Latin America

Executive Summary Mexico: Inflation Is At A Two-Decade High Mexico: Inflation Is At A Two-Decade High Mexico: Inflation Is At A Two-Decade High Mexican financial markets – stocks, fixed-income and the currency – will continue outperforming their EM counterparts. The Mexican economy is vulnerable to faltering US growth, but this negative shock will be mitigated by robust auto shipments, tourism revenues and remittances. Notably, Mexican exports will suffer less than those of Emerging Asia and South America. Economic activity in Mexico has barely recovered to its pre-pandemic level. Conditions for a lasting inflationary outbreak are currently absent. Considering these factors, we believe that a major economic bust is not in the cards. Very tight monetary and fiscal policies are favorable for Mexican fixed-income markets as they will slow down the economy and cap inflationary pressures. Mexican assets are likely to be re-rated versus their EM counterparts in the coming years due to geopolitical considerations. On EM Equity Benchmark Recommendation Inception Date RETURN Long MXN / Short BR 2022-07-28   Bottom Line: We continue to recommend investors overweight Mexican equities, and local and sovereign fixed income within their respective EM portfolios. We are instituting a stop buy on Mexican local currency 10-year government bonds. For currency traders, we recommend a long MXN/short BRL position. Feature We have been overweighting Mexican markets on a cyclical and structural basis since early 2018 and this strategy has played out well (Chart 1 and Chart 2). Chart 1Our Calls On Mexican Equities And Currencies Have Done Really Well... Our Calls On Mexican Equities And Currencies Have Done Really Well... Our Calls On Mexican Equities And Currencies Have Done Really Well... Chart 2...And So Have Our Fixed-Income Calls ...And So Have Our Fixed-Income Calls ...And So Have Our Fixed-Income Calls In this report, we elaborate on the reasons why Mexican financial markets – stocks, fixed-income and the currency – remain among our favorites within the EM space, and why they are in a strong position to continue outperforming their EM counterparts, even amidst a US growth slump. Is The Economy Overheating? As in many economies around the world, headline inflation has reached a two-decade high in Mexico (Chart 3, top panel). How big of a threat is it for the Mexican economy? In our view, the Mexican economy has not been overheating, and a wage-price spiral has not yet developed. Hence, inflation in Mexico is not fully entrenched and is not likely to be persistent. First, the business cycle is only now moving from a recovery to an expansionary phase. Chart 4 shows that various segments of the economy have only recently reached – or are nearing – their pre-pandemic levels. Note that the chart shows the series as a three-year rate of change, i.e., the last datapoints compare 2022 with 2019. In brief, economic activity and demand have not yet surpassed their pre-pandemic (2019) levels. Chart 3Mexico: Inflation Is At A Two-Decade High Mexico: Inflation Is At A Two-Decade High Mexico: Inflation Is At A Two-Decade High Chart 4Mexico: Economic Activity Is Only Back To Pre-Pandemic Levels Mexico: Economic Activity Is Only Back To Pre-Pandemic Levels Mexico: Economic Activity Is Only Back To Pre-Pandemic Levels Chart 5Mexico: The Labor Market Is Tightening, But Slack Remains Mexico: The Labor Market Is Tightening, But Slack Remains Mexico: The Labor Market Is Tightening, But Slack Remains Second, according to data from the central bank (Banxico), the output gap remains quite negative at around -4% of potential GDP, suggesting there is plenty of slack in the economy. Third, there is still room for the labor market is tighten further without major upward pressure on wages. The top two panels of Chart 5 show that the unemployment and underemployment rates have not yet dropped to new lows, i.e., they remain above pre-pandemic levels. Further, although average wage growth has accelerated, it remains within its historical range, and is well below core CPI (Chart 5, bottom panel). Finally, Mexico lacks a key driver of genuine inflation, which is mushrooming unit labor costs – defined as the ratio of wages over productivity. Inflation is unlikely to become entrenched unless unit labor costs rise sharply, i.e., unless wage growth outstrips productivity growth. In Mexico, unit labor costs – using real not nominal wages – are actually falling (Chart 6). Please see our latest strategy report for a more detailed explanation of the relationship between unit labor costs and inflation. Chart 6Unit Labor Costs In Mexico Are Falling Unit Labor Costs In Mexico Are Falling Unit Labor Costs In Mexico Are Falling Overall, rising inflation has by and large not been due to excessive demand, and a wage-price spiral has not yet developed. Consistently, even though alternative core measures of inflation – like trimmed-mean CPI and services CPI – have also risen, they remain much more contained than headline and core CPI (Chart 3, bottom panel, above). This makes Mexico stand apart from Chile, Brazil, and Colombia, where economic overheating has created fertile grounds for genuine and persistent inflation. In these countries, part of the inflationary outbreak can be explained by massive pandemic fiscal packages and a slow response from monetary authorities, leading to an overheating scenario. Accordingly, the Mexican central bank will not have to raise rates as much as its regional peers because the Mexican economy is not overheating. Bottom Line: Economic activity in Mexico has barely recovered to its pre-pandemic level. Conditions for a lasting inflationary outbreak are currently absent. Considering these factors, we believe that a major economic bust is not in the cards. Monetary And Fiscal Policies: Ahead Of The Inflation Curve? A tight monetary and fiscal policy mix will slow down the economy and cap inflationary pressures. The central bank is in full hawkish mode, and it will continue raising rates until the end of this year. The basis is that Banxico will be reluctant to go on hold when the nation’s inflation remains well above target. In addition, the Fed is set to continue hiking rates into next year. The US, in contrast to Mexico, is already experiencing a wage-price spiral. The Fed’s tightening will continue supporting the US dollar and weigh on other currencies, including the Mexican peso. In brief, Banxico will at least match the Fed hikes in the reminder of this year. Overall, high and rising borrowing costs in Mexico will restrain domestic demand. Our proxy for the marginal propensity to consume indicates that household consumption will slow down in the coming months (Chart 7, top panel). This will likely lead to a roll-over in core CPI. In fact, the sharp deceleration in narrow money (M1) supply points to cresting inflationary pressures (Chart 7, bottom panel)  On the fiscal front, while left-wing in name, the government of Mexico continues to run one of the most austere fiscal policies in the world. The primary fiscal balance has been around zero and the overall deficit has not exceeded 3% of GDP – even during the peak of the pandemic (Chart 8, top panel). The fiscal thrust in 2022 is expected to be -1.3% of GDP (Chart 8, bottom panel). This will also curtail domestic demand growth, and thereby diminish inflationary pressures. Chart 7Mexico's Growth And Inflation Will Slow Down Mexico's Growth And Inflation Will Slow Down Mexico's Growth And Inflation Will Slow Down Chart 8Mexico's Fiscal Policy Has Been Among The Tightest In The World Mexico's Fiscal Policy Has Been Among The Tightest In The World Mexico's Fiscal Policy Has Been Among The Tightest In The World   Furthermore, government policies have also kept inflation at bay by subsidizing the cost of gasoline at the pumps. In effect, this has allowed gasoline prices in Mexico to fall below those in the US for the first time in over five years. Given the high pass-through effect from fuel to other prices in developing economies, this policy will also limit the rise in core inflation. We can expect this subsidy policy to remain in place for the coming months. The basis is that the net cost of this subsidy from March to May has been around $3 billion USD or a mere 0.2% of GDP. Given that the primary fiscal balance is at zero and public debt stands at a manageable 42% of GDP, the government will be able to continue financing this policy with little fiscal risk. Bottom Line: Very tight monetary and fiscal policies are favorable for Mexican fixed-income markets as they will slow down the economy and cap inflationary pressures. The External Backdrop Favors Mexico Relative To Other EMs The global macro outlook will help the Mexican economy and its financial markets outperform their EM peers. In our view, the global economy is experiencing a material growth slowdown. On the one hand, developed countries (the US and the EU) are experiencing a shift from demand for consumer goods (ex-autos) towards vehicles and services. On the other hand, China’s newly enacted infrastructure financing will serve to only offset the fall in government revenues from land sales. Hence, there is little new stimulus for infrastructure beyond what has been approved in the budget plan earlier this year. In brief, China’s business cycle recovery will be U-shaped rather than V-shaped with risks to the downside. This will weigh heavily on developing countries dependent on Chinese imports. Our baseline global macro scenario assumes contracting global trade and a further drop in commodity prices. This is indeed worrisome for Mexico, which is both a major manufacturing hub supplying the US and a commodity producer. That said, the country will likely outperform other EMs during this global downturn for the following reasons. First, Mexico will suffer less from the shift in US household spending from consumer goods towards autos and services due to its unique export composition. Mexican vehicle exports constitute 23% of its total exports, while exports of non-auto consumer goods (excluding food and beverages) make up only 13%. Further, Mexican vehicle exports remain below pre-pandemic levels in unit terms (Chart 9). As the global chip shortage eases, Mexico will experience a boom in auto exports as it increases production. Pent-up demand for cars in the Americas combined with the large share of autos in Mexican exports will help Mexico outperform Asian economies – which export a lot of consumer goods (non-autos) to DM – and LATAM economies that sell commodities. In short, Mexican exports will suffer less than those of Emerging Asia and South America in the coming months. Second, Mexico stands to benefit from the shift in DM/US demand from goods to services due to its large tourism industry. Not only has the number of tourists recently surged, but also the average revenue per visitor has skyrocketed by 50% (Chart 10, top and middle panel). However, the number of visitors is still well below the pre-pandemic level, meaning the upside potential is still substantial. Chart 9Mexican Vehicle Exports Have Much More Upside Mexican Vehicle Exports Have Much More Upside Mexican Vehicle Exports Have Much More Upside Chart 10Mexican Tourism Revenues Will Continue Rising Mexican Tourism Revenues Will Continue Rising Mexican Tourism Revenues Will Continue Rising   Mexico’s overall tourism revenues will expand given the pent-up demand for travel (Chart 10, bottom panel).   Chart 11Remittances Into Mexico Will Remain Robust Remittances Into Mexico Will Remain Robust Remittances Into Mexico Will Remain Robust Third, remittance flows into Mexico will remain robust for now (Chart 11). US nominal wages are rising sharply, and employment among low-skilled workers will not decline much. The basis for this is that there are still many open positions to be filled. Hence, US household nominal income growth, and thereby remittances to Mexico, will remain robust in the months ahead. Finally, even though oil prices will likely drop materially in the coming months for reasons we discussed in last week’s report, the peso will not be affected as much as other commodity currencies. The basis is that oil exports comprise only 6.7% of Mexican total exports. Plus, the government typically hedges a portion of its oil revenues. Thus, Mexico did not benefit a lot from the oil price surge earlier this year, and it will not suffer enormously as crude prices drop further. Bottom Line: Robust auto shipment, tourism revenues and remittances will mitigate the negative shock to the Mexican economy and balance of payments from faltering US growth. Consumer goods (ex-autos) account for a larger share of Asian exports vis-à-vis Mexican exports. Meanwhile, South American countries export a significant amount of commodities. Contracting shipments of consumer goods to the US and the EU will hurt emerging Asian economies significantly while deflating commodity prices will weigh down on the balance of payments, growth and financial markets of South American economies. Overall, Mexico will be a relative winner. Structural Backdrop Chart 12Mexico: Foreign And Domestic Investments Are Turning Around Mexico: Foreign And Domestic Investments Are Turning Around Mexico: Foreign And Domestic Investments Are Turning Around Mexico’s structural backdrop is also somewhat more benign relative to many other emerging economies: As we have written in previous reports, Mexico is in a unique position to profit from the US’s and global multinationals’ nearshoring efforts to shift manufacturing away from China. There is some anecdotal evidence1 and data confirming that this process has started: FDI inflows and capital expenditures are bottoming, and capital goods imports are back to their previous highs (Chart 12). More FDIs will enhance manufacturing productivity and the competitiveness of Mexico’s maquiladora sector. Besides, business confidence has finally recovered to levels prior to the election of president Andrés Manuel López Obrador (commonly known as AMLO). Importantly, while AMLO has been interventionist in the energy sector (oil and electricity), he has not meddled in other industries. Improved business confidence could lead to more domestic investment (Chart 13). Mexico badly needs more capital spending to boost meager productivity growth in domestic sectors. The risk premium on Mexican markets will probably drop relative to other EMs due to geopolitical considerations, i.e., Mexican assets are likely be re-rated versus their EM counterparts in the coming years. The geopolitical confrontation between the US and China might split the world into two competing camps: US- and China-centric geopolitical and economic blocs, with Mexico surely being in the US-centric one. As a result, multinationals as well as US, European and Japanese portfolio investors will feel more comfortable investing in Mexico than in many Asian markets. Some Emerging Asian financial markets might experience international portfolio capital exodus if they join the China-centric bloc. Structural macro parameters – such as the current account, fiscal deficit and public debt, and private sector leverage – are more favorable in Mexico compared to other EMs. Mexico’s current account balance is almost at zero (Chart 14, top panel). Public debt is at 42% of GDP and private credit penetration stands at only 19% of GDP (Chart 14, bottom panel). Even if state-owned oil company PEMEX’s entire debt is taken over by the government, it will add about 8% of GDP to Mexico’s public debt burden, i.e., the latter will rise to only 50% of GDP. Chart 13Mexico: Business Confidence Has Recovered Despite AMLO Mexico: Business Confidence Has Recovered Despite AMLO Mexico: Business Confidence Has Recovered Despite AMLO Chart 14Mexico: Balance Of Payments And Debt Backdrops Are Healthy Mexico: Balance Of Payments And Debt Backdrops Are Healthy Mexico: Balance Of Payments And Debt Backdrops Are Healthy   These benign macro parameters – coupled with the orthodox and tight fiscal and monetary policy mix – suggest that downside in the peso will be limited. The basis is that global fixed-income investors typically favor currencies where monetary and fiscal policies are orthodox and err on the side of tightness. Finally, banks are well capitalized and their provisions are high. Banks are in a healthy position to finance the nation’s growth. Overall, we are not suggesting that Mexico is free from serious socio-economic problems and that its economy is set to boom. This nation has numerous structural issues like organized crime, corruption in local governments, weak rule of law, low productivity, and high concentration (oligopolistic structure) in select industries that enable their pricing power and make inflation persistent. However, compared with many other developing countries, Mexico’s profile is slightly more favorable, especially adjusted for its financial market valuations. Investment Recommendations To come up with an investment strategy for Mexican financial markets, we must incorporate our global macro view. Two of our broad macro themes are: (1) the Fed and the US stock market are on a collision course;  and (2) the US dollar will continue overshooting. Together these suggest that, in absolute terms, Mexican financial markets and the exchange rate remain at risk of selling off in the coming months. Nevertheless, we reiterate our overweight stance on Mexico across all EM asset classes: stocks, local bonds, sovereign credit and currencies. Equities: Keep overweighting Mexico within an EM equity portfolio. Mexican equity valuations remain attractive in absolute terms and relative to EMs based on the various multiples (Chart 15 and Chart 16).  Chart 15Mexican Stocks Are Cheap In Absolute Terms!... Mexican Stocks Are Cheap In Absolute Terms!... Mexican Stocks Are Cheap In Absolute Terms!... Chart 16...And Are Also Attractive Relative To EM ...And Are Also Attractive Relative To EM ...And Are Also Attractive Relative To EM Furthermore, relative bond yields between Mexico and mainstream EM will drop. This will support the outperformance of Mexican equities versus EM non-TMT stocks and the overall EM benchmark. Currency: The Mexican peso is vulnerable in the near term as the Fed continues ratcheting up interest rates and the US economy slumps. However, the peso is cheap, and its depreciation will be more limited compared to other LATAM countries.  Therefore, we recommend investors long the MXN and short the BRL. Not only are Mexico’s macro variables more favorable than those of Brazil, but also the peso is cheap while the Brazilian real is slightly expensive (Chart 17). We elaborated on Brazil’s macroeconomic, financial and political outlook in our May 17 report. Sovereign credit (US dollar bonds): We continue to recommend an overweight position in Mexican sovereign credit within an EM credit portfolio. The rationale for this is Mexico’s benign structural macro parameters, as discussed above. Local currency bonds: 10-year local currency bond yields at 8.8% offer very good value. Weighing long-term pros and near-term cons, we are instituting a stop buy trade on Mexican 10-year domestic government bonds when either yields hit 10% or the MXN/USD reaches 22.5 (Chart 18). Chart 17Go Long MXN Versus BRL Go Long MXN Versus BRL Go Long MXN Versus BRL Chart 1810-Year Domestic Mexican Bonds Offer Good Value 10-Year Domestic Mexican Bonds Offer Good Value 10-Year Domestic Mexican Bonds Offer Good Value Chart 19We Have Been Betting On Yield Curve Flattening We Have Been Betting On Yield Curve Flattening We Have Been Betting On Yield Curve Flattening For now, we continue betting on further yield curve inversion. We instituted this position on August 12, 2021 and it has been very profitable (Chart 19).   Juan Egaña Associate Editor juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes 1     George Lei and Michael O’Boyle, “Mexico’s ‘Super Peso’ Shocks Traders Who Were Betting On Wipeout,” Bloomberg, July 26, 2022, www.bloomberg.com.

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 Brazil: NPL Provisioning Cycles Explain Bank Share Prices Brazil: NPL Provisioning Cycles Explain Bank Share Prices Brazil: NPL Provisioning Cycles Explain Bank Share Prices Inflation is well above the central bank’s target. To assert their credibility, monetary authorities have no choice but to extend the rate hiking cycle. Drastic monetary tightening has been and will continue to occur in a context where the level of real economic activity is well below the 2013/14 level. The economy is heading into another recession in H2 this year. Such an economic contraction will weigh on banks and other domestic stocks.  Materials stocks are at risk from a relapse in industrial metal prices while Petrobras is at risk from government intervention. Brazilian equity and credit market valuations are no longer attractive relative to their EM peers. The currency is not cheap either. We find value in 10-year government local currency bonds – currently yielding 12.7% – given that the economy is heading into recession and inflation will likely peak. However, we do advise to hedge the currency risk for now. Recommendation Inception Date Return Equities: Overweight Brazil vs. Emerging Markets  2022-02-08 19.6% Sovereign Credit: Overweight Brazil vs. Emerging Markets 2022-02-08 7.2% Local Currency Government Bonds : Overweight Brazil vs. Emerging Markets 2022-02-08 18.9% Long Brazil Small Caps / Short Brazil Overall Stocks 2022-02-08 1.0% Bottom Line: We recommend that investors reduce their exposure to Brazilian risk assets by downgrading their allocation from overweight to neutral on equities, and local and sovereign fixed income within their respective EM portfolios. Feature We upgraded Brazilian financial markets to overweight versus their EM peers on February 8, and since then the nation’s stocks, local bonds as well as sovereign and corporate credit have outperformed their respective EM benchmarks (Chart 1). Presently, we recommend that EM equity and fixed-income dedicated investors scale down their exposure to Brazil to marketweight. The Central Bank Is In “Overkill” Mode Inflation in Brazil continues to surprise to the upside: headline CPI is 12%, core CPI is 9% and trimmed-mean CPI is 9.5%. All are well above the central bank’s (BCB) target band of 3.5%+/-1.5% (Chart 2, top panel). Further, consumer, business and market participants’ inflation expectations continue to inch higher and are well above the central bank’s target (Chart 2, middle and bottom panels). Chart 1Book Profits On Overweighting Brazil Versus EM Book Profits On Overweighting Brazil Versus EM Book Profits On Overweighting Brazil Versus EM Chart 2Brazil: Inflation Is Out Of Control Brazil: Inflation Is Out Of Control Brazil: Inflation Is Out Of Control Chart 3Brazil: Economic Activity Is Well Below Its 2013 Level Brazil: Economic Activity Is Well Below Its 2013 Level Brazil: Economic Activity Is Well Below Its 2013 Level In order to assert its credibility, the central bank has no choice but to extend its tightening cycle. The BCB has already hiked the policy rate by 1075 bps to 12.75%. This has been occurring in a context where the level of real economic activity is well below its 2013/14 level (Chart 3). There are also political motives that will influence the BCB’s hawkish stance in the medium term. As we wrote in the February report, the BCB has a political incentive to bring down inflation toward 5% (the upper range of its target), as it must prove that it is capable of achieving its inflation mandate in order to keep its recently granted independence. With ex-president Luiz Inácio Lula da Silva as the preferred presidential candidate in this year’s election, whose party opposes central bank autonomy and would prefer looser monetary policy, the BCB will continue tightening dramatically this year to reach target inflation. That will allow the central bank to cut rates next year when Lula assumes the presidency and, hence, avoid a major conflict with the government. To read our complete analysis on Brazilian politics and its implications for monetary policy, please access our February 8 report. In addition, fiscal policy will remain tight throughout the year, barring a new round of the cash handout program Auxílio Brasil. All in all, the fiscal thrust will be only mildly positive at 1% of GDP. This means that government spending will not offset dramatic monetary tightening. Bottom Line: Severe monetary tightening is occurring during a period in which the economy has not fully recovered. As a result, Brazil is heading into another recession. Recession Ahead Rising borrowing costs (shown inverted in Chart 4) will curtail bank lending. Further, Brazil’s business cycle has already rolled over, and chances are there will be an outright contraction in the second half of this year: The combined credit and fiscal impulse points to a major relapse in economic activity (Chart 5, top panel). Chart 4Monetary Tightening Will Curtail Bank Lending Monetary Tightening Will Curtail Bank Lending Monetary Tightening Will Curtail Bank Lending Chart 5Brazil: Prepare For A Recession In H2 2022 Brazil: Prepare For A Recession In H2 2022 Brazil: Prepare For A Recession In H2 2022   Our proxy for the marginal propensity to consume has plunged, meaning that household spending will continue to contract (Chart 5, middle panel). Consistently, the narrow money (M1) impulse will remain depressed as the BCB tightens monetary policy. This heralds a downbeat growth outlook, including shrinking manufacturing output (Chart 5, bottom panel). Another economic contraction does not bode well for Brazilian equities: Banks will become saddled with non-performing loans (NPLs). As they increase NPL provisions, their profitability will take a hit, and so will bank stocks. Chart 6 illustrates bank share prices correlate with loan provision cycles (provisions are shown inverted). Given that financials make up 25% of the Brazil MSCI index, their drawdown will weigh on the overall index. The bear market in share prices of Chinese materials points to a relapse in Brazilian materials stocks (Chart 7). Chart 6Brazil: NPL Provisioning Cycles Explain Bank Share Prices Brazil: NPL Provisioning Cycles Explain Bank Share Prices Brazil: NPL Provisioning Cycles Explain Bank Share Prices Chart 7Brazilian Materials: Heed The Message From Chinese Materials Brazilian Materials: Heed The Message From Chinese Materials Brazilian Materials: Heed The Message From Chinese Materials   Higher state interventionism in Petrobras will spook investors and damage confidence. The oil producer has a policy of raising domestic fuel prices in accordance with international markets. However, this has led and will lead to backlash from both presidential contenders, Jair Bolsonaro and Lula da Silva. Both candidates have argued for more government control of the oil producer and are not shy about placing loyalists at the head of the board and in the energy ministry in a bid to curb fuel prices and with it please the population. This is negative for Petrobras’ share price. While this sort of policy is expected from Lula, markets have been caught by surprise as the current right-wing government is trying to influence the oil producer as well. As we wrote in July of 2021, we expect Bolsonaro to increase his populist tendencies in order to appeal to poorer households and take support away from Lula’s traditional voter base. Valuations Chart 8Brazilian Equities Have A Neutral Valuation Relative To EM Brazilian Equities Have A Neutral Valuation Relative To EM Brazilian Equities Have A Neutral Valuation Relative To EM Brazilian financial markets are not undervalued anymore relative to their EM peers: Equities: The cyclically-adjusted P/E ratio for Brazil relative to Emerging Markets is now at a neutral valuation (Chart 8). Currency: The Brazilian real has been a stellar performer this year, to the point that the currency is no longer inexpensive (Chart 9). Investor positioning is presently a risk to the BRL. The aggregate position of leveraged funds and asset managers is now long as of May 10 (Chart 10). Chart 9The BRL Is No Longer Cheap The BRL Is No Longer Cheap The BRL Is No Longer Cheap Chart 10Investor Positioning On The BRL Is Net Long Investor Positioning On The BRL Is Net Long Investor Positioning On The BRL Is Net Long     Anecdotal evidence also suggests that Brazilian businesses have been using the rebound in the real to hedge their foreign currency risks. Large corporations have begun purchasing back their foreign currency bonds in anticipation of currency weakness. Further, according to Anbima, the country’s financial markets association, corporate bond sales outside of Brazil have halved compared to 1Q 2021.   We recommended a long BRL/short ZAR trade on February 8 and took a 7.4% profit on April 13. Chart 11Core Inflation Will Drop In H2 2022 Core Inflation Will Drop In H2 2022 Core Inflation Will Drop In H2 2022 Local Rates: Currency weakness risks will weigh on domestic bonds. The relative total return in USD terms of Brazilian domestic bonds versus the EM GBI index has rolled over at its previous high. That said, we find value in 10-year government domestic (local currency) bonds – currently yielding 12.7% – given that the economy is heading into recession and inflation will likely peak (Chart 11). However, we do recommend that investors hedge the currency risk for now. Sovereign and corporate credit: In terms of sovereign and corporate credit (USD bonds), Brazil has outperformed its EM benchmarks substantially in recent months. A pause in outperformance or a relapse is overdue on the back of the recession and exchange rate risks. Investment Recommendations We recommend that investors reduce their exposure to Brazilian risk assets by downgrading their allocation from overweight to neutral on equities and local and sovereign fixed income within their respective EM portfolios. We are also closing our long small caps / short the overall index trade. This trade has produced only a 1% gain since initiation on February 8 this year. Juan Egaña Associate Editor juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes

Executive Summary The Economy Will Enter A Slowdown The Economy Will Enter A Slowdown The Economy Will Enter A Slowdown Colombian stock prices and the peso rallied earlier this year, but the rebound is over. Hawkish monetary and tight fiscal policies will slow down domestic demand considerably. Despite high oil prices, the current account deficit will remain wide. This will weigh on the peso. Political risks will rise ahead of the presidential elections which will prove to be a very tight race. Odds of far-left candidate Gustavo Petro winning are not low. His victory would present institutional risks to Colombia’s market-friendly economic model.         Recommendation Inception Date Return A New Trade: Receive 10-Year / Pay 6-Month Swap Rates 2022-05-04    Bottom Line: Colombian financial markets will be buffeted by ongoing monetary tightening, an impending growth slowdown and rising political volatility. Remain underweight Colombian stocks within an EM equity portfolio and continue shorting the currency versus the US dollar. Maintain a neutral allocation to Colombia in both EM domestic bond and sovereign credit portfolios. We are also initiating a new trade: Bet on substantial yield curve inversion. Feature Chart 1Colombian Equities And Currency Have Underwhelmed Despite High Oil Prices Colombian Equities And Currency Have Underwhelmed Despite High Oil Prices Colombian Equities And Currency Have Underwhelmed Despite High Oil Prices This year’s rally in Colombian stocks and the peso has largely been the result of strong domestic demand and a catch up to sky-high oil prices (Chart 1). In the past month, however, alongside other commodity producers such as Brazil and Chile, Colombian risk assets have been buffeted. This is because the outlook for commodity prices has become more uncertain with an ongoing slowdown in the Chinese economy and an impending slump in DM domestic demand for goods. Going forward, Colombian markets will trade on oil price fluctuation, the local business cycle and the presidential elections. The global commodity trade appears to be struggling at present. The business cycle outlook is negative as hawkish monetary and fiscal policies will slow down growth decisively. The political risks have not yet materialized but they could pose a serious menace to financial markets as frontrunner Gustavo Petro presents institutional risks with his plans to upend Colombia’s market-friendly economic model. All in all, we recommend that investors maintain an underweight stance on Colombian stocks and a short position in the currency, while keeping a neutral allocation to domestic bonds and sovereign credit within their respective EM portfolios. We also recommend betting on yield curve inversion by receiving 10-year and paying 6-month swap rates. Cyclical Forces: Growth Slowdown The Colombian economy is overheating: core measures of inflation are reaching their highest point in two decades (Chart 2). Particularly, hairdresser inflation – which we view as a signpost of genuine inflation given that costs are mainly labor and rent – is high and accelerating (Chart 2, bottom panel). Further, nominal wages are rising at 11% in annual terms, the unemployment rate has fallen almost to pre-pandemic levels, and business inflation expectations remain above the central bank’s (Banrep) target of 3% +/- 1% (Chart 3). These are signs that inflation is genuine and broad based in Colombia. Hence, monetary tightening will continue. Chart 2Colombia: Inflation Is Reaching Historic Highs! Colombia: Inflation Is Reaching Historic Highs! Colombia: Inflation Is Reaching Historic Highs! Chart 3Inflationary Pressures Are Genuine And Broad Inflationary Pressures Are Genuine And Broad Inflationary Pressures Are Genuine And Broad Just last week, the central bank raised the policy rate by 100 basis points to 6%, while three of the seven board members voted for a larger increase of 150 basis points. Rapidly raising the policy rate from a historical low of 1.75% comes at a cost, however, and it will result in a notable growth slowdown. The top panel of Chart 4 shows that banking credit has been strong but is set to roll over as Banrep raises interest rates significantly. Our marginal propensity to consume proxy and the narrow money impulse are also foreshadowing a growth slowdown in domestic demand (Chart 4, bottom two panels) Regarding fiscal policy, the fiscal thrust is going to be negative this year (Chart 5). Chart 4The Economy Will Enter A Slowdown... The Economy Will Enter A Slowdown... The Economy Will Enter A Slowdown... Chart 5... And Fiscal Stimulus Will Not Save The Boat ... And Fiscal Stimulus Will Not Save The Boat ... And Fiscal Stimulus Will Not Save The Boat   A combination of tight fiscal and monetary policies also presents a notable risk to the credit cycle and to banking profitability. Banks’ EPS in local currency terms has reached a historic high, and their share of non-performing loans (NPLs) and provisions has fallen drastically in the past months. As interest rates rise further and the economy slows down, financial stocks – which make up 47% and 54% of the nation’s COLCAP stock index or the MSCI index, respectively – will experience a soft spot. Banks will have to lift their NPL provisions on the back of rising lending rates and a slowdown in growth (Chart 6, top panel). Any time NPL provisions rise (shown inverted in the top and bottom panels of Chart 6), bank share prices drop. As a result, banks will tighten credit standards and reduce loan origination. This will be a hurdle to both economic growth and banks’ profitability. Chart 6Banks' Share Prices And NPLs Banks' Share Prices And NPLs Banks' Share Prices And NPLs Bottom Line: The Colombian economy is facing strong domestic headwinds, which will result in a growth slowdown. The Current Account Deficit: Colombia’s Achilles’ Heel Despite very high oil prices and the rally in commodity plays around the world early this year, the Colombian peso has appreciated only mildly and has given up most of its gains in the past month (Chart 1 above, bottom panel). Odds are the currency will weaken further in the near term (next 3 months), so we are reiterating our recommendation to stay short the peso versus the US dollar: First, it is not certain whether commodity prices will rise significantly in the coming months. While commodity supply constraints remain acute, global demand is deteriorating. In a nutshell, high crude prices are causing oil demand destruction. We elaborated on the outlook for Chinese overall growth and DM domestic demand for goods in our April 21 Strategy Report. This analysis is more pertinent for industrial commodities, less so for oil and has little relevance for agricultural commodities. Second, the chronic massive current account deficit will continue exerting downward pressure on the exchange rate. The current account deficit remains large at $18 billion or 6.2% of GDP as of Q4 2021. Further, even if we assume oil prices will average US $120 per barrel in 2022, the current account deficit will be large in 2022 (Chart 7, top and middle panels). Excluding oil, the current account deficit is also wide. Third, FDI inflows have been meager both in the oil sector and the rest of the economy (Chart 7, bottom panel). There is little chance that FDI will be strong in the coming months given election uncertainty. The front-runner in this year’s presidential elections, Gustavo Petro, has a hardline stance against oil exploration, which would disincentivize foreign investment in the sector. In general, his left-wing policies are not conducive for overall FDI inflows. We elaborate on this topic below. Finally, foreign portfolio flows into local bonds have been a large source of funding for the current account deficit. With the currency depreciating and elevated political risks, net portfolio inflows into domestic bonds could dry up in the near term (Chart 8). Chart 7The Current Account Will Remain In Deficit Despite High Oil Prices The Current Account Will Remain In Deficit Despite High Oil Prices The Current Account Will Remain In Deficit Despite High Oil Prices Chart 8Colombian Local Bonds Will Underperform Colombian Local Bonds Will Underperform Colombian Local Bonds Will Underperform Bottom Line: The current account deficit remains wide. Even a marginal decline in foreign net portfolio inflows will lead to currency depreciation. In turn, given the tight correlation between the exchange rate and headline inflation, the central bank will respond by raising interest rates more to curb inflation. Political Risks: Will Colombia Elect A Left-Wing Government? Since June of last year, we have been arguing that Colombian politics would take a left-ward shift given the massive demonstrations demanding higher government expenditures on social programs. In that report, we also flagged the growing popularity of veteran left-wing candidate Gustavo Petro. Presently, Colombia has never been closer to electing a far-left president. Going forward, we expect Colombian markets will trade on two factors: (1) the possibility of Petro winning the election, and (2) his potential to undermine Colombian institutions if he is elected president. Both will insert volatility in Colombian markets from today till the outcome of the second round is known on June 19. First, we believe the contest between the far-left Gustavo Petro and the conservative Federico “Fico” Gutiérrez will be a very close race. While Petro is set to dominate the first round on May 29 (Chart 9), Fico has had a meteoric rise in popularity since last year, which suggests he can possibly bridge the remaining 7% gap between the contenders before the second round on June 19 (Chart 10). Chart 9Petro Will Dominate In The First Round… Colombia: Market Turbulence Ahead Colombia: Market Turbulence Ahead Chart 10… But The Race Will Be Tight In The Second Round Colombia: Market Turbulence Ahead Colombia: Market Turbulence Ahead The result of the election largely depends on both candidates’ ability to attract moderate voters, which Fico has been more successful in doing. While Petro has doubled down on his left-wing base by choosing progressive environmentalist Francia Márquez as his running mate, Fico has made conscious steps to separate himself from rightwing leaders (particularly ex-president Álvaro Uribe), in line with the leftward shift in Colombian voters. He has done this by campaigning on a more centrist platform, which includes increasing government spending on infrastructure, pensions, primary education and housing. Further, he has secured the support of the centrist Liberal party, which has a large voter base and holds 17% of seats in congress. So far, we believe the election will be largely a toss-up between Petro and Fico. Second, if Petro does manage to win, investors have reasons to worry. Among his policy proposals, some of the most alarming to the business and financial communities include bypassing congress and legislating freely for the first 30 days, forcing private landowners to dedicate land for agriculture, stripping the central bank’s independence and partly nationalizing funds of private pensions. Further, Petro has promised to outright ban new oil explorations due to environmental concerns, which would largely deter domestic and foreign investment into the sector. This would severely reduce dollar inflows and hurt productivity and oil production in the long run, thereby negating the short-term positive effects of high oil prices.   On the other hand, we doubt Petro will be able to fully implement his left-wing agenda. Congress is fragmented between left, right and centrist parties, but the right and center right faction still holds a majority of 51%. Petro will therefore have to negotiate and water down his most radical proposals. Nevertheless, he can still enact presidential decrees, and his intentions to bypass congress to legislate freely for 30 days and his plan to revoke the central bank’s independence are worrying signs for Colombia’s institutions. All in all, the tight race in the second round and the possibility of Petro winning present large risks that we believe financial markets have not fully priced in. Now that domestic demand is set to decelerate and the outlook for oil prices has become muddled, investors will shift their focus to the presidential race. Petro remains the favorite candidate albeit his lead over Fico has narrowed substantially. While Petro may not be able to fully implement his government plan, Colombian risk assets will trade on the loss of business and investor confidence and institutional risks if he wins the election. Further, while conservative candidate Fico’s rise in the polls has been impressive and could get more votes in the final round as other right-wing and centrist candidates drop out of the race after May 29, his victory in the second round is not assured. Expect more political and financial volatility until then. Investment Recommendations We have the following investment recommendations: Equities: maintain an underweight stance within an EM-equity portfolio. A combination of slowing growth, rising interest rates and political risks will be negative for share prices. We will consider upgrading this bourse to neutral when election risks are priced in and if the right-wing candidate Fico secures the presidential victory. Currency: keep shorting the Colombian peso versus the US dollar. Domestic Bonds: maintain a neutral allocation relative to the respective EM benchmark. Local yields offer value (the 10-year bond yield stands at 10.5%), and the macro policy mix remains fairly orthodox. Nevertheless, given that foreign investors hold 25% of the local bond market, the risk of Petro’s victory would entail large outflows from this asset class. We are initiating a yield curve flattening trade: Receive 10-year and pay 6-month swap rates (Chart 11). As Banrep hikes rates and the economy slows down, chances are high that the yield curve will invert considerably. Sovereign Credit: maintain a neutral allocation within an EM-dedicated credit portfolio. Colombia’s sovereign spreads offer a lot of value: credit spreads are above mainstream Latin American countries (Chart 12). However, the possible election of Petro presents a risk to this asset class. Chart 11Colombia: Prepare For A Yield Curve Inversion Colombia: Prepare For A Yield Curve Inversion Colombia: Prepare For A Yield Curve Inversion Chart 12Colombian Sovereign Credit Is Cheap! Colombian Sovereign Credit Is Cheap! Colombian Sovereign Credit Is Cheap!   Juan Egaña Associate Editor juane@bcaresearch.com

Executive Summary Copper Will Remain Tight Even In Recession Copper Will Remain Tight Even In Recession Copper Will Remain Tight Even In Recession Supply-chain disruptions arising from Russia's invasion of Ukraine and demand hits from lockdowns in Shanghai are increasing the odds of a global recession, which can be seen in the WTO's latest economic forecast. Cyclical base-metals demand, particularly copper's, will slow in a recession. Still, markets will remain physically short and well bid, as incremental demand from the global renewable-energy and defense buildouts gathers strength. Global GDP growth will return to trend in 2024. Renewables and defense-related demand will continue to power ahead. Physical deficits will persist. Copper-supply growth increasingly is tied to local political risk – e.g., Chile's government sued miners over water-use disputes this month. Miners now are seeking assurances investment will be protected before committing to higher capex. The environmental stain arising from the global competition for metals will redound to the benefit oil and gas E+Ps involved in natural gas and hydrogen production. Bottom Line: A higher likelihood of a global recession will not diminish the drive to secure base metals critical to renewables and defense, particularly copper. This will keep metals bid and inventories strained. Stagflation likely ensues. We remain long commodity-index exposure expecting longer-term backwardation, and ETFs with exposures to the equity of miners. We continue to expect copper prices to average $5/lb on the COMEX this year, and $6/lb in 2023. Feature The World Trade Organization (WTO) released a sharply lower expectation for global growth this week – from a robust 5.7% rate in 2021 to 2.8% this year and 3.2% next year.1 This effectively translates into a global recession arriving this year. The WTO forecast also calls for global merchandise trade volume to grow 3.0% in 2022 and 3.4% in 2023, which also will dampen cyclical aluminium demand. Related Report  Commodity & Energy StrategyCopper Will Grind Higher The WTO's forecast is one of the first among major agencies to incorporate the impact of the Ukraine war and supply-chain disruptions arising from lockdowns in Shanghai. If the WTO's forecast is realized, cyclical copper and base metals demand will slow, but markets will remain physically short – i.e., in deficit – and well bid, in our view (Chart 1). Incremental demand from the global renewable-energy and defense buildouts in the Big 3 military-industrial blocs – the EU, US and China – will gather strength and keep metals markets tight over the course of this decade (Chart 2). Chart 1Copper Will Remain Tight Even In Recession Copper Will Remain Tight Even In Recession Copper Will Remain Tight Even In Recession Chart 2Copper Inventories Will Remain Tight Copper Demand Will Ignore Recession Copper Demand Will Ignore Recession Global refined copper demand is highly sensitive to GDP growth: While not exactly a 1-for-1 correspondence, a 1% increase in global GDP translates into a 0.76% increase in refined copper demand. A 1% increase in EM GDP translates into a 0.54% increase in refined copper demand in these economies (Chart 3). Interestingly, our modeling finds DM GDP growth has had little if any effect on global refined copper demand, most likely because, historically, DM economies were not building infrastructure to the extent EM economies, particularly China and the Asian Tigers, has been building over past decades. Chart 3World, EM GDP Drive Copper Demand World, EM GDP Drive Copper Demand World, EM GDP Drive Copper Demand Estimating New Incremental Copper Demand The DM base metals demand profile – particularly for copper – is set to change dramatically following the Russian invasion of Ukraine. Russian aggression prompted the EU to double-down on its renewable energy build-out, and to restore a credible military to protect its borders and the safety of its citizens. Both of these efforts will be funded by new bond-issuance programs from the EU. Practically, this means the EU will join the US and Chinese military-industrial complexes in the global competition for critical materials required for the renewable-energy and defense buildouts. The EU and China already were active on the renewables side; it is the US that will be joining that race on a larger scale following the passage of legislation by the Biden administration to fund and incentivize renewables.2 The US and China have been in an intense competition to build military capacities; now the EU joins that race. None of these military-industrial complexes will provide actual spending estimates for these buildouts, which means markets have to continually revise their supply-demand estimates for base metals as data becomes available. Copper markets provide the best data for such an exercise – it is the bellwether market for base metals, with useful data to estimate supply and demand. As a starting point for our estimation of copper balances going forward, we assume global cyclical demand will remain a function of global GDP; EM demand also can be modelled using EM GDP as an explanatory variable. We also assume that the 10 years ending in 2030 will require refined copper production to double in order to meet demand for renewable-energy and from the military-industrial complex globally. We make some reasonable first approximations of what this will look like initially, and then will iterate as actual data becomes available. Chart 1 shows the evolution we expect for global consumption as a function of cyclical and incremental demand. On the supply side, we use estimated annual production for refined copper production from the Australian government's Department of Industry, Science, Energy and Resources, and the World Bureau of Metals Statistics. We note there are a few noteworthy projects due to come on line – e.g., Canada (Kena Gold-Copper project; Blue Cove Copper Project); Congo (Kamoa-Kakula project ramping up); Peru (Quellaveco) and Chile (Pampa Norte). We again note that copper supply in critically important states accounting for huge shares of global production – e.g., Chile (30% of global mining output) and Peru (10%) – increasingly is vulnerable to local political risks.3 Chile, in particular, is facing environmental and political challenges on the mining side: It is in the 13th year of a drought, which forced the government to institute water rationing in the capital Santiago this week. In addition, last week the federal government sued major mining companies over water-rights disputes. Our price view will evolve as we get data on cyclical and incremental demand, and supply additions.We would note in this regard major miners already are sounding the alarm on how difficult it will be to lift supply over the next 10 years given the likely demand markets will be pricing in. For now, we are maintaining our expectation COMEX copper prices will average $5/lb this year and $6/lb next year, and that markets will remain backwardated with inventories remaining under pressure (Chart 2).4 Investment Implications Base metals markets – copper included – are facing a moment of reckoning in terms of being able to support the global push for renewable energy. While the odds of a global recession in the wake of Russia's invasion of Ukraine and China's lockdowns to address the COVID-19 outbreak in Shanghai are higher – which ordinarily would point to inventory accumulation, all else equal – we believe markets will remain tight. A recession will cause cyclical demand to soften, which, along with marginal new supply, will keep the COMEX forward curve relatively flat over the short term (3-9 months). However, over the next two years and beyond, supply will not be coming on fast enough to offset cyclical and incremental demand from the global renewables and defense buildouts (Chart 3). This will keep copper markets in physical-deficit conditions, and inventories will have to draw to meet demand (Chart 4). We expect this will translate into renewed backwardation in the COMEX forward curve. Chart 4Global Inventories Will Continue To Draw Copper Demand Will Ignore Recession Copper Demand Will Ignore Recession Chart 5Backwardation Will Re-emerge Backwardation Will Re-emerge Backwardation Will Re-emerge We remain bullish copper over the medium and longer terms, and remain long commodity index exposure expecting a return of backwardation in COMEX copper, and the XME ETF, which gives us exposure to base metals miners (Chart 5).   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodity Round-Up Energy: Bullish US LNG exports hit record highs again in March, continuing a streak that began in December 2021. Exports averaged 11.9 Bcf/d for the month, on the back of new liquefaction capacity coming on line at the beginning of March. The US EIA is expecting LNG exports to average 12.2 Bcf/d this year, which would represent a 25% increase in shipments abroad. This US is accounting for the bulk of European LNG exports at present. European storage ended March at 26% of capacity, vs. a five-year average capacity of 34% at end-March. Separately, China became the largest importer of LNG in the world in 2021, displacing Japan for the top spot. According to the EIA, China’s LNG imports averaged 10.5 Bcf/d last year, which was close to 20% above 2020 levels. China's LNG imports exceeded Japan's , a 1.7 Bcf/d (19%) increase over its 2020 average, and 0.8 Bcf/d more than Japan’s imports. Base Metals: Bullish The Fraser Institute released a report assessing states’ and countries’ mining investment attractiveness for 2021. Investment attractiveness is measured by accounting for the mineral availability in the region and the effect of government policy on exploration investment. Western Australia topped the charts, while the copper-rich nations of Chile and Peru ranked 38th and 49th. This is telling of the policy adversity and uncertainty towards mining in these two countries and resonates with a BHP executive’s remarks a few weeks ago. Last week, the Chilean government sued mines operated by BHP, Albemarle, and Antofagasta over alleged environmental damage. One of the mines sued is BHP’s Escondida, the world’s largest copper mine. Precious Metals: Bullish According to Impala Platinum, palladium and rhodium prices are expected to rally for the next four-to-five years on tight market fundamentals. Low palladium supply coupled with an increase in the metal’s demand for catalytic converters, as pollution control regulations tighten, are causing the supply squeeze. On April 8 London’s Platinum and Palladium Market suspended Russian refiners from minting platinum and palladium for the London market, boosting the price of both metals (Charts 6 and 7). Russia supplies 10% and 40% of global mined platinum and palladium respectively. Depending on the period of the suspension, Europe may need to substitute Russian imports of the metals from South Africa. Chart 6 Copper Demand Will Ignore Recession Copper Demand Will Ignore Recession Chart 7 Copper Demand Will Ignore Recession Copper Demand Will Ignore Recession       Footnotes   1     Please see the WTO's "TRADE STATISTICS AND OUTLOOK: Russia-Ukraine conflict puts fragile global trade recovery at risk," released by the WTO on April 12, 2022. Revisions are subject to the evolution of the war in Ukraine following Russia's invasion in February 2022. 2     Worthwhile noting here the Biden Administration in the US invoked the Defense Production Act (DPA) to "to support the production and processing of minerals and materials used for large capacity batteries – such as lithium, nickel, cobalt, graphite, and manganese." In addition, the US Department of Defense will be tasked in implementing this authority. Lastly, the White House readout notes, "The President is also reviewing potential further uses of DPA – in addition to minerals and materials – to secure safer, cleaner, and more resilient energy for America." Practically, the US and China are treating access to critical materials as a defense issue. The EU likely joins this club in the very near future. 3    Please see our report from February 24, 2022 entitled Copper Will Grind Higher for additional discussion. It is available at ces.bcaresearch.com. 4    Please see, e.g., Bigger investment in mining needed to meet climate goals, says LGIM, published by ft.com on  April 5, 2022. The article summarizes a study done by Legal & General Investment and BHP, which notes that without a significant increase in mining activity – which is itself a hydrocarbon-intensive undertaking – there will not be sufficient supplies to achieve the IEA's 2050 net-zero goals.     Investment Views and Themes Strategic Recommendations Trades Closed in 2021 Image  

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