. China’s government will be forced to ease policy, creating a positive impact on global growth in 2023, but the impact will be fleeting. Bottom Line: The underlying debt-deflationary context will prevail before long in China, weighing on global growth and inflation expectations on a cyclical basis. Middle East: Why Did Biden Go And What Will He Get? President Biden traveled to Israel and now Saudi Arabia because he wants Saudi Arabia and the Gulf Arab members of OPEC to increase oil production to reduce gasoline prices at the pump for Americans ahead of the midterm elections (Chart 5). Chart 5Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia Biden Goes To Israel And Saudi Arabia True, fears of recession are already weighing on prices, but Biden embarked on this mission before the growth slowdown was fully appreciated and he is not going to lightly abandon the anti-inflation fight before the midterm election. Biden also went because one of his top foreign policy priorities – the renegotiation of the 2015 nuclear deal with Iran – is falling apart. The Iranians do not want to freeze their nuclear program because they want regime survival and security. While Biden is offering a return to the 2015 deal, the conditions that produced the deal are no longer applicable: Russia and China are not cooperating with the US and EU to isolate Iran. Russia is courting Iran, oil prices are high and sanction enforcement is weak (unlike 2015). The Iranians now know, after the Trump administration, that they cannot trust the Americans to give credible security guarantees that will last across parties and administrations. The war in Ukraine also underscores the weakness of diplomatic security guarantees as opposed to a nuclear deterrent. Hence the joint US and Israeli declaration that Iran will never be allowed to obtain nuclear weapons. The good news is that this kind of joint statement is precisely what needed to occur – the underscoring of the red line – to try to change Ayatollah Ali Khamenei’s calculus regarding his drive to achieve nuclear breakout. In 2015 Khamenei gave diplomacy a chance to try to improve the economy, stave off social unrest, prepare the way for his eventual leadership succession process, and secure the Islamic Republic. The bad news is that Khamenei probably cannot make the same decision this time, as the hawkish faction now runs his government, the Americans are unreliable, and Russia and China are offering an alternative strategic orientation. The Saudis will pump more oil if necessary to save the global business cycle but not at the beck and call of a US president. The drop in oil prices reduces their urgency. The Americans can reassure the Saudis and Israel as long as the deal with Iran is not going forward. That looks to be the case. But then the US and Israel will have to undertake joint actions to underline their threat to Iran – and Iran will have to threaten to stage attacks across the region so as to deter any attack. Bottom Line: If a US-Iran deal does not materialize at the last minute, Middle Eastern instability will revive and a new source of oil supply constraint will plague the global economy. We continue to believe a US-Iran deal is unlikely, with only 40% odds of happening. Europe: Will Russia Turn Back On The Natural Gas? Russia’s objective in cutting off European natural gas is to inflict a recession on Europe. It wants a better bargaining position on strategic matters. Therefore we assume Russia will continue to squeeze supplies from now through the winter, when European demand rises and Russian leverage will peak. If Russia allows some flow to return, then it will be part of the negotiating process and will not preclude another cutoff before winter. It is possible that Russia is merely giving Europe a warning and will revert back to supplying natural gas. The problem is that Russia’s purpose is to achieve a strategic victory in Ukraine and in negotiations over NATO’s role in the Nordic countries. Russia has not achieved these goals, so natural gas cutoff will likely continue. Russia also hopes that by utilizing its energy leverage – while it still has it – it will bring forward the economic pain of Europe’s transition away from reliance on Russian energy. In that case European countries will experience recession and households will begin to change their view of the situation. European governments will be more likely to change their policies, to become more pragmatic and less confrontational toward Russia. Or European governments will be voted out of power and do the same thing. Other states could join Hungary in saying that Europe should never impose a full natural gas embargo on Russia. Russia would be able to salvage some of its energy trade with Europe over the long run, despite the war in Ukraine and the inevitable European energy diversification. In recent months we highlighted Italy as the weakest link in the European chain and the country most likely to see such a shift in policy occur. Italy’s national unity coalition had lost its reason for being, while the combination of rising bond yields and natural gas prices weighed on the economy. The Italian bond spread over German bunds has long served as our indicator of European political stress – and it is spiking now, forcing the European Central Bank to rush to plan an anti-fragmentation strategy that would theoretically enable it to tighten monetary policy while preventing an Italian debt crisis (Chart 6). The European Union remains unlikely to break up – Russian aggression was always one of our chief arguments for why the EU would stick together. But Italy will undergo a recession and an election (due by June 2023 but that could easily happen this fall), likely producing a new government that is more pragmatic with regard to Russia so as to reduce the energy strain. Chart 6Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy's Crisis Points To EU Divisions On Russia Italy’s political turmoil shows that European states are feeling the energy crisis and will begin to shift policies to reduce the burden on households. Households will lose their appetite for conflict with Russia on behalf of Ukrainians, especially if Russia begins offering a ceasefire after completing its conquest of the Donetsk area. If Russia expands its invasion, then Europe will expand sanctions and the risk of further strategic instability will go up. But most likely Russia will seek to quit while it is ahead and twist Europe’s arm into foisting a ceasefire onto Ukraine. Bottom Line: A change of government in Italy will increase the odds that the EU will engage in diplomacy with Russia in the coming year, if Russia offers, so as to reach a new understanding, restore natural gas flows, and salvage the economy. This would leave NATO enlargement unresolved but a shift in favor of a ceasefire in Ukraine in 2023 would be less negative for European assets and the euro. UK: Who Will Replace Boris Johnson? Last week UK Prime Minister Boris Johnson fell from power and now the Conservative Party is engaging in a leadership competition to replace him. We gave up on Johnson after he survived his no-confidence vote and yet it became clear that he could not recover in popular opinion. The inflation outburst destroyed his premiership and wiped away whatever support he had gained from executing Brexit. In fact it reinforced the faction that believed Brexit was the wrong decision. Going forward the UK will be consumed with domestic political turmoil as the cost of stagflation mounts, and geopolitical turmoil as Scotland attempts to hold a second independence referendum, possibly by October 2023. Global investors should focus primarily on Scotland’s attempt to secede, since the breakup of the United Kingdom would be a momentous historical event and a huge negative shock for pound sterling. While only 44.7% of Scots voted for independence in 2014, now they have witnessed Brexit, Covid-19, and stagflation, producing tailwinds for the Scots nationalist vote (Chart 7). Chart 7Forget Bojo's Exit, Watch Scotland Questions From The Road Questions From The Road There are still major limitations on Scotland exiting, since its national capabilities are limited, it would need to join the European Union, and Spain and possibly others will threaten to veto its membership in the European Union for fear of feeding their own secessionist movements. But any new referendum – including one done without the approval of Westminster – should be taken very seriously by investors. Bottom Line: Johnson’s removal will only marginally improve the Tories’ ability to manage the rebellion brewing in the north. A snap election that brings the Labour Party back into power would have a greater chance of keeping Scotland in the union, although it is not clear that such a snap election will happen in time to affect any Scottish decision. The UK faces economic and political turmoil between now and any referendum and investors should steer clear of the pound. (Though we still favor GBP over eastern European currencies). Britain will remain aggressive toward Russia but its ability to affect the Russian dynamic will fall, leaving the US and EU to decide the fate of Russian relations. Japan: What Is The Significance Of Shinzo Abe’s Assassination? Former Japanese Prime Minister Shinzo Abe was assassinated by a lone fanatic with a handmade gun. The significance of the incident is that Abe will become a martyr for a certain vision of Japan – his vision of Japan, which is that Japan can become a “normal country” that moves beyond the shackles of the guilt of its imperial aggression in World War II. A normal country is one that is economically stable and militarily capable of defending itself – not a pacifist country mired in debt-deflation. Abe stood for domestic reflation and a proactive foreign policy, along with the normalization of the Japanese Self-Defense Forces (JSDF). True, economic policy can become less dovish if necessary to deal with inflation. Some changes at the Bank of Japan may usher in a less dovish shift in monetary policy in particular. But monetary policy cannot become outright hawkish like it was before Abe. And Abe’s fiscal policy was never as loose as it was made out to be, given that he executed several hikes to the consumption tax. Japan’s structural demographic decline and large debt burden will continue to weigh on economic activity whenever real rates and the yen rise. The government will be forced to reflate using monetary and fiscal policy whenever deflation threatens to return. Debt monetization will remain an option for future Japanese governments, even if it is restrained during times of high inflation. Chart 8Shinzo Abe's Legacy Questions From The Road Questions From The Road ​​​​​​​ This is not only because Japanese households will become depressed if deflation is left unchecked but also because economic growth must be maintained in order to sustain the nation’s new and growing national defense budgets. Japan’s growing need for self defense stems from China’s strategic rise, Russia’s aggression, and North Korea’s nuclearization, plus uncertainty about the future of American foreign policy. These trends will not change anytime soon. Indeed the Liberal Democratic Party’s popularity has increased under Abe’s successor, Prime Minister Fumio Kishida, who will largely sustain Abe’s vision. The Diet still has a supermajority in favor of constitutional revision so as to enshrine the self-defense forces (Chart 8). And the de facto policy of rearmament continues even without formal revision. Bottom Line: Any Japanese leader who attempts to promote a hawkish BoJ, and a dovish JSDF, will fail sooner rather than later. The revolving door of prime ministers will accelerate. As Japan’s longest-serving prime minister, Shinzo Abe opened up the reliable pathway, which is that of a dovish BoJ and a hawkish foreign policy. This is important for the world, as well as Japan, because a more hawkish Japan will increase China’s fears of strategic containment. The frozen conflicts in Asia will continue to thaw, perpetuating the secular rise in geopolitical risk. We remain long JPY-KRW, since the BoJ may adjust in the short term and Chinese stimulus is still compromised, but that trade is on downgrade watch. Investment Takeaways Russia’s energy cutoff is aimed at pushing Europe into recession so as to force policy changes or government changes in Europe that will improve Russia’s position at the negotiating table over Ukraine, NATO, and other strategic disputes. Hence Russia is unlikely to increase the natural gas flow until it believes it has achieved its strategic aims and multiple veto players in the EU will prevent the EU from ever implementing a full-blown natural gas embargo. Chinese stimulus cannot be fully effective until it relaxes Covid-19 restrictions, likely beginning in December or next year when Xi Jinping uses his renewed political capital to try to stabilize the economy. However, China’s government powers alone are insufficient to prevent the debt-deflationary tendency of the property bust. The Middle East faces rising geopolitical tensions that will take markets by surprise with additional energy supply constraints. The implication is continued oil volatility given that global growth is faltering. Once global demand stabilizes, the Middle East’s turmoil will add to existing oil supply constraints to create new price pressures. The odds are not very high of the Federal Reserve achieving a “soft landing” in the context of a global energy shock and a stagflationary Europe and China.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com ​​​​​​​ Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades () Section II: Special (EDIT this Header) Section III: Geopolitical Calendar

Executive Summary China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator A new equilibrium between NATO, which now includes Sweden and Finland, and Russia needs to be reestablished before geopolitical risks in Europe subside. Russia aims to inflict a recession on the EU which will revive dormant geopolitical risks embedded in each country. Investors should ignore the apparent drop in China’s geopolitical risk as it could rise further until Xi Jinping consolidates power at the Party Congress this fall. Stay on the sideline on Brazilian, South African, Australian, and Canadian equities despite the commodity bull market, at least until China’s growth stabilizes. Korean risk will rise, albeit by less than Taiwanese risk. The US political cycle ensures that Biden may take further actions against adversaries in Europe, Middle East, and East Asia, putting a floor under global geopolitical risk. Tactical Recommendation Inception Date Return LONG GLOBAL AEROSPACE & DEFENSE / BROAD MARKET EQUITIES 2020-11-27 9.3% Bottom Line: Geopolitical risk will rise in the near term. Stay long gold and global defensive stocks. Feature This month we update our GeoRisk Indicators and make observations about the status of political risk for each territory, and where risks are underrated or overrated by global financial markets. Russia GeoRisk Indicator Our “Original” quantitative measure of Russian political risk – the Russian “geopolitical risk premium” shown in the dotted red line below – has fallen to new lows (Chart 1). One must keep in mind that this geopolitical premium is operating under the assumption of a “free market” but the Russian market in the past few months had been anything but free. The Russian government and central bank had been manipulating the ruble and preventing capital outflows. Hence, Russian assets and any indicator derived from it does not reflect its true risk premium, merely the resolve of its government in the geopolitical struggle. Chart 1Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator While the Russia Risk Premium accurately detected the build-up in tensions before the invasion of Ukraine this year, today it gives the misleading impression that Russian geopolitical risk is low. In reality the risk level remains high due to the lack of strategic stability between Russia and the West, particularly the United States, and particularly over the question of NATO enlargement. Our “Old” Russia GeoRisk Indicator remains elevated but has slightly fallen back. This measure failed to detect the rise in risk ahead of this year’s invasion of Ukraine. We predicted the war based on non-market variables, including qualitative analysis. As a result of the failure of our indicator, we devised a “New” Russia GeoRisk Indicator after this year’s invasion, shown as the green line below. This measure provides the most accurate reading. It is pushing the upper limits, which we truncated at 4, as it did during the invasion of Georgia in 2008 and initial invasion of Ukraine in 2014. Related Report  Geopolitical StrategyThird Quarter Geopolitical Outlook: Thunder And Lightning Has Russian geopolitical risk peaked for Europe and the rest of the world? Not until a new strategic equilibrium is established between the US and Russia. That will require a ceasefire in Ukraine and a US-Russia understanding about the role of Finland and Sweden within NATO. However, Hungary is signaling that the EU should impose no further sanctions on Russia. Russia’s cutoff of natural gas exports to Europe will create economic hardship that will start driving change in European governments or policies. A full ban on Russian natural gas may not be implemented in the coming years due to lack of EU unanimity. Still, the EU cannot lift sanctions on Russia because that would enable economic recovery and hence military rehabilitation, which could enable new aggression. Also, Russia will not relinquish the territories it has taken from Ukraine even if President Putin exits the scene. No Russian leader will have the political capital to do that given the sacrifices that Russia has made. Bottom Line: Russia’s management of the ruble is distorting some of our risk indicators. Russia remains un-investable for western investors. Substantial sanction relief will not come until late in the decade, if at all. UK GeoRisk Indicator British political risk is rising, and it may surpass the peaks of the Brexit referendum period in 2016 now that Scotland is pursuing another independence referendum (Chart 2). Chart 2United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator New elections are not due until January 25, 2025 and the ruling Conservative Party has every reason to avoid an election over the whole period so that inflation can come down and the economy can recover. But an early election is possible between now and 2025. Prime Minister Boris Johnson has become a liability to his party but he is still a more compelling leader than the alternatives. If Johnson is replaced, then the change of leadership will only temporarily boost the Tories’ public approval. It will ultimately compound the party’s difficulties by dividing the party without resolving the Scottish question.  Regardless, the Tories face stiff headwinds in the coming referendum debate and election, having been in power since 2010 and having suffered a series of major shocks (Brexit, the pandemic, inflation). Bottom Line: The US dollar is not yet peaking against pound sterling, As from a global geopolitical perspective it can go further. Investors should stay cautious about the pound in the short term. But they should prefer the pound to eastern European currencies exposed to Russian instability. Germany GeoRisk Indicator German political risk spiked around the time of the 2021 election and has since subsided, including over the course of the Ukraine war (Chart 3). However, risk will rise again now that Germany has declared that it is under “economic attack” from Russia, which is cutting natural gas in retaliation to Germany’s oil embargo. Chart 3Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator This spike in strategic tensions should not be underrated. Germany is entering a new paradigm in which Russian aggression has caused a break with the past policy of Ostpolitik, or economic engagement. Germany will have to devote huge new resources to energy security and national defense and will have to guard against Russia for the foreseeable future. Domestic political risk will also rise as the economy weakens and industrial activity is rationed. Germany does not face a general election until October 26, 2025. Early elections are rare but cannot be ruled out over the next few years. The ruling coalition does not have a solid foundation. It only has a 57% majority in the Bundestag and consists of an ideological mix of parties (a “traffic light” coalition of Social Democrats, Greens, and Free Democrats). Still, Germany’s confrontation with Russia will keep the coalition in power for now. Bottom Line: From a geopolitical point of view, there is not yet a basis for the dollar to peak and roll over against the euro. That is not likely until there is a ceasefire in Ukraine and/or a new NATO-Russia understanding. France GeoRisk Indicator French political risks are lingering at fairly high levels in the wake of the general election and will only partially normalize given the likelihood of European recession and continued tensions around Russia (Chart 4). Chart 4France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator President Emmanuel Macron was re-elected, as expected, but his Renaissance party (previously En Marche) lost its majority and Macron will struggle to win over 39 deputies to gain a majority of 289 seats in the Assembly. He will, however, be able to draw from an overall right-wing ideological majority – especially the Republicans – when it comes to legislative compromises. The election produced some surprises. The right-wing, anti-establishment National Rally of Marine Le Pen, which usually performs poorly in legislative elections, won 89 seats. The left-wing alliance (NUPES) underperformed opinion polls and has not formed a unified bloc within the Assembly. Still, the left will be a powerful force as it will command 151 seats (the sum of the left-wing anti-establishment leader Jean-Luc Mélenchon’s La France Insoumise party and the Communists, Socialists, and Greens). Macron’s key reform – raising the average retirement age from 62 to 65 – will require an ad hoc majority in the Assembly. The Republicans, with 74 seats, can provide the necessary votes. But some members have already refused to side with Macron on this issue. Macron will most likely get support from the populist National Rally on immigration, including measures to make it harder to be naturalized or obtain long-term residence permits, and measures making it easier to expel migrants whose asylum applications have been refused. France will remain hawkish on immigration, but Macron will be able to rein in the populists. On energy and the environment, Macron may be able to cooperate with the Left on climate measures, but ultimately any cooperation will be constrained by the fact that Mélenchon opposes nuclear power. The Republicans and the National Rally will support Macron’s bid to shore up France’s nuclear energy sector. Popular opinion will hold up for France’s energy security in the face of Russian weaponization of natural gas. Macron and Mélenchon will clash on domestic security. Police violence has emerged as a major source of controversy since the Yellow Vest protests. Macron and the Right will protect the police establishment while the Left will favor reforms, notably the concept of “proximity police,” which would entail police officers patrolling in a small area to create stronger, more personal links between the police and the population; officers being under the control of the mayor and prefect; and ultimately most officers not carrying lethal weapons, and the ban of physically dangerous arrest techniques. Grievances over the police as well as racial inequality will likely erupt into significant social unrest in the coming years. As a second-term president without a single-party majority, Macron will increasingly focus on foreign policy. He will aim to become the premier European leader on the world stage. He will seek to revive France’s historic role as a leading diplomatic power and arbiter of Europe. He will strengthen France’s position in the EU and NATO, keep selling arms to the Middle East, and maintain a French military presence in the Sahel. Macron will favor Ukraine’s membership in the EU but also a ceasefire with Russia. He will face a difficult decision on whether to join Israeli and American military action against Iran should the latter reach nuclear breakout capacity and pursue weaponization. Bottom Line: The outperformance of French equities is stretched relative to EMU counterparts. But France will not underperform until the EU’s natural gas crisis begins to subside and a new equilibrium is established with Russia. Italy GeoRisk Indicator Italy is perhaps the weakest link in Europe both economically and strategically (Chart 5). Elections are due by June 2023 but could come earlier as the ruling coalition is showing strains. A change of government would likely compromise the EU’s attempt to maintain a unified front against Russia over the war in Ukraine. Chart 5Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Before the war Italy received 40% of its natural gas from Russia and maintained pragmatic relations with the Putin administration. Now Russia is reducing flows to Italy by 50%, forcing the country into an energy crisis at a time when expected GDP growth had already been downgraded to 2.3% this year and 1.7% in 2023. Meanwhile Italian sovereign bond spreads over German bunds have risen by 64 basis points YTD as a result of the global inflation. The national unity coalition under Prime Minister Mario Draghi came together for two purposes. First, to distribute the EU’s pandemic recovery funds across the country, which amounted to 191.5 billion euros in grants and cheap loans for Italy, 27% of the EU’s total recovery fund and 12% of Italy’s GDP. Second, to elect an establishment politician in the Italian presidency to constrain future populist governments (i.e. re-electing President Sergio Mattarella). Now about 13% of the recovery funds have been distributed in 2021, the economy is slowing, Russia is cutting off energy, and elections are looming. The coalition is no longer stable. Coalition members will jockey for better positioning and pursue their separate interests. The anti-establishment Five Star Movement has already split, with leader Luigi di Maio walking out. Five Star’s popular support has fallen to 12%. The most popular party in the country is now the right-wing, anti-establishment Brothers of Italy, who receive 23% support in polling. Matteo Salvini, leader of the League, another right-wing populist party, has seen its public support fall to 15% and will be looking for opportunities. On the whole, far-right parties command 38% of popular voting intentions, while far-left parties command 17% and centrist parties command 39%. Italy’s elections will favor anti-incumbent parties, especially if the country falls into recession. These parties will be more pragmatic toward Russia and less inclined to expand the EU’s stringent sanctions regime. Implementing a ban on Russian natural gas by 2027 will become more difficult if Italy switches. Italy will be more inclined to push for a ceasefire. A substantial move toward ceasefire will improve investor sentiment, although, again, a durable new strategic equilibrium cannot be established until the US and Russia come to an understanding regarding Finland, Sweden, and NATO enlargement. Bottom Line: Investors should steer clear of Italian government debt and equities until after the next election. Spain GeoRisk Indicator Infighting and power struggles within the People’s Party (PP) have provided temporary relief for the ruling Socialist Worker’s Party (PSOE) and Spanish Prime Minister Pedro Sanchez. However, with Alberto Nunez Feijoo elected as the new leader of PP on April 2, the People’s Party quickly recovered from its setback. It not only retook the first place in the general election polling, but also scored a landslide victory in the Andalusia regional election. Andalusia is the most populous autonomous community in Spain, contributing 17% of the seats in the lower house. The Andalusian regional election was a test run for the parties before next year’s general election. Historically, Andalusia was PSOE’s biggest stronghold, but it was ousted by the center-right People’s Party-Citizens coalition in 2018. Since then, the People’s party has consolidated their presence and popularity in Andalusia. The snap election in June, weeks after Feijoo was elected as the new national party leader, expanded PP’s seats in the regional parliament. It now has an absolute majority in the regional parliament while the Socialists suffered its worst defeat. With the sweeping victory in Andalusia, the People’s Party is well positioned for next year’s general election. In addition, the ruling Socialist Worker’s Party continues to suffer from the stagflationary economic condition. In May, Spain recorded the second highest inflation figure in more than 30 years, slightly below its March number. Furthermore, the recent deadly Melilla incident which resulted in dozens of migrants’ death, also caused some minor setbacks within Sanchez’s ruling coalition. His far-left coalition partner joined the opposition parties in condemning Sanchez for being complacent toward the Moroccan police. The pressure is on the Socialists now, and political risk will rise in the coming months, till after the election (Chart 6). Chart 6Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Bottom Line: Domestic political risk will remain elevated in this polarized country, as elections are due by December 2023 and could come sooner. Populism may return if Europe suffers a recession. Russia aims to inflict a recession on the EU which is negative for cyclical markets like Spain, but Spain benefits from Europe’s turn to liquefied natural gas and has little to fear from Russia. Investors should favor Spanish stocks relative to Italian stocks. Turkey GeoRisk Indicator Turkey faces extreme political and economic instability between now and the general election due by June 2023 (Chart 7). Chart 7Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Almost any country would see the incumbent ruling party thrown from power under Turkey’s conditions. The ruling Justice and Development Party has been in charge since 2002, the country’s economy has suffered over that period, and today inflation is running at 73% while unemployment stands at 11%. However, President Recep Tayyip Erdoğan is doing everything he can with his recently expanded presidential powers to stay in office. He is making amends with the Gulf Arab states and seeking their economic support. He is also warming relations with Israel, as Turkey seeks to diversify away from Russian gas and Israel/Egypt are potential suppliers. He is doubling down on military distractions across the Middle East and North Africa. And he waged a high-stakes negotiation with the West over Finnish and Swedish accession to NATO. Russian aggression poses a threat to Turkish national interests. Turkey ultimately agreed to Finnish and Swedish membership after a show of Erdoğan strong hands in negotiating with the West over their membership, to show his domestic audience that he is one of the big boys ahead of the election. A risk to this view is that Erdoğan stages military operations against Greek-controlled Cyprus. This would initiate a crisis within NATO and put Finnish and Swedish accession on hold for a longer period. Bottom Line: Investors should not attempt to bottom-feed Turkish lira or stocks and should sell any rallies ahead of the election. A decisive election that removes Erdoğan from power is the best case for Turkish assets, while a decisive Erdoğan victory is second best. Worse scenarios include indecisive outcomes, a contested or stolen election, a constitutional breakdown, or a military coup. China GeoRisk Indicator China’s geopolitical risk is falling and relative equity performance is picking up now that the government has begun easing monetary, fiscal, and regulatory policy to try to secure the economic recovery (Chart 8). Chart 8China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator Easing regulation on Big Tech has spurred a rebound in heavily sold Chinese tech shares, while the Politburo will likely signal a pro-growth turn in policy at its July economic meeting. The worst news of the country’s draconian “Covid Zero” policy is largely priced, while positive news regarding domestic vaccines, vaccine imports, or anti-viral drugs could surprise the market. However, none of these policy signals are reliable until Xi Jinping consolidates power at the twentieth national party congress sometime between September and November (likely October). Chinese stimulus could fail to pick up as much as the market hopes and policy signals could reverse or could continue to contradict themselves. After the party congress, we expect the Xi administration to intensify its efforts to stabilize the economy. The economic work conference in December will release a pro-growth communique. The March legislative session will provide more government support for the economy if needed. However, short-term measures to stabilize growth should not be mistaken for a major reacceleration, as China will continue to struggle with debt-deflation as households and corporations deleverage and the economic model transitions to a post-manufacturing model. Bottom Line: A Santa Claus rally in the fourth quarter, and/or a 2023 rally, is likely, both for offshore and onshore equities. But long-term investors, especially westerners, should steer clear of Chinese assets. China’s reversion to autocracy and confrontation with the United States will ultimately result in tariffs and sanctions and geopolitical crises and will keep risk premiums high. Taiwan GeoRisk Indicator Taiwan’s geopolitical risk has spiked as expected due to confrontation with China. Tensions will remain high through the Taiwanese midterm election on November 26, the Chinese party congress, and the US midterm (Chart 9). But China is not ready to stage a full-scale military conflict over Taiwan yet – that risk will grow over in the later 2020s and 2030s, depending on whether the US and China provide each other with adequate security assurances. Chart 9Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Still, Taiwan is the epicenter of global geopolitical risk. China insists that it will be unified with the mainland eventually, by force if not persuasion. China’s potential growth is weakening so it is losing the ability to absorb Taiwan through economic attraction over time. Meanwhile the Taiwanese people do not want to be absorbed – they have developed their own identity and prefer the status quo (or independence) over unification. Taiwan does not have a mutual defense treaty with the United States and yet the US and Taiwan are trying to strengthen their economic and military bonds. This situation is both threatening to China and yet not threatening enough to force China to forswear the military option. At some point China could believe it must assert control over Taiwan before the US increases its military commitment. Meanwhile China, the US, Japan, South Korea, and Europe are all adopting policies to promote semiconductor manufacturing at home, and/or outside Taiwan, so that their industries are not over-reliant on Taiwan. That means Taiwan will lose its comparative advantage over time. Bottom Line: Structurally remain underweight Taiwanese equities. Korea GeoRisk Indicator The newly elected President Yoon reaffirmed the strong military tie between Korea and the US, when he hosted President Biden in Seoul in May. Both Presidents expressed interests in expanding cooperation into new areas like semiconductors, economic security, and stability in the Indo-Pacific region. The new administration is also finding ways to improve relations with Japan, which soured in the past few years over the issue of forced labor during the Japanese occupation of Korea. A way forward is yet to be found, but a new public-private council will be launched on July 4 to seek potential solutions before the supreme court ruling in August which could further damage bilateral ties. President Yoon’s various statements throughout the NATO summit in Madrid on wanting a better relationship with Japan and to resolve historical issues showed this administration’s willingness towards a warming of the relations between the two countries, a departure from the previous administration. On the sideline of the NATO summit, Yoon also engaged with European leaders, dealing Korean defense products, semiconductors, and nuclear technologies, with a receptive European audience eager to bolster their defense, secure supply chain, and diversify energy source. North Korea ramped up its missile tests this year as it tends to do during periods of political transitions in South Korea. It is also rumored to be preparing for another nuclear test. Provocations will continue as the North is responding to the hawkish orientation of the Yoon administration. Investors should expect a rise in geopolitical risk in the peninsular, but on a relative basis, due to its strong alliance network, Korean risk will be lower compared to Taiwan (Chart 10). Korea will benefit from a rebound in China in the near term, but in the long-term, it is a secure source of semiconductors and high-tech exports, as Greater China will be mired in long-term geopolitical instability. Chart 10Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Bottom Line: Overweight South Korean equities relative to emerging markets as a play on Chinese stimulus. Overweight Korea versus Taiwan. Australia GeoRisk Indicator Australia’s Labor Party ultimately obtained a one-seat majority in the House of Representatives following the general election in May (77 seats where 76 are needed). It does not have a majority in the Senate, where it falls 13 seats short of the 39 it needs. It will rely on the Green Party (12 seats) and a few stragglers to piece together ad hoc coalitions to pass legislation. Hence Prime Minister Anthony Albanese’s domestic agenda will be heavily constrained. Pragmatic policies to boost the economy are likely but major tax hikes and energy sector overhauls are unlikely (Chart 11). Chart 11Australia: GeoRisk Indicator Australia: GeoRisk Indicator Australia: GeoRisk Indicator Fortunately for Albanese, his government is taking power in the wake of the pandemic, inflation, and Chinese slowdown, so that there is a prospect for the macroeconomic context to improve over his term in office. This could give him a tailwind. But for now he is limited. Like President Biden in the US, Albanese can attempt to reduce tensions with China after Xi Jinping consolidates power. But also like Biden, he will not have a basis for broad and durable re-engagement, since China’s regional ambitions threaten Australian national security over the long run. Global commodity supply constraints give Australia leverage over China. Bottom Line: Stay neutral on Australian currency and equities until global and Chinese growth stabilize. Brazil GeoRisk Indicator It would take a bolt of lightning to prevent former President Lula da Silva from winning re-election in Brazil’s October 2 first round election. Lula is more in line with the median voter than sitting President Jair Bolsonaro. Bolsonaro’s term has been marred with external shocks, following on a decade of recession and malaise. Polls may tighten ahead of the election but Lula is heavily favored. While ideologically to the left, Lula is a known quantity to global investors (Chart 12). However, Bolsonaro may attempt to cling to power, straining the constitutional system and various institutions. A military coup is unlikely but incidents of insubordination cannot be ruled out. Once Lula is inaugurated, a market riot may be necessary to discipline his new administration and ensure that his policies do not stray too far into left-wing populism. Chart 12Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil’s macroeconomic context is less favorable than it was when Lula first ruled. During the 2000s he rode the wave of Chinese industrialization and a global commodity boom. Today China is slipping into a balance sheet recession and the next wave of industrialization has not yet taken off. Brazil’s public debt dynamics discourage a structural overweight on Brazil within emerging markets. At least Brazil is geopolitically secure – far separated from the conflicts marring Russia, East Europe, China, and East Asia. It also has a decade of bad news behind it that is already priced. Bottom Line: Stay neutral Brazilian assets until global and Chinese growth stabilize and the crisis-prone election season is over. South Africa GeoRisk Indicator South Africa’s economy continues to face major headwinds amid persistent structural issues that have yet to be adequately addressed and resolved by policy makers. The latest bout of severe energy supply cuts by the state-run energy producer, Eskom, serve as a reminder to investors that South Africa’s economy is still dealing with a major issue of generating an uninterrupted supply of electricity. Each day that electricity supply is cut to businesses and households, the local economy stalls. Among other macroeconomic issues such as high unemployment and rising inflation, low-income households which are too the median voter, are facing increasing hardships. The political backdrop is geared toward further increases in political risk going forward (Chart 13). Chart 13South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Fiscal reform and austerity are underway but won’t last long enough to make a material difference in government finances. The 2024 election is not that far out and the ruling political party, the ANC, will look to quell growing economic pressures to shore up voter support and reinforce its voter base. Fiscal austerity will unwind. Meanwhile, the bull market in global metal prices stands to moderate on weakening global growth, which reduces a tailwind for the rand, South African equities relative to other emerging markets, and government coffers, reducing our reasons for slight optimism on South Africa until global growth stabilizes. Bottom Line: Shift to a neutral stance on South Africa until global and Chinese growth stabilize. Canada GeoRisk Indicator Canadian political risk has spiked since the pandemic (Chart 14). Populist politics can grow over time in Canada, especially if the property sector goes bust. However, the country is geopolitically secure and benefits from proximity to the US economy. Chart 14Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Global commodity supply constraints create opportunities for Canada as governments around the world pursue fiscal programs directed at energy security, national defense, and supply chain resilience. Bottom Line: Stay neutral Canadian currency and equities. While Canada benefits from the high oil price and robust US economy, rising interest rates pose a threat to its high-debt model, while US growth faces disappointments due to Europe’s and China’s troubles.     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Alice Brocheux Research Associate alice.brocheux@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar

Executive Summary German GeoRisk Indicator German GeoRisk Indicator German GeoRisk Indicator Russia and Germany have begun cutting off each other’s energy in a major escalation of strategic tensions. The odds of Finland and Sweden joining NATO have shot up. A halt to NATO enlargement, particularly on Russia’s borders, is Russia’s chief demand. Tensions will skyrocket. China’s reversion to autocracy and de facto alliance with Russia are reinforcing the historic confluence of internal and external risk, weighing on Chinese assets. Geopolitical risk is rising in South Korea and Hong Kong, rising in Spain and Italy, and flat in South Africa. France’s election will lower domestic political risk but the EU as a whole faces a higher risk premium. The Biden administration is doubling down on its defense of Ukraine, calling for $33 billion in additional aid and telling Russia that it will not dominate its neighbor. However, the Putin regime cannot afford to lose in Ukraine and will threaten to widen the conflict to intimidate and divide the West. Trade Recommendation Inception Date Return LONG GLOBAL DEFENSIVES / CYCLICALS EQUITIES 2022-01-20 14.2% Bottom Line: Stay long global defensives over cyclicals. Feature Chart 1Geopolitical Risk And Policy Uncertainty Drive Up Dollar Geopolitical Risk And Policy Uncertainty Drive Up Dollar Geopolitical Risk And Policy Uncertainty Drive Up Dollar The dollar (DXY) is breaking above the psychological threshold of 100 on the back of monetary tightening and safe-haven demand. Geopolitical risk does not always drive up the dollar – other macroeconomic factors may prevail. But in today’s situation macro and geopolitics are converging to boost the greenback (Chart 1). Global economic policy uncertainty is also rising sharply. It is highly correlated with the broader trade-weighted dollar. The latter is nowhere near 2020 peaks but could rise to that level if current trends hold. A strong dollar reflects slowing global growth and also tightens global financial conditions, with negative implications for cyclical and emerging market equities. Bottom Line: Tactically favor US equities and the US dollar to guard against greater energy shock, policy uncertainty, and risk-aversion. Energy Cutoff Points To European Recession Chart 2Escalation With Russia Weighs Further On EU Assets Escalation With Russia Weighs Further On EU Assets Escalation With Russia Weighs Further On EU Assets Russia is reducing natural gas flows to Poland and Bulgaria and threatening other countries, Germany is now embracing an oil embargo against Russia, while Finland and Sweden are considering joining NATO. These three factors are leading to a major escalation of strategic tensions on the continent that will get worse before they get better, driving up our European GeoRisk indicators and weighing on European assets (Chart 2). Russia’s ultimatum in December 2021 stressed that NATO enlargement should cease and that NATO forces and weapons should not be positioned east of the May 1997 status quo. Russia invaded Ukraine to ensure its military neutrality over the long run.1 Finland and Sweden, seeing Ukraine’s isolation amid Russian invasion, are now reviewing whether to change their historic neutrality and join NATO. Public opinion polls now show Finnish support for joining at 61% and Swedish support at 57%. The scheduling of a joint conference between the country’s leaders on May 13 looks like it could be a joint declaration of their intention to join. The US and other NATO members will have to provide mutual defense guarantees for the interim period if that is the case, lest Russia attack. The odds that Finland and Sweden remain neutral are higher than the consensus holds (given the 97% odds that they join NATO on Predictit.org). But the latest developments suggest they are moving toward applying for membership. They fear being left in the cold like Ukraine in the event of an attack. Russia’s response will be critical. If Russia deploys nuclear weapons to Kaliningrad, as former President Dmitri Medvedev warned, then Moscow will be making a menacing show but not necessarily changing the reality of Russia’s nuclear strike capabilities. That is equivalent to a pass and could mark the peak of the entire crisis. The geopolitical risk premium would begin to subside after that. Related Report  Geopolitical StrategyLe Pen And Other Hurdles (GeoRisk Update) However, Russia has also threatened “military-political repercussions” if the Nordics join NATO. Russia’s capabilities are manifestly limited, judging by Ukraine today and the Winter War of 1939, but a broader war cannot entirely be ruled out. Global financial markets will still need to adjust for a larger tail risk of a war in Finland/Sweden in the very near term. Most likely Russia will retaliate by cutting off Europe’s natural gas. Clearly this is the threat on the table, after the cutoff to Poland and Bulgaria and the warnings to other countries. In the near term, several companies are gratifying Russia and paying for gas in rubles. But these payments violate EU sanctions against Russia and the intention is to wean off Russian imports as soon as possible. Germany says it can reduce gas imports starting next year after inking a deal with Qatar. Hence Russia might take the initiative and start reducing the flow earlier. Bottom Line: If Europe plunges into recession as a result of an immediate natural gas cutoff, then strategic stability between Russia and the West will become less certain. The tail risk of a broader war goes up. Stay cyclically long US equities over global equities and tactically long US treasuries. Stay long defense stocks and gold. Stay Short CNY At the end of last year we argued that Beijing would double down on “Zero Covid” policy in 2022, at least until the twentieth national party congress this fall. Social restrictions serve a dual purpose of disease suppression and dissent repression. Now that the state is doubling down, what will happen next? The economy will deteriorate: imports are already contracting at a rate of 0.1% YoY. The manufacturing PMI has fallen to 48.1  and the service sector PMI to 42.0, indicating contraction. Furthermore, social unrest could emerge, as lockdowns serve as a catalyst to ignite underlying socioeconomic disparities. Hence the national party congress is less likely to go smoothly, implying that investors will catch a glimpse of political instability under the surface in China as the year progresses. The political risk premium will remain high (Chart 3). Chart 3China's Confluence Of Domestic And Foreign Risk Weighs On Stocks And Currency China's Confluence Of Domestic And Foreign Risk Weighs On Stocks And Currency China's Confluence Of Domestic And Foreign Risk Weighs On Stocks And Currency While Chairman Xi Jinping is still likely to clinch another ten years in power, it will not be auspicious amid an economic crash and any social unrest. Xi could be forced into some compromises on either Politburo personnel or policy adjustments. A notable indicator of compromise would be if he nominated a successor, though this would not provide any real long-term assurance to investors given the lack of formal mechanisms for power transfer. After the party congress we expect Xi to “let 100 flowers bloom,” meaning that he will ease fiscal, regulatory, and social policy so that today’s monetary and fiscal stimulus can work effectively. Right now monetary and fiscal easing has limited impact because private sector actors are averse to taking risk. Easing policy to boost the economy could also entail a diplomatic charm offensive to try to convince the US and EU to avoid imposing any significant sanctions on trade and investment flows, whether due to Russia or human rights violations. Such a diplomatic initiative would only succeed, if at all, in the short run. The US cannot allow a deep re-engagement with China since that would serve to strengthen the de facto Russo-Chinese strategic alliance. In other words, an eruption of instability threatens to weaken Xi’s hand and jeopardize his power retention. While it is extremely unlikely that Xi will fall from power, he could have his image of supremacy besmirched. It is likely that China will be forced to ease a range of policies, including lockdowns and regulations of key sectors, that will be marginally positive for economic growth. There may also be schemes to attract foreign investment. Bottom Line: If China expands the range of its policy easing the result could be received positively by global investors in 2023. But the short-term outlook is still negative and deteriorating due to China’s reversion to autocracy and confluence of political and geopolitical risk. Stay short CNY and neutral Chinese stocks. Stay Short KRW South Koreans went to the polls on March 9 to elect their new president for a five-year term. The two top candidates for the job were Yoon Suk-yeol and Lee Jae-myung. Yoon, a former public prosecutor, was the candidate for the People Power Party, a conservative party that can be traced back to the Saenuri and the Grand National Party, which was in power from 2007 to 2017 under President Lee Myung-bak and President Park Geun-hye. Lee, the governor of the largest province in Korea, was the candidate for the Democratic Party, the party of the incumbent President Moon Jae-in. Yoon won by a whisker, garnering 48.6% of the votes versus 47.8% for Lee. The margin of victory for Yoon is the lowest since Korea started directly electing its presidents. President-elect Yoon will be inaugurated in May. He will not have control of the National Assembly, as his party only holds 34% of the seats. The Democratic Party holds the majority, with 172 out of 300 seats. The next legislative election will be in 2024, which means that President Yoon will have to work with the opposition for a good two years before his party has a chance to pass laws on its own. President-elect Yoon was the more pro-business and fiscally restrained candidate. His nomination of Han Duck-soo as his prime minister suggests that, insofar as any domestic policy change is possible, he will be pragmatic, as Han served under two liberal administrations. Yoon’s lack of a majority and nomination of a left-leaning prime minister suggest that domestic policy will not be a source of uncertainty for investors through 2024. Foreign policy, by contrast, will be the biggest source of risk for investors. Yoon rejects the dovish “Moonshine” policy of his predecessor and favors a strong hand in dealing with North Korea. “War can be avoided only when we acquire an ability to launch pre-emptive strikes and show our willingness to use them,” he has argued. North Korea responded by expanding its nuclear doctrine and resuming tests of intercontinental ballistic missiles with the launch of the Hwasong-17 on March 24 – the first ICBM launch since 2017. In a significant upgrade of North Korea’s deterrence strategy, Kim Yo Jong, the sister of Kim Jong Un, warned on April 4 that North Korea would use nuclear weapons to “eliminate” South Korea if attacked (implying an overwhelming nuclear retaliation to any attack whatsoever). Kim Jong Un himself claimed on April 26 that North Korea’s nuclear weapons are no longer merely about deterrence but would be deployed if the country is attacked. President-elect Yoon welcomes the possibility of deploying of US strategic assets to strengthen deterrence against the North. The hawkish turn is not surprising considering that North-South relations failed to make any substantive improvements during President Moon’s five-year tenure as a pro-engagement president. South Koreans, especially Yoon’s supporters, are split on whether inter-Korean dialogue should be continued. They are becoming more interested in developing their own nuclear weapons or at the very least deploying US nuclear weapons in South Korea. Half of South Korean voters support security through alliance with the US, while a third support security through the development of independent nuclear weapons. The nuclear debate will raise tensions on the peninsula. An even bigger change in South Korea’s foreign policy is its policy towards China. President-elect Yoon has accused President Moon of succumbing to China’s economic extortion. Moon had established a policy of “three No’s,” meaning no to additional THAAD missiles in South Korea, no to hosting other US missile defense systems, and no to joining an alliance with Japan and the United States. By contrast, Yoon’s electoral promises include deploying more THAAD and joining the Quadrilateral Dialogue (US, Japan, Australia, India). Polls show that South Koreans hold a low opinion of all of their neighbors but that China has slipped slightly beneath Japan and North Korea in favorability. Even Democratic Party voters feel more negative towards China. While negative attitudes towards China are not unique to Korea, there is an important difference from other countries: the Korean youth dislike China the most, not the older generations. Negative sentiment is less tied to old wounds from the Korean war and more related to ideology and today’s grievances. Younger Koreans, growing up in a liberal democracy and proud of their economic and cultural success, have been involved in campus clashes against Chinese students over Korean support for Hong Kong democrats. Negative attitudes towards China among the youth should alarm investors, as young people provide the voting base for elections to come, and China is the largest trading partner for Korea. Korea’s foreign policy will hew to the American side, at risk to its economy (Chart 4). Chart 4South Korean Geopolitical Risk Rising Under The Radar South Korean Geopolitical Risk Rising Under The Radar South Korean Geopolitical Risk Rising Under The Radar President-elect Yoon’s policies towards North Korea and China will increase geopolitical risk in East Asia. The biggest beneficiary will be India. Both Korea and Japan need to find a substitute to Chinese markets and labor, which have become less reliable in recent years. South Korea’s newly elected president is aligned with the US and West and less friendly toward China and Russia. He faces a rampant North Korea that feels emboldened by its position of an arsenal of 40-50 deliverable nuclear weapons. The North Koreans now claim that they will respond to any military attack with nuclear force and are testing intercontinental ballistic missiles and possibly a nuclear weapon. The US currently has three aircraft carriers around Korea, despite its urgent foreign policy challenges in Europe and the Middle East. Bottom Line: Stay long JPY-KRW. South Korea’s geopolitical risk premium will remain high. But favor Korean stocks over Taiwanese stocks. Stay Neutral On Hong Kong Stocks Hong Kong’s leadership change will trigger a new bout of unrest (Chart 5). Chart 5Hong Kong: More Turbulence Ahead Hong Kong: More Turbulence Ahead Hong Kong: More Turbulence Ahead On April 4, Hong Kong’s incumbent Chief Executive, Carrie Lam, confirmed that she would not seek a second term but would step down on June 30. John Lee, the current chief secretary of Hong Kong, became the only candidate approved to run for election, which is scheduled to be held on May 8. With the backing of the pro-Beijing members in the Election Committee, Lee is expected to secure enough nominations to win the race. Lee served as security secretary from when Carrie Lam took office in 2017 until June 2021. He firmly supported the Hong Kong extradition bill in 2019 and National Security Law in 2020, which provoked historic social unrest in those years. He insisted on taking a tough security stance towards pro-democracy protests. With Lee in power, Hong Kong will face more unrest and tougher crackdowns in the coming years, which will likely bring more social instability. Lee will provoke pro-democracy activists with his policy stances and adherence to Beijing’s party line. For example, his various statements to the news media suggest a dogmatic approach to censorship and political dissent. With the adoption of the National Security Law, Hong Kong’s pro-democracy faction is already deeply disaffected. Carrie Lam was originally elected as a popular leader, with notable support from women, but her popularity fell sharply after the passage of the extradition bill and National Security Law, as well as her mishandling of the Covid-19 outbreak. Her failure to handle the clashes between the Hong Kong people and Beijing damaged public trust in government. Trust never fully recovered when it took another hit recently from the latest wave of the pandemic. Putting another pro-Beijing hardliner in power will exacerbate the trend. Hong Kong equities are vulnerable not merely because of social unrest. During the era of US-China engagement, Hong Kong benefited as the middleman and the symbol that the Communist Party could cooperate within a liberal, democratic, capitalist global order. Hence US-China power struggle removes this special status and causes Hong Kong financial assets to contract mainland Chinese geopolitical risk. As a result of the 2019-2020 crackdown, John Lee and Carrie Lam were among a list of Hong Kong officials sanctioned by the US Treasury Department and State Department in 2020. Now, after the Ukraine war, the US will be on the lookout for any Hong Kong role in helping Russia circumvent sanctions, as well as any other ways in which China might further its strategic aims by means of Hong Kong. Bottom Line: Stay neutral on Hong Kong equities. Favor France Within European Equities French political risk will fall after the presidential election, which recommits the country to geopolitical unity with the US and NATO and potentially pro-productivity structural reforms (Chart 6). France is already a geopolitically secure country so the reduction of domestic political risk should be doubly positive for French assets, though they have already outperformed. And the Russia-West conflict is fueling a risk premium regardless of France’s positive developments. Chart 6France's Domestic Political Risk Will Subside But Russian War Will Keep Geopolitical Risk Elevated France's Domestic Political Risk Will Subside But Russian War Will Keep Geopolitical Risk Elevated France's Domestic Political Risk Will Subside But Russian War Will Keep Geopolitical Risk Elevated The French election ended with a solid victory for the political establishment as we expected. President Emmanuel Macron gaining 58% of the vote to Marine Le Pen’s 42%. Macron beat his opinion polling by 4.5pp while Le Pen underperformed her polls by 4.5pp. A large number of voters abstained, at 28%, compared to 25.5% in 2017. The regional results showed a stark divergence between overseas or peripheral France (where Marine Le Pen even managed to get over half of the vote in several cases) and the core cities of France (where Macron won handily). Macron had won an outright majority in every region in 2017. Macron did best among the young and the old, while Le Pen did best among middle-aged voters. But Macron won every age group except the 50 year-olds, who want to retire early. Macron did well among business executives, managers, and retired people, but Le Pen won among the working classes, as expected. Le Pen won the lowest paid income group, while Macron’s margin of victory rises with each step up the income ladder. Macron’s performance was strong, especially considering the global context. The pandemic knocked several incumbent parties out of power (US, Germany) and required leadership changes in others (Japan, Italy). The subsequent inflation shock now threatens to cause another major political rotation in rapid succession, leaving various political leaders and parties vulnerable in the coming months and years (Australia, the UK, Spain). Only Canada and now France marked exceptions, where post-pandemic elections confirmed the country’s leader. The Ukraine war constitutes yet another shock but it helped Macron, as Le Pen had objective links and sympathies with Russian President Vladimir Putin. Macron’s timing was lucky but his message of structural reform for the sake of economic efficiency still resonates in contemporary France, where change is long overdue – at least compared with Le Pen’s proposal of doubling down on statism, protectionism, and fiscal largesse. The French middle class was never as susceptible to populism as the US, UK, and Italy because it had been better protected from the ravages of globalization. Populism is still a force to be reckoned with, especially if left-wing populists do well in the National Assembly, or if right-wing populists find a fresher face than the Le Pen dynasty. But the failure of populism in the context of pandemic, inflation, and war suggests that France’s political establishment remains well fortified by the economic structure and the electoral system. Whether Macron can sustain his structural reforms depends on legislative elections to be held on June 12-19. Early projections are positive for his party, which should keep a majority. Macron’s new mandate will help. Le Pen’s National Rally and its predecessors may perform better than in the past but that is not saying much as their presence in the National Assembly has been weak. Bottom Line: France is geopolitically secure and has seen a resounding public vote for structural reform that could improve productivity depending on legislative elections. French equities can continue to outperform their European peers over the long run. Our European Investment Strategy recommends French equities ex-consumer stocks, French small caps over large caps, and French aerospace and defense.   Favor Spanish Over Italian Stocks Chart 7Italian And Spanish Political Risk Will Rise But Favor Spanish Stocks Italian And Spanish Political Risk Will Rise But Favor Spanish Stocks Italian And Spanish Political Risk Will Rise But Favor Spanish Stocks What about Spain? It is still a “divided nation” susceptible to a rise in political risk ahead of the general election due by December 10, 2023 (Chart 7). In the past few months, a series of strategic mistakes and internal power struggles have led to a significant decline in the popularity of Spain’s largest opposition party, the People’s Party. Due to public infighting and power struggle, Pablo Casado was forced to step down as the leader of the People’s Party on February 23, as requested by 16 of the party’s 17 regional leaders. It is yet to be seen if the new party leader, Alberto Nunez Feijoo, can reboot People’s Party. The far-right VOX party will benefit from the People Party’s setback. The latter’s misstep in a regional election (Castile & Leon) gave VOX a chance to participate in a regional government for the very first time. Hence VOX’s influence will spread and it will receive greater recognition as an important political force. Meanwhile the ruling Socialist Worker’s Party (PSOE) faces anger from the public amid inflation and high energy prices. However, Spanish Prime Minister Pedro Sanchez’s decision to send offensive military weapons to Ukraine is widely supported among major parties, including even his reluctant coalition partner, Unidas Podemos. The People’s Party’s recent infighting gives temporary relief to the ruling party. The Russia-Ukraine issue caused some minor divisions within the government but they are not yet leading to any major political crisis, as nationwide pro-Ukraine sentiment is largely unified. The Andalusia regional election, which is expected this November, will be a check point for Feijoo and a pre-test for next year’s general election. Andalusia is the most populous autonomous community in Spain, consisting about 17% of the seats in the congress (the lower house). The problem for Sanchez and the Socialists is that the stagflationary backdrop will weigh on their support over time. Bottom Line: Spanish political risk is likely to spike sooner rather than later, though Spanish domestic risk it is limited in nature. Madrid faces low geopolitical risk, low energy vulnerability, and is not susceptible to trying to leave the EU or Euro Area. Favor Spanish over Italian stocks. Stay Constructive On South Africa The political and economic status quo is largely unchanged in South Africa and will remain so going into the 2024 national elections. Fiscal discipline will weaken ahead of the election, which should be negative for the rand, but the global commodity shortage and geopolitical risks in Russia and China will probably overwhelm any negative effects from South Africa’s domestic policies. Rising commodity prices have propped up the local equity market and will bring in much-needed revenue into the local economy and government coffers. But structural issues persist. Low growth outcomes amid weak productivity and high unemployment levels will remain the norm. The median voter is increasingly constrained with fewer economic opportunities on the horizon. Pressure will mount on the ruling African National Congress (ANC), fueling civil unrest and adding to overall political risk (Chart 8). Chart 8South Africa's Political Status Quo Is Tactically Positive For Equities And Currency South Africa's Political Status Quo Is Tactically Positive For Equities And Currency South Africa's Political Status Quo Is Tactically Positive For Equities And Currency Almost a year has passed since the civil unrest episode of 2021. Covid-19 lockdowns have lifted and the national state of disaster has ended, reducing social tensions. This is evident in the decline of our South Africa GeoRisk indicator from 2021 highs. While we recently argued that fiscal austerity is under way in South Africa, we also noted that fiscal policy will reverse course in time for the 2024 election. In this year’s fiscal budget, the budget deficit is projected to narrow from -6% to -4.2% over the next two years. Government has increased tax revenue collection through structural reforms that are rooting out corruption and wasteful expenditure. But the ANC will have to tap into government spending to shore up lost support come 2024. Already, the ANC have committed to maintaining a special Covid-19 social-grant payment, first introduced in 2020, for another year. This grant, along with other government support, will feature in 2024 and possibly beyond. Unemployment is at 34.3%, its highest level ever recorded. The ANC cannot leave it unchecked. The most prevalent and immediate recourse is to increase social payments and transfers. Given the increasing number of social dependents that higher unemployment creates, government spending will have to increase to address rising unemployment. President Cyril Ramaphosa is still a positive figurehead for the ANC, but the 2021 local elections showed that the ANC cannot rely on the Ramaphosa effect alone. The ANC is also dealing with intra-party fighting. Ramaphosa has yet to assert total control over the party elites, distracting the ANC from achieving its policy objectives. To correct course, Ramaphosa will have to relax fiscal discipline. To this outcome, investors should expect our GeoRisk indicator to register steady increases in political risk moving into 2024. The only reason to be mildly optimistic is that South Africa is distant from geopolitical risk and can continue to benefit from the global bull market in metals. Bottom Line: Maintain a cyclically constructive outlook on South African currency and assets. Tight global commodity markets will support this emerging market, which stands to benefit from developments in Russia and China. Investment Takeaways Stay strategically long gold on geopolitical and inflation risk, despite the dollar rally. Stay long US equities relative to global and UK equities relative to DM-ex-US. Favor global defensives over cyclicals and large caps over small caps. Stay short CNY, TWD, and KRW-JPY. Stay short CZK-GBP. Favor Mexico within emerging markets. Stay long defense and cyber security stocks. We are booking a 5% stop loss on our long Canada / short Saudi Arabia equity trade. We still expect Middle Eastern tensions to escalate and trigger a Saudi selloff.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Footnotes 1   The campaign in the south suggests that Ukraine will be partitioned, landlocked, and susceptible to blockade in the coming years. If Russia achieves its military objectives, then Ukraine will accept neutrality in a ceasefire to avoid losing more territory. If Russia fails, then it faces humiliation and its attempts to save face will become unpredictable and aggressive. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Geopolitical Calendar

Executive Summary Macron Still Favored, But Le Pen Cannot Be Ruled Out Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Macron is still favored to win the French election but Le Pen’s odds are 45%. Le Pen would halt France’s neoliberal structural reforms, paralyze EU policymaking, and help Russia’s leverage in Ukraine. But she would lack legislative support and would not fatally wound the EU or NATO. European political risk will remain high in Germany, Italy, and Spain. Favor UK equities on a relative basis. Financial markets are complacent about Russian geopolitical risk again. Steer clear of eastern European assets. Do not bottom feed in Chinese stocks. China faces social unrest. North Korean geopolitical risk is back. Australia’s election is an opportunity, not a risk. Stay bullish on Latin America. Prefer Brazil over India. Stay negative on Turkey and Pakistan.   Trade Recommendation Inception Date Return TACTICALLY LONG US 10-YEAR TREASURY 2022-04-14   Bottom Line: Go long the US 10-year Treasury on geopolitical risk and near-term peak in inflation. Feature Last year we declared that European political risk had reached a bottom and had nowhere to go but up. Great power rivalry with Russia primarily drove this view but we also argued that our structural theme of populism and nationalism would feed into it. Related Report  Geopolitical StrategyThe Geopolitical Consequences Of The Ukraine War In other words, the triumph of the center-left political establishment in the aftermath of Covid-19 would be temporary. The narrow French presidential race highlights this trend. President Emmanuel Macron is still favored but Marine Le Pen, his far-right, anti-establishment opponent, could pull off an upset victory on April 24. The one thing investors can be sure of is that France’s ability to pursue neoliberal structural reforms will be limited even if Macron wins, since he will lack the mandate he received in 2017. Our GeoRisk Indicators this month suggest that global political trends are feeding into today’s stagflationary macroeconomic context. Market Complacent About Russia Again Global financial markets are becoming complacent about European security once again. Markets have begun to price a slightly lower geopolitical risk for Russia after it withdrew military forces from around Kyiv in an open admission that it failed to overthrow the government. However, western sanctions are rising, not falling, and Russia’s retreat from Kyiv means it will need to be more aggressive in the south and east (Chart 1). Chart 1Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia has not achieved its core aim of a militarily neutral Ukraine – so it will escalate the military effort to achieve its aim. Any military failure in the east and south would humiliate the Putin regime and make it more unpredictable and dangerous. The West has doubled down on providing Ukraine with arms and hitting Russia with sanctions (e.g. imposing a ban on Russian coal). Germany prevented an overnight ban on Russian oil and natural gas imports but the EU is diversifying away from Russian energy rapidly. Sanctions that eat away at Russia’s export revenues will force it to take a more aggressive posture now, to achieve a favorable ceasefire before funding runs out. Sweden and Finland are reviewing whether to join NATO, with recommendations due by June. Russia will rattle sabers to underscore its red line against NATO enlargement and will continue to threaten “serious military-political repercussions” if these states try to join. We would guess they would remain neutral as a decision to join NATO could lead to a larger war. Bottom Line: Global equities will remain volatile due to a second phase of the war and potential Russian threats against Ukraine’s backers. European equities and currency, especially in emerging Europe, will suffer a persistent risk premium until a ceasefire is concluded. What If Le Pen Wins In France? By contrast with the war in Ukraine, the French election is a short-term source of political risk. A surprise Le Pen victory would shake up the European political establishment but investors should bear in mind that it would not revolutionize the continent or the world, as Le Pen’s powers would be limited. Unlike President Trump in 2017, she would not take office with her party gaining full control of the legislature. Le Pen rallied into the first round of the election on April 10, garnering 23% of the vote, up from 21% in 2017. This is not a huge increase in support but her odds of winning this time are much better than in 2017 because the country has suffered a series of material shocks to its stability. Voters are less enthusiastic about President Macron and his centrist political platform. Macron, the favorite of the political establishment, received 28% of the first-round vote, up from 24% in 2017. Thus he cannot be said to have disappointed expectations, though he is vulnerable. The euro remains weak against the dollar and unlikely to rally until Russian geopolitical risk and French political risk are decided. The market is not fully pricing French risk as things stand (Chart 2). Chart 2France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator The first-round election results show mixed trends. The political establishment suffered but so did the right-wing parties (Table 1). The main explanation is that left-wing, anti-establishment candidate Jean-Luc Mélenchon beat expectations while the center-right Republicans collapsed. Macron is leading Le Pen by only five percentage points in the second-round opinion polling as we go to press (Chart 3). Macron has maintained this gap throughout the race so far and both candidates are very well known to voters. But Le Pen demonstrated significant momentum in the first round and momentum should never be underestimated. Table 1Results Of France’s First-Round Election Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) ​​​​​​ Chart 3French Election: Macron Maintains Lead French Election: Macron Maintains Lead French Election: Macron Maintains Lead ​​​​​​ Are the polls accurate? Anti-establishment candidates outperformed their polling by 7 percentage points in the first round. Macron, the right-wing candidates, and the pro-establishment candidates all underperformed their March and April polls (Chart 4). Hence investors should expect polls to underrate Le Pen in the second round. Chart 4French Polls Fairly Accurate Versus First-Round Results Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Given the above points, it is critical to determine which candidate will gather the most support from voters whose first preference got knocked out in the first round. The strength of anti-establishment feeling means that the incumbent is vulnerable while ideological camps may not be as predictable as usual. Mélenchon has asked his voters not to give a single vote to Le Pen but he has not endorsed Macron. About 21% of his supporters say they will vote for Le Pen. Only a little more of them said they would vote for Macron, at 27% (Chart 5). Chart 5To Whom Will Voters Drift? Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Diagram 1, courtesy of our European Investment Strategy, illustrates that Macron is favored in both scenarios but Le Pen comes within striking distance under certain conservative assumptions about vote switching. Diagram 1Extrapolating France’s First-Round Election To The Second Round Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Macron’s approval rating has improved since the pandemic. This is unlike the situation in other liberal democracies (Chart 6). Chart 6Macron Handled Pandemic Reasonably Well Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) The pandemic is fading and the economy reviving. Unemployment has fallen from 8.9% to 7.4% over the course of the pandemic. Real wage growth, at 5.8%, is higher than the 3.3% that prevailed when Macron took office in 2017 (Chart 7). Chart 7Real Wages A Boon For Macron Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) But these positives do not rule out a Le Pen surprise. The nation has suffered not one but a series of historic shocks – the pandemic, inflation, and the war in Ukraine. Inflation is rising at 5.1%, pushing the “Misery Index” (inflation plus unemployment) to 12%, higher than when Macron took office, even if lower than the EU average (Chart 8). Chart 8Misery Index The Key Threat To Macron Misery Index The Key Threat To Macron Misery Index The Key Threat To Macron   Le Pen has moderated her populist message and rebranded her party in recent years to better align with the median French voter. She claims that she will not pursue a withdrawal from the European Union or the Euro Area currency union. This puts her on the right side of the one issue that disqualified her from the presidency in the past. Yet French trust in the EU is declining markedly, which suggests that Le Pen is in step with the median voter on wanting greater French autonomy (Chart 9). Le Pen’s well-known sympathy toward Vladimir Putin and Russia is a liability in the context of Russian aggression in Ukraine. Only 35% of French people had a positive opinion of Russia back in 2019, whereas 50% had a favorable view of NATO, and the gap has likely grown as a result of the invasion (Chart 10). However, the historic bout of inflation suggests that economic policy could be the most salient issue for voters rather than foreign policy. Chart 9Le Pen Only Electable Because She Accepted Europe Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) ​​​​​ Chart 10Le Pen’s NATO Stance Not Disqualifying Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) ​​​​​ Le Pen’s economic platform is fiscally liberal and protectionist, which will appeal to voters upset over the rising cost of living and pressures of globalization. She wants to cut the income tax and value-added tax, while reversing Macron’s attempt at raising the retirement age and reforming the pension system. France’s tax rates on income, and on gasoline and diesel, are higher than the OECD average. In other words, Macron is running on painful structural reform while Le Pen is running on fiscal largesse. This is another reason to take seriously the risk of a Le Pen victory. What should investors expect if Le Pen pulls off an upset? France’s attempt at neoliberal structural reforms would grind to a halt. While Le Pen may not be able to pass domestic legislation, she would be able to halt the implementation of Macron’s reforms. Productivity and the fiscal outlook would suffer. Le Pen’s ability to change domestic policy will be limited by the National Assembly, which is due for elections from June 12-19. Her party, the National Rally (formerly the Front National), has never won more than 20% of local elections and performed poorly in the 2017 legislative vote. Investors should wait to see the results of the legislative election before drawing any conclusions about Le Pen’s ability to change domestic policy. France’s foreign policy would diverge from Europe’s. If Le Pen takes the presidency, she will put France at odds with Brussels, Berlin, and Washington, in much the same way that President Trump did. She would paralyze European policymaking. Yet Le Pen alone cannot take France out of the EU. The French public’s negative view of the EU is not the same as a majority desire to leave the bloc – and support for the euro currency stands at 69%. Le Pen does not have the support for “Frexit,” French exit from the EU. Moreover European states face immense pressures to work together in the context of global Great Power Rivalry. Independently they are small compared to the US, Russia, and China. Hence the EU will continue to consolidate as a geopolitical entity over the long run. Russia, however, would benefit from Le Pen’s presidency in the context of Ukraine ceasefire talks. EU sanctions efforts would freeze in place. Le Pen could try to take France out of NATO, though she would face extreme opposition from the military and political establishment. If she succeeded on her own executive authority, the result would be a division among NATO’s ranks in the face of Russia. This cannot be ruled out: if the US and Russia are fighting a new Cold War, then it is not unfathomable that France would revert to its Cold War posture of strategic independence. However, while France withdrew from NATO’s integrated military command from 1966-2009, it never withdrew fully from the alliance and was always still implicated in mutual defense. In today’s context, NATO’s deterrent capability would not be much diminished but Le Pen’s administration would be isolated. Russia would be unable to give any material support to France’s economy or national defense. Bottom Line: Macron is still favored for re-election but investors should upgrade Le Pen’s chances to a subjective 45%. If she wins, the euro will suffer a temporary pullback and French government bond spreads will widen over German bunds. The medium-term view on French equities and bonds will depend on her political capability, which depends on the outcome of the legislative election from June 12-19. She will likely be stymied at home and only capable of tinkering with foreign policy. But if she has legislative support, her agenda is fiscally stimulative and would produce a short-term sugar high for French corporate earnings. However, it would be negative for long-term productivity. UK, Italy, Spain: Who Else Faces Populism? Chart 11Rest Of Europe: GeoRisk Indicators Rest Of Europe: GeoRisk Indicators Rest Of Europe: GeoRisk Indicators Between Russian geopolitical risk and French political risk, other European countries are likely to see their own geopolitical risk premium rise (Chart 11). But these countries have their own domestic political dynamics that contribute to the reemergence of European political risk. Germany’s domestic political risk is relatively low but it faces continued geopolitical risk in the form of Russia tensions, China’s faltering economy, and potentially French populism (Chart 11, top panel). In Italy, the national unity coalition that took shape under Prime Minister Mario Draghi was an expedient undertaken in the face of the pandemic. As the pandemic fades, a backlash will take shape among the large group of voters who oppose the EU and Italian political establishment. The Italian establishment has distributed the EU recovery funds and secured the Italian presidency as a check on future populist governments. But it may not be able to do more than that before the next general election in June 2023, which means that populism will reemerge and increase the political risk premium in Italian assets going forward (Chart 11, second panel). Spain is still a “divided nation” susceptible to a rise in political risk ahead of the general election due by December 10, 2023. However, the conservative People’s Party, the chief opposition party, has suffered from renewed infighting, which gives temporary relief to the ruling Socialist Worker’s Party of Prime Minister Pedro Sanchez. The Russia-Ukraine issue caused some minor divisions within the government but they are not yet leading to any major political crisis, as nationwide pro-Ukraine sentiment is largely unified. The Andalusia regional election, which is expected this November, will be a check point for the People’s Party’s new leadership and a test run for next year’s general election. Andalusia is the most populous autonomous community in Spain, consisting about 17% of the seats in the congress (the lower house). The risk for Sanchez and the Socialists is that the opposition has a strong popular base and this fact combined with the stagflationary backdrop will keep political polarization high and undermine the government’s staying power (Chart 11, third panel). While Prime Minister Boris Johnson has survived the scandal over attending social events during Covid lockdowns, as we expected, nevertheless the Labour Party is starting to make a comeback that will gain momentum ahead of the 2024 general election. Labour is unlikely to embrace fiscal austerity or attempt to reverse Brexit anytime soon. Hence the UK’s inflationary backdrop will persist (Chart 11, fourth panel). Bottom Line: European political risk has bottomed and will rise in the coming months and years, although the EU and Eurozone will survive. We still favor UK equities over developed market equities (excluding the US) because they are heavily tilted toward consumer staples and energy sectors. Stay long GBP-CZK. Favor European defense stocks over tech. Prefer Spanish stocks over Italian. China: Social Unrest More Likely China’s historic confluence of internal and external risks continues – and hence it is too soon for global investors to try to bottom-feed on Chinese investable equities (Chart 12). A tactical opportunity might emerge for non-US investors in 2023 but now is not the right time to buy. Chart 12China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator In domestic politics, the reversion to autocracy under Xi is exacerbating the economic slowdown. True, Beijing is stimulating the economy by means of its traditional monetary and fiscal tools. The latest data show that the total social financing impulse is reviving, primarily on the back of local government bonds (Chart 13). Yet overall social financing is weaker because private sector sentiment remains downbeat. The government is pursuing excessively stringent social restrictions in the face of the pandemic. Beijing is doubling down on “Covid Zero” policy by locking down massive cities such as Shanghai. The restrictions will fail to prevent the virus from spreading. They are likely to engender social unrest, which we flagged as our top “Black Swan” risk this year and is looking more likely. Lockdowns will also obstruct production and global supply chains, pushing up global goods inflation. Meanwhile the property sector continues to slump on the back of weak domestic demand, large debt levels, excess capacity, regulatory scrutiny, and negative sentiment. Consumer borrowing appetite and general animal spirits are weak in the face of the pandemic and repressive political environment (Chart 14). Chart 13China's Stimulus Has Clearly Arrived China's Stimulus Has Clearly Arrived China's Stimulus Has Clearly Arrived ​​​​​​ Chart 14Yet Chinese Animal Spirits Still Suffering Yet Chinese Animal Spirits Still Suffering Yet Chinese Animal Spirits Still Suffering ​​​​​​ Hence China will be exporting slow growth and inflation – stagflation – to the rest of the world until after the party congress. At that point President Xi will feel politically secure enough to “let 100 flowers bloom” and try to improve economic sentiment at home and abroad. This will be a temporary phenomenon (as were the original 100 flowers under Chairman Mao) but it will be notable for 2023. In foreign politics, Russia’s attack on Ukraine has accelerated the process of Russo-Chinese alliance formation. This partnership will hasten US containment strategy toward China and impose a much faster economic transition on China as it pursues self-sufficiency. The result will be a revival of US-China tensions. The implications are negative for the rest of Asia Pacific: Taiwanese geopolitical risk will continue rising for reasons we have outlined in previous reports. In addition, Taiwanese equities are finally starting to fall off from the pandemic-induced semiconductor rally (Chart 15). The US and others are also pursuing semiconductor supply security, which will reduce Taiwan’s comparative advantage. Chart 15Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator South Korea faces paralysis and rising tensions with North Korea. The presidential election on May 9 brought the conservatives back into the Blue House. The conservative People Power Party’s candidate, Yoon Suk-yeol, eked out a narrow victory that leaves him without much political capital. His hands are also tied by the National Assembly, at least for the next two years. He will attempt to reorient South Korean foreign policy toward the US alliance and away from China. He will walk away from the “Moonshine” policy of engagement with North Korea, which yielded no fruit over the past five years. North Korea has responded by threatening a nuclear missile test, restarting intercontinental ballistic missile tests for the first time since 2017, and adopting a more aggressive nuclear deterrence policy in which any South Korean attack will ostensibly be punished by a massive nuclear strike. Tensions on the peninsula are set to rise (Chart 16). Three US aircraft carrier groups are around Japan today, despite the war in Europe (where two are placed), suggesting high threat levels. Chart 16South Korea: GeoRisk Indicator South Korea: GeoRisk Indicator South Korea: GeoRisk Indicator Australia’s elections present opportunity rather than risk. Prime Minister Scott Morrison formally scheduled them for May 21. The Australian Labor Party is leading in public opinion and will perform well. The election threatens a change of parties but not a drastic change in national policy – populist parties are weak. No major improvement in China relations should be expected. Any temporary improvement, as with the Biden administration, will be subject to reversal due to China’s long-term challenge to the liberal international order. Cyclically the Australian dollar and equities stand to benefit from the global commodity upcycle as well as relative geopolitical security due to American security guarantees (Chart 17). Chart 17Australia: GeoRisk Indicator Australia: GeoRisk Indicator Australia: GeoRisk Indicator Bottom Line: China’s reversion to autocracy will keep global sentiment negative on Chinese equities until 2023 at earliest. Stay short the renminbi and Taiwanese dollar. Favor the Japanese yen over the Korean won. Favor South Korean over Taiwanese equities. Look favorably on the Australian dollar. Turkey, South Africa, And … Canada Turkish geopolitical risk will remain elevated in the context of a rampant Russia, NATO’s revival and tensions with Russia, the threat of commerce destruction and accidents in the Black Sea region, domestic economic mismanagement, foreign military adventures, and the threat posed to the aging Erdogan regime by the political opposition in the wake of the pandemic and the lead-up to the 2023 elections (Chart 18). Chart 18Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator While we are tactically bullish on South African equities and currency, we expect South African political risk to rise steadily into the 2024 general election. Almost a year has passed since the civil unrest episode of 2021. Covid-19 lockdowns have been lifted and the national state of disaster has ended, which has helped quell social tensions. This is evident in the decline of our South Africa GeoRisk indicator from 2021 highs (Chart 19). While fiscal austerity is under way in South Africa, we have argued that fiscal policy will reverse course in time for the 2024 election. In this year’s fiscal budget, the budget deficit is projected to narrow from -6% to -4.2% over the next two years. Government has increased tax revenue collection through structural reforms that are rooting out corruption and wasteful expenditure. But the ANC will have to tap into government spending to shore up lost support come 2024. Thus South Africa benefits tactically from commodity prices but cyclically the currency is vulnerable. Chart 19South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Canadian political risk will rise but that should not deter investors from favoring Canadian assets that are not exposed to the property bubble. Prime Minister Justin Trudeau has had a net negative approval rating since early 2021 and his government is losing political capital due to inflation, social unrest, and rising difficulties with housing affordability (Chart 20). While he does not face an election until 2025, the Conservative Party is developing more effective messaging. Chart 20Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator India Will Stay Neutral But Lean Toward The West Chart 21Sino-Pak Alliance’s Geopolitical Power Is Thrice That Of India Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) US President Joe Biden has openly expressed his administration’s displeasure regarding India’s response to Russia’s invasion of Ukraine. This has led many to question the strength of Indo-US relations and the direction of India’s geopolitical alignments. To complicate matters, China’s overtures towards India have turned positive lately, leading clients to ask if a realignment in Indo-China relations is nigh. To accurately assess India’s long-term geopolitical propensities, it is important to draw a distinction between ‘cyclical’ and ‘structural’ dynamics that are at play today. Such a distinction yields crystal-clear answers about India’s strategic geopolitical leanings. In specific: Indo-US Relations Will Strengthen On A Strategic Horizon: As the US’s and China’s grand strategies collide, minor and major geopolitical earthquakes are bound to take place in South Asia and the Indo-Pacific. Against this backdrop, India will strategically align with the US to strengthen its hand in the region (Chart 21). While the Russo-Ukrainian war is a major global geopolitical event, for India this is a side-show at best. True, India will retain aspects of its historic good relations with Russia. Yet countering China’s encirclement of India is a far more fundamental concern for India. Since Russia has broken with Europe, and China cannot reject Russia’s alliance, India will gradually align with the US and its allies. India And China Will End Up As A Conflicting Dyad: Strategic conflict between the two Asian powers is likely because China’s naval development and its Eurasian strategy threaten India’s national security and geopolitical imperatives, while India’s alliances are adding to China’s distrust of India. Thus any improvement in Sino-Indian diplomatic relations will be short-lived. The US will constantly provide leeway for India in its attempts to court India as a key player in the containment strategy against China. The US and its allies are the premier maritime powers and upholders of the liberal world order – India serves its national interest better by joining them rather than joining China in a risky attempt to confront the US navy and revolutionize the world order. Indo-Russian Relations Are Bound To Fade In The Long Run: India will lean towards the US over the next few years for reasons of security and economics. But India’s movement into America’s sphere of influence will be slow – and that is by design. India is testing waters with America through networks like the Quadrilateral Dialogue. It sees its historic relationship with Russia as a matter of necessity in the short run and a useful diversification strategy in the long run. True, India will maintain a trading relationship with Russia for defense goods and cheap oil. But this trade will be transactional and is not reason enough for India to join Russia and China in opposing US global leadership. While these factors will mean that Indo-Russian relations are amicable over a cyclical horizon, this relationship is bound to fade over a strategic horizon as China and Russia grow closer and the US pursues its grand strategy of countering China and Russia. Bottom Line: India may appear to be neutral about the Russo-Ukrainian war but India will shed its historical stance of neutrality and veer towards America’s sphere of influence on a strategic timeframe. India is fully aware of its strategic importance to both the American camp and the Russo-Chinese camp. It thus has the luxury of making its leanings explicit after extracting most from both sides. Long Brazil / Short India Brazil’s equity markets have been on a tear. MSCI Brazil has outperformed MSCI EM by 49% in 2022 YTD. Brazil’s markets have done well because Brazil is a commodity exporter and the war in Ukraine has little bearing on faraway Latin America. This rally will have legs although Brazil’s political risks will likely pick back up in advance of the election (Chart 22). The reduction in Brazil’s geopolitical risk so far this year has been driven mainly by the fact that the currency has bounced on the surge in commodity prices. In addition, former President Lula da Silva is the current favorite to win the 2022 presidential elections – Lula is a known quantity and not repugnant to global financial institutions (Chart 23). Chart 22Brazil's Markets Have Benefitted From Rising Commodity Prices Brazil's Markets Have Benefitted From Rising Commodity Prices Brazil's Markets Have Benefitted From Rising Commodity Prices Chart 23Brazil: Watch Out For Political Impact Of Commodity Prices Brazil: Watch Out For Political Impact Of Commodity Prices Brazil: Watch Out For Political Impact Of Commodity Prices Whilst there is no denying that the first-round effects of the Ukraine war have been positive for Brazil, there is a need to watch out for the second-round effects of the war as Latin America’s largest economy heads towards elections. Surging prices will affect two key constituencies in Brazil: consumers and farmers. Consumer price inflation in Brazil has been ascendant and adding to Brazil’s median voter’s economic miseries. Rising inflation will thus undermine President Jair Bolsonaro’s re-election prospects further. The fact that energy prices are a potent polling issue is evinced by the fact that Bolsonaro recently sacked the chief executive of Petrobras (i.e. Brazil’s largest listed company) over rising fuel costs. Furthermore, Brazil is a leading exporter of farm produce and hence also a large importer of fertilizers. Fertilizer prices have surged since the war broke out. This is problematic for Brazil since Russia and Belarus account for a lion’s share of Brazil’s fertilizer imports. Much like inflation in general, the surge in fertilizer prices will affect the elections because some of the regions that support Bolsonaro also happen to be regions whose reliance on agriculture is meaningful (Map 1). They will suffer from higher input prices. Map 1States That Supported Bolso, Could Be Affected By Fertilizer Price Surge Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) Chart 24Long Brazil Financials / Short India Long Brazil Financials / Short India Long Brazil Financials / Short India Given that Bolsonaro continues to lag Lula on popularity ratings – and given the adverse effect that higher commodity prices will have on Brazil’s voters – we expect Bolsonaro to resort to fiscal populism or attacks on Brazil’s institutions in a last-ditch effort to cling to power. He could even be emboldened by the fact that Sérgio Moro, the former judge and corruption fighter, decided to pull out of the presidential race. This could provide a fillip to Bolso’s popularity. Bottom Line: Brazil currently offers a buying opportunity owing to attractive valuations and high commodity prices. But investors should stay wary of latent political risks in Brazil, which could manifest themselves as presidential elections draw closer. We urge investors to take-on only selective tactical exposure in Brazil for now. Equities appear cheap but political and macro risks abound. To play the rally yet stave off political risk, we suggest a tactical pair trade: Long Brazil Financials / Short India (Chart 24). Whilst we remain constructive on India on a strategic horizon, for the next 12 months we worry about near-term macro and geopolitical headwinds as well as India’s rich valuations. Don’t Buy Into Pakistan’s Government Change Chart 25Pakistan’s Military Is Unusually Influential Le Pen And Other Hurdles (GeoRisk Update) Le Pen And Other Hurdles (GeoRisk Update) The newest phase in Pakistan’s endless cycle of political instability has begun. Prime Minister Imran Khan has been ousted. A new coalition government and a new prime minister, Shehbaz Sharif, have assumed power. Prime Minister Sharif’s appointment may make it appear like risks imposed by Pakistan have abated. After all, Sharif is seen as a good administrator and has signaled an interest in mending ties with India. But despite the appearance of a regime change, geopolitical risks imposed by Pakistan remain intact for three sets of reasons: Military Is Still In Charge: Pakistan’s military has been and remains the primary power center in the country (Chart 25). Former Prime Minister Khan’s rise to power was possible owing to the military’s support and he fell for the same reason. Since the military influences the civil administration as well as foreign policy, a lasting improvement in Indo-Pak relations is highly unlikely. Risk Of “Rally Round The Flag” Diversion: General elections are due in Pakistan by October 2023. Sharif is acutely aware of the stiff competition he will face at these elections. His competitors exist outside as well as inside his government. One such contender is Bilawal Bhutto-Zardari of the Pakistan People’s Party (PPP), which is a key coalition partner of the new government that assumed power. Imran Khan himself is still popular and will plot to return to power. Against such a backdrop the newly elected PM is highly unlikely to pursue an improvement in Indo-Pak relations. Such a strategy will adversely affect his popularity and may also upset the military. Hence we highlight the risk of the February 2021 Indo-Pak ceasefire being violated in the run up to Pakistan’s general elections. India’s government has no reason to prevent tensions, given its own political calculations and the benefits of nationalism. Internal Social Instability Poor: Pakistan is young but the country can be likened to a social tinderbox. Many poor youths, a weak economy, and inadequate political valves to release social tensions make for an explosive combination. Pakistan remains a source of geopolitical risk for the South Asian region. Some clients have inquired as to whether the change of government in Pakistan implies closer relations with the United States. The US has less need for Pakistan now that it has withdrawn from Afghanistan. It is focused on countering Russia and China. As such the US has great need of courting India and less need of courting Pakistan. Pakistan will remain China’s ally and will struggle to retain significant US assistance. Bottom Line: We remain strategic sellers of Pakistani equities. Pakistan must contend with high internal social instability, a weak democracy, a weak economy and an unusually influential military. As long as the military remains excessively influential in Pakistan, its foreign policy stance towards India will stay hostile. Yet the military will remain influential because Pakistan exists in a permanent geopolitical competition with India. And until Pakistan’s economy improves structurally and endemically, its alliance with China will stay strong. Investment Takeaways Cyclically go long US 10-year Treasuries. Geopolitical risks are historically high and rising but complacency is returning to markets. Meanwhile inflation is nearing a cyclical peak. Favor US stocks over global. It is too soon to go long euro or European assets, especially emerging Europe. Favor UK equities over developed markets (excluding the US). Stay long GBP-CZK. Favor European defense stocks over European tech. Stay short the Chinese renminbi and Taiwanese dollar. Favor the Japanese yen over the Korean won. Favor South Korean over Taiwanese equities.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Alice Brocheux Research Associate alice.brocheux@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar

Executive Summary From Net Borrower To Net Lenders From Net Borrower To Net Lenders From Net Borrower To Net Lenders Yields are rising across Europe. Peripheral spreads are unlikely to experience the same violent widening as last decade. Europe now has a buyer of last resort. Italy and Spain have moved from current account deficit to current account surplus nations. However, Italy and Spain are not conducting the kind of structural reforms necessary to cause public debt-to-GDP ratios to fall back below the Maastricht Treaty criteria. Nonetheless, based on our stress tests, Italian and Spanish yields can rise significantly more before debt-servicing costs become a major problem in these nations. Economic activity, not Spanish or Italian public finances, is the true constraint on European yields. Bottom Line: German yields can rise above 2% without causing a public finance crisis in Italy and Spain. To reach this level, however, nominal growth in Europe must remain robust. As a result, any pullback in yields caused by oversold conditions in the bond market will be temporary.     Year-to-date, German 10-year yields have risen more than 80bps, while spreads have widened in the periphery. This has supercharged the interest rate moves: Italian BTP yields and Spanish Bono yields are up nearly 120bps and 110bps, respectively. As a result, Italian government bonds now offer a 2.4% yield, a level not experienced durably since the first half of 2019. Meanwhile, Spanish yields are close to 1.7%—their highest levels since 2017. Investors are increasingly concerned by the damage levied by higher yields in Southern Europe. Since 2018, Italian public debt has risen by 32% of GDP to 170% of GDP, and Spanish public debt has risen by 28% of GDP to 138% of GDP. These higher debt burdens beg the following question: How high can European yields rise before a new sovereign debt crisis engulfs the Eurozone? Private sector financial balances and the balance of payments in the periphery are now very different from what they were between 2008 and 2012. As a result, the odds of a similar crisis are much lower than last decade, which should allow German yields to rise further in the coming years. Italy and Spain have moved on from experiencing an EM-style balance of payment crisis with explosive debt market dynamics. They are now stuck in a Japanese scenario of excess private sector savings and low economic growth. “This Time Is Different” These might be the four most dangerous words in finance, but understanding the differences between the present situation and the sovereign debt crisis is essential to assessing the impact of higher yields on Italian and Spanish public finances. Chart 1From Net Borrower To Net Lenders From Net Borrower To Net Lenders From Net Borrower To Net Lenders The most important transformation in the Southern European economies is the rise in private sector savings. From 1999 to 2013, Italy’s private sector financial balance averaged 2.2% of GDP. Constant government deficits resulted in a significant national dissaving, forcing the country to borrow from abroad as expressed by a current account deficit that lasted from 2000 to 2013 (Chart 1, top panel). At the present moment, Italy’s current account is in a surplus equal to 3.5% of GDP, as private savings stand at 13% of GDP, up from 5% before COVID-19. The change is even more dramatic in Spain. The Spanish private sector financial balance was in a large deficit from 1999 to 2008, which averaged 5.6% of GDP and reached a nadir of 11.3% of GDP in 2007. As a result, Spain relied on foreign lending between 1980 and 2012, with a current account deficit that averaged 3% of GDP over that period (Chart 1, second panel). The switch from the status of foreign borrower to the status of surplus nation is fundamental. A country where excess private savings are so abundant they can finance large public deficits and still generate current account surpluses will experience more limited pressure on borrowing costs than a country that needs to borrow from abroad. Japan is a perfect example. Elevated public borrowing ends up being a vehicle to absorb private sector excess savings and does not constitute profligacy. Despite higher debt loads, Italy’s public finances seem more sustainable than those of Spain. The International Monetary Fund’s (IMF) October 2021 Fiscal Monitor forecast shows the Italian primary budget balance, both on an absolute basis and on a cyclically-adjusted basis, moving from -6% and -2.9% of GDP, respectively, closer to zero by 2026 (Chart 2). In Spain, primary budget balances, both on an absolute basis and on a cyclically-adjusted basis, are anticipated to improve from -8.9% and -3.4% of GDP, respectively, to -2.5% of GDP by 2026. Despite these deficits, the IMF also expects public debt to decrease by 10% of GDP to 146% in Italy and to remain flat at 120% of GDP in Spain (Chart 3). Importantly, in both cases, the upward pressure on public debt will be limited over the next five years because private savings are already high and unlikely to rise further. Chart 2Public Deficits Will Narrow Further Public Deficits Will Narrow Further Public Deficits Will Narrow Further Chart 3Debt Will Stay High, So Will Private Savings Debt Will Stay High, So Will Private Savings Debt Will Stay High, So Will Private Savings The role of the European Central Bank (ECB) as a backstop also contributes to creating a different environment than the one that prevailed prior to the “whatever it takes” era. Before Mario Draghi’s landmark July 2012 speech, there was no explicit buyer of last resort in the European sovereign debt market. Now, there is one, and its presence limits how rapidly private sector buyers might lose confidence in a country’s bond market and how far spreads can widen, even if the central bank buying has its own limit. In fact, Draghi’s forward guidance calmed the markets and caused a 250bps and 280bps collapse in Italian and Spanish 10-year yields before the ECB had even purchased a single BTP or Bono. The role of the ECB as a buyer of last resort remains crucial going forward. Yields in Italy and Spain are still 480bps and 600bps below their 2011-2012 peaks at a time when investors anticipate an end to the PEPP and APP purchases. Importantly, these spreads are narrower, even though the APP and the PEPP have purchased far more German and French sovereign bonds than Italian and Spanish bonds (Chart 4). As long as the ECB continues to emphasize that it maintains its optionality to support Italian and Spanish bond markets, even as its asset purchases end, peripheral spreads will not move back above 300bps, especially since Euroscepticism is not the risk it once was (Chart 5). Chart 4Germany and France, Not Spain and Italy, Dominated PEPP Buying Stress Testing Italian And Spanish Yields Stress Testing Italian And Spanish Yields Chart 5Euroscepticism on the Wane Euroscepticism on the Wane Euroscepticism on the Wane Bottom Line: As illustrated by the evolution of their current account balances, peripheral Eurozone economies have moved from deep savings deficits to a state of surplus savings. This makes them less vulnerable to the funding crises that prompted the European sovereign debt crisis. Moreover, the Eurozone now has a buyer of last resort for sovereign bonds: the post-Draghi ECB. Its presence, not its continued buying, creates the necessary insurance to limit buying strikes by the private sector, which also curtails how far Italian or Spanish spreads can widen. Long-Term Problems Abound In the long term, Italy and Spain will only be able to curtail government debt-to-GDP ratios meaningfully if trend growth recovers. This means more reforms are needed to boost productivity and labor participation rates (Chart 6). Chart 6Reforms, Not Austerity, Will Bring Debt Down Below Maastricht Levels Stress Testing Italian And Spanish Yields Stress Testing Italian And Spanish Yields Chart 7Competitiveness Problems In The Periphery Competitiveness Problems In The Periphery Competitiveness Problems In The Periphery For now, the picture remains bleak. Spain emerged out of the sovereign debt crisis with strong reform zeal. The Mariano Rajoy government reformed pensions and the labor market, which prompted a significant decline in unit labor costs compared to the Euro Area average. The pace of reforms has slowed, however, and the Pedro Sánchez government has eroded some of its predecessor’s efforts. As a result, since 2018, Spanish unit labor costs have increased once again relative to the rest of the Eurozone (Chart 7). Italy never implemented significant reforms, because it has long been beset by political paralysis. Unit labor costs are not outstripping the rest of the Eurozone, but productivity continues to lag. Economic growth in Italy and Spain will remain tepid in the coming years, which will prevent any meaningful decline in debt. The poor trend in relative competitiveness and productivity of the past few years is unlikely to be undone. Work by the OECD shows that prior to the pandemic, Spain and Italy had shifted away from being among the leading reformers in Europe. Instead, this role now falls to France, Greece, Austria, and Germany (Chart 8), which confirms last week’s analysis that France’s reform effort remains serious, even if it is less ambitious than what transpired over the past five years.  As a consequence of slow growth, investment in Spain and Italy will trail behind the rest of the Eurozone. Thus, private sector savings will remain elevated and private nonfinancial sector debt loads are unlikely to increase meaningfully (Chart 9). As a result, the public sector will continue to absorb the private sector’s excess savings, which means that the debt-to-GDP ratio could sustain more upside pressure than what either the IMF or the OECD anticipate. Chart 8Italy And Spain As Reform Laggards Stress Testing Italian And Spanish Yields Stress Testing Italian And Spanish Yields Chart 9Private Debt Is Not The Problem Private Debt Is Not The Problem Private Debt Is Not The Problem These dynamics bear a striking resemblance to what happened in Japan. They also imply that Italy and Spain will remain a drag on European growth for years to come, as long as the fundamental reasons behind the private sector’s elevated savings rate are not addressed. Bottom Line: Italian and Spanish public debt-to-GDP ratios will continue to deteriorate as reform efforts are too tepid to lift durably trend GDP growth. Their private sectors will continue to save more than they invest, which, in turn, will push government debt higher. The Italian and Spanish economies will remain a drag on European growth for the foreseeable future. Stress Test Scenarios How high can yields rise in the Eurozone before Italy and Spain experience meaningful funding stresses? We explore two scenarios: one in which 10-year yields rise by an additional 2%, and a very aggressive scenario in which they rise a whopping 5%, bringing Italian and Spanish borrowing costs in the vicinity of the European debt crisis of 2011-2012. To conduct this experiment, we use a simple approach of regressing debt-service payments as a share of GDP on the level of yields. Modeling debt payments in euros was another alternative, but yield levels are also affected by the evolution of nominal GDP. As a result, using this approach considers both the numerator and the denominator of the debt-service payment modeling. Chart 10Private Debt Is Not The Problem Private Debt Is Not The Problem Private Debt Is Not The Problem Under the first scenario, Italian 10-year yields would rise to 4.4% from 2.4% today. This is still well below the 7.5% yield recorded in late 2011. In this context, government debt servicing would reach 4.5% of GDP, which is comparable to the average that prevailed prior to the Euro Area crisis (Chart 10). This suggests that Italian yields slightly above 4% are still somewhat manageable, albeit far from ideal. Under the second scenario, 10-year BTP yields would rise to 7.4% from 2.4% today. This is comparable to the level of yields observed at the apex of the European sovereign debt crisis, but it assumes that this yield level would remain in place for a year. As a result of the higher debt load today compared to a decade ago, the resulting debt-servicing costs have reached 5.4% of GDP, which is higher than those between 2012 and 2013 (Chart 10). This scenario is clearly unsustainable and suggests that yields of this magnitude would cripple the Italian government. Moving to Spain, the dynamics are slightly different. Spain’s refinancing schedule is more front-loaded than that of Italy. As a result, using the yields on 10-year Bonos as an independent variable in our regression approach does not explain well the evolution of Spanish debt-servicing costs. Instead, a simple regression model using both 3-year and 10-year yields does a much better job, because it reflects the heavier rollover of Spanish debt. Chart 11Stress Testing Spanish Public Finances Stress Testing Spanish Public Finances Stress Testing Spanish Public Finances In the first scenario, 3-year yields would rise by 1% to 1.7% and 10-year yields would increase from 2% to 3.7%, well below the 7% yields that prevailed in 2012. As a result, the Spanish government’s debt-servicing costs would be expected to rise to 2.8% of GDP, which is well below the levels that prevailed at the apex of the European debt crisis, but still above the level that existed in the first decade following the introduction of the euro (Chart 11). While far from ideal, this level is easily manageable for the Spanish government and is comparable to the Eurozone average prior to 2008. In the second scenario, 3-year yields are assumed to rise 2.5% to 3.2% and 10-year yields to increase an extra 5% to 6.7%, still slightly shy of the 7% yields from 2012. In this scenario, debt servicing costs are expected to jump above 3.5% of GDP (Chart 11) and are unsustainable unless nominal GDP growth remains above 7% and the primary budget balance improves to zero. As a result, an increase in Bono yields toward 7% is far too high for the Spanish government to withstand. We acknowledge that, although it points to an upper bound in yields, the second scenario is highly unlikely for several reasons. First, a 500bps increase in 10-year yields would far exceed the roughly 350bps rise experienced during the sovereign debt crisis of the previous decade. More importantly, many factors have changed since then: Spain and Italy’s shift from borrowing nations to surplus savings nations, the role of the ECB as buyer of last resort, greater support for the euro across all the Eurozone nations, and greater unity among EU countries as exemplified by the NextGenerationEU (NGEU) program. The first scenario would be painful but manageable for both Italy and Spain. It suggests that peripheral yields may rise meaningfully in the coming years, especially if nominal GDP growth remains higher than it was last decade when fiscal austerity was Europe’s mantra. However, fiscal austerity was self-defeating because, the more orthodox countries tried to be, the worse their growth was, making debt arithmetic unmanageable (Chart 12). Chart 12Counterproductive Austerity Stress Testing Italian And Spanish Yields Stress Testing Italian And Spanish Yields We can go one step further. Even if Italian and Spanish spreads widen another 100bps from this point on and settle between 200bps and 300bps above German yields, European public finances can withstand German yields rising to 2%. This seems surprising, but we cannot forget the context. German yields cannot reach those levels in a vacuum. If they increase that much, it is because nominal growth is strong, which makes debt arithmetic more manageable in the European periphery. Statistically, the relationship between Spanish debt servicing costs and German yields is negative, while the link between Italian debt servicing costs and German yields is statistically low, underscoring the role of growth. However, if German yields were to rise as Europe’s nominal GDP growth settled back to last decade’s range, then Italian and Spanish debt would implode. This is a far-fetched scenario; even the recent ECB’s pivot reflects stronger nominal activity. This does not mean that German yields will rise above 2% in the next five years, but rather it highlights that economic activity, not the peripheral nations’ public finances, is the true constraint on European yields. Bottom Line: The ECB’s role as a buyer of last resort, the shift to savings surpluses in Italy and Spain, as well as the greater European unity and lower Euroscepticism prevalent across the continent limit how far spreads can rise in the periphery. In this context, Spain and Italy can withstand higher yields than those of the last decade, since these higher borrowing costs reflect stronger nominal economic activity. Ultimately, the true constraint on German yields is not the finances of Southern Europe, but rather the state of economic growth in the Eurozone. Conclusions Related Report  European Investment StrategyThe Lasting Bond Bear Market European yields continue to have significant upside, as we expect European growth to remain stronger than it was last decade even if Italy and Spain will continue to lag behind the rest of Europe. As we observed two weeks ago, Europe is no longer burdened by untimely fiscal austerity. Furthermore, the efforts to decrease the energy dependence on Russia and modernize the European economy will continue to support capex and aggregate demand. The upper band on German yields seems to be around 2%, assuming that Italian and Spanish spreads rise 100bps to 150bps over the coming years. Even the banking sector in the periphery can withstand significant upside in bond yields. BTPs and Bonos represent 11% and 6.8% of the Spanish and Italian financial sectors’ balance sheet, respectively (Chart 13). This is much higher than the role of OATs and Bunds in the French and German financial sectors, but Spanish and Italian banks have much lower NPLs and enjoy much more robust Tier-1 capital ratios than they did a decade ago (Chart 14). As a result, the doom-loop that plagued those economies ten years ago is not as pronounced. In fact, bank lending rates in Italy and Spain are now lower than they are in Germany, which contrasts greatly with the previous decade (Chart 14, bottom panel). Chart 13Exposure To The Home Country Exposure To The Home Country Exposure To The Home Country Chart 14Improved Bank Health In The Periphery Improved Bank Health In The Periphery Improved Bank Health In The Periphery Bottom Line: Bonds around the world and in Europe are massively oversold and are due for a countertrend rally. This pullback in yields, however, will be transitory. Higher trend nominal GDP growth around the world and in Europe indicates that yields have much further to rise over the next five years.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary Our recommended model bond portfolio outperformed its custom index by a robust +48bps in Q1/2022 – an impressive performance given the significant uncertainties stemming from the Ukraine war, surging commodity prices and hawkish central banks. This outperformance came entirely from the rates side of the portfolio (+52bps) as global government bond yields surged, driven by a large underweight to US Treasuries. The credit side of the portfolio was largely unchanged versus the benchmark (-4bps). Looking ahead, we see global bond yields as being more rangebound over the next six months. A lot of rate hikes in 2022 are already discounted (most notably in the US) and global inflation is likely to decelerate in Q2 & Q3. As the global monetary tightening cycle evolves, positioning more defensively in global credit, rather than duration management, will provide the better opportunity to generate alpha in bond portfolios. GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Bottom Line: In our model bond portfolio, we are downgrading US investment grade corporates to underweight, and reducing high-yield exposure in the US and Europe to neutral. We are also reducing inflation-linked bond allocations in the US and euro area to underweight versus nominals. Feature The first three months were horrific for global bond markets. The Bloomberg Global Aggregate index delivered a total return of -6.2%, the second worst quarter since 1990. No sector, from government bonds to corporate debt to emerging market spread product, was immune to the pressures from soaring energy prices, war-driven uncertainty and hawkish central bankers belated responding to the worst bout of global inflation since the 1970s. Related Report  Global Fixed Income StrategyOur Model Bond Portfolio Strategy To Begin 2022: Choosing Our Battles Wisely That toxic cocktail for bond returns may lose some potency in the coming months if a de-escalation of the Ukraine tensions can be reached. However, the bigger drivers of bond market volatility – high global inflation and the monetary tightening necessary to combat it – are more likely to linger for longer than expected. Government bond yields are unlikely to fall much in this environment. Increasingly, global credit spreads, especially for corporate debt in the US, will face intensifying widening pressure as central banks rapidly dial back pandemic-era monetary accommodation, led by the US Federal Reserve. With that in mind, we present our quarterly review of the BCA Research Global Fixed Income Strategy (GFIS) model bond portfolio for the first quarter of 2022. We also present our recommended positioning for the portfolio for the next six months, as well as portfolio return expectations for our base case and alternative investment scenarios. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. We do this by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q1/2022 Model Bond Portfolio Performance: Regional Allocation Drives Outperformance Chart 1Q1/2022 Performance: Big Gains From Rising Bond Yields Q1/2022 Performance: Big Gains From Rising Bond Yields Q1/2022 Performance: Big Gains From Rising Bond Yields The total return for the GFIS model portfolio (hedged into US dollars) in the third quarter was -4.6%, outperforming the custom benchmark index by +48bps (Chart 1).1 In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +52bps of outperformance versus our custom benchmark index while the latter underperformed by -4bps. In an extremely negative quarter for fixed income both in terms of the breadth and depth of losses, our regional allocation choices helped us continue generating outperformance after we transitioned to a neutral overall portfolio duration stance in mid-February. Throughout the quarter, we maintained a significant underweight on US Treasuries in the portfolio, even after we tactically upgraded our duration tilt. We expected US government debt to still underperform that of other developed markets, even in an environment where the rise in global bond yields was due for a breather. Our rationale worked – admittedly helped by the inflationary shock of the Russian invasion of Ukraine - with the US Treasury part of our portfolio generating a whopping +63bps of outperformance (Table 1). Table 1GFIS Model Bond Portfolio Q1/2022 Overall Return Attribution GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Meanwhile, our biggest government bond overweights were in Europe, a market we expected to perform defensively in a portfolio context. We were obviously caught offside on this call as energy prices and inflation expectations in Europe surged in response to the Ukraine conflict. In total, our portfolio lost -30bps in active return terms in euro area government bonds, with the losses spread evenly between the core and periphery. We did staunch the bleeding somewhat by reducing our allocation to the periphery in the last two weeks of the quarter and using the proceeds to fund an increased allocation to European investment grade corporates. The European corporate index spread has tightened -23bps since that switch. Turning to the credit side of the portfolio, the most successful position was our underweight tilt on emerging market (EM) USD-denominated corporates (+10bps) and sovereigns (+9bps) during a catastrophic quarter for EM risky assets driven by the conflict as well as weakness in the Chinese economy. We sustained losses from our overweight on US CMBS (-11bps) which was broadly offset by gains from our underweight on US MBS (+10bps). Lastly, while we were hurt by the sell-off in euro area high-yield (-13bps), where we were overweight to start 2022, we did scale back some of that exposure towards the end of the quarter when markets started to discount the risk of a “worst case” scenario of direct NATO intervention in Ukraine. The bar charts showing the total and relative returns for each individual government bond market and spread product sector in our model portfolio are presented in Charts 2 & 3. Chart 2GFIS Model Bond Portfolio Q1/2022 Government Bond Performance Attribution GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Chart 3GFIS Model Bond Portfolio Q1/2022 Spread Product Performance Attribution By Sector GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Biggest Outperformers: Underweight US Treasuries with a maturity greater than 10 years (+23bps) Underweight UK Gilts with a maturity greater than 10 years (+14bps) Underweight US treasuries with a maturity between 3 and 5 years (+12bps) Biggest Underperformers: Overweight euro area high-yield corporates (-13bps) Overweight US CMBS (-11bps) Overweight Spanish Bonos (-5bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q1/2022. Returns are hedged into US dollars (we do not take active currency risk in this portfolio) and adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color coded the bars in each chart to reflect our recommended investment stance for each market during Q1 (red for underweight, dark green for overweight, gray for neutral). Chart 4Ranking The Winners & Losers From The GFIS Model Bond Portfolio Universe In Q1/2022 GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. That pattern largely held true in Q1/2022, especially at the tail ends of the chart. During a quarter where all the major asset classes in our portfolio lost money on a hedged and duration-matched basis, we outperformed by selectively underweighting the worst performers. Notably, we were underweight UK Gilts (-1280bps) and EM Sovereigns (-1103bps) on the extreme right side of the chart. We were also underweight US Treasuries (-531bps) which, despite being in the middle of Chart 4, contributed hugely to our portfolio outperformance due to their large market cap weighting in the benchmark index. Broadly, this means that, except for Europe and Australia, our highest conviction calls worked in our favor during the quarter. Bottom Line: Our model bond portfolio outperformed its benchmark index in the third quarter of the year by +48bps – a positive result coming largely from underweight positions in US Treasuries, UK Gilts, and EM credit. Changes To Our Model Bond Portfolio Allocations The uncertainty stemming from the Russia/Ukraine conflict led us to temporarily neutralize many of the recommended exposures in the model bond portfolio. We not only moved to neutral on overall portfolio duration, we also neutralized individual country yield curve tilts and inflation-linked bond allocations. While the situation remains fluid, the worst-case scenarios of the conflict expanding beyond the borders of Ukraine appear to have been avoided. This leads us to reconsider where to once again take active risks on the rates side of the portfolio. Chart 5Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Our Duration Indicator Calling For Slowing Global Yield Momentum Duration On overall portfolio duration, we are maintaining a neutral (“at benchmark”) stance in the portfolio. Our Global Duration Indicator is currently signaling that the strong upward momentum of global bond yields should fade over the next few months (Chart 5). Slowing global growth expectations – a trend that was already in place prior to the Ukraine conflict - are the major reason why our Duration Indicator has turned lower. The war-fueled surge in energy prices has helped push global bond yields higher through rising inflation breakevens, which also prompted central banks – most notably the Fed and the Bank of England (BoE)- to signal a need for a faster pace of interest rate hikes in 2022 despite softening growth momentum. Looking ahead, that strong link between oil prices and bond yields will not be broken until there is some sort of de-escalation of the Ukraine conflict, which does not appear imminent. This supports a near-term neutral overall duration stance. Yield Curve Allocations In terms of yield curve exposure, we see some opportunities to adjust allocations (Chart 6). US curves have inverted and UK curves are flirting with inversion as markets are pricing in more Fed/BoE tightening, while curves in Germany and France have bear-steepened with longer-term inflation expectations going up faster than shorter-term interest rate expectations. In the US and UK, the yield curve flattening also reflects the “front loading” of Fed/BoE rate hike expectations. Overnight index swap (OIS) curves are pricing in 190bps of rate hikes in the US, and 134bps in the UK, by the end of 2022. This is followed quickly by rate cuts discounted in H2/2023 and 2024 in both countries. We see it as more likely that both central banks will deliver fewer hikes than discounted in 2022 and but will push rates to higher levels than priced by the end of 2024. That leads us to add a mild steepening bias into our US and UK government bond allocations in the model bond portfolio. We offset that by inserting a flattening bias in the German and French yield curve allocations to keep the overall portfolio duration at 7.5 years, matching that of the custom benchmark index (Chart 7). Chart 6Curve Flattening In The US & UK Is Overdone Curve Flattening In The US & UK Is Overdone Curve Flattening In The US & UK Is Overdone ​​​​​ Chart 7Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral Overall Portfolio Duration: Stay Neutral ​​​​​ Chart 8No Change To Our Country Allocations To Begin Q2/22 No Change To Our Country Allocations To Begin Q2/22 No Change To Our Country Allocations To Begin Q2/22 Country Allocations Turning to our country allocations, we see no need to make major changes right now (Chart 8). We still prefer to maintain an underweight stance on countries that are more likely to see multiple central bank rate hikes in 2022 (the US, UK, Canada) versus those that are less likely (Germany, France, Japan, Australia). We are also staying neutral on Italian and Spanish government bonds with the ECB set to taper the pace of its asset purchases in Q2. Less ECB buying raises the risk that higher yields will be required to entice private sector buyers to buy Italian and Spanish debt with a smaller central bank backstop. Inflation-Linked Bonds Our Comprehensive Breakeven Inflation (CBI) indicators assess the potential for a significant move in 10-year breakeven inflation rates, based on deviations from variables that typically correlate with breakevens like oil prices or survey-based measures of inflation expectations. At the moment, none of the CBIs for the eight countries in our model bond portfolio are below zero (Chart 9), which would be a signal that breakevens are too low and can move higher. Chart 9Inflation-Linked Bond Exposure: Reduce Europe & The US, Increase Canada GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Canada has the lowest CBI, and last week, we added a tactical trade to go long 10-year Canadian inflation breakevens. We will add that position to our model bond portfolio this week, moving the Canadian “linkers” allocation to overweight versus nominal Canadian government bonds (within an overall underweight allocation to Canada in the model bond portfolio). On the other side of our CBI rankings are countries where the CBIs are well above zero and breakevens are more stretched: Germany, Italy, France and the US. We are currently neutral inflation-linked bonds in those four countries, but strictly as a hedge against the war-fueled risks of further increases in oil prices. Now, however, 10-year breakevens have widened to levels that already factor in more expensive oil, even with oil prices struggling to break out to new highs. As a result, we are downgrading the allocation to linkers in Germany, Italy, France and the US to underweight within the model bond portfolio (Chart 10). Corporate Bonds The most meaningful changes we are making to our model bond portfolio, and in our strategic investment recommendations, are to our corporate bond allocations: We are downgrading US investment grade corporate bond exposure from neutral to underweight (2 out of 5) We are downgrading US high-yield corporate bond exposure from overweight to neutral (3 out of 5) We are also downgrading euro area high-yield exposure from overweight to neutral (3 out of 5) Credit spreads across the developed market and EM space have fully unwound the surge seen after Russia invaded Ukraine on February 24 (Chart 11). We had turned more cautious on global spread product exposure in early March because of the war-fueled shock to energy prices and investor sentiment. We viewed this as a bigger issue for European and EM credit, with Europe heavily reliant on Russian energy supplies and EM market liquidity impacted by bans on trading of Russian assets. We therefore reduced exposures to European high-yield and EM hard currency debt in the model bond portfolio. Chart 10Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Our Inflation-Linked Bond Country Allocations Now, while markets have become more sanguine about the prospects of a long war that can more directly draw in Western forces, a bigger threat to financial market stability has emerged – more aggressive tightening of global monetary policy led by the Fed. Chart 11Global Credit Spreads Have Returned To Pre-Invasion Levels Global Credit Spreads Have Returned To Pre-Invasion Levels Global Credit Spreads Have Returned To Pre-Invasion Levels ​​​​​​ Chart 12Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Global Monetary Backdrop Turning More Negative For Credit Already, the move away from quantitative easing by the Fed, ECB and BoE has led to a negative impulse for global credit returns (Chart 12). Excess returns for the Bloomberg Global Corporate and High-Yield indices are now essentially flat on a year-over-year basis, and the riskiest credit tiers of both indices are seeing the greater spread widening (bottom panel). Another indicator of tightening monetary policy, the flat US Treasury curve, is also signaling a poor environment for US credit market returns. Our colleagues at our sister service, BCA Research US Bond Strategy, have noted that when the 2-year/10-year US Treasury curve flattens below +25bps, the odds of US investment grade credit outperforming duration-matched Treasuries decline sharply. Dating back to 1973, the average excess return (over Treasuries) for the Bloomberg US investment grade index over the twelve months after the 2/10 curve flattens below +25bps is -0.56%. The 2/10 US Treasury curve is now inverted at -3bps, even with the Fed having only delivered a single +25bp rate hike so far in the current cycle. This is a highly unusual occurrence, as the Treasury curve typically inverts after the Fed has delivered multiple rate hikes in a tightening cycle. Bond investors are clearly “front-running” the Fed in discounting aggressive rate hikes in 2022 in response to US inflation near 8%. We think the Fed will deliver fewer hikes than markets are discounting this year, but will do more in 2023 and 2024. Yet the message from the now-inverted yield curve, and what it means for corporate bond performance, is too powerful to ignore. This underpins our decision to downgrade our recommended allocation to US investment grade to underweight. We do not, however, see a need to move the allocations for other corporate bond markets as aggressively. The credit spread widening seen so far in 2022 in the US and Europe – a trend that was already in place before the start of the Ukraine war – has restored more value to European corporate spreads compared to US equivalents. That can be seen when looking at our preferred measure of spread valuations, 12-month breakeven spreads.2 The historical percentile ranking of the 12-month breakeven spread is 63% for euro area investment grade and a much lower 23% for US investment grade (Chart 13). The absolute level of the euro area ranking justifies maintaining an overweight stance on euro area investment grade, both in absolute terms and relative to US investment grade. A smaller gap exists for high-yield, where the euro area 12-month breakeven spread percentile ranking is 50% versus 33% in the US. Those lower percentile rankings justify no higher than a neutral allocation to high-yield on either side of the Atlantic. On the surface, maintaining a higher allocation to US high-yield over US investment grade does appear counter-intuitive in an environment where the US Treasury curve is inverted and investors are growing increasingly worried that the Fed will need to engineer a major growth slowdown to cool inflation. However, that same high inflation helps to maintain a fast enough pace of nominal economic growth to limit the default risk for riskier borrowers. Moody’s estimates that the default rate for high-yield corporates will reach 3.1% in the US and 2.6% in Europe by year-end. Using those estimates, we can calculate a default-adjusted spread, or the current high-yield spread minus one-year-ahead expected default losses. That spread is currently 134bps in the US and 206bps in Europe, both well above the low end of the long-run range and closer to the long-run average (Chart 14). Those are levels that are consistent with a neutral allocation to high-yield in both regions, as current spreads offer a decent cushion in an environment of relatively low default risk. Chart 13More Attractive Spread Levels In Europe Vs. US More Attractive Spread Levels In Europe Vs. US More Attractive Spread Levels In Europe Vs. US ​​​​​​ Chart 14Low Default Risk Helps Support High-Yield Valuations Low Default Risk Helps Support High-Yield Valuations Low Default Risk Helps Support High-Yield Valuations ​​​​​​ Chart 15Persistent Headwinds To EM Credit Performance Persistent Headwinds To EM Credit Performance Persistent Headwinds To EM Credit Performance Emerging Markets Finally, we continue to see more reasons to be cautious on EM USD-denominated credit, given the lack of support from typical fundamental drivers (Chart 15). Weak Chinese growth, slowing commodity price momentum (on a year-over-year basis), and a firm US dollar are all factors that weigh on EM economic growth and the ability to service hard-currency debt. We are maintaining an underweight allocation to EM USD-denominated sovereign and corporate debt in our model bond portfolio. Indications that China is ready to introduce more fiscal and monetary stimulus, and/or if the Fed’s messaging turned less hawkish – and less US dollar bullish – would be the signals necessary for us to consider an EM upgrade. Summing It All Up The full list of our recommended portfolio allocations after making all of the above changes can be seen in Table 2. The changes leave the portfolio with the following high-level characteristics: Table 2GFIS Model Bond Portfolio Recommended Positioning For The Next Six Months GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Chart 16Overall Portfolio Allocation: Underweight Spread Product Vs Governments GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase the overall duration exposure remains at-benchmark (i.e. neutral) the portfolio has now flipped to an underweight stance on the exposure of spread product to government bonds, equal to four percentage points of the portfolio (Chart 16) the tracking error of the portfolio, or its expected volatility in excess of that of the benchmark, is 80bps – a level similar to that before the changes were made and still well below our self-imposed 100bps tracking error limit (Chart 17) the portfolio now has a yield below that of the custom benchmark index, equal to 2.51% (Chart 18). Chart 17Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate Overall Portfolio Risk: Moderate ​​​​​​ Chart 18Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark Overall Portfolio Yield: Below-Benchmark ​​​​​​ The changes leave the portfolio much more exposed to a widening of global credit spreads than a rise in government bond yields – a desired outcome with bond yields already discounting a lot of tightening but credit spreads still at historically tight levels. Bottom Line: As the global monetary tightening cycle evolves, positioning more defensively in global credit, rather than duration management, will provide the better opportunity to generate alpha in bond portfolios. We are expressing that by cutting the exposure to corporate bonds in our model bond portfolio. Portfolio Scenario Analysis For The Next Six Months After making all the specific changes to our model portfolio weightings, which can be seen in the tables on pages 23-25, we now turn to our regular quarterly scenario analysis to determine the return expectations for the portfolio for the next six months. On the credit side of the portfolio, we use risk-factor-based regression models to forecast future yield changes for global spread product sectors as a function of four major factors - the VIX, oil prices, the US dollar and the fed funds rate (Table 3A). For the government bond side of the portfolio, we avoid using regression models and instead use a yield-beta driven framework, taking forecasts for changes in US Treasury yields and translating those in changes in non-US bond yields by applying a historical yield beta (Table 3B). Table 3AFactor Regressions Used To Estimate Spread Product Yield Changes GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Table 3BEstimated Government Bond Yield Betas To US Treasuries GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase For our scenario analysis over the next six months, we use a base case scenario plus two alternate “tail risk” scenarios. In the current environment, our scenarios center around developments in the Ukraine/Russia conflict and the impacts on uncertainty and commodity-fueled inflation. Base Case There is no further escalation of the Ukraine/Russia conflict, possibly resulting in a temporary ceasefire. Oil prices pull back on a lower war risk premium, helping lower inflation expectations. Global realized inflation peaks during Q2/2022, alongside some moderation of global growth in lagged response to high energy prices. Within that slower pace of global growth, the US outperforms Europe while Chinese growth remains weak because of COVID lockdowns (although that will eventually lead to more stimulus from Chinese policymakers). The Fed delivers 100bps of rate hikes by July, starting with a 50bp increase at the May meeting, before pausing at the September meeting in response to slowing US inflation and growth. There is a mild bear flattening of the US Treasury curve, but yields remain broadly unchanged over the full six month scenario period with the Fed not hiking by more than currently discounted. The Brent oil price retreats by -10%, the US dollar modestly appreciates by 2%, the VIX stays close to current levels at 20 and the fed funds rate reaches 1.5%. Escalation Scenario The is no reduction in Ukraine war tensions, with increased Russian aggression resulting in greater NATO military involvement. The risk premium in oil prices increases, delaying the expected peak in global inflation until the second half of 2022. Inflation expectations remain elevated. Global growth weakens more than in the base case scenario because of higher energy prices, but with US growth still outperforming Europe. China’s economy remains weighed down by COVID lockdowns and an inadequate fiscal/monetary/credit policy response. The Fed is forced to be more aggressive because of high inflation expectations, delivering 150bps of hikes by September. The US Treasury curve bear-flattens, but with Treasury yields rising across the curve through wider TIPS breakevens and greater-than-expected rate hikes keeping real yields stable. The Brent oil price rises +25%, the VIX index climbs to 30, the US dollar appreciates by +5% thanks to slowing global growth and a more aggressive move by the Fed to push the funds rate to 2%. De-Escalation Scenario There is a full and lasting ceasefire between Russia and Ukraine. The war risk premium in oil prices collapses, allowing global inflation to peak in Q2 and then decline rapidly. Global growth sentiment improves because of lower energy prices and diminished worries about a wider world war. European growth outperforms US growth (relative to expectations) as European natural gas prices decline. China responds faster than expected to the latest COVID wave with more aggressive policy stimulus. Lower inflation allows the Fed to be more patient on rate hikes, delivering only 75bps of hikes by July before pausing. The Treasury curve moderately bull-steepens, although the absolute decline in nominal Treasury yields is fairly small as lower TIPS breakevens are partially offset by higher real yields (as growth sentiment improves). The Brent oil price falls -20%, the VIX index drifts down to 18, and the US dollar depreciates by -3% as global growth improves and the Fed pushes the funds rate to a less-than-expected 1.25% by July. The excess return scenarios for the model bond portfolio, using the above inputs in our simple quantitative return forecast framework, are shown in Table 4A. The US Treasury yield assumptions are shown in Table 4B. For the more visually inclined, we present charts showing the model inputs and Treasury yield projections in Chart 19 and Chart 20, respectively. Table 4AGFIS Model Bond Portfolio Scenario Analysis For The Next Six Months GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Table 4BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase Chart 19Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis Risk Factor Assumptions For The Scenario Analysis ​​​​​​ Chart 20US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis US Treasury Yield Assumptions For The Scenario Analysis ​​​​​​ Given our neutral overall portfolio duration stance, and the mild changes in nominal bond yields implied by our forecasts, it should not be surprising that the rates side of the portfolio is expected to not contribute any excess return in Q2 and Q3. However, Fed rate hikes – which push up yields on spread product in the forecasting regressions – result in negative credit returns in all scenarios (especially in the cases where the VIX is expected to rise). Thus, the return on the credit side of the model portfolio, where we are now underweight credit risk, will be the main driver of performance, delivering a range of excess return outcomes between +29bps and +53bps. Bottom Line: The next six months will be about locking in the significant gains in our model bond portfolio performance from rising bond yields, and transitioning to outperforming via wider credit spreads in US investment grade and EM hard currency debt.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma Senior Analyst ShaktiS@bcaresearch.com Footnotes 1      The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high-quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2     12-month breakeven spreads compare the option-adjusted spread (OAS) of a credit market or sector to its duration, using Bloomberg bond index data. The breakeven spread is the amount of spread widening that must occur over a one-year horizon to make the total return of a credit instrument equal to that of duration-matched risk-free government debt. GFIS Model Bond Portfolio Recommended Positioning     Active Duration Contribution: GFIS Recommended Portfolio Vs. Custom Performance Benchmark GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Global Fixed Income - Strategic Recommendations* Cyclical Recommendations (6-18 Months) GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase GFIS Model Bond Portfolio Q1/2022 Review & Outlook: Trading The Consolidation Phase  

Dear Client, There will be no weekly report next week. Instead, we will host our quarterly webcast on Tuesday, October 26 for the US and EMEA regions and Wednesday, October 27 for the Asia Pacific region. We will resume our regular publishing schedule on Monday, November 1. In the meantime, we look forward to seeing many of you at our BCA Research Investment Conference this week. Best regards, Mathieu Savary   Highlights This year’s decline in EUR/USD has rendered this pair sufficiently inexpensive and oversold to account for the near-term risks we highlighted in March. Nonetheless, some risks remain—among them, the continued credit slowdown in China, diverging monetary policy trends, and the energy crisis hurting Europe. However, long-term fundamentals continue to support the euro’s 12- to 18-month outlook. Moreover, Chinese credit growth may soon stabilize and markets already largely factor in the policy divergence between the Fed and the ECB. As a result, we buy the euro today with a preliminary target at 1.25 and a stop loss at 1.1175. The Bank of England will lift rates this December, but the market already prices in a hawkish BoE. GBP/USD has upside, even if the euro should outpace the pound in the coming months. Look to upgrade UK small-cap stocks. Italian equities do not appear particularly appealing on a cyclical horizon, neither in absolute nor relative terms. Investors should favor Spanish stocks over Italian ones for the next 12-to-18 months. Feature EUR/USD recently flirted with 1.15. Did this move create a buying opportunity? Last March, we warned that the euro would correct to the 1.12 to 1.15 zone because short-term models flagged it as expensive, speculators carried a substantial net-long exposure, and Chinese credit growth was set to slow meaningfully. These forces have now mostly played out; thus, the euro’s near-term outlook is becoming more positive. Despite this more constructive view, EUR/USD still carries ample downside risks, especially if Chinese authorities remain reluctant to reflate their economy. Moreover, the energy crisis facing Europe clouds the euro. We are nonetheless buyers of EUR/USD, with a target at 1.25. Investors should set a wide stop in at 1.1175. Cheap And Oversold The internal dynamics of the euro indicate that the bulk of the sell-off is behind us. First, the euro is now cheap on a tactical basis. Back in March, our short-term fair value model for EUR/USD flagged at 7% overvaluation based on real rate differentials, on the slope of the German yield curve relative to that of the US, and on the copper-to-lumber prices ratio. Today, this same measure shows a 5% undervaluation. BCA’s Foreign Exchange Strategy Intermediate Term Timing Model (ITTM) flags an even clearer buy signal.  The ITTM framework combines interest rate parity models, with risk aversion and considerations for the currency’s trend. Currently, this model is at -8% or nearly minus one standard error. Historically, such a depressed reading points to generous returns in the subsequent 12 months (Chart 1). Second, the euro is oversold. BCA’s Intermediate Term Technical Indicator has hit 7, which is consistent with past rebounds in EUR/USD (Chart 2). While some of these rallies have been extremely short-lived, the technical indicator’s message is stronger when it is matched by a buy signal from the ITTM. Chart 1Strong Buy Signal From Short-Term Valuations Strong Buy Signal From Short-Term Valuations Strong Buy Signal From Short-Term Valuations Chart 2EUR/USD is Oversold EUR/USD is Oversold EUR/USD is Oversold Chart 3Stale Euro Longs Have Been Purged Stale Euro Longs Have Been Purged Stale Euro Longs Have Been Purged Third, speculators do not carry a large net long position in the euro anymore. This variable suggests that the worst of the selling pressure is behind us, but it has yet to send a strong buy signal on its own (Chart 3). Bottom Line: The euro is sufficiently inexpensive that our Intermediate-term timing model flags a strong buy signal. Moreover, our technical indicators paint an oversold picture consistent with a reversal. Nonetheless, speculators may not be long EUR/USD anymore, but they are not aggressively selling it either. Thus, macro dynamics remain important to the future trend of this currency. Macro Fog Remains The macro environment is not yet conducive to a euro rally, especially when Chinese credit growth remains weak. However, considering the euro’s valuation and technical picture, small changes in the macro environment could be enough to catalyze a jump in EUR/USD. A key problem for the euro is that the dollar remains well bid. The yen and the dollar are the two momentum currencies within the G-10 (Chart 4). This property of the dollar is a large handicap for the euro, because it remains the most liquid vehicle to bet on the USD. Thus, as long as the dollar’s momentum is strong, the euro will find it difficult to rally. Relative economic growth is another headwind for EUR/USD. European activity is weakening versus that of the US. Since 2019, the relative manufacturing PMIs between the Euro Area and the US track EUR/USD, and they currently confirm the euro’s weakness (Chart 5). Moreover, European economic surprises are significantly weaker than US ones, which adds to the euro’s malaise (Chart 5, bottom panel). Chart 4The Dollar Is A Momentum Currency Time For The Euro To Shine? Time For The Euro To Shine? Chart 5Deteriorating European Growth Hurts EUR/USD Deteriorating European Growth Hurts EUR/USD Deteriorating European Growth Hurts EUR/USD The near-term outlook does not signal a resolution of this issue until the first half of 2022. The declines in the expectation and current situation components of both the ZEW and Sentix surveys herald an additional deceleration in manufacturing activity (Chart 6). The Eurozone’s growth problems reflect China’s slowing credit flows. Europe economic activity is still extremely sensitive to the evolution of the global industrial cycle (Chart 7, top panel), much more so than the US GDP is. China’s business cycle is an essential determinant of the robustness of the global manufacturing sector. Consequently, when measures of China’s marginal propensity to consume decelerate, such as the gap between M1 and M2 growth, European PMIs and industrial production underperform those of the US (Chart 7, second and bottom panels). Chart 6A Bit More Time Before Europe's Slowdown Ends A Bit More Time Before Europe's Slowdown Ends A Bit More Time Before Europe's Slowdown Ends Chart 7China's Travails Hurt Europe China's Travails Hurt Europe China's Travails Hurt Europe     The fourth quarter of 2021 is likely to represent the tail end of the Chinese headwind on EUR/USD. The Chinese credit impulse remains weak, but signs of a floor are beginning to appear. For example, the decline in Chinese commercial banks excess reserve growth warned us of the coming decline in the credit impulse. Today, excess reserves have begun to stabilize, which points to an upcoming imporvement in credit flows (Chart 8). Additionally, the Evergrande problems continue to weigh on Europe in the near-term because of the deceleration in Chinese construction activity;  however, the crisis will also intensify the pressure on Beijing to revive credit growth in order to avoid a systemic collapse. Chart 8Will China's Credit Impulse Bottom Soon? Will China's Credit Impulse Bottom Soon? Will China's Credit Impulse Bottom Soon? Monetary policy differentials also remain euro bearish. The US Federal Reserve will announce the start of its tapering program on November 3. The FOMC is set to hike rates by the end of 2022. Meanwhile, the ECB is unphased by the increase in European inflation, which remains mostly a reflection of energy prices and base effects. Thus, Europe will lag behind the US when it comes to monetary policy tightening. Nonetheless, investors already understand this dichotomy very well. The US OIS curve anticipates four hikes in 2023. Meanwhile, the EONIA curve shows a first 25-bps hike only by September 2023. Thus, the euro will suffer more from policy differentials if the Fed generates hawkish surprises relative to this pricing. The energy crisis shaking Europe is the last major headwind currently affecting the euro. Historically, EUR/USD and the ratio of European to US natural gas prices track each other (Chart 9). This relationship reflects relative growth dynamics. A stronger Eurozone economy relative to the US pushes up the value of the euro and European natural gas, which is a commodity with heavy industrial usage.  However, since this summer, the spike in European natural gas prices has coincided with a decline in the euro. This divergence highlights the negative effect on European activity of the current energy shock, which raises fears of stagflation. The cross-Atlantic bond market dynamics confirm the notion that the energy shock increases the perceived stagflation risk in the Eurozone. German yields have risen relative to US ones because of a pick-up in inflation expectations, not real rates (Chart 10). The lack of traction for relative real rates is appropriate because market participants believe that the ECB wants to ignore the spike in energy prices. An environment of rising relative inflation expectations but stable relative real rates is very negative for any currency, including the euro. However, European inflation expectations should decrease relative to those of the US once European natural gas prices normalize, which we expect to take place in the coming months (Chart 10, bottom panel). This process will be very positive for the euro. Chart 9The European Energy Crisis Harms The Euro The European Energy Crisis Harms The Euro The European Energy Crisis Harms The Euro Chart 10Pricing In European Stagflation? Pricing In European Stagflation? Pricing In European Stagflation? Bottom Line: While euro pricing and technicals suggest EUR/USD will bottom soon, the economic environment is murkier. The dollar is a momentum currency, and its current strength feeds the euro’s weakness. China’s credit flows continue to decelerate, which hurts the euro; however, credit flows may stabilize in early 2022. The Fed is a tailwind for the dollar, but markets already price in this reality. Finally, the energy crisis hurts European growth and thus EUR/USD; nonetheless, the spike in natural gas prices will soon give way to a period of decline, which will lessen the pain for the euro. What To Do? When we balance the positives and negative for the euro, we are becoming more comfortable with buying EUR/USD outright, even if it is still a risky bet. To begin with, the big fundamental forces point to a firmer euro on an 18- to 24-month basis: BCA’s Foreign Exchange strategists see greater cyclical downside for the USD and believe the current rebound is a pronounced countertrend move within a multi-year dollar bear market. The euro will naturally benefit over the coming years from a weak greenback. EUR/USD is still inexpensive on long-term valuation metrics. Based on BCA’s purchasing power parity model, this pair trades 17% below its fair value. Moreover, the PPP estimate keeps rising in favor of the euro, a result of the Eurozone’s lower inflation compared to the US (Chart 11). The relative balance of payments favors the euro. The European economy generates a current account surplus of 3% of GDP compared to a current account deficit of 3.1% for the US. The US current account deficit is unlikely to narrow, even if the federal government’s budget hole declines because the private sector’s savings rate is falling even faster. Moreover, US real two-year rates remain well below those of its trading partners. Investors underweight Eurozone assets aggressively. For the past ten years, capital has consistently flowed out of the Euro Area relative to the US (Chart 12). European growth should converge toward the US next year, especially if Chinese credit activity stabilizes. Therefore, 2022 should witness a period of inflows into the Eurozone. Chart 11EUR/USD Significant Long-Term Discount EUR/USD Significant Long-Term Discount EUR/USD Significant Long-Term Discount Chart 12Investors Underweight Eurozone Assets Investors Underweight Eurozone Assets Investors Underweight Eurozone Assets We argued that the valuation and technical backdrop shows the Euro is becoming increasingly supportive and our timing model is clearly arguing against selling EUR/USD. However, the biggest technical risk is the momentum sensitivity of the dollar, which means that the euro’s weakness could last somewhat longer. Nevertheless, BCA’s Dollar Capitulation Index now warns of a pullback in the USD, especially as speculators are very long DXY futures (Chart 13). The biggest downside risk remains China’s credit trend. If it takes more time than we anticipate for Beijing to put an end to the credit impulse slowdown, the euro will experience greater downside pressure. Moreover, the longer it takes Beijing to reflate, the greater the chance of an uncontrolled selloff in the CNY, which would drag down the euro (Chart 14). Chart 13Is The Dollar Technically Vulnerable? Is The Dollar Technically Vulnerable? Is The Dollar Technically Vulnerable? Chart 14China Remains The Euro's Main Risk China Remains The Euro's Main Risk China Remains The Euro's Main Risk Despite this level of near-term uncertainty, we recommend investors buy the euro, with a target at 1.25, and a stop loss at 1.1175. Bottom Line: Conditions are falling in place for the countertrend decline in the euro to end soon. As a result, the euro should converge back toward the upward path driven by fundamentals. The greatest near-term risk remains the path of Chinese credit trends. We recommend investors buy the euro with a preliminary target at EUR1.25 and a stop loss at 1.1175.   Country Focus: A Well Discounted BoE Hike The Bank of England will begin to increase interest rates at its December meeting. The BoE’s communication has been clear that it does not see a need to wait between the end of its tapering program in December and the beginning of its hiking campaign. Recent comments by senior MPC members, including new Chief Economist Huw Pill, also suggest a rate hike is looming. Chart 15The BoE's Inflation Problem The BoE's Inflation Problem The BoE's Inflation Problem We see little reason to doubt the willingness of the MPC to start lifting the Bank Rate. UK Core CPI stands at 3.1% or 110 basis points above the BoE’s inflation target. Moreover, both market-based and survey-based long-term inflation expectations are well above 3.5%, which increases the risk of a dangerous dis-anchoring of UK inflation (Chart 15). UK economic activity remains inflationary. Wages are strong, climbing 7.2% in August. This number probably exaggerates the underlying wage growth due to compositional effects, but job creation remains robust and the unemployment rate fell to 5.2%. The BoE was concerned that the end of the furlough scheme last month would cause a jump in unemployment, but their fears have dwindled, because job vacancies stand at a record high and capex intentions are solid (Chart 16). The housing market continues to be a tailwind to growth. House prices are up 10% annually, which lifts household net worth considerably (Chart 17). The pace of transactions in the real estate market will slow this spring because the stamp duty holiday will end; however, low mortgage rates and expectations of further housing gains may fuel greater appreciation. This creates long-term financial stability risks for the UK because household leverage will rise. This worries the BoE. Chart 16The UK's Labor Market Strength Will Continue The UK's Labor Market Strength Will Continue The UK's Labor Market Strength Will Continue Chart 17Rising Household Net Worth Rising Household Net Worth Rising Household Net Worth Market participants already expect a hawkish BoE. A rate hike is priced in for December and the SONIA curve embeds almost two more increases in 2022. The 4.3% underperformance of the UK government bond index over the global benchmark in seven weeks also underscores the rapid adjustment in investors’ perceptions of the UK policy path. BCA’s Global Fixed-Income strategists have underweighted UK government bonds for two months, and they maintain a negative view over the coming quarters.  Nonetheless, the risk of a short-lived countertrend rebound in UK bonds’ relative performance is significant. However, it would be a temporary position squaring, while hedge funds and CTAs take profits. BCA’s Foreign Exchange strategists expect GBP/USD to rebound. Cable is oversold and trades at a 12% discount to BCA’s PPP fair-value estimate. GBP/USD is also hurt by fears that the BoE hikes will damage the UK economy. From a contrarian perspective, this creates a positive entry point to buy cable, especially because the pound should benefit from the anticipated dollar weakness and the euro’s upcoming rally. However, BCA’s FX strategists also foresee some decline in the pound versus the euro, because GBP is a low beta play on EUR/USD. Hence, the trade-weighted pound could remain flat to slightly down in the coming months. We stay neutral on UK small-cap stocks relative to large-cap equities, but we are putting them on an upgrade alert. Small-cap stocks benefit from the strength in the domestic economy; however, they are also extremely expensive compared to large-cap ones (Chart 18). The arbiter of performance will be profits. The forward EPS of small-caps have lagged behind those of large-caps by 9% since the COVID recession, after underperforming since 2016 (Chart 19). Small-caps’ relative profits are currently trying to stabilize, but the durability of this trend will be tested if the trade-weighted pound remains flat in the coming months. Thus, the EPS of small-cap shares must regain more ground before moving more aggressively in this market. Chart 18UK Small Cap Are Pricey UK Small Cap Are Pricey UK Small Cap Are Pricey Chart 19Follow The Profits Follow The Profits Follow The Profits Bottom Line: On the back of a strong UK economy and significant inflationary forces, the BoE will start elevating interest rates this December. The market already prices in this outcome. Nonetheless, UK bonds should continue to underperform the global benchmark, and cable has upside, even if the near-term outlook favors the EUR over the GBP. We are putting UK small-cap stocks on a buy alert. They are expensive, but a turnaround in profits would solve this problem. Market Focus: A Quick Take On Italian Equities The Italian equity market remains Europe’s problem child. The Italian MSCI index has underperformed the rest of the Euro Area by 40% since 2010. This underperformance holds even after adjusting for sectoral differences, although it becomes less dramatic (Chart 20, top panel). Despite this underperformance, Italian equities have managed to outperform their Spanish counterparts by 27% since 2010, but this outperformance dissipates once sectoral difference are accounted for (Chart 20, bottom panel). The RoE of Italian non-financial listed equities is equivalent to the rest of the Eurozone, but it only reflects elevated financial leverage, as is the case in Spain (Chart 21). Italy’s RoA is poor, because Italy’s excess capital stocks hurts its return on capital. As a result, Italian equities continue to face a structural handicap. Chart 20A Problem Child A Problem Child A Problem Child Chart 21Italy's Return On Asset Is Poor Italy's Return On Asset Is Poor Italy's Return On Asset Is Poor The good run in Italian equities in absolute terms faces headwinds. Italian stocks are very sensitive to the global business cycle; however, they often respond with a delay and in an exaggerated fashion to decelerations in the global PMI (Chart 22, top panel). Moreover, since 2010, widening European high-yield corporate bond spreads have preceded falling Italian stock prices. Thus, the recent slide in the global PMI and the widening in European high-yield OAS create a period of vulnerability for Italian equities. Finally, Italian share prices have overshot the path implied by US yields (Chart 22, bottom panel). Nonetheless, Italian stocks may be sniffing out further increases in global yields. The cleanest way to play these vulnerabilities in the Italian is via a short bet against Spain. A steeper global yield curve will help both markets due to their heavy exposure to financials. However, we still favor Spanish financials, which benefit from higher RoEs than their Italian counterparts (Chart 23) and lower NPLs. As a result, the forward EPS of Spanish financials should begin to outperform those of Italian financials. Chart 22Some Risks To Italian Stocks Some Risks To Italian Stocks Some Risks To Italian Stocks Chart 23Spanish Banks Are Better Placed To Benefit From Rising Global Yields Spanish Banks Are Better Placed To Benefit From Rising Global Yields Spanish Banks Are Better Placed To Benefit From Rising Global Yields   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Jeremie Peloso, Associate Editor JeremieP@bcaresearch.com Tactical Recommendations Time For The Euro To Shine? Time For The Euro To Shine? Cyclical Recommendations Time For The Euro To Shine? Time For The Euro To Shine? Structural Recommendations Time For The Euro To Shine? Time For The Euro To Shine? Closed Trades Time For The Euro To Shine? Time For The Euro To Shine? Currency Performance Fixed Income Performance Equity Performance