Latin America

Executive Summary Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade  Petrocurrencies have lagged the surge in crude prices. This has been specific to the currency space since energy stocks have been in an epic bull market.Both cyclical and structural factors explain this conundrum.Cyclically, rising interest rate expectations in the US have dwarfed the terms-of-trade boost that the CAD, NOK, MXN, COP and even BRL typically enjoy (Feature Chart).Structurally, the US is now the biggest oil producer in the world (and a net exporter of natural gas). This has permanently shifted the relationship between the foreign exchange of traditional oil producers and the US dollar.Oil prices are overbought and vulnerable tactically to any resolution in the Russo-Ukrainian conflict. That said, they are likely to remain well bid over a medium-term horizon, ultimately supporting petrocurrencies.Petrocurrencies also offer a significant valuation cushion and carry relative to the US dollar, making them attractive for longer-term investors.Tactically, the currencies of oil producers relative to consumers could mean revert. It also suggests the Japanese yen, which is under pressure from rising energy imports, could find some footing, even as oil prices remain volatile.RECOMMENDATIONINCEPTION LEVELINCEPTION DATERETURNShort NOK/SEK1.112022-03-24-Bottom Line: Given our thesis of lower oil prices in the near term, but firmer prices in the medium term, we will be selling a basket of oil producers relative to oil consumers, with the aim of reversing that trade from lower levels.FeatureOil price volatility is once again dominating global market action. After hitting a low of close to $96/barrel on March 16th, Brent crude is once again at $120 as we go to press. Over the last two years, Brent crude has been as cheap as $16, and as expensive as $140. Energy stocks (and their respective bourses) have been the proximate winner from rising oil prices (Chart 1).Related ReportForeign Exchange StrategyWhat Next For The RMB?In foreign exchange markets, the currencies of commodity-producing countries have surprisingly lagged the improvement in oil prices (Chart 2). Historically, higher oil prices have had a profound impact on the external balance of oil producing versus consuming countries in general and petrocurrencies in particular. Chart 1Energy Stocks Have Tracked Forward Oil Prices Energy Stocks Have Tracked Forward Oil Prices Energy Stocks Have Tracked Forward Oil Prices   Chart 2Petrocurrencies Have Lagged Oil Prices Petrocurrencies Have Lagged Oil Prices Petrocurrencies Have Lagged Oil Prices  Based on the observation above, this report addresses three key questions:Are there cyclical factors depressing the performance of petrocurrencies?Are there structural factors that have changed the relationship of these currencies with the US dollar?What is the outlook for oil, and the impact on short term versus longer-term currency strategy?We will begin our discussion with the outlook for oil.Russia, Oil, And PetrocurrenciesA high-level forecast from our Commodity & Energy Strategy colleagues calls for oil prices to average $93 per barrel this year and next.1 The deduction from this forecast is that we could see spot prices head lower from current levels this year but remain firm in 2023. From our perspective, there are a few factors that support this view:Forward prices tend to move in tandem with the spot fixing (Chart 3), but recently have also been a fair predictor of where current prices will settle over the medium term. Forward oil prices are trading at a significant discount to spot, suggesting some measure of mean reversion (Chart 4). Chart 3Forward And Spot Oil Prices Move Together Forward And Spot Oil Prices Move Together Forward And Spot Oil Prices Move Together   Chart 4The Oil Curve And Spot Prices The Oil Curve And Spot Prices The Oil Curve And Spot Prices  There is a significant geopolitical risk premium embedded in oil prices. According to the New York Federal Reserve model, the demand/supply balance would have caused oil prices to fall between February 11 and February 25 this year. They however rose. This geopolitical risk premium has surely increased since then (Chart 5).Chart 5Oil Prices Embed A Significant Geopolitical Risk Premium The Oil-Petrocurrency Conundrum The Oil-Petrocurrency Conundrum  Russian crude is trading at a sizeable discount compared to other benchmarks. This means that the incentive for substitution has risen significantly. Our Chief Commodity expert, Robert Ryan, noted on BLU today that intake from India is rising. This is helping put a floor on the Russian URAL/Brent discount blend at around $30 (Chart 6). Oil is fungible, and seaborne crude can be rerouted from unwilling buyers to satiate demand in starved markets.A fortnight ago, we noted how the US sanctions on Russia could shift the foreign exchange landscape, especially vis-à-vis the RMB. Specifically, RMB-denominated trade in oil is likely to increase significantly going forward. China has massively increased the number of bilateral swap lines it has with foreign countries, while stabilizing the RMB versus the US dollar.2Finally, smaller open economies such as Canada, Norway and even Mexico are opening the oil spigots (Chart 7). While individually these countries cannot fill any potential gap in Russian production, collectively they could help in the redistribution of oil supplies. Chart 6Russian Oil Is Selling At A Discount Russian Oil Is Selling At A Discount Russian Oil Is Selling At A Discount   Chart 7Small Oil Producers Will Benefit From High Prices Small Oil Producers Will Benefit From High Prices Small Oil Producers Will Benefit From High Prices  The observations above suggest that the currencies of small oil-producing nations are likely to benefit in the medium term from a redistribution in oil demand. Remarkably, there has been little demand destruction yet from the rise in prices, according to the New York Fed. This suggests that as the global economy reopens, and the demand/supply balance tightens, longer-term oil prices will remain well bid.The key risk in the short term is the geopolitical risk premium embedded in oil prices fades, especially given the potential that Europe, China, and India continue to buy Russian supplies. We have been playing this very volatile theme via a short NOK/SEK position. We are stopped out this week for a modest profit and are reinitiating the trade if NOK/SEK hits 1.11.On The Underperformance Of Petrocurrencies? Chart 8Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade Petrocurrencies Have Lagged Terms Of Trade  The more important question is why the currencies of oil producers like the CAD, NOK, MXN or even BRL have not kept pace with oil prices as they historically have. As our feature chart shows (Chart 8), petrocurrencies have severely lagged the improvement in their terms of trade. This has been driven by both cyclical and structural factors.Cyclically, the underlying driver of FX in recent quarters has been the nominal interest rate spread between the US and its G10 counterparts. We have written at length on this topic, and on why we think there is a big mispricing in market behavior in our report – “The Biggest Macro Question By FX Investors Could Potentially Be The Least Relevant.” In a nutshell, two-year yields in the G10 have been lagging US rates, despite other central banks being ahead of the curve in hiking interest rates. This means that rising interest rate expectations in the US have dwarfed the terms of trade boost that the CAD, NOK, MXN, COP and even BRL typically enjoy.Structurally, the US is now the biggest oil producer in the world (Chart 9). This means the CAD/USD and NOK/USD exchange rates are experiencing a tectonic shift on a terms-of-trade basis. In 2010, the US accounted for only about 6% of global crude output. Collectively, Canada, Norway, and Mexico shared about 10% of global oil production. The elephant in the room was OPEC, with a market share just north of 40%. Today, the US produces over 14%, with Russia and Saudi Arabia around 13% each, the US having grabbed market share from many other countries. Chart 9The US Dominates Oil Production The US Dominates Oil Production The US Dominates Oil Production   Chart 10The US Dollar Is Becoming Increasingly Correlated To Oil The US Dollar Is Becoming Increasingly Correlated To Oil The US Dollar Is Becoming Increasingly Correlated To Oil  As a result of this shift, the positive correlation between petrocurrencies and oil has gradually eroded. Measured statistically, the dollar had a near-perfect negative correlation with oil around the time US production was about to take off. Since then, that correlation has risen from around -0.9 to around -0.2 (Chart 10).A Few Trade IdeasThe analysis above suggests a few trade ideas are likely to generate alpha over the medium term:Long Oil Producers Versus Oil Consumers: This trade will suffer in the near term as oil prices correct but benefit from a relatively tighter market over a longer horizon. It will also benefit from the positive carry that many oil producers provide (Chart 11). We will go long a currency basket of the CAD, NOK, MXN, BRL, and COP versus the euro at 5% below current levels.Chart 11Real Rates Are High Amongst Petrocurrencies The Oil-Petrocurrency Conundrum The Oil-Petrocurrency Conundrum  Sell CAD/NOK As A Trade: Norway is at the epicenter of the likely redistribution that will occur with a Russian blockade of crude, while Canada is further away from it. Terms of trade in Norway are doing much better than a relative measure in Canada (Chart 12). The discount between Western Canadian Select crude oil and Brent has also widened, which has historically heralded a lower CAD/NOK exchange rate. Chart 12CAD/NOK And Terms Of Trade CAD/NOK And Terms Of Trade CAD/NOK And Terms Of Trade  Follow The Money: Oil now trades above the cash costs for many oil-producing countries. This means the incentive to boost production, especially when demand recovers, is quite high. This incentivizes players with strong balance sheets to keep the taps open. This could be a particular longer-term boon for the Canadian dollar which is seeing massive portfolio inflows (Chart 13). Chart 13Canadian Oil Export Boom And Portfolio Flows Canadian Oil Export Boom And Portfolio Flows Canadian Oil Export Boom And Portfolio Flows  On The Yen (And Euro): Rising oil prices have been a death knell for the yen which is trading in lockstep with spot prices. Ditto for the euro. However, the yen benefits from very cheap valuations and extremely depressed sentiment. Any temporary reversal in oil prices will boost the yen (Chart 14). In our trading book, we were stopped out of a short CHF/JPY position last Friday, and we will look to reinitiate this trade in the coming days.  Chart 14The Yen And Oil Prices The Yen And Oil Prices The Yen And Oil Prices   Chester NtoniforForeign Exchange Strategistchestern@bcaresearch.comFootnotes1 Please see Commodity & Energy Strategy Weekly Report, “Uncertainty Tightens Oil Supply”, dated March 17, 2022.2 Please see Foreign Exchange Strategy Special Report, “What Next For The RMB?”, dated March 11, 2022.Trades & ForecastsStrategic ViewTactical Holdings (0-6 months)Limit OrdersForecast Summary

Executive Summary Chile: Stocks Rally When Inflation Rolls Over Chile: Stocks Rally When Inflation Rolls Over Chile: Stocks Rally When Inflation Rolls Over The Chilean economy is overheating. Headline and core inflation have more than doubled the central bank’s target and wage growth is surging. Odds are inflation will climb higher before falling. The central bank has no choice but to hike rates aggressively and slow the economy considerably to bring inflation within its target range. Provided the newly elected Congress is fragmented, president Boric will be compelled to negotiate and balance the interests of both the left- and right-wing factions. As a result, the outcome will be more balanced policies.  The only political risk emanates from the Constitutional Assembly veering too much to the left. Recommendation Inception Date Return Upgrade Chilean Equities To Neutral Within EM       March 14, 2022   Take Profits On Short CLP/Long USD Position                       March 25, 2021  7.6% Bottom Line: Chilean equities tend to rally only after core inflation rolls over and when the domestic yield curve is steepening. Neither of these two conditions are satisfied at the moment. Thereby we are upgrading Chilean stocks to neutral rather than overweight within an EM equity portfolio. We are also booking profits on our short CLP/long USD position. Feature Chart 1Chile: Inflation Is Out Of Control Chile: Inflation Is Out Of Control Chile: Inflation Is Out Of Control Inflation is out of control in Chile: headline and core CPI measures have more than doubled the central bank’s (CBoC) target of 3% +/-1%, and trimmed mean CPI is following suit (Chart 1). Given inflation in Chile is now genuine (more on this below) and is overshooting, monetary authorities have no choice but to slow the economy considerably for inflation to drop within the central bank’s target range. Hence, the central bank will continue to hike interest rates aggressively, which will ultimately lead to a growth slump. The implications for financial markets are mixed. On the one hand, the aggressive monetary tightening and an eventual economic downturn are negative for equities. On the other hand, Chilean equities are cheap, and political volatility has largely dissipated as president-elect Gabriel Boric has proven to be more pragmatic than markets had initially thought. All in all, we are upgrading our allocation to Chilean equities to neutral relative to the EM benchmark and are placing this bourse on an upgrade watchlist. We are also taking profits on our short CLP/long USD position. Overheating, Monetary Tightening And Downturn Aggressive fiscal and monetary stimulus during the pandemic have pushed the economy into overdrive. Domestic demand has recovered well above pre-pandemic levels, and various segments have expanded at double-digit rates (Chart 2). Particularly, the economy has entered a wage-inflation spiral. In the past 12 months, wage growth, while robust, has not kept pace with headline inflation, i.e., real wages have not risen (Chart 3, top two panels). Thus, employees will be demanding faster wage growth to offset their eroding purchasing power from last year and safeguard against rampant inflation going forward. Chart 2The Economy Is Overheating The Economy Is Overheating The Economy Is Overheating Chart 3The Labor Market Is Tight, Wages Will Accelerate The Labor Market Is Tight, Wages Will Accelerate The Labor Market Is Tight, Wages Will Accelerate   With a tight labor market (Chart 3, bottom panel) and sales booming, companies have little choice but to grant employees hefty wage increases. Wages rising faster than productivity will push up unit labor costs and squeeze corporate profit margins. Businesses faced with strong demand will raise their selling prices, unleashing a wage-inflation spiral. Chart 4Inflation Has Yet To Reach A Peak Inflation Has Yet To Reach A Peak Inflation Has Yet To Reach A Peak Our core CPI model shows inflation has yet to reach its peak (Chart 4). Further, the oil and wheat price shock emanating from the Ukrainian geopolitical conflict will push inflation upwards at the margin. The only way to stop this wage-inflation spiral and bring inflation down within the CBoC’s target range is to tighten policy substantially so the economy slows dramatically, companies’ pricing power is constrained and rising unemployment curbs wage pressures. The central bank appears ready to raise rates from 5.5% now to well over the upper limit of their policy rate corridor of 6.5-7%: Inflation expectations have reached their highest levels in a decade. Business inflation expectations for the next 12 months stand at 5.75% (Chart 5), and the bond market is pricing in 6% in the same period, well above the CBoC’s inflation target band of 3% +/-1%. Bank credit for both consumers and enterprises is booming, a sign that interest rates are too low. The new central bank governor Rosanna Costa is particularly determined to bring down inflation. Costa was appointed by leaving president Sebastián Piñera after Boric selected governor Mario Marcel as his finance minister. Costa is a close ally of Piñera and was deputy director of a conservative think tank before joining the CBoC’s board in 2017. She belongs to the camp of conservative orthodox economists and will not give in to pressure from the new government to tighten monetary policy gradually. Investors should expect hawkish monetary policy surprises from the new governor. Further, the new government will not curtail fiscal spending to rein in inflation, as the key policy proposal from Boric was to increase government spending on social programs. His government entered office on March 11. Finally, it seems that the Constituent Assembly is veering too much to the left in its draft of the new constitution. This could also fuel inflation expectations as such a leftward shift in Chile might be associated with higher price pressures. We elaborate on these topics below. The CBoC, headed by a conservative economist and being the guarantor of price stability, will respond by raising rates aggressively. Monetary authorities will hike rates considerably to bring inflation within the target range. The upshot is the economy will enter a major downturn. The 10-year/1-year yield curve has recently drastically inverted, signaling an economic downtrend ahead (Chart 6).  Chart 5Business Inflation Expectations Are Very High Business Inflation Expectations Are Very High Business Inflation Expectations Are Very High Chart 6An Inverted Yield Curve Foreshadows A Major Slowdown An Inverted Yield Curve Foreshadows A Major Slowdown An Inverted Yield Curve Foreshadows A Major Slowdown   Bottom Line: The Chilean economy is in classic overheating mode, and the central bank will tighten aggressively. The outcome will be a major growth deceleration toward the end of this year. A Word On Politics     While we argued in our previous reports  that Boric will win the elections and prove to be a pragmatic president, we did not upgrade our stance on Chilean financial markets back on December 15. Since winning the election, the president-elect has nominated a largely pragmatic cabinet, has chosen orthodox former CBoC governor Mario Marcel as his finance minister, and has pledged fiscal responsibility by keeping public debt under control and disallowing another round of pension fund withdrawals. Share prices and the peso have rallied on these developments despite the global equity riot. Thus, our political analysis has proven to be correct, yet our investment strategy has been wrong footed. We do not expect much market volatility to arise from the new government’s policies. Boric and his team have promised to increase fiscal expenditures on social programs, and intend to finance this bill by gradually raising taxes on the wealthiest Chileans and enacting a progressive tax on mining exports. The result will be somewhat but not overly expansionary fiscal policy. Further, the newly elected Congress is fragmented. Boric will therefore be compelled to negotiate and balance the interests of both the left- and right-wing factions. As a result, the outcome will be more balanced government policies.  The primary source of political volatility could come from the Constitutional Assembly, which is dominated by independent and left-wing representatives. There have recently been fears that the Assembly is becoming too radical, by going beyond expanding social rights and proposing nationalizing mining industries and prohibiting commodity extraction on indigenous lands. Nevertheless, it is important to note that the voting process on the new constitution should prevent any radical outcome. There will be a national vote by the second half of the year in which voters must choose between the new or old constitution. If the Constitutional Assembly veers too much to the left, voters will reject it and the previous one will remain in place. According to Cadem’s survey from March 6, 44% of Chileans support the new constitution, compared to 56% in January. This is in stark contrast to the overwhelming support of 78% it received last year in the national plebiscite.  All in all, the higher the risk that the new constitution becomes too radical, the higher the probability that it will be rejected by Chilean voters. This self-regulating process entails political volatility is likely but will be contained. On the whole, this could lead to a period of volatility in Chilean risk assets, but we will be looking to use that weakness to upgrade Chilean stocks to overweight. Investment Recommendations Chart 7Chilean Equities Are Inexpensive Chilean Equities Are Inexpensive Chilean Equities Are Inexpensive We recommend that investors upgrade Chilean equities to neutral within an EM equity portfolio. Chilean equities are cheap (Chart 7). Given that Boric’s pragmatic approach has largely dissipated political risks, an upgraded at least to neutral is warranted. To further lift this bourse to overweight, we need to see the following: 1. Inflation rollover: Chart 8 shows that Chilean equities tend to rally in absolute terms only after core inflation peaks. As we discussed above, inflation will not top out soon. In fact, share prices typically drop during the period of overheating when growth is robust, inflation is rising, and the central bank is tightening. This is because stocks are forward looking and struggle to rally due to the poor profit outlook. 2. Yield curve steepening: Share prices typically fall when the yield curve is flattening (Chart 9). The recent divergence between share prices and the yield curve is unsustainable. We think the yield curve will invert more as the CBoC hikes rates aggressively. This entails that share prices are at risk at the moment. Chart 9A Flattening Yield Curve Signals Equity Risks A Flattening Yield Curve Signals Equity Risks A Flattening Yield Curve Signals Equity Risks Chart 8Chile: Stocks Rally When Inflation Rolls Over Chile: Stocks Rally When Inflation Rolls Over Chile: Stocks Rally When Inflation Rolls Over               We are booking profits on our short CLP/ long USD position, which has generated a 7.6% return since March 25, 2021. Sharply rising interest rates amid still robust growth and high copper prices will put a floor under the currency. Fixed income investors should overweight Chile in both local currency bond and USD bond portfolios.   Juan Egaña Research Analyst juane@bcaresearch.com

Executive Summary Russia Not Prepared To Invade West Ukraine Yet Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) Russia is escalating its aggressiveness in Ukraine, marked by the shelling of a nuclear power station, troop reinforcements, and rhetorical threats of nuclear attack. Global financial markets will continue to suffer from negative news arising from this event until Russia achieves its aims in eastern Ukraine. Private sector boycotts on Russian commodity exports are imposing severe strains on the Russian economy, provoking it to apply more pressure on Ukraine and the West. Western governments are losing the ability to control the pace of strategic escalation, a dangerous dynamic. Moscow’s demand for security guarantees from Finland and Sweden will lead to a further escalation of strategic tensions between Russia and the West. During the Cold War the US and USSR saw a “balance of terror” due to rapidly expanding nuclear arms, which prevented them from waging war against each other. Today the same balance will probably prevent nuclear war but a nuclear scare that rattles financial markets may be required first. Trade Recommendation Inception Date Return Long Gold (Strategic) 2019-12-06 32.1% Bottom Line: Russia’s aggressiveness toward the US and Europe, including nuclear threats and diplomatic demands, will continue to escalate until it achieves its core military objectives. Investors should stick to safe havens and defensive equity markets and sectors on a tactical basis. Book profits on tactical trade long Japan/Germany industrials at close of trading on March 4. Feature Russian military forces shelled the Zaporizhzhia Nuclear Power Station on March 4, causing a fire. The International Atomic Energy Agency (IAEA) declared that “essential equipment” was not damaged and that the facility possessed adequate containment structures to prevent a nuclear meltdown. Local authorities said the facility was “secured.” This incident, which may or may not be settled, should be added to several others to highlight that Russia is escalating its aggression in Ukraine and global financial markets face more bad news that they will be forced to discount. Signposts For Further Escalation Map 1 shows the status of the Russian invasion of Ukraine, along with icons for the nuclear power plants. Map 1War In Ukraine, Status Of Russian Invasion As Of March 2, 2022 Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) To understand the end-game in Ukraine – and why we think the war will escalate and are keeping open our bearish trade recommendations – we need to review our net assessment for this conflict: Our 65% “limited invasion” scenario included the seizure of strategic territory east of the Dnieper river and all of the southern coastline. Energy trade would be exempt from sanctions, saving Europe from a recession and limiting the magnitude of global energy shock. We gave 10% odds to a “full-scale invasion of all of Ukraine” (deliberate wording) because we viewed it as highly unlikely that Russia would invade the mountainous and guerilla-happy far west, the ethnic Ukrainian core. Energy trade would be sanctioned, delivering a global energy shock and European recession. A handful of clients have criticized us for not predicting that Russia would attack Kiev and for not defining a full-scale invasion as one that involved replacing the government. We never gave a view on whether Russia would invade Kiev. It is not clear that the focus on Kiev is warranted since the US and EU had committed to powerful sanctions in the event of any invasion at all. This fixed price of invasion may have given Moscow the perverse incentive to invade Kiev. Either way, Russia invaded Kiev and eastern Ukraine and the US and EU imposed crippling sanctions but exempted the energy trade. Thus anything that breaks off energy trade between the EU and Russia – and any Russian attempt to invade the west of the country to Poland – should be seen as a significant escalation. Unfortunately there are signs that the energy trade is being disrupted. Any westward campaign to Poland will be delayed until Putin sacks Kiev and controls the east and south of Ukraine, at which point he will be forced either to invade the west to cut off the supply lines of the insurgency or, more likely, to negotiate a ceasefire that partitions Ukraine. Global investors will not care about the war in Ukraine as long as strategic stability is achieved between Russia and the West. But that is far away. Today, as Russia’s economic situation deteriorates, Putin is escalating on the nuclear front. Bottom Line: Russia’s showdown with the West is escalating. Good news for the Ukrainians will lead to bad news for financial markets. Global investors should not view the situation as stabilized and should maintain safe haven trades and defensive equity positioning. Energy Boycotts Will Antagonize Russia Chart 1Russia Not Prepared To Invade West Ukraine Yet Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) So far Russia has not conducted a full-scale invasion of all of Ukraine. The reason is that it does not have the necessary military forces, as we have highlighted. Russia is limiting its invasion force to around 200,000 troops while Ukraine consists of 30 million prime age citizens (Chart 1). Unless Russia massively reinforces its troops, it does not have the basic three-to-one troop ratio that is the minimum necessary to invade, conquer, and hold the entire country. However, Russia is likely to increase troop sizes. We are inclined to believe that Russia has started shifting troops from its southern and eastern military districts to reinforce the Ukraine effort, according to the Kyiv Independent, citing the Ukrainian armed forces’ general staff. Apparently it aims to conquer the east and then either invade further west or negotiate a new ceasefire with greater advantage. Investors should not accept the consensus narrative in the western world that Russia is losing the war in the east. Russia is encountering various difficulties but it is gradually surrounding and blockading Ukraine and cutting its power supply. It is capable of improving its supply lines and increasing the size and destructiveness of its forces. Remember that the US took 20 days to sack Baghdad in 2003. Russia has only been fighting for nine days. Having incurred crippling economic sanctions, Putin cannot afford to withdraw without changing the government in Kiev. The odds of Ukraine “winning” the war are low, while the odds of Russia dramatically intensifying its efforts are high. This is why new developments on the energy front and worrisome: Chart 2Energy Trade Remains The Fulcrum Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) While western governments refrained from sanctioning Russian energy as predicted, private companies are boycotting Russian energy to avoid sanctions and unpopularity. Estimates vary but about 20% of Russian oil exports could be affected so far.1 Russian oil will make its way to global markets – Russian, Chinese, and other third parties will pick up the slack – but in the meantime the Russian economy is suffering more than expected due to the cutoff. Energy is the vital remaining source of Russian economic stability and Russo-European relations (Chart 2). If it fails then Russia could grow more desperate while Europe’s economy would fall into recession and Europe would become less stable and less coordinated in its responses to the conflict. These private boycotts make it beyond the control of western governments to control the pace and intensity of pressure tactics, since it is politically impractical to demand that companies trade with the enemy. Bottom Line: With the rapidly mounting economic pressure, it should be no surprise that Russia is escalating its threats – it is under increasing economic pressure and wants to drive the conflict to a quick decision in its favor. Russia’s Nuclear Threats And Putin’s Mental State Russia is terrorizing Ukraine and the western world with threats of either nuclear missile attacks or a nuclear meltdown. Putin put the country’s nuclear deterrent forces on “special combat status” on February 27. His forces began shelling the Zaporizhzhia nuclear power plant on March 4. Russia is also demanding security guarantees from Finland and Sweden, which are becoming more favorable toward joining the NATO alliance.2 Their lack of membership in NATO, while maintaining a strong military deterrent with defense support from the US, was a linchpin of stability in the Cold War but is now at risk. They will retain the right to choose their alliances at which point Russia will need to threaten them with attack. Since Russia cannot plausibly invade them with full armies while invading Ukraine, it may resort to nuclear brinksmanship. The western media is greatly amplifying a narrative in which Russia’s actions can only be understood in the context of Putin’s insanity or fanaticism. This may be true. But it is also suspicious because it saves the West from having to address the problem of NATO enlargement, which, along with Russia’s domestic weaknesses, contributed to Russia’s decision over the past 17 years to stage an aggressive campaign to control Ukraine and the former Soviet Union. There is a swirl of conspiracy theories in the news about Putin’s illnesses, age, vaccines, or psychology, none of which are falsifiable. Putin has an incentive to appear reckless and insane so that his enemies capitulate sooner. The decision to invade a non-NATO member, rather than a NATO member, suggests that he is still making rational calculations. Rational, that is, from the perspective of Russian history and an anarchic international system in which nation states that seek to survive, secure themselves, and expand their power. If Ukraine were to become a military ally of the US then Russian security would suffer a permanent degradation. Of course, Putin may be a fanatic and it is possible that he grows desperate or miscalculates. The western public (and global investors) will thus be reminded of the “balance of terror” that prevailed throughout the Cold War, in which the world lived and conducted business under the shadow of nuclear holocaust. Today Russia has 1,588 deployed strategic nuclear warheads, contra the US’s 1,644. Both countries can deliver nuclear weapons via ballistic missiles, submarines, and bombers and are capable of destroying hundreds of each other’s cities on short notice (Table 1). While the US has at times contemplated the potential for nuclear attacks to occur but remain limited, the Soviet Union’s nuclear doctrine ultimately rejected the likelihood of limitations and anticipated maximum escalation.3 Table 1The Return Of The Balance Of Terror Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) Ultimately the US and Russia avoided nuclear war in the Cold War because it entailed “mutually assured destruction” which violated the law of self-preservation. Neither Stalin nor Mao used nukes on their opponents, including when they lost conflicts (e.g. to Afghanistan and Vietnam). The US tied with North Korea and lost to Vietnam without using nukes. However in the current context the US has been wary of antagonizing Putin for fear of his unpredictable and aggressive posture. In response to Putin’s activation of combat-ready nuclear forces, the US called attention to its own nuclear deterrent subtly by canceling the regular test of a ballistic missile and issuing a press statement highlighting the fact and saying that it was too responsible to bandy in nuclear threats. Yet the autocratic nature of Putin’s regime means that if Putin ultimately does prove to be a lunatic then large parts of the world face existential danger. Our Global Investment Strategist Peter Berezin ascribes Russian Roulette odds to nuclear Armageddon – while arguing that investors should stay invested over the long run anyway. Sanctions on the Russian central bank have frozen roughly half of the country’s $630 billion foreign exchange reserves (Table 2). If the energy trade also stops, then the economy will crash and Putin could become desperate. Table 2Western Sanctions On Russia As Of March 4, 2022 Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) Bottom Line: Global financial markets have yet to experience the full scare that is likely as Russia escalates its aggression and nuclear brinksmanship to ensure it achieves it strategic aims in Ukraine and prevents Finland from joining NATO. GeoRisk Indicators In March In what follows we provide our monthly update of our quantitative, market-based GeoRisk Indicators. Russian geopolitical risk is surging as the ruble and equity markets collapse (Chart 3). The violent swings of the underlying macroeconomic variables as Russia saw a V-shaped recovery from the COVID-19 lockdowns, then sharply decelerated again, prevented our risk indicator from picking up the full scale of the geopolitical risk until recently. But alternative measures of Russian risk show the historic increase more clearly – and it can also be demonstrated by reducing the weighting of the underlying macroeconomic variables relative to the USD-RUB exchange rate in the indicator’s calculation (Chart 4). Chart 3Russian GeoRisk Indicator Russian GeoRisk Indicator Russian GeoRisk Indicator Chart 4Other Measures Of Russian Geopolitical Risk Other Measures Of Russian Geopolitical Risk Other Measures Of Russian Geopolitical Risk This problem of dramatically volatile pandemic-era macro data skewing our risk indicators has been evident over the past year and is more apparent with some indicators than with others. China’s geopolitical risk as measured by the markets is starting to peak and stall but we do not recommend investors try to take advantage of the situation. China’s domestic and international political risk will remain elevated through the twentieth national party congress this fall. The sharp increase in commodity prices will amplify the problem. The earliest China’s political environment can improve substantially is in 2023 after President Xi Jinping cements another ten years’ in power (Chart 5). And yet that very process is negative for long-term political stability. Chart 5China GeoRisk Indicator China GeoRisk Indicator China GeoRisk Indicator British geopolitical risk is contained. It enjoys some insulation from the war on the continent, underpinning our long GBP-CZK trade and long UK equities trade relative to developed markets other than the United States (Chart 6). Chart 6United Kingdom GeoRisk Indicator United Kingdom GeoRisk Indicator United Kingdom GeoRisk Indicator German and French geopolitical risk is being priced higher as expected (Charts 7 and 8). Of these two Germany is the more exposed due to the risk of energy shortages. France is nuclear-armed and nuclear-powered, and unlikely to see a change of president in the April presidential elections. Italian risk was already at a higher level than these countries but the Russian conflict and high energy supply risk will keep it elevated (Chart 9). Chart 7Germany GeoRisk Indicator Germany GeoRisk Indicator Germany GeoRisk Indicator Chart 8France GeoRisk Indicator France GeoRisk Indicator France GeoRisk Indicator Chart 9Italy GeoRisk Indicator Italy GeoRisk Indicator Italy GeoRisk Indicator Canada’s trucker strikes are over and the loonie will benefit from the country’s status as energy producer and insulation from geopolitical threats due to proximity with the United States (Chart 10). Chart 10Canada GeoRisk Indicator Canada GeoRisk Indicator Canada GeoRisk Indicator Spain still has substantial domestic political polarization but this will have little impact on markets amid the Ukraine war. Spain is distant from the fighting and will act as a conduit for liquefied natural gas imports into Europe (Chart 11). Chart 11Spain GeoRisk Indicator Spain GeoRisk Indicator Spain GeoRisk Indicator Australia’s political risk will remain elevated due to its clash with China amid the emerging global conflict between democracies and autocracies as well as the country’s looming general election, which threatens a change of ruling party (Chart 12). However, as a commodity and LNG producer and staunch US ally the country’s risks are overrated. Chart 12Australia GeoRisk Indicator Australia GeoRisk Indicator Australia GeoRisk Indicator Markets are gradually starting to price the risk of an eventual China-Taiwan military conflict as a result of the Ukrainian conflict. China is unlikely to invade Taiwan on Russia’s time frame given the greater difficulties and risks associated with an amphibious invasion of a much more strategically critical territory in the world. But Taiwan’s situation is comparable to that of Ukraine and it is ultimately geopolitically unsustainable, so we expect Taiwanese assets to suffer a higher risk premium over the long run (Chart 13). Chart 13Taiwan Territory GeoRisk Indicator Taiwan Territory GeoRisk Indicator Taiwan Territory GeoRisk Indicator South Korea faces a change of ruling parties in its March 9 general election as well as uncertainties emanating from China and a new cycle of provocations from North Korea (Chart 14). However these risks are probably not sufficient to prevent a rally in South Korean equities on a relative basis as China stabilizes its economy. Chart 14Korea GeoRisk Indicator Korea GeoRisk Indicator Korea GeoRisk Indicator Turkey’s international environment has gotten even worse as a result of Russia’s invasion of Ukraine and effective closure of the Black Sea to international trade. Turkey has invoked the 1936 Montreux Convention to close the Dardanelles and Bosporus straits to Russian warships, although it will let those ships return to home from outside the Black Sea. The Black Sea is highly vulnerable to “Black Swan” events, highlighted by the sinking of an Estonian ship off Ukraine’s coast in recent days. Turkey’s domestic political situation will also generate a political risk premium through the 2023 presidential election (Chart 15), as President Recep Erdogan’s reelection bid may benefit from international chaos and yet he is an unorthodox and market-negative leader, and if he loses the country will be plunged into factional conflict. Chart 15Turkey GeoRisk Indicator Brazil GeoRisk Indicator Brazil GeoRisk Indicator South Africa looks surprisingly attractive in the current environment given our assessment that the government is stable and relatively friendly to financial markets, the next general election is years away, and the search for commodity alternatives to Russia amid a high commodity price context will benefit South Africa (Chart 16). Chart 16South Africa GeoRisk Indicator South Africa GeoRisk Indicator South Africa GeoRisk Indicator India And Brazil: A Tale Of Two Emerging Markets Russia’s invasion of Ukraine will have a minimal impact on the growth engines of India and Brazil. This is because Russia directly accounts for a smidgeon of both these countries trade pie. However, the main route through which this war will be felt in both markets is through commodity prices. Brazil by virtue of being a commodity exporter is better positioned as compared to India which is a commodity importer and is richly valued to boot. The year 2022 promises to be important from the perspective of domestic politics in both countries and will add to the policy risks confronting both EMs. Our Brazilian GeoRisk indicator has collapsed but is highly likely to recover and rise from here (Chart 17). Chart 17Brazil GeoRisk Indicator Brazil GeoRisk Indicator Brazil GeoRisk Indicator Commodity Price Spike – Advantage Brazil Politically India and Brazil have a lot in common today. The popularity ratings of their respective right-leaning heads of states, Prime Minister Narendra Modi in India and President Jair Bolsonaro in Brazil, have suffered over the last two years. The economic prospects of the median voter in both countries have weakened over the last year (Chart 18). Policymakers in both countries face a dilemma: they cannot stimulate their way out of their problems without an adverse market reaction since both countries are loaded with public debt. Chart 18Economic Miseries Rising For Both India's And Brazil's Median Voter Economic Miseries Rising For Both India's And Brazil's Median Voter Economic Miseries Rising For Both India's And Brazil's Median Voter Despite these commonalties, Brazil’s equity markets have outperformed relative to EMs whilst India has underperformed (Chart 19). On a tactical horizon, we expect this divergent performance to continue as the effects of the Russian invasion feed through commodity markets. Chart 19India Is Richly Valued, Brazil Has Outperformed EMs India Is Richly Valued, Brazil Has Outperformed EMs India Is Richly Valued, Brazil Has Outperformed EMs ​​​​​ Commodity markets were tight even before the Russian invasion. The ongoing war will force inventories to draw across a range of commodities including oil, iron ore and even corn. Given that India is a net importer of oil whilst Brazil is a net commodity exporter, the current spike in commodity prices will benefit Brazil over India in the short term. However, our Commodity & Energy Strategy team expects supply responses from oil producers to eventually come through, thereby sending the price of Brent crude to $85 per barrel by the end of 2022. Hence if Indian equities correct in response to the current oil spike or domestic politics (see below), then investors can turn constructive on India on a tactical horizon. Elections Stoke Policy Risks – In India And Brazil Results of key state elections in India will be announced on March 10, 2022. Of all the state elections, the results that the market will most closely watch will be those of Uttar Pradesh, the most populous state of India. In a base case scenario, we expect the Bhartiya Janata Party (BJP) which rules this state, to cross the 50% seat share mark and retain power. But the BJP will not be able to beat the extraordinary 77% seat share it won at the 2017 elections in Uttar Pradesh. A sharp deviation from this benchmark may lead the BJP to focus on populism ahead of the next round of state elections due in 4Q 2022. At a time when the Indian government’s appetite to take on structural reforms is waning, we worry that such a populist tilt could perturb Indian equity markets. Also, general elections are due in India in 2024. If the latest state election results suggest that the BJP has ceded a high vote share to regional parties (such as the Samajwadi Party in Uttar Pradesh or Aam Aadmi Party in Punjab), then this would mean that regional parties can pose a credible threat to BJP’s ability to maintain a comfortable majority in 2024. In Brazil, some polls show that left-leaning former president Lula da Silva's lead on President Bolsonaro may have narrowed. While we expect Lula to win the presidential elections due in Brazil in October 2022, the road to victory will not be as smooth as markets expect. If the difference between the two competitors’ popularity stays narrow, then there is real a chance that President Bolsonaro will make a last-ditch effort to cling to power. He will resort to fiscal populism and attacks on Brazil’s institutions, potentially opening up institutional or civil-military rifts that generate substantially greater uncertainty among investors. Bolsonaro already appears to be planning a cut in fuel prices and a bill to further this could be tabled as soon as next week. He has coddled Russian President Putin to shore up his base of authoritarian sentiment at home. To conclude, investors must balance these two opposing forces affecting Brazilian markets today. On one hand are the latent policy risks engendered by a far-right populist who still has a few months left in office. On the other hand, in a year’s time Bolsonaro will likely be gone while Brazil stands to benefit as commodity prices rise and EM investors shift funds into commodity exporters like Brazil. Against this backdrop, we re-iterate our view that investors should take-on selective tactical exposure in Brazil. Risk-adjusted returns in Brazil at this juncture can be maximized by buying into sectors like financials as these sectors’ inherent political and policy sensitivity is low. Postscript: Is India’s Foreign Policy Reverting To Non-Alignment? India traditionally has followed a foreign policy of non-alignment, carefully maintaining ties with both America and Russia through the Cold War. Things changed in the 2000s as Russia under President Putin courted closer ties with China while the US tried to warm up to India. India’s decision to join the newly energized US-led “quadrilateral” alliance in 2017 is a clear sign that India is gradually shedding its historical stance of neutrality and veering towards America. However, this thesis is being questioned as India, like China, is continuing to trade and transact with Russia despite its invasion of Ukraine, providing Russia with a lifeline as it suffers punishing sanctions from the US and European Union. India repeatedly abstained from voting resolutions critical of Russia at the United Nations in recent weeks. In other words, India’s process of transitioning over to the US alignment will be “definitive yet slow,” owing to reasons of both history and practicality. The former Soviet Union’s support played a critical role in helping India win several regional battles like the Indo-Pakistan war of 1971. Russia’s military and security influence in Central Asia makes it useful to India, which seeks a counter to Pakistan on its flank in Afghanistan. India sees Russia as a fairly dependable partner that cannot be abandoned until America is willing to provide much greater and more reliable guarantees and subsidies to India – through military support and beneficial trade deals. The backbone of Indo-Russia relations has been their arms trade (Chart 20). India’s reliance on Russia for arms could decline in the long term. But in the short term, as India tilts towards the US at a calibrated pace, India could remain a source of meaningful defense revenue for Russia. It is possible but not likely that the US would impose sanctions on India for maintaining this trade. Chart 20India Today Is A Key Buyer Of Russian Weapons Imbalance Of Terror (GeoRisk Update) Imbalance Of Terror (GeoRisk Update) The fundamental long-term dynamic is that Russia has foreclosed its relations with the West and will therefore be lashed to China, at least until the Putin regime falls and a Russian diplomatic reset with the West can be arranged. In the face of this combined geopolitical bloc, India will gradually be driven to cooperate more closely with the United States. But India will not lead the transition away from Russia – rather it will react appropriately depending on the US’s focus and resolve in countering China and assisting India’s economy.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      Energy Aspects long-term estimate. 2     Tzvi Joffre, “Russian FM repeats nuclear war rhetoric as invasion of Ukraine continues,” Reuters, March 3, 2022. 3     Jack L. Snyder, “The Soviet Strategic Culture : Implications for Limited Nuclear Operations,” Rand Corporation, R-2154-AF (1977), argues that Soviet and American strategic cultures differ greatly and that the US should not be “sanguine about the likelihood that the Soviets would abide by American-formulated rules of intrawar restraint." Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix "Batting Average": Geopolitical Strategy Trades (2022) Section III: Geopolitical Calendar

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

Executive Summary Upgrading Brazil Within An EM Equity Portfolio Upgrading Brazil Within An EM Equity Portfolio Upgrading Brazil Within An EM Equity Portfolio Brazilian risk assets are cheap and will get a positive impetus from the rising odds of ex-president Lula winning this year's election. As we have argued since July 2021, Lula will adopt pragmatic policies that will appeal to both moderate voters and investors.  Even though the economy is heading into a recession and corporate profits will likely contract in the coming 12 months, we are upgrading our allocation to Brazilian equities and domestic bonds from underweight to overweight relative to their respective EM benchmarks. Structurally, however, the new government will be unable to prevent the public debt-to-GDP ratio from rising. In the long run, odds are that Lula’s government will attempt to “inflate its way out of debt.” Hence, our long-term strategy on Brazil remains intact: long stocks but hedge currency risk. Bottom Line: Upgrade Brazilian equities and fixed income to overweight relative to their EM counterparts. We are also starting a new trade: go long 10-year domestic government bonds in Brazil. Feature In our reports from July 8 and October 26, 2021, we argued that Luiz Inácio Lula da Silva will likely become Brazil’s next president. We contended that this expectation would initially produce a financial market selloff. However, we also stated that investors would, at some point, begin to look through the ongoing economic downturn and begin to price in pragmatic policymaking from a newly elected Lula. These views have by and large played out: Brazilian financial markets sold off and underperformed their EM counterparts dramatically in H2 2021. However, in recent weeks, Brazilian markets have rebounded and have outperformed their EM peers. Could this outperformance be the beginning of a lasting move? We believe it could be, and, hence, for investors with a medium-term horizon, we recommend upgrading Brazilian equities and local bonds to overweight (within their respective EM portfolios) and sovereign credit from neutral to overweight. We are also closing our short BRL/USD trade. The highly probable return of Lula to the presidency later this year implies that investors will likely treat president Bolsonaro as a lame duck. Thereby, markets will be driven more by hints about Lula’s policies than by the current government’s actions. Lula’s current policy proposals and his agenda following the election will be moderate, providing a positive impetus to financial markets. Depressed Valuations And Investor Sentiment Equities: Brazilian stocks are structurally cheap. The cyclically adjusted P/E ratio (CAPE) is well below its historical mean (Chart 1). Relative to emerging markets, Brazilian stocks are also attractive based on this measure (Chart 2). Chart 2Brazilian Stocks Are Also Cheap Relative To EM Brazilian Stocks Are Also Cheap Relative to EM Brazilian Stocks Are Also Cheap Relative to EM Chart 1Brazilian Stocks Are Cheap From A Structural Perspective Brazilian Stocks Are Cheap From A Structural Perspective Brazilian Stocks Are Cheap From A Structural Perspective     Additionally, various equity multiples are low both in absolute terms and relative to overall EM (Charts 3 and 4). Chart 3Brazilian Equity Multiples In Absolute Terms Brazilian Equity Multiples In Absolute Terms Brazilian Equity Multiples In Absolute Terms Chart 4Brazilian Equity Multiples Relative To EM Brazilian Equity Multiples Relative to EM Brazilian Equity Multiples Relative to EM Further, the equity risk premium – calculated using the earnings yield from the CAPE ratio and forward earnings yield minus Brazilian inflation-adjusted (real) bond yields – is rather high (Chart 5). In addition, analysists’ net EPS revisions have plunged both in absolute terms and relative to overall EM (Chart 6). This entails that a lot of the bad news on the profit outlook for the next 12 months are priced in, at least relative to other EMs. Chart 6Sentiment On Brazilian Stocks Is Downbeat Sentiment On Brazilian Stocks Is Downbeat Sentiment On Brazilian Stocks Is Downbeat Chart 5The Equity Risk Premium Is High The Equity Risk Premium Is High The Equity Risk Premium Is High   Overall, we are upgrading Brazilian stocks from underweight to overweight within an EM equity portfolio. Brazilian stocks have massively underperformed their EM peers over the past 12 years. Odds are that Brazil’s equity underperformance is over now. Currency: The BRL on the other hand is not cheap – its valuation is neutral. Chart 7 demonstrates the real’s real effective exchange rate, which shows that the currency is close to its fair value in real trade-weighted terms. However, the risk-reward profile of shorting the real is no longer attractive for the reasons we elaborate on this report. Therefore, we are closing our short in the BRL versus the USD. Concerning positioning, according to data from the US Commodity Futures Trading Commission, leveraged funds are net short the real and asset managers are moderately long (Chart 8, top and middle panels), with the aggregate position being modestly short (Chart 8, bottom panel).  Chart 8Investor Positioning On The BRL Is Net Short Investor Positioning On The BRL Is Net Short Investor Positioning On The BRL Is Net Short Chart 7The BRL Is Not Cheap The BRL Is Not Cheap The BRL Is Not Cheap   Sovereign credit: A stable currency and positive rhetoric from the potential next president entail that sovereign credit risks will stay contained. We recommend EM credit investors to upgrade Brazil from neutral to overweight within an EM credit portfolio. Local bonds: Domestic bond yields offer value. Nominal government bond yields are at 11.5% and inflation-adjusted (real) domestic bond yields are at a record high of 5.5%. With the economy heading into another recession (see below on this), Brazilian local yields are attractive in both nominal and real terms. Any upside in yields will be capped by disappointing growth and falling inflation. A hawkish central bank and a promise of more centrist policies from Lula will also limit any rise in domestic rates and will eventually open the door for a material drop in yields. Critically, in an environment of rising US nominal and real bond yields, Brazil’s super high yields will at least partially shield its financial markets from capital flight. Particularly, foreigners only hold around 10.5% of the domestic bond market. The same measure is much higher in many other EM fixed-income markets. We are therefore upgrading Brazilian domestic bonds from underweight to overweight within an EM local bond portfolio. We also recommend buying 10-year domestic bonds, unhedged. Inflation Is Set To Drop As The Economy Shrinks Inflation in Brazil will roll over. The primary reason is that the economy is entering another recession, the third one in the past eight years. The combined credit and fiscal impulse has fallen substantially, heralding a major downtrend in the economy (Chart 9, top panel). The central bank’s aggressive rate hikes have led to a relapse in the credit cycle and fiscal spending has been pulled back following the large pandemic stimulus. Several segments of the economy have already fallen back into negative territory and our forward-looking indicators are foreshadowing a material contraction in the coming months (Chart 9). The central bank (BCB) will remain hawkish for now even as the economy shrinks. The BCB will not ease until headline and core inflation drop close to the upper band of its target range of 3.5-5%. Monetary authorities will err on the overly hawkish side because many private and public sector wages are linked to the most recent inflation prints. Plus, consumer inflation expectations for 2022 remain above the BCB’s upper range (Chart 10). Chart 9Brazil: The Economy Is Headed Into Recession Brazil: The Economy Is Headed Into Recession Brazil: The Economy Is Headed Into Recession Chart 10Have Inflation Expectations In Brazil Peaked? Have Inflation Expectations In Brazil Peaked? Have Inflation Expectations In Brazil Peaked? Chart 11Brazil: Household Debt Servicing And Credit Origination Brazil: Household Debt Servicing And Credit Origination Brazil: Household Debt Servicing And Credit Origination Monetary authorities’ reluctance to cut interest rates despite a recession entails that domestic demand will undershoot. Worryingly, Brazilian household finances are in poor shape. The top panel of Chart 11show that the household debt-service ratio is at 30%, a very high level, and that individuals have been financing their expenditure with credit to battle inflation. With interest rates having surged, consumer loan delinquencies will balloon, and banks will cut back their lending to both households and businesses. In fact, loan origination to households has relapsed and usually it leads business loan origination (Chart 11, bottom panel). While president Bolsonaro will be tempted to increase fiscal expenditures to boost his approval ratings heading into the election, the BCB will counteract this with even tighter policy, as they have repeatedly stated. Currently, the government’s fiscal stance remains restrained, as shown by a negative fiscal impulse for 2022 (Chart 12). Further, Bolsonaro’s flagship handout program, Auxílio Brasil, stands at just 1% of GDP. On the inflation front, inflation in Brazil has been more supply-driven than demand-induced. In particular, even though headline consumer price inflation now stands at 10%, core inflation measures are much lower. Core CPI is presently 7%, trimmed-mean 7%, and non-tradable 5.4% (Chart 13). They are still above the central bank’s target range but will drop within it in H2 2022. Chart 13Brazil: Will Core Inflation Fall Within The BCB's Target Range? Brazil: Will Core Inflation Fall Within The BCB's target Range? Brazil: Will Core Inflation Fall Within The BCB's target Range? Chart 12Brazil: Fiscal Thrust Is Mildly Negative In 2022 Brazil: Fiscal Thrust Is Mildly Negative In 2022 Brazil: Fiscal Thrust Is Mildly Negative In 2022   Very tight monetary and fiscal policies as well as another recession will ensure that core consumer price inflation drops significantly, bringing it within the central bank’s target range in H2 2022 (Chart 14). On the flip side, the price to pay for lower inflation will be another period of utter growth contraction.  Chart 14Brazil Core Inflation Will Drop In 2022 Brazil Core Inflation Will Drop in 2022 Brazil Core Inflation Will Drop in 2022 Lula 2.0: Economic Policies And Central Bank Reaction The path of the economy and financial markets depends on the interplay between the election, current and future fiscal policy, and the BCB’s policy response. 2022 General Elections Odds are now considerable that ex-president Lula will win the 2022 presidential elections. He continues to massively outperform in voting intentions according to local polling company IPEC (Chart 15). The ex-president’s advantage is so large that he could theoretically win the presidency in the first round, as he would gather the absolute majority of all valid votes (which excludes blank and null votes). Third-way centrist candidates are falling significantly behind Lula and Bolsonaro for a variety of reasons. First, Lula has used pragmatic and reasonable policy statements that appeal to the majority of Brazilians. In doing so, he has largely moved to the center. In particular, Lula has been successfully appealing to moderate voters by forming alliances with centrist figures. For example, he has heavily hinted at selecting center-right icon and former political opponent Geraldo Alckmin as his running mate. Second, corruption has become less of a concern to Brazilians, which is a key policy of many centrist candidates and of former judge Sergio Moro in particular. According to the latest Genial Investimentos/Quaest polls, voters have rated corruption as only the fourth most important issue affecting Brazil (Chart 16). Further, Lula is the preferred candidate to address social issues, the pandemic and most importantly the economy. Chart 15Lula Is Massively Ahead Of The Other Candidates Is Lula Brazil’s Savior? Is Lula Brazil’s Savior? Chart 16Brazilian Voters Are Not Worried About Corruption Is Lula Brazil’s Savior? Is Lula Brazil’s Savior?   All of the above will improve investor sentiment and will likely allow Brazil’s recent outperformance to continue despite major growth disappointments in the next 12 months. For more analysis on these political dynamics, please refer to our reports “Brazil: The Wheels Are Coming Off” and “Can Brazil Break Out Of A Vicious Circle?”  Economic Policies Under Lula 2.0 We believe that, if elected, Lula’s governance and policies will be pragmatic and reasonable, similar to those during his first presidential term (2003-06) rather than with those of his more leftist second term and those of his successor, Dilma Rousseff. Lula now understands that he has to move toward the center if he is to appeal to the majority of the population, boost business confidence and create a positive backdrop for financial markets. To begin, Lula is positioning himself as a center-left politician and is also marginally distancing himself from his leftist Worker’s Party (PT). While Lula remains quite popular throughout the country, the PT remains controversial due to the corruption that was unearthed during Dilma Rousseff’s mandate.  Fiscal policy under Lula will be moderately loose. Lula will negotiate with Congress to abandon the fiscal spending rule that has straightjacketed the government and depressed the economy over the past five years. This implies that efforts to make public debt sustainable will be delayed. In addition, structural reforms might not be enacted or will be passed in a watered-down manner. That being said, given the broad centrist support for Lula, his economic program would not be exclusively dictated by his party. Instead of focusing on cash handouts and state intervention, his government is set to adopt a more centrist approach, such as financing infrastructure and more business-friendly policies than the PT’s core would prefer. All in all, we believe that Lula wants to be remembered as a positive figure in Brazil’s history and not as a politician who was jailed for corruption. Therefore, he will be appealing to moderate voters and separating himself from the PT. Such shifts in policies and allegiance will boost investor sentiment toward Brazil. A Big Unknown: How Will The BCB React To Fiscal Loosening? For Lula’s fiscal loosening to put Brazil on a path of sustainable growth, monetary policy cannot remain as hawkish as it is today. President Bolsonaro signed a bill in 2021 to grant autonomy to the central bank, which entails the government cannot replace the central bank president and other board members. In turn, the current BCB president Roberto Campos Neto has explicitly stated that interest rates must remain elevated to balance deteriorating fiscal accounts. Further, Neto will remain in his post until December 2024, while other board members’ terms expire between 2022 and 2024.  The key question is therefore whether Campos Neto and the monetary policy committee are willing to negotiate with Lula and moderate the BCB’s hawkishness despite fiscal loosening. We believe that an agreement between the government and the central bank is more likely than not. Campos Neto wants to protect the independence of the BCB. If he proves to be too stubborn, Lula (with the support of Congress) could threaten to abolish the central bank’s autonomy. Congress and the general public will be sympathetic to Lula’s position on the need to reduce interest rates substantially. As the economy shrinks and inflation drops toward 5%, the BCB board risks alienating the public and Congress if they remain very hawkish. Lula, on the other hand, will not want to risk alienating moderate voters by siding with the PT and starting off his term by lobbying against the central bank’s independence, especially given the support he has garnered from center-right figures such as Geraldo Alckmin and Fernando Henrique Cardoso. In order to prevent a clash between the government and the BCB, Campos Neto has an incentive to overtighten monetary policy this year, thereby entering 2023 with lower inflation and more scope to cut rates. This would also fall neatly under the central bank’s mandate to keep inflation under target, thereby securing its reputation and its independence.  Consequently, we expect monetary policy to be overly hawkish this year and for the central bank to cut interest rates aggressively in 2023. Financial markets will look through the valley and start pricing lower rates sometime in the coming quarters. Structural Outlook Under Lula 2.0 Despite all the positive momentum that Lula’s presidency and his policies will likely generate in the medium term, they will not likely improve Brazil’s structural outlook meaningfully. Brazil’s public debt has grown to unsustainable levels and Lula will not be able to prevent it from rising further (Chart 17, top panel). With elevated domestic bond yields and a crippling recession, government borrowing costs will exceed nominal GDP growth in the coming months, worsening government debt dynamics (Chart 17, bottom panel). Chart 17Brazil: Public Debt Dynamics Remain Worrisome Brazil: Public Debt Dynamics Remain Worrisome Brazil: Public Debt Dynamics Remain Worrisome For a more detailed analysis, please refer to our previous report on what it will take for Brazil to stabilize its public debt to GDP ratio. In short, authorities must either boost nominal GDP growth above borrowing costs and maintain this wide gap over a number of years or the government has to run large and recurring primary surpluses. It is neither economically nor politically feasible to accomplish these feats under any government in Brazil. Chart 18Potential Growth In Brazil Is Unflattering Potential Growth In Brazil Is Unflattering Potential Growth In Brazil Is Unflattering The only way Lula might succeed in stabilizing the public debt-to-GDP ratio is to inflate the public sector out of debt, i.e., run easy fiscal and monetary policies and cap bond yields at low levels, thereby persistently running negative real rates. The victim of this policy mix would be the exchange rate: the real will depreciate significantly. Lula is unlikely to turn to such policies in the first two years of his presidency. Plus, the current BCB governor will not accommodate such aggressive policies. However, odds are that these policies might well make an appearance in the second half of Lula’s presidency, especially when he appoints a new central bank governor in 2025 who will be more open to the idea of capping government bond yields to stabilize public debt dynamics. Barring “inflating out of debt” policies, the only way for Brazil to escape this debt trap is to significantly raise the economy’s potential (real) growth rate. To do this, the country must boost its labor productivity through much needed structural reforms. These include simplifying the tax regime, alleviating labor laws, reducing subsidies and pursuing privatization. Given in Brazil’s working age population growth has fallen below 1%, the only remedy is to boost productivity (Chart 18). Will Lula be able to achieve such a breakthrough in Brazil’s potential growth? We are not holding our breath for now. Investment Recommendations We are upgrading our stance on Brazilian financial markets to overweight even though we believe the economy will be in recession in the next 12 months (Chart 19). The rationale of the upgrade is our belief that investors will start viewing Lula’s presidency as a positive shift for Brazil. This will likely lend support to financial markets that have sold off and offer value as per our discussion above. That said, we are not yet turning bullish on Brazilian equities in absolute term. We are more confident about Brazil outperforming the rest of EM than we are in seeing an imminent sizable rally in the nation’s risk assets. The latter will be driven not only by local dynamics but also by the trajectory of global financial markets. We maintain that EM risk assets and currencies will be weak in absolute terms in the coming months. We are also upgrading Brazilian local currency bonds from underweight to overweight (Chart 20, top panel) and Brazilian credit from neutral to overweight. Chart 20Upgrading Brazil vs. EM Upgrading Brazil vs. EM Upgrading Brazil vs. EM Chart 19Is Brazil Set For A New Period Of Outperformance? Is Brazil Set For A New Period Of Outperformance? Is Brazil Set For A New Period Of Outperformance?   In our opinion, local long-term bond yields will be a couple of hundred basis points below the current levels by year-end. Hence, absolute return investors should go long Brazilian 10-year domestic government bonds, currency unhedged. We have a higher conviction on falling yields than on the exchange rate. For the currency, we are closing our short BRL/USD trade (Chart 20, bottom panel), and recommend going long BRL versus ZAR. Chart 21Brazilian Equities: Overweight Small Cap Stocks Within The Overall Market Brazilian Equities: Overweight Small Cap Stocks Within The Overall Market Brazilian Equities: Overweight Small Cap Stocks Within The Overall Market Finally, within the Brazilian equity market, we recommend going long small caps / short the overall index (Chart 21). Odds of lower interest rates down the road and a potential soft spot in commodity prices might create a window of opportunity for small caps to outperform. All in all, given our poor structural view on Brazil, our long-term strategy remains long stocks / short the BRL. This is due to our belief that the government will eventually resort to running loose fiscal and monetary policies to inflate their way out of debt. The result will be strong nominal growth but a depreciating currency. Juan Egaña Research Analyst juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com

Highlights Odds favor left-wing candidate Gabriel Boric to win the second round of this weekend’s presidential elections. If this scenario takes place, Chilean equities and the currency will sell off considerably. Nevertheless, once the dust settles, a buying opportunity might emerge in Chile. Political volatility will be contained and congress will push back on extreme policies. Feature Chart 1Chilean Stocks: New Lows Ahead? Chilean Stocks: New Lows Ahead? Chilean Stocks: New Lows Ahead? Since late 2019, we have been arguing that Chile will undergo a leftward shift in domestic politics and policies. Major outcomes of this transformation would entail permanently larger social spending and higher taxes for top earners and businesses. Gabriel Boric, the left-wing candidate in the presidential elections on December 19, represents this change. The opposing candidate, José Antonio Kast, embodies a conservative backlash against the country’s progressive wave of the last two years. Odds favor Boric’s victory in the second round of this weekend’s presidential elections. Chilean equities and the currency will sell off considerably if Boric wins, as we expect (Chart 1). Chart 2 shows that Boric has a comfortable lead of more than 10 percentage points over Kast based on the polling from local firms. The key reason that Boric will likely win the election, despite trailing Kast in the first round, is that he will attract centrist and undecided voters: As stated above, Boric’s policies largely represent protesters’ demands from the 2019-2020 uprisings: creating a public pension system, higher social spending on education and healthcare, and higher taxes for top earners and large corporations. The fact that Chile overwhelmingly voted for a new constitution earlier this year (at 78% of total votes) favors Boric over Kast. The country’s leftward shift in the past two years has its bases in Chile’s profound socioeconomic disparities. Chart 3 shows the shares of wages and profits in national income. Even compared to an unequal US, Chile’s income distribution is much more uneven. We elaborated on the underlying causes and structural reasons for the nationwide protests in our December 5, 2019 Special Report.    Chart 2 Chart 3The Wages-Profit Mix Is More Unequal In Chile Than In The US The Wages-Profit Mix Is More Unequal In Chile Than In The US The Wages-Profit Mix Is More Unequal In Chile Than In The US   Over the past few weeks, Boric has been distancing himself from the communist party and adopting more pragmatic policies. This includes condemning autocratic leftist regimes in Latin America and embracing a hardline stance against drug-related violence and illegal immigration/refugees.   Further, he has sought to calm the investor and business communities by signaling fiscal prudence in 2022. He has modified his economic plan to enact reforms – such as a higher minimum wage, increasing tax collection and raising taxes for high earners and mining companies – in a gradual manner over four years and has promised to stabilize the public debt-to-GDP by the end of his term. According to the latest polls from Cadem and Activa, centrist and independent voters prefer Boric over Kast by a margin of seven percentage points. This is critical as 66% of the electorate either identifies as being centrist or independent. This also means Boric can take a large share of the vote from Franco Parisi, an independent centrist presidential candidate who came in third in the first round with 13% of the vote (this compares with 28% for Kast and 26% for Boric). How Parisi’s first round votes are split will be critical to the outcome of the second round. The Cadem poll shows that 45% of Parisi’s base intends to vote for Boric, compared to just 18% for Kast. Hence, this supports Boric’s significant advantage over Kast in the second round. Further, Boric’s ideological base is larger than Kast’s: approximately 15.6% of voters identify with right or center right policies, and 18.8% identify with the left or center left. Critically, Boric leads Kast in three out of the top four key issues affecting voters: social rights (health, education and housing), pension reform and women’s inequality. Kast has projected himself as the candidate for economic growth. However, the latest poll from Cadem shows that 75% of businesses and 65% of individuals are satisfied or very satisfied with their economic situation, the highest level since 2017. This favors Boric’s agenda as voters are currently more concerned with income redistribution than with pro-growth policies. On the whole, Chilean share prices and the exchange rate are set to tumble as Boric emerges as the winner of the second round of presidential elections. The bounce in Chilean stocks following Kast’s lead over Boric in the first round has faded in the past weeks (Chart 1 above). Odds are that share prices and the peso will drop to new lows. Chilean equities will continue de-rating as Boric’s victory entails less business-friendly policies. Further, the peso will continue depreciating due to capital outflows from high-net worth individuals and businesses. In addition, business confidence will plummet, negatively affecting investment and hiring. Once the dust settles, however, a buying opportunity might emerge in Chile. We have long argued that Chile will shift to a welfare state model (as in Canada and Northern Europe) and not towards fiscal profligacy and heightened regulations like in neighboring Argentina. Boric’s latest shift to the center and the fragmented nature of congress (which will force negotiations and prevent extreme policy outcomes) corroborate this thesis.  Further, his election would ensure medium-term stability. Chile needs to undertake income and wealth redistribution policies now to prevent further political volatility and violence. If it fails to do so, the outcome could be more protests and heightened political volatility. Bottom Line: Prepare for a Boric win in the second round of the presidential elections, which will be negative for Chilean financial markets. That said, a major setback in Chile's risk assets will likely lead us to re-evaluate our stance on Chilean markets. Investment Recommendations For now, we recommend that investors continue underweighting Chilean equities within an EM portfolio. While Chilean stocks are somewhat cheap in absolute and relative terms according to the cyclically-adjusted P/E ratio (Chart 4), we will await a better entry point. We also reiterate our short CLP versus the US dollar position. The Chilean peso's valuation is neutral, not cheap (Chart 5). Additionally, besides political risk and domestic capital outflows, external factors such as a slowdown in China’s old economy (in the form of weaker copper prices) and a stronger dollar will be headwinds for the currency. Chart 4Chilean Equity Valuations Are Low, But Could Undershoot Chilean Equity Valuations Are Low, But Could Undershoot Chilean Equity Valuations Are Low, But Could Undershoot Chart 5The Chilean Peso's Valuation Is Neutral The Chilean Peso's Valuation Is Neutral The Chilean Peso's Valuation Is Neutral   In terms of local rates, we believe the central bank will continue its hiking cycle into the new year. Chile has been hit by its highest inflation prints in over a decade, with headline and core measures at 6.7% and 5.8% respectively (Chart 6, top panel). Further, nominal wage growth remains at a healthy 6%, the highest in over five years (Chart 6, bottom panel). Chart 6Chile: Inflation Must Be Curtailed With More Rate Hikes Chile: Inflation Must Be Curtailed With More Rate Hikes Chile: Inflation Must Be Curtailed With More Rate Hikes In addition, fiscal policy was among the most expansive in the EM space this year and bank credit is growing at a healthy pace. All in all, the central bank will continue pushing rates above the neutral range of 3.25%-3.75%. That being said, while we are betting on rising interest rates, we recommend that investors maintain a neutral allocation to domestic bonds and an overweight allocation to sovereign credit within their respective EM portfolios. Public debt remains at a minimal 33% of GDP, and while Boric is advocating for larger fiscal spending, he will encounter considerable pushback from congress. Besides, weak capital spending and hiring will cap inflationary pressures. Overall, Chilean local currency bonds might not underperform their EM peers substantially. Juan Egaña Research Analyst juane@bcaresearch.com

Dear Client, Next week, we will be sending you BCA Research’s Annual Outlook, featuring long-time BCA client Mr. X, who visits towards the end of each year to discuss the economic, financial and commodity market outlook for the year ahead. All the best, Bob Ryan Chief Commodity & Energy Strategist  Highlights Local politics in Chile and Peru will become critical to the global energy transition, particularly as regards the supply side of the most critical metal for this transition: copper. Chile's runoff elections next month will pit a former congressman portrayed as a hard-right candidate against a protest leader-turned-legislator in a battle for the presidency of a country that accounts for ~ 30% of global copper mining output. In Peru, which accounts for just over 10% of global copper production, the left-of-center administration indicated it will mediate talks to close two gold and silver mines, despite protests from its corporate owners. Tightly balanced supply-demand fundamentals will keep inventories of refined copper extremely low, which will slow the early-stage global transition to renewable power generation until these stocks can be replenished (Chart of the Week).  Chinese copper smelters reportedly are collaborating to move refined metal to LME-approved warehouses to restock depleted inventories.  While this could reduce backwardations in futures markets, it has not overly depressed flat-price levels, which are within ~ 7% of all-time highs of $4.78/lb ($10,533/MT) put up in May. Fundamentally, base metals – especially copper and aluminum – will remain tight, which supports our long positions in the S&P GSCI and the COMT ETF. Feature Despite a marked deceleration of growth in China brought on by fuel and power shortages, and a strong USD creating tighter financial conditions globally, copper prices – and base metals generally – remain well supported, even as speculative interest, for the most part, has waned this year (Chart 2). Chart of the WeekTight Copper Inventories Support Prices, Backwardation Tight Copper Inventories Support Prices, Backwardation Tight Copper Inventories Support Prices, Backwardation Chart 2Specs Back The Truck Up For Copper Spec Interest Wanes Specs Back The Truck Up For Copper Spec Interest Wanes Specs Back The Truck Up For Copper Spec Interest Wanes   Copper and the other metals are well bid because of tight fundamentals – the level of demand has been and remains above the level of supply globally (Chart3). This will continue to exert pressure on inventories and force a re-shuffling of stocks globally – likely from China bonded warehouses to the LME (Chart 4). The London Metal Exchange (LME) was forced to take extraordinary measures to maintain orderly markets and has prompted Chinese smelters to collaborate on shifting material to LME sheds in Asia.1 However, much more refined copper will have to be shipped to these sheds to keep markets from launching into another steep backwardation on the LME similar to last month's $1,100/MT first-to-third-month spread last month – an indication of desperation on the buy side. Chart 3Low Copper Stocks Will Persist Low Copper Stocks Will Persist Low Copper Stocks Will Persist That said, if the only thing that improves LME stocks is a re-shuffle from existing inventories, the net position of the world will largely remain unchanged over time. Demand will be met with inventory draw-downs, but supply will not have increased, which, at the end of the day, means markets will continue to tighten. Chart 4Globally, Exchange Warehouses Tighten Globally, Exchange Warehouses Tighten Globally, Exchange Warehouses Tighten Chile, Peru Politics Become Fundamental Geopolitics always is at the heart of commodity markets: Who's in power and the agendas being pursued matter so much, because, in many cases, unrefined exports of raw commodities sustain governments and important elements of economies in many states. This is becoming clear in Chile and Peru, two states with contestable elections, where the outcomes can profoundly affect the supply side of global fundamentals. Earlier this year, it looked like Chile's presidential and congressional elections would favor left-of-center candidates who did not campaign on market-oriented policies. National elections this past weekend resulted in a run-off that will be held 19 December, as neither the left- nor right-of-center candidates polled an absolute majority. Right-of-center candidates also polled unexpectedly well in congressional elections. This likely translates into something resembling the divided government in the US, which means neither side will be able to get all it wants through the legislature. In the lead-up to the Constitutional re-write expected following elections, the agendas of the left and right are markedly opposed. On the left, greater government involvement in the resources sector has been part of the campaigning, while on the right increased private investment in the stated-owned Codelco, the largest copper producer in the world, is advocated. Both sides also disagree on changes in taxes and royalties, which obviously is of great concern to investors and copper-market participants.2 Chile also is a world-class supplier of lithium, zinc, gold, silver and lead, so it's not just copper markets following developments there with concern. In Peru, the country's newly sworn-in prime minister said she is willing to broker talks on shutting down gold and silver mines in communities where residents have been protesting as soon as possible. This drew a heated reply from mining interests immediately. Peru is the second largest copper miner in the world behind Chile, and the treatment of the owner of the disputed gold and silver mines, Hochschild Mining, is being followed closely. Base and precious metals markets are being forced to factor in a new set of political dynamics, as local political tensions spill into the supply side, causing overall political uncertainty in critical mining states to increase. This will restrain investment, which bodes ill for the global renewable- energy transition. Copper Defies Stronger USD  Despite a stronger-than-expected USD this year – boosted most recently by the re-appointment of Jay Powell as Fed Chair and the elevation of Lael Brainard as Vice Chair – copper and base metals have held up well.3 Generally, a strong dollar is bearish for base metals prices (Chart 5), and copper especially (Chart 6). A stronger USD tightens global financial conditions, which, not unexpectedly, is bearish for copper; however, as Chart 7 shows, this effect also has been overcome by the tight copper fundamentals globally.4 We remain bearish the USD going into next year, in line with our colleagues at BCA's Foreign Exchange Strategy. Massive fiscal stimulus in the US in particular, along with continued monetary accommodation from the Fed to fund the deficits this will produce, is expected to weaken the dollar and boost trade. Chart 5Base Metals Defy Strong USD Base Metals Defy Strong USD Base Metals Defy Strong USD Chart 6Copper Defies USD Strength, Boosted By Cyclicals Performance Copper Defies USD Strength, Boosted By Cyclicals Performance Copper Defies USD Strength, Boosted By Cyclicals Performance Chart 7Copper Overcomes Tighter Global Financial Conditions Copper Overcomes Tighter Global Financial Conditions Copper Overcomes Tighter Global Financial Conditions In a recent simulation, we show a 10% fall in the USD and a 5% pick-up in EM imports, along with continued strong performance from cyclicals would lift copper prices to $5.30/lb on the CME Comex by year-end 2022, in our estimation (Chart 8). Chart 8Weaker USD, Stronger EM Imports, Cyclical Strength Would Booster Copper. Weaker USD, Stronger EM Imports, Cyclical Strength Would Booster Copper. Weaker USD, Stronger EM Imports, Cyclical Strength Would Booster Copper. Investment Implications Base metals markets, particularly copper, have withstood tightening financial conditions brought on by a strong USD, a sharp slowdown in Chinese growth brought on by an energy shortage and rising interest rates. This is largely due to extremely tight supply-demand fundamentals, which continue to keep global inventories under pressure. Copper, metals generally, and precious metals also will get a lift from local political tensions spilling into the supply side of markets as overall political uncertainty in critical mining states restrains investment. We remain long the S&P GSCI and the COMT ETF, anticipating higher copper prices and a return to steeper backwardation.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com   Commodities Round-Up Energy: Bullish Oil markets looked right through the announcement the US will tap its Strategic Petroleum Reserve (SPR) for 50mm barrels beginning next month, rallying 3.3% to $82.31/bbl by Tuesday's close following the announcement (Chart 9). Under a Congressionally mandated release, the 18mm barrels already authorized had been factored into market balances. The incremental 32mm barrels of crude oil being supplied to the market will be released to successful bidders between 16Dec21 and 30Apr22. These volumes will be repaid during US fiscal years 2022-24, with a volumetric premium added to the initial volume lifted by the successful bidders, which will be specified in the terms of the crude-oil loan. The US fiscal year begins on 1 October. The longer it takes to return the crude oil back to the SPR, the higher the premium volume of crude oil will be required, per the SPR's terms and conditions. The Biden administration succeeded in persuading the governments of China, India, Japan, South Korea and the UK to release unspecified volumes from their SPRs as well. Although volume commitments and release dates were not included in the press release from the White House some 20mm to 30mm barrels reportedly could be supplied from these SPRs. Precious Metals: Bullish Gold prices fell violently, and the US dollar rose following Jay Powell’s re-nomination to Fed chair (Chart 10). Markets assume the Fed will stay the course on its current monetary policy, as opposed to loosening further, which would have lifted gold prices on the back of higher inflation expectations. We believe interest rate hikes will not be brought forward unless inflation expectations become unhinged. In the short run, however, high fuel prices and logistical bottlenecks will continue to feed into higher inflation, implying the Fed will remain behind the curve. Both Powell and Lael Brainard, who was nominated as vice chair of the Fed, stressed vigilance against inflation. In his statement following Biden's decision to re-appoint him as Fed Chair, Powell noted: "Today, the economy is expanding at its fastest pace in many years, carrying the promise of a return to maximum employment. … We know that high inflation takes a toll on families, especially those less able to meet the higher costs of essentials like food, housing, and transportation. We will use our tools both to support the economy and a strong labor market, and to prevent higher inflation from becoming entrenched." Brainard's remarks struck a similar tone. Chart 9 Brent Prices Are Going Up... Brent Prices Are Going Up... Chart 10 ...As Well As Gold Prices ...As Well As Gold Prices   Footnotes 1     Please see Column: All eyes on China as LME copper spreads collapse: Andy Home, published by reuters.com 18 November 2021. 2     Please see Chile elections may impact a third of the world’s copper supply, published by mining.com on November 19, 2021.  3    Please see Precious Metals commentary in the Commodity Round-Up section. 4    The model shown in Chart 7 also includes iron ore and steel traded in China as explanatory variables.  It is noteworthy that copper prices remain resilient to a collapse in iron ore prices brought on by forced closures in China of steel mills to conserve coal and natural gas supplies for human-needs use going into what is expected to be a colder-than-normal winter on the back of a second La Niña in the Northern Hemisphere.  Please see our report published 30 September entitled La Niña And The Energy Transition for additional discussion.   Investment Views and Themes Strategic Recommendations