Recession-Hard/Soft Landing

Listen to a short summary of this report.     Executive Summary Higher Real Yields Have Weighed On Equity Valuations Higher Real Yields Have Weighed On Equity Valuations Higher Real Yields Have Weighed On Equity Valuations I had the pleasure of visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi last week. In contrast to the rest of the world, the mood in the Middle East was very positive. While high oil prices are helping, there is also a lot of optimism about ongoing structural reforms. Petrodollar flows are increasingly being steered towards private and public equities. EM assets stand to benefit the most. Producers in the region are trying to offset lost Russian output, but realistically, they will not be able to completely fill the gap in the near term. Today’s high energy prices have largely baked in this reality, as reflected in strongly backwardated futures curves. There was no consensus about how high oil prices would need to rise to trigger a global recession, although the number $150 per barrel got bandied about a lot. Given that most Middle Eastern currencies are pegged to the dollar, there was a heavy focus on Fed policy. Market estimates of the neutral rate in the US have increased rapidly towards our highly out-of-consensus view. Nevertheless, we continue to see modest upside for bond yields over a multi-year horizon. Over a shorter-term 6-to-12-month horizon, the direction of bond yields will be guided by the evolution of inflation. While US CPI inflation rose much more than expected in May, the details of the report were somewhat less worrying, as they continue to show significant supply-side distortions. Bottom Line: Inflation should come down during the remainder of the year, allowing the Fed to breathe a sigh of relief and stocks to recover some of their losses. A further spike in oil prices is a major risk to this view.   Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Chester Ntonifor, BCA Research’s Chief Foreign Exchange Strategist, discussing the outlook for gold. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the following week, on Thursday, July 7th. Best regards, Peter Berezin Chief Global Strategist Peter in Arabia I had the pleasure of visiting clients in Saudi Arabia, Bahrain, and Abu Dhabi last week. This note summarizes my impressions and provides some commentary about recent market turmoil. The Mood in the Region is Very Positive In contrast to the rest of the world, the mood in the Middle East was upbeat. Obviously, high oil prices are a major contributor (Chart 1). Across the region, stock markets are still up for the year (Chart 2). Chart 1Oil Prices Have Shot Up Oil Prices Have Shot Up Oil Prices Have Shot Up Chart 2Middle Eastern Stock Markets Are Doing Relatively Well This Year Middle Eastern Stock Markets Are Doing Relatively Well This Year Middle Eastern Stock Markets Are Doing Relatively Well This Year   That said, I also felt that investors were encouraged by ongoing structural reforms, especially in Saudi Arabia where the Vision 2030 program is being rolled out. The program seeks to diversify the Saudi economy away from its historic reliance on petroleum exports. A number of people I spoke with cited the Saudi sovereign wealth fund’s acquisition of a majority stake in Lucid, a California-based EV startup, as the sort of bold move that would have been unthinkable a few years ago. I first visited Riyadh in May 2011 where I controversially delivered a speech entitled “The Coming Commodity Bust” (oil was $120/bbl then and copper prices were near an all-time high). The city has changed immensely since then. The number of restaurants and entertainment venues has increased exponentially. The ban on women drivers was lifted only four years ago. In that short time, it has become a common-day occurrence. Capital Flows Into and Out of the Region are Reflecting a New Geopolitical Reality In addition to high oil prices and structural reforms, geopolitical considerations are propelling significant capital inflows into the region. The freezing of Russia’s foreign exchange reserves sent a shockwave across much of the world, with a number of other EM countries wondering if “they are next.” Ironically, the Middle East has emerged as a neutral player of sorts in this multipolar world, and hence a safer destination for capital flows. On the flipside, the region’s oil exporters appear to be acting more strategically in how they allocate their petrodollar earnings. Rather than simply parking the proceeds of oil sales in overseas US dollar bank accounts, they are investing them in ways that further their economic and political goals. One clear trend is that equity allocations to both overseas public and private markets are rising. Other emerging markets stand to benefit the most from this development, especially EMs who have assets that Middle Eastern countries deem important – assets tied to food security being a prime example. Assuming that the current level of oil prices is maintained, we estimate that non-US oil exports will rise to $2.5 trillion in 2022, up from $1.5 trillion in 2021 (Chart 3). About 40% of this windfall will flow to the Middle East. That is a big slug of cash, enough to influence the direction of equity markets. Chart 3Oil Exporters Reaping The Benefits Of High Oil Prices An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East Middle Eastern Energy Producers Will Boost Output, But Don’t Expect Any Miracles in the Short Term Russian oil production will likely fall by about 2 million bpd relative to pre-war levels over the next 12 months. To help offset the impact, OPEC has already raised production by 200,000 barrels and will almost certainly bump it up again following President Biden’s visit to the region in July (Chart 4). The decision to raise production to stave off a super spike in oil prices is not entirely altruistic. The region’s oil exporters know that excessively high oil prices could tip the global economy into recession, an outcome that would surely lead to much lower oil prices down the road. There was not much clarity on what that tipping point is, but the number $150 per barrel got bandied around a lot. Politics is also a factor. A further rise in oil prices could compel the US to make a deal with Iran, something the Saudis do not want to see happen. Still, there is a practical limit to how much more oil the Saudis and other Middle Eastern producers can bring to market in the near term. Today’s high energy prices have largely baked in this reality, as reflected in strongly backwardated futures curves (Chart 5). Chart 4Output Trends In The Major Oil Producers Output Trends In The Major Oil Producers Output Trends In The Major Oil Producers Chart 5Energy Prices On Both Sides Of The Atlantic An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East Data on Saudi’s excess capacity is notoriously opaque, but I got the feeling that an extra 1-to-1.5 million bpd was the most that the Kingdom could deliver. The same constraints apply to natural gas. Qatar is investing nearly $30 billion to expand its giant North Field, which should allow gas production to rise by as much as 60%. However, it will take four years to complete the project. The share of Qatari liquefied natural gas (LNG) going to Europe has actually declined this year. About 80% of Qatar’s LNG is sold to Asian buyers under long-term contracts that cannot be easily adjusted. And even if those contracts could be rewritten, this would only bring limited benefits to Europe. For example, Germany has no terminals to accept LNG imports, although it is planning to build two. While there was plenty of sympathy to Europe’s plight in the region, there was also a sense that European governments had been cruising for a bruising by doubling down on strident anti-fossil fuel rhetoric over the past decade without doing much to end their dependence on Russian oil and gas. In that context, few in the region seemed willing to bend over backwards to help Europe. In the meantime, the US remains Europe’s best hope. US LNG shipments to Europe have tripled since last year. The US is now sending nearly three quarters of its liquefied gas to Europe. This has pushed up US natural gas prices, although they still remain a fraction of what they are in Europe. Huge Focus on the Fed Chart 6Most Of The Increase In Bond Yields Has Been In The Real Component Most Of The Increase In Bond Yields Has Been In The Real Component Most Of The Increase In Bond Yields Has Been In The Real Component Most Middle Eastern currencies are pegged to the dollar, and hence the region effectively imports its monetary policy from the US. Not surprisingly, clients were very focused on the Federal Reserve. Many expressed concern about the abrupt pace of rate hikes. One of our high-conviction views is that the neutral rate of interest in the US has risen as the household deleveraging cycle has ended, fiscal policy has become structurally looser, and a growing number of baby boomers have transitioned from working (and saving) to retirement (and dissaving). The markets have rapidly priced in this view over the course of 2022. The 5-year/5-year forward Treasury yield – a proxy for the neutral rate – has increased from 1.90% at the start of the year to 3.21% at present. Most of this increase in the market’s estimate of the neutral rate has occurred in the real component. The 5-year/5-year forward TIPS yield has climbed from -0.49% to 0.84%; in contrast, the implied TIPS breakeven inflation rate has risen from only 2.24% to 2.37% (Chart 6). Implications of Higher Bond Yields on Equity Prices and the Economy Chart 7Higher Real Yields Have Weighed On Equity Valuations Higher Real Yields Have Weighed On Equity Valuations Higher Real Yields Have Weighed On Equity Valuations As both theory and practice suggest, there is a strong negative correlation between real bond yields and equity valuations. Chart 7 shows that the S&P 500 forward P/E ratio has been moving broadly in line with the 5-year/5-year forward TIPS yield. The bad news is that there is still scope for bond yields to rise over the long haul. Our fair value estimate of 3.5%-to-4% for the neutral rate is about 25-to-75 basis points above current pricing. The good news is that a high neutral rate helps insulate the economy from a near-term recession. Recessions typically occur only when monetary policy turns restrictive. A few clients cited the negative Q1 GDP reading and the near-zero Q2 growth estimate in the Atlanta Fed GDPNow model as evidence that a US recession is either close at hand or has already begun (Chart 8). Chart 8Underlying US Growth Is Expected To Be Solid In Q2 An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East We would push back against such an interpretation. In contrast to the -1.5% real GDP print, real Gross Domestic Income (GDI) rose by 2.1% in Q1. Conceptually, GDP and GDI should be equal, but since the two numbers are compiled in different ways, there can often be major statistical discrepancies. A simple average of the two suggests the US economy still grew in the first quarter. More importantly, real final sales to private domestic purchasers rose by 3.9% in Q1. This measure of economic activity – which strips out the often-noisy contributions from inventories, government expenditures, and net exports – is the best predictor of future GDP growth of any item in the national accounts (Table 1). Table 1A Good Sign: Real Final Sales To Private Domestic Purchasers Rose By 3.9% In Q1 An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East As far as Q2 is concerned, real final sales to private domestic purchasers are tracking at 2.0% according to the Atlanta Fed model – a clear deceleration from earlier this year, but still consistent with a generally healthy economy. Growth will probably slow in the third quarter, reflecting the impact of higher gasoline prices, rising interest rates, and lower asset prices. Nevertheless, the fundamental underpinnings for the economy – low household debt, $2.2 trillion in excess savings, a dire need to boost corporate capex and homebuilding, and a strong labor market – remain in place. The odds of a recession in the next 12 months are quite low. Gauging Near-Term Inflation Dynamics A higher-than-expected neutral rate of interest implies that bond yields will probably rise from current levels over the long run. Over a shorter-term 6-to-12-month horizon, however, the direction of yields will be guided by the evolution of inflation. While the core CPI surprised on the upside in May, the details of the report were somewhat less worrying, as they continue to show significant supply-side distortions. Excluding vehicles, core goods prices rose 0.3% in May, down from a Q1 average of 0.7% (Chart 9). Recent commentary from companies such as Target suggest that goods inflation will ease further. Chart 9Goods Inflation Is Moderating, While Service Price Growth Is Elevated An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East Stripping out energy-related services, services inflation slowed slightly to 0.6% in May from 0.7% in April. A deceleration in wage growth should help keep a lid on services inflation over the coming months (Chart 10). Chart 10A Deceleration In Wage Growth Should Help Keep Services Inflation Contained An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East During his press conference, Fed Chair Powell described the rise in inflation expectations in the University of Michigan survey as “quite eye-catching.” Although long-term inflation expectations remain a fraction of what they were in the early 1980s, they did rise to the highest level in 14 years in June (Chart 11). Powell also noted that the Fed’s Index of Common Inflation Expectations has been edging higher. The Fed’s focus on ensuring that inflation expectations remain well anchored is understandable. That said, there is a strong correlation between the level of gasoline prices and inflation expectations (Chart 12). If gasoline prices come down from record high levels over the coming months, inflation expectations should drop.  Chart 11Consumer Long-Term Inflation Expectations Keep Rising, But Are Still Not At Historically High Levels Consumer Long-Term Inflation Expectations Keep Rising, But Are Still Not At Historically High Levels Consumer Long-Term Inflation Expectations Keep Rising, But Are Still Not At Historically High Levels Chart 12Lower Gasoline Prices Would Help Soothe Consumer Fears Over Inflation Lower Gasoline Prices Would Help Soothe Consumer Fears Over Inflation Lower Gasoline Prices Would Help Soothe Consumer Fears Over Inflation The Fed expects core PCE inflation to fall to 4.3% on a year-over-year basis by the end of 2022. This would require month-over-month readings of about 0.35 percentage points, which is slightly above the average of the past three months (Chart 13). Our guess is that the Fed may be highballing its near-term inflation projections in order to give itself room to “underpromise and overdeliver” on the inflation front. If so, we could see inflation estimates trimmed later this year, which would provide a more soothing backdrop for risk assets. Chart 13AUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (I) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (I) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (I) Chart 13BUS Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (II) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (II) US Inflation Will Fall By More Than The Fed Expects If The Monthly Change In Core PCE Is Less Than 0.35% (II) Concluding Thoughts on Investment Strategy According to Bank of America, fund managers cut their equity exposure to the lowest since May 2020. Optimism on global growth fell to a record low. Meanwhile, bears outnumbered bulls by 39 percentage points in this week’s AAII poll (Chart 14). If the stock market is about to crash, it will be the most anticipated crash in history. In my experience, markets rarely do what most people expect them to do. Chart 14Sentiment Towards Equities Is Pessimistic Sentiment Towards Equities Is Pessimistic Sentiment Towards Equities Is Pessimistic Chart 15Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Global Equities Are More Attractively Valued After The Recent Sell-Off Chart 16US And European EPS Estimates Have Been Trending Higher This Year US And European EPS Estimates Have Been Trending Higher This Year US And European EPS Estimates Have Been Trending Higher This Year US equities are trading at 16.3-times forward earnings, with non-US stocks sporting a forward P/E ratio of 12.1 (Chart 15). Despite the decline in share prices, earnings estimates in both the US and Europe have increased since the start of the year (Chart 16). The consensus is that those estimates will fall. However, if our expectation that a recession will be averted over the next 12 months pans out, that may not happen. A sensible strategy right now is to maintain a modest overweight to stocks while being prepared to significantly raise equity exposure once clear evidence emerges that inflation has peaked. Peter Berezin Chief Global Strategist peterb@bcaresearch.com Follow me on        LinkedIn Twitter       View Matrix An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East Special Trade Recommendations Current MacroQuant Model Scores An Oasis Of Optimism: Notes From The Middle East An Oasis Of Optimism: Notes From The Middle East

Dear Client, Next Friday we will publish a Special Report on Gold in conjunction with our colleagues in BCA Research’s Foreign Exchange and Global Investment strategy groups.  We will return to our regular schedule of publishing on Thursdays the following week, with our June 30 ESG report.  Sincerely, Robert Ryan Chief Commodity & Energy Strategist Executive Summary Brent Forecast Slightly Lower On Global Growth Downgrade Brent Forecast Slightly Lower On Global Growth Downgrade Brent Forecast Slightly Lower On Global Growth Downgrade The World Bank’s somewhat sanguine expectation re stagflation risks for 2023 and beyond misreads continuing pressure on commodity markets due to low capex, and disincentives to invest. If central banks are successful in cooling consumer spending via a policy-induced recession, pressure on spare capacity in oil-producing and refining markets will lessen slightly. However, higher interest rates will increase capex costs. Weaker demand from a recession will not batter crude oil prices: core-OPEC 2.0 – KSA and the UAE – and US shale producers will maintain their production-management strategies, keeping markets relatively balanced. Our forecast for 2H22 and 2023 Brent is $115/bbl and $117/bbl on average, down ~ $6 and $5/bbl from last month’s forecast. WTI will trade $3/bbl lower. Europe will enter a recession earlier than other DMs, with natural-gas shipments to the EU from the US and Russia set to decline precipitously. This will tighten food and metals markets, and keep inflation expectations elevated. Bottom Line: Low spare capacity and continued production management by core-OPEC 2.0 and US shale producers will offset lower demand, and continue to support crude and product prices. The odds of prices exceeding $140/bbl remain high. We remain long the S&P GSCI index, and the COMT and CRAK ETFs. At tonight’s close, we will get long the iShares U.S. Oil Equipment & Services ETF (IEZ). Separately, we were stopped out of our XOP, XME and PICK ETFs, with gains of 19%, 7.2% and 7.6% respectively. We will look for opportunities to re-instate them. Feature Related Report  Commodity & Energy StrategyOne Hot Mess: EU Energy Policy While the World Bank sharply downgraded its global growth expectations for this year and next, it nonetheless maintains a somewhat sanguine view of the risk of stagflation going forward.1 The Bank notes current market conditions closely resemble those of the last bout of prolonged stagflation in the 1970s – characterized by flat-to-lower economic growth and high inflation – but differs in important ways that reduce the likelihood of a recurrence.2 In particular, the Bank cites research indicating the proximate causes of the 1970s stagflation have mostly been addressed, and how central banks are better equipped to avoid the mistakes that produced it: Thus far, markets expect that inflation in the near future will decline, albeit remaining elevated, as global growth cools, monetary policy gets tighter, fiscal support is withdrawn, energy and food prices level off, and supply bottlenecks ease. Moreover, most commentators argue that monetary policy has the tools to return inflation to target rates over time (pp. 53-4). We disagree with this assessment, and expect stagflation risks to remain elevated. This is driven by our high-conviction view that weak capex – and, importantly, continued disincentives to invest in hydrocarbon production and refining – will keep industrial-commodity markets tight well into this decade. Base metals producers also have been parsimonious in capex allocations. The Russia-Ukraine war brought forward the capex reckoning for commodity markets and inflation by highlighting the EU’s near-total dependence on Russian oil and natural gas imports, and the risks on outsourced manufacturing and refining away from domestic markets.3 Addressing long-term policy errors and re-forging global supply chains will be expensive, and will require decades of capex investment to overcome the lack of capacity needed to meet higher demand for coal, oil and natgas. This will delay the global energy-transition to a zero- or low-carbon economy and – because exploration, production, refining and distribution of hydrocarbon-based fuels remains constrained – will keep energy markets, particularly oil, tight. As a result, these markets will be predisposed to frequent price spikes, which will lift the average cost of crude oil and refined products over the foreseeable future. Downgrading Oil Demand Again We are once again downgrading our demand expectation for this year and next, on the back of the macro forces outlined in the World Bank’s June forecast: 1) Tightening monetary policy globally, led by the Fed; 2) Higher inflation, which has been exacerbated by the Russia-Ukraine war; and 3) Supply dislocations in energy and grain markets. Global GDP growth this year is expected to be close to half that of 2021 – 2.9% in real terms vs 5.7% – and was revised sharply lower vs the Bank’s January forecast of 4% growth. On the heels of the Bank’s lower growth expectation, we lowered our 2022 oil demand growth forecast to 2.0mm b/d this year vs 4.8mm b/d in our January forecast (Chart 1). For next year, we expect oil demand to grow 1.8mm b/d. Of particular interest, China’s growth in the first five months of this year was negative – actual demand from Jan-May22 averaged 15.2mm b/d vs 15.4mm b/d last year. This reflects the demand destruction caused by the lockdowns arising from China’s COVID-19 zero-tolerance policy, and is the first time since 2009 y/y growth has fallen (Chart 2). Chart 1Oil Demand Downgraded Following Lower Growth Expectation Oil Demand Downgraded Following Lower Growth Expectation Oil Demand Downgraded Following Lower Growth Expectation Chart 2Oil Demand Destruction In China Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices OPEC 2.0 Will Adjust Output We expect core-OPEC 2.0 – the Kingdom of Saudi Arabia (KSA) and the UAE – to continue to calibrate its supply to match the ebb and flow of demand. As a result we expect production declines among “the other guys” – i.e., member states that cannot increase supply or maintain current output – to not be fully compensated by the core producers if they see actual demand falling sharply in 2H22 and next year (Chart 3). As the supplier of the last resort, crude oil production from core-OPEC 2.0 tracks demand. This is the cohort of suppliers within OPEC 2.0 which has sufficient spare capacity to bring supply online and, importantly, is able to maintain higher levels of production in order to meaningfully influence oil markets. Chart 3Core-OPEC 2.0 Might Be Slower Offseting Declines Among "The Other Guys" Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices All else equal, in 2023 KSA and UAE – the two core-OPEC 2.0 nations with most spare capacity within OPEC 2.0 – will need to collectively raise supply by ~ 2mm b/d relative to average oil production in 2021 to ensure inventories do not draw sharply. OPEC 2.0 has been unable to stick to the 400 kb/d monthly crude oil production increases agreed in its July 2021 meeting, as declining investment and weak governance have plagued output from member states. Most recently, Libya has closed nearly all oil fields over the course of this month and last, taking nearly 1.1 mmb/d of oil supply off the market. The difference between the actual and agreed OPEC 2.0 output increases accumulated to ~ 2.0mm b/d as of May 2022. We continue to expect Russia to be firmly in the camp of the “other guys,” with production falling 1.6mm b/d this year and 2mm b/d in 2023 (vs 2021 levels). The production lost due to not being able to fully offset lost sales to the EU following its invasion of Ukraine could approach 3mm b/d next year (vs 2021 levels), depending on how successful Russia is in finding new customers. We also expect the US shale-oil producers to continue to maintain their capital discipline, and not ramp production in response to higher prices (Chart 4). This will be critical for maintaining access to capital markets, particularly if oil demand weakens in response to a global GDP decline. Chart 4US Shale Producers Forced To Maintain Capital Discipline US Shale Producers Forced To Maintain Capital Discipline US Shale Producers Forced To Maintain Capital Discipline Markets Will Remain Balanced Our supply-demand assessments leave oil markets relatively balanced with slightly lower prices resulting from lower demand (Chart 5). Oil inventories likely rise somewhat before resuming their downward trajectory as supply and demand adjust to lower growth prospects (Chart 6). Chart 5Expect Oil Markets To Remain Balanced Expect Oil Markets To Remain Balanced Expect Oil Markets To Remain Balanced Chart 6Oil Inventories Will Draw Oil Inventories Will Draw Oil Inventories Will Draw Importantly, OPEC 2.0’s core producers might welcome a slight rebuilding of inventories, given the relatively low levels of spare capacity available to meet unexpected supply outages or product shortages, say, for a hurricane in the US Gulf (Chart 7). This becomes particularly acute next year, when, as mentioned above, we expect core-OPEC 2.0 will have to increase their output by 2mm b/d vs 2021 levels to balance markets. Given the dynamics of our supply-demand modeling described above, our price forecasts for 2H22 and 2023 are little changed from last month’s estimates (Chart 8). We expect 2H22 Brent prices to average $115/bbl vs $121.30/bbl. This leaves the 2022 average at $110/bbl vs. $113/bbl estimate last month. For 2023, we expect Brent to average $117/bbl vs our earlier estimate of $122/bbl. Chart 7OPEC Spare Capacity Likely Will Tighten Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices Chart 8Brent Forecast Slightly Lower On Global Growth Downgrade Brent Forecast Slightly Lower On Global Growth Downgrade Brent Forecast Slightly Lower On Global Growth Downgrade These price forecasts and balances are our base case (Table 1). We do not estimate the risk premium the market is likely to impound in prices to cover the high level of uncertainty around oil, natgas and electricity prices in global markets. A sudden cut-off of Russian oil supplies to the EU could easily spike Brent prices above $140/bbl, e.g. Indeed, we continue to accord this outcome a non-trivial probability. Likewise, the Atlantic Hurricane Season starts this month, with the US Climate Prediction Center calling for a higher-than-average number of hurricanes for 2022, given above-average Atlantic temperatures and an ongoing La Niña event.4 Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices Investment Implications The World Bank’s weaker GDP growth forecast leads us to expect slightly lower demand in 2H22 and 2023. However, low spare capacity and continued production management by core-OPEC 2.0 and US shale producers will keep Brent prices close to $115-117/bbl in 2H22 and 2023, which, as our base case, is not far removed from last month’s forecasts. The odds of prices exceeding $140/bbl remain high, reflecting the razor-thin back-up supply margins available to the crude and product markets globally. We remain long the S&P GSCI index, and the COMT and CRAK ETFs. At tonight’s close, we will get long the iShares U.S. Oil Equipment & Services ETF (IEZ). We will look for opportuities to re-establish our XOP, XME and PICK ETF positions, which were stopped out with gains of 19%, 7.2% and 7.6%, respectively, over the course of this past week.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish European natural gas prices are surging on the back of a loss of exportable LNG volumes from the US Gulf, and on press reports Russia will cut exports to Germany on the Nord Stream (NS) 1 pipeline by ~ 40%. The US supply loss arises from an explosion to at a Freeport LNG terminal in Texas, which accounts for more than 15% of US LNG exports and takes ~ 5 bcm of gas out of the export market. Repairs reportedly will take three months. The loss of natgas supplies on NS1 is being blamed by Russia on an inability to move parts needed to repair the line from Canada due to sanctions imposed following its invasion of Ukraine in February. European gas prices – at the Title Transfer Facility (TTF) in the Netherlands and the National Balancing Point in the UK – surged on the back of this news, and were up 44.28% and 10.15% respectively from Monday’s close to Wednesday trading this week (Chart 9). US gas futures were down 13.81% this week, reflecting a back-up of pipeline natgas that will not make it to the LNG pool until repairs at Freeport are done. Base Metals: Bullish BCA’s China Investment Strategy reported a possible inflection point in household borrowing after nearly two decades of growth (Chart 10). Pandemic-induced lockdowns and declining home prices reduced households’ propensity to take on new debt. Household deleveraging could reduce demand for durables spending and real estate investment, driving down industrial metals’ demand. If deleveraging and lower demand becomes structural, China’s relevance in global metal demand likely will decline. Precious Metals: Bullish On the back of last Friday’s hot inflation data, the Federal Reserve announced a 75 bps rate hike following the June Federal Open Market Committee (FOMC) meeting. This likely will reduce the Fed’s credibility after Powell hinted at a 50 bps rate hike for the June meeting in last month’s meeting. The higher rate hike puts the Fed on a more hawkish path, risking the soft landing it has been aiming for. A US recession will be supportive for gold prices.   Chart 9 Recession Unlikely To Batter Oil Prices Recession Unlikely To Batter Oil Prices Chart 10 Chinese Households Leverage Ratio Fell The Most Since The GFC Chinese Households Leverage Ratio Fell The Most Since The GFC     Footnotes 1     Please see Stagflation Risk Rises Amid Sharp Slowdown in Growth, which includes a link to the Bank’s full June 2022 update. 2     Please see discussion beginning on p. 51 of the Banks June report, “Special Focus 1, Global Stagflation.”  This focus provides a well-researched history of the evolution of inflation. 3    Please see One Hot Mess: EU Energy Policy and Commodities' Watershed Moment, which we published 26 May and on March 10, 2022, for discussion of the EU’s energy dependence on Russia. See also La Niña And The Energy Transition, published on September 30, 2021, for a discussion of refining-concentration risks – particularly for base metals refining, where roughly half of global capacity is concentrated in China. 4    Please see NOAA predicts above-normal 2022 Atlantic Hurricane Season published on May 24, 2022.   Investment Views and Themes Recommendations  New, Pending And Closed Trades WE WERE STOPPED OUT OF OUR LONG S&P OIL & GAS EXPLORATION & PRODUCTION (XOP) ETF TRADE ON JUNE 13, 2022 WITH A RETURN OF 19%. WE WERE STOPPED OUT OF OUR LONG MSCI GLOBAL METALS & MINING PRODUCERS (PICK) ETF TRADE ON JUNE 9, 2022 WITH A RETURN OF 7.56%. WE WERE STOPPED OUT OF OUR LONG SPDR S&P METALS AND MINING (XME) ETF TRADE ON JUNE 9, 2022 WITH A RETURN OF 7.17%. Strategic Recommendations Tactical Trades Trades Closed in 2022

In lieu of next week’s report, I will host a Webcast on Monday, June 27 to explain the recent market turmoil and how to navigate it through the second half of 2022. Please mark the date, and I do hope you can join. Executive Summary The recent sharp underperformance of the HR and employment services sector presages an imminent rise in the US unemployment rate. Central banks have decided that a recession is a price worth paying to slay inflation. In this sense, the current setup rhymes with 1981-82, when the Paul Volcker Fed made the same decision. The correct investment strategy for stocks, bonds, sectors and FX is to follow the template of 1981-82. In a nutshell, an imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Go long the December 2023 Eurodollar (or SOFR) futures contract. While interest rates are likely to overshoot in the near term, the pain that they will unleash will require a commensurate undershoot in 2023-24. Cryptocurrencies will rally strongly once the Nasdaq reaches a near-term bottom, which in turn will depend on a peak in long bond yields. Fractal trading watchlist: Czechia versus Poland, German telecoms, Japanese telecoms, and US utilities. The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over Bottom Line: An imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Feature Financial markets have collapsed in 2022, but jobs markets have held firm, at least so far. For example, the US economy has added an average of 500 thousand jobs per month1, and the unemployment rate, at 3.6 percent, remains close to a historic low. But now, an excellent real-time indicator warns that cracks are appearing in the US jobs market. The excellent real-time indicator of the jobs market is the performance of the human resources (HR) and employment services sector. After all, with its role to place and support workers in their jobs, what better pulse for the jobs market could there be than HR? What better pulse for the jobs market could there be than the human resources sector? Worryingly, the recent sharp underperformance of the HR and employment services sector warns that the pulse of the jobs market is weakening, and that consumers will soon be reporting that jobs are becoming less ‘plentiful’ (Chart I-1). In turn, consumers reporting that jobs are becoming less plentiful presages an imminent rise in the unemployment rate (Chart I-2). Chart I-1The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over The Underperformance Of Human Resources Warns That The US Jobs Market Is Rolling Over Chart I-2Jobs Becoming Less 'Plentiful' Presages Higher Unemployment Jobs Becoming Less 'Plentiful' Presages Higher Unemployment Jobs Becoming Less 'Plentiful' Presages Higher Unemployment 2 Percent Inflation Will Require A Sharp Rise In Unemployment The health of the jobs market has a huge bearing on the big issue du jour – inflation. Specifically, in the US, the unemployment rate (inversely) drives the inflation of rent and owners’ equivalent rent (OER) because, to put it simply, you need a steady job to pay the rent. Furthermore, with rent and OER comprising almost half of the core CPI basket, the ‘rent of shelter’ component is by far the most important long-term driver of core inflation.2 Shelter inflation at 3.5 percent equates to core inflation at 2 percent. For the past couple of decades, full employment has been consistent with rent of shelter inflation running at 3.5 percent, which itself has been consistent with core inflation running at 2 percent (Chart I-3). Hence, the Fed could achieve the Holy Grail of full employment combined with inflation running close to 2 percent. Chart I-3Core Inflation At 2 Percent = Shelter Inflation At 3.5 Percent... Core Inflation At 2 Percent = Shelter Inflation At 3.5 Percent... Core Inflation At 2 Percent = Shelter Inflation At 3.5 Percent... But here’s the Fed’s problem. In recent months, there has been a major disconnect between the jobs market and rent of shelter inflation. The current state of full employment equates to rent of shelter inflation running not at 3.5 percent, but at 5.5 percent (Chart I-4). Chart I-4...But Full Employment Now = Shelter Inflation At 5.5 Percent ...But Full Employment Now = Shelter Inflation At 5.5 Percent ...But Full Employment Now = Shelter Inflation At 5.5 Percent This means that to bring rent of shelter and core inflation back to 3.5 percent and 2 percent respectively, the unemployment rate will have to rise by 2 percent. In other words, to achieve its inflation goal, the Fed will have to sacrifice its full employment goal. Put more bluntly, if the Fed wants to reach 2 percent inflation quickly, it will have to take the economy into recession. The cracks appearing in the HR and employment services sector suggest this process is already underway. There Are Two ‘Neutral Rates Of Interest’. Which One Will Central Banks Choose? The ‘neutral rate of interest rate’, also known as the long-run equilibrium interest rate, the natural rate and, to insiders, r-star or r*, is the short-term interest rate that is consistent with the economy at full employment and stable inflation: the rate at which monetary policy is neither contractionary nor expansionary. But here’s the subtle point that many people miss. The neutral rate is defined in terms of stable inflation without stating what that stable rate of inflation is. Therein lies the Fed’s problem. The near-term neutral rate that is consistent with inflation at 2 percent is much higher than the near-term neutral rate that is consistent with full employment. The near-term neutral rate that is consistent with inflation at 2 percent is much higher than the near-term neutral rate that is consistent with full employment. Now let’s add a third goal of ‘financial stability’, and the message from the ongoing crash in stock, bond, and credit markets is crystal clear. The near-term neutral rate that is consistent with inflation at 2 percent is also much higher than the near-term neutral rate that is consistent with financial stability (Chart I-5 and Chart I-6). Chart I-5Markets Have Crashed Because Valuations Have Crashed. Profits Have Held Up… So Far 5. Markets Have Crashed Because Valuations Have Crashed. Profits Have Held Up... So Far 5. Markets Have Crashed Because Valuations Have Crashed. Profits Have Held Up... So Far Chart I-6When The Mortgage Rate Exceeds The Rental Yield, It Spells Trouble For House Prices When The Mortgage Rate Exceeds The Rental Yield, It Spells Trouble For House Prices When The Mortgage Rate Exceeds The Rental Yield, It Spells Trouble For House Prices This leaves the Fed, and other central banks, with a major dilemma. Which neutral rate goal to pursue – full employment and financial stability, or inflation at 2 percent? In the near term, the answer seems to be inflation at 2 percent. This is because the lifeblood of central banks is their credibility. With their credibility as inflation fighters in tatters, this may be the last chance to repair it before it is shredded forever. Taking this long-term existential view, central banks have decided that a recession is a price worth paying to slay inflation and repair their credibility. In this important sense, the current setup rhymes with 1981-82 when the Paul Volcker Fed made the same decision. Therefore, the correct investment strategy for stocks, bonds, sectors and FX is to follow the template of 1981-82, which we detailed in More On 2022-2023 = 1981-82, And The Danger Ahead. In a nutshell, an imminent recession will require a defensive strategy for most of 2022, before a strong recovery in markets unfolds in 2023. Eventually, the central banks’ major dilemma between inflation and growth will resolve itself. The triple whammy of a recession in asset prices, profits, and jobs will unleash a strong disinflationary – or even outright deflationary – impulse, causing inflation to collapse to well below 2 percent in 2023-24. And suddenly, there will be no conflict between the neutral rate that is consistent with full employment and financial stability, and that which is consistent with inflation at 2 percent. Both neutral rates will be ultra-low.  Hence, while interest rates are likely to overshoot in the near term, the pain that they will cause will require a commensurate undershoot in 2023-24. On this basis, go long the December 2023 Eurodollar (or SOFR) futures contract (Chart I-7). Chart I-7Go Long The Dec 2023 Eurodollar (Or SOFR) Future Go Long The Dec 2023 Eurodollar (Or SOFR) Future Go Long The Dec 2023 Eurodollar (Or SOFR) Future Cryptos Will Bottom When The Nasdaq Bottoms The turmoil across financial markets has naturally engulfed cryptocurrencies, and this has generated the usual Schadenfreude among the crypto-doubters. But in the short-term, cryptocurrencies just behave like leveraged tech stocks, meaning that as the Nasdaq has fallen sharply, cryptos have fallen even more sharply (Chart I-8). Chart I-8In the Short Term, Cryptos = A Leveraged Nasdaq In the Short Term, Cryptos = A Leveraged Nasdaq In the Short Term, Cryptos = A Leveraged Nasdaq Most cryptocurrencies are just the tokens that secure their underlying blockchains, so their long-term value hinges on whether their underlying blockchain technologies will succeed in displacing the current ‘trusted third party’ model of intermediation. In this sense, blockchain tokens are the ultimate long-duration growth stocks, whose present values are highly sensitive to the performance of the blockchain technology sector, which in turn is highly sensitive to the long-duration bond yield. Hence, while the bear markets in bonds, Nasdaq, and cryptos appear to be separate stories, they are just one massive correlated trade! Given that nothing fundamental has changed in the outlook for blockchains, long-term investors should treat this crypto crash, just like all the previous crypto crashes, as a buying opportunity. Cryptos will rally strongly once the Nasdaq reaches a near-term bottom, which in turn will depend on a peak in long bond yields. Fractal Trading Watchlist Amazingly, while most markets have crashed, the financial-heavy Czech stock market is up by 20 percent this year, in sharp contrast to its neighbouring Polish stock market which is down by 25 percent. In fact, over the last year, Czechia has outperformed Poland by 100 percent. From both a fundamental and technical perspective, this outperformance is now vulnerable to reversal (Chart I-9). Accordingly, a recommended trade is to underweight Czechia versus Poland, setting the profit target and stop-loss at 15 percent. Elsewhere, the outperformances of German telecoms, Japanese telecoms, and US utilities are all at, or close, to points of fractal fragilities which make them vulnerable to reversals. As such, these have entered out watchlist. The full watchlist of 27 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Chart I-9Czechia's Spectacular Outperformance Is Vulnerable To Reversal Czechia's Spectacular Outperformance Is Vulnerable To Reversal Czechia's Spectacular Outperformance Is Vulnerable To Reversal Fractal Trading Watchlist: New Additions German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal German Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal Japanese Telecom Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal US Utilities Outperformance Vulnerable To Reversal Chart 1BRL/NZD At A Resistance Point Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 2Homebuilders Versus Healthcare Services Has Turned Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 3CNY/USD At A Potential Turning Point Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 4US REITS Are Oversold Versus Utilities Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 5CAD/SEK Is Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 6Financials Versus Industrials Has Reversed Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 7The Outperformance Of Resources Versus Biotech Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 8The Outperformance Of Resources Versus Healthcare Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 9FTSE100 Outperformance Vs. Euro Stoxx 50 Is Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 10Netherlands' Underperformance Vs. Switzerland Is Ending Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 11The Sell-Off In The 30-Year T-Bond At Fractal Fragility Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 12The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 13Food And Beverage Outperformance Is Exhausted Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 14German Telecom Outperformance Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 15Japanese Telecom Outperformance Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 16The Strong Downtrend In The 18-Month-Out US Interest Rate Future Is Fragile Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 17The Strong Downtrend In The 3 Year T-Bond Is Fragile Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 18A Potential Switching Point From Tobacco Into Cannabis Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 19Biotech Is A Major Buy Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 20Norway's Outperformance Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 21Cotton Versus Platinum Is At Risk Of Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 22Switzerland's Outperformance Vs. Germany Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 23USD/EUR Is Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 24The Outperformance Of MSCI Hong Kong Versus China Has Ended Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 25A Potential New Entry Point Into Petcare Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 26GBP/USD At A Potential Turning Point Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Chart 27US Utilities Outperformance Vulnerable To Reversal Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1  Based on the nonfarm payrolls. 2 Rent of shelter also includes lodging away from home, but the two dominant components are rent of primary residence and owners’ equivalent rent of residences. Fractal Trading System Fractal Trades Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator Higher Unemployment Is Coming, Says This Indicator 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary Hiring is slowing and layoffs have begun to rise, but today's robust net increases in non-farm payrolls are inconsistent with an approaching recession. The demise of the American consumer has been greatly exaggerated. Households have lots of savings to spend and the capacity to borrow against them if they choose. The extensive forward guidance that the Fed has been at pains to provide to markets may have fueled a sharp preemptive tightening in financial conditions that might prove premature if it reduces the Fed's need to cool the economy itself. None of the three components of our simple recession indicator (the slope of the yield curve, the year-over-year change in the Leading Economic Index and our assessment of monetary policy settings) is sounding the alarm, or even flashing yellow. No Recession Warning In This Series No Recession Warning In This Series No Recession Warning In This Series Bottom Line: Although gloom is increasingly pervasive among investors, we remain constructive on risk assets and the economy over the next twelve months, and reiterate our recommendation to overweight equities in a balanced portfolio. Feature Per the mosaic theory of security analysis, analysts, portfolio managers and independent investors piece together fragments of publicly available information to form a thesis about a company’s prospects. After appraising the company’s securities based on that thesis, the analyst/PM/investor determines whether they’re overvalued, undervalued or fairly valued and takes the appropriate action in his/her portfolio. All market participants are in a race to be among the first to see the outline of the complete picture as the opportunities to exploit mispricings are inversely related to the available share of relevant data. Security fair values become more apparent as more bits of colored glass begin to circulate and alpha-seeking investors have to move on to the next mostly incomplete puzzle to find an edge. Related Report  US Investment StrategyAll The Way To Ticker Symbols The same framework applies to macroeconomic analysis. It’s especially apt now, given the lack of a close precedent for the monetary and fiscal support policy makers lavished on the economy to protect it from COVID-19’s potential ravages and the way that data flows have refused to conform to a well-defined trend supported by a stable narrative theme. Macro data and news from individual companies are stuck in a one-step-forward, one-step-back pattern as embodied by stagnant stock indexes. The S&P 500 paced the same 100-point path between 4,075 and 4,175 for two full weeks before tumbling through the bottom of the range last Thursday and losing contact with it on Friday after the May CPI report showed that inflation remains stubbornly high (Chart 1). Chart 1Stocks See The Glass As Half-Empty Assembling The Mosaic Assembling The Mosaic The details of the May CPI report weren’t as bad as the headlines, though we were surprised and disappointed by its failure to confirm our view that inflation is peaking. From the full range of puzzle pieces we already have, however, we continue to think the picture for risk assets and the economy one year from now will be encouraging. We spent last week speaking and mingling at a conference and meeting with clients one-on-one last week, confirming that our sanguine view is decidedly in the minority as investors have become increasingly resigned to the idea that inflation cannot be brought down to a tolerable level without squeezing the economy. We think there is a middle way, at least over the next twelve months, as we highlight below by reviewing some of the largest and most important factors. Employment If a recession were imminent, we would expect to see hiring begin to sputter. Year-over-year payrolls growth has slowed, but it remains more than a standard deviation above the mean (Chart 2, top panel), at its highest level in 38 years. Annualized month-over-month growth is strong as well, if not as much of an outlier as year-over-year growth (Chart 2, bottom panel). Going forward, payrolls growth is poised to remain strong (Chart 3, top panel), as small businesses’ hiring intentions are very high (Chart 3, second panel), temporary employment is still elevated (Chart 3, third panel) and initial unemployment claims, while rising, are extremely low (Chart 3, bottom panel). Chart 2Payrolls Are Growing At A Nice Clip ... Payrolls Are Growing At A Nice Clip ... Payrolls Are Growing At A Nice Clip ... ​​​​​​ Chart 3... And Will Continue To Do So ... And Will Continue To Do So ... And Will Continue To Do So ​​​​​​ Consumption Chart 4Solid Footing Solid Footing Solid Footing We have stressed that households’ massive pandemic savings have provided them with ample ability to consume. They have worked down the debt they took on ahead of the financial crisis, restoring the household debt-to-GDP ratio to its 2002 level (Chart 4, second panel), which is much more lightly borne today than it was then, thanks to interest rates that remain extremely low despite their recent backup (Chart 4, bottom panel). It is an open question, subject to occasionally fierce debate within BCA, if households have the willingness to consume the mountain of savings they have amassed since COVID-19 reached the US. Our answer has been an unequivocal yes, and we have been working under the purposely conservative assumption that households will spend just half of their $2 trillion-plus stash. So far, the data are on our side: consumers have not lost their appetite for dining out, returning to restaurants at their pre-pandemic pace once the Omicron coast was clear (Chart 5, top panel). Travelers are returning to the skies, as well, undeterred by soaring airfares (Chart 5, bottom panel). Although passenger levels have not made it all the way back to their 2019 levels, nearly 60% more passengers have passed through TSA checkpoints so far this year than they did at this point in 2021, and credit card usage indicates that reduced business travel is responsible for the shortfall, as individuals have eagerly sought to cure their cabin fever (Chart 6). Chart 5Back To Restaurants, Bars ... Back To Restaurants, Bars ... Back To Restaurants, Bars ... ​​​​​​ Chart 6... And The Friendly Skies ... And The Friendly Skies ... And The Friendly Skies ​​​​​​ Private Investment/Credit Spreads Although consumption accounts for two-thirds of overall US output, or three-and-a-half times more than investment, the latter is slightly more likely to bring about a contraction in GDP because it is considerably more volatile.1 Nonresidential investment accounts for the lion’s share of private investment and BCA’s capex model projects that it will remain robust over the next two quarters (Chart 7). Residential investment will have to grapple with the housing slowdown imposed by the sudden and significant increase in mortgage rates, but we agree with our Bank Credit Analyst colleagues’ assessment that housing is unlikely to tank the economy.2 Homes remain undersupplied after several years of insufficient construction and the spread between the baseline 30-year fixed mortgage rate and the 10-year Treasury yield has become so stretched that it appears that the mortgage rate may have already reached its 2022 peak (Chart 8). Chart 7Capex Prospects Are Good ... Capex Prospects Are Good ... Capex Prospects Are Good ... Wider corporate bond spreads and intimations that banks are becoming less eager to lend could signal a further tightening of financial conditions. There have been three major spread-widening episodes in the high yield era (Chart 9, top panel) and none began until three preconditions had been met. Chart 8... And Mortgage Borrowers Are Due For A Break ... And Mortgage Borrowers Are Due For A Break ... And Mortgage Borrowers Are Due For A Break ​​​​​ The Fed had to have completed its rate hiking cycle (Chart 9, second panel), our proprietary Corporate Health Monitor (CHM) had to have crossed into deterioration (Chart 9, third panel) and the Fed’s quarterly Senior Loan Officer survey had to indicate that a majority of banks was imposing tighter credit standards on business borrowers (Chart 9, bottom panel). None of those conditions is in place yet, though banks' lending appetites may be shrinking and the first quarter was not great for corporate health. Chart 9Perhaps Forward Guidance Was TMI Perhaps Forward Guidance Was TMI Perhaps Forward Guidance Was TMI Broad Recession Probability Pulling back to 30,000 feet, none of the key recession prerequisites we constantly monitor is yet signaling any distress. The 3-month bill/10-year note segment of the Treasury yield curve remains solidly upward sloping (Chart 10). The Leading Economic Index (LEI) is nowhere close to contracting on a year-over-year basis (Chart 11), and the target fed funds rate is far below our estimate of the equilibrium fed funds rate (Chart 12). Each series has issued its own false signal – an above-equilibrium fed funds rate has been a necessary, but hardly sufficient, recession condition – but they have a perfect track record when considered together. Chart 10When The Yield Curve Inverts, ... When The Yield Curve Inverts, ... When The Yield Curve Inverts, ... Chart 11... Year-Over-Year LEI Contracts ... ... Year-Over-Year LEI Contracts ... ... Year-Over-Year LEI Contracts ... Chart 12... And Monetary Policy Settings Are Restrictive, A Recession Soon Follows ... And Monetary Policy Settings Are Restrictive, A Recession Soon Follows ... And Monetary Policy Settings Are Restrictive, A Recession Soon Follows Investment Implications The May CPI report only strengthened the conviction of those holding bearish views and will at least temporarily fuel a barrage of gloomy headlines that might sway the uncommitted. It has reduced the marginal probability that the Fed will be able to thread the needle and meet its price stability mandate without taking direct aim at its full employment goals. We still expect that the Fed will be able to maintain its balancing act for another twelve months because we think inflation will begin to come down on its own once the fevers in new and used auto prices and airfares finally break. The more remote that prospect seems to investors, the more stock prices will fall and bond yields will rise if the bullish view, or something slightly less bearish than discounted, comes to pass. The University of Michigan’s consumer sentiment survey made an all-time low in the preliminary June data released Friday morning. We are less concerned about the headline number – Open Table reservations and busy TSA security lines suggest investors are better served by focusing on what consumers do than how they feel, and the Michigan gloom is contradicted by the Conference Board survey's modest optimism – than we are about the upward turn in consumers’ long-run inflation expectations. Respondents to the Michigan survey increased their median estimate for inflation in five to ten years to 3.3% from 3% over the previous four months (the estimate had been between 2.9 and 3.1% for ten months beginning last August). If workers’, businesses’, investors’ and consumers’ long-run inflation expectations become unmoored, an inflation mindset in which high prices beget still higher prices could threaten to take hold, forcing the Fed to channel its inner Paul Volcker, shattering our temporary thread-the-needle thesis. For now, the term structure of inflation expectations remains sharply inverted. That’s to say that TIPS breakevens, CPI swaps and survey respondents continue to expect that intermediate- and long-term inflation will slow considerably from its currently elevated levels. If they begin to lose faith that very high inflation readings are a temporary phenomenon, we will have to revisit our glass-half-full perspective. We are not irresolute, but like Lord Keynes, when the data change, we change our minds.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1      The probability that investment could decline enough in any given quarter to zero out 2% growth in consumption and government spending is 23%, based on its historical distribution. The probability that consumption could wipe out 2% growth in investment and government spending is 17.6%. Government spending, which is one-fourth the size of consumption and considerably more stable than comparably sized investment, has just a 2.3% probability of negating trend growth in the other components. (All calculations disregard net exports.) 2     "Is The US Housing Market Signaling An Imminent Recession?" Bank Credit Analyst Special Report, June 2022.

Executive Summary Autocracy Hurts Productivity Autocracy Hurts Productivity Autocracy Hurts Productivity Over the next six-to-18 months, the Xi Jinping administration will “let 100 flowers bloom” – i.e., relax a range of government policies to secure China’s economic recovery from the pandemic. The first signs of this policy are already apparent via monetary and fiscal easing and looser regulation of Big Tech. However, investors should treat any risk-on rally in Chinese stocks with skepticism over the long run. Political risk and policy uncertainty will remain high until after Xi consolidates power this fall. Xi is highly likely to remain in office but uncertainty over other personnel – and future national policy – will be substantial. Next year China’s policy trajectory will become clearer. But global investors should avoid mistaking temporary improvements for a change of Xi’s strategy or China’s grand strategy. Beijing is driven by instability and insecurity to challenge the US-led world order. The result will be continued economic divorce and potentially military conflicts in the coming decade. Russia’s reversion to autocracy led to falling productivity and poor equity returns. China is also reverting to autocratic government as a solution to its domestic challenges. Western investors should limit long-term exposure to China and prefer markets that benefit from China’s recovery, such as in Southeast Asia and Latin America. Image Bottom Line: The geopolitical risk premium in Chinese equities will stay high in 2022, fall in 2023, but then rise again as global investors learn that China in the Xi Jinping era is fundamentally unstable and insecure. Feature Chart 1Market Cheers China's Hints At Policy Easing Market Cheers China's Hints At Policy Easing Market Cheers China's Hints At Policy Easing In 1957, after nearly a decade at the helm of the People’s Republic of China, Chairman Mao Zedong initiated the “Hundred Flowers Campaign.” The campaign allowed a degree of political freedom to try to encourage new ideas and debate among China’s intellectuals. The country’s innovative forces had suffered from decades of foreign invasion, civil war, and repression. Within three years, Mao reversed course, reimposed ideological discipline, and punished those who had criticized the party.  It turned out that the new communist regime could not maintain political control while allowing liberalization in the social and economic spheres.1 This episode is useful to bear in mind in 2022 as General Secretary Xi Jinping restores autocratic government in China. In the coming year, Xi will ease a range of policies to promote economic growth and innovation. Already his administration is relaxing some regulatory pressure on Big Tech. Global financial markets are cheering this apparent policy improvement (Chart 1). In effect, Xi is preparing to let 100 flowers bloom. However, China’s economic trajectory remains gloomy over the long run – not least because the US and China lack a strategic basis for re-engagement. Chinese Leaders Fear Foreign Encroachments Mao’s predicament was not only one of ideology and historical circumstance. It was also one of China’s geopolitics. Chinese governments have always struggled to establish domestic control, extend that control over far-flung buffer territories, and impose limits on foreign encroachments. Mao reversed his brief attempt at liberalization because he could not feel secure in his person or his regime. In 1959, the Chinese economy remained backward. The state faced challenges in administration and in buffer spaces like Tibet and Taiwan. The American military loomed large, despite the stalemate and ceasefire on the Korean peninsula in 1952. Russia was turning against Stalinism, while Hungary was revolting against the Soviet Union. Mao feared that the free exchange of ideas would do more to undermine national unity than it would to promote industrialization and technological progress. The 100 flowers that bloomed – intellectuals criticizing government policy – revealed themselves to be insufficiently loyal. They could be culled, strengthening the regime. However, what followed was a failed economic program and nationwide famine. Fast forward to today, when circumstances have changed but the Chinese state faces the same geopolitical insecurities. Xi Jinping, like all Chinese rulers, is struggling to maintain domestic stability and territorial integrity while regulating foreign influence. Although the People’s Republic is not as vulnerable as it was in Mao’s time, it is increasingly vulnerable – namely, to a historic downshift in potential economic growth and a rise in international tensions (Chart 2). The Xi administration has repeatedly shown that it views the US alliance system, US-led global monetary and financial system, and western liberal ideology as threats that need to be counteracted. Chart 2China: Less Stable, Less Secure China: Less Stable, Less Secure China: Less Stable, Less Secure In addition, Russia’s difficulties invading Ukraine suggest that China faces an enormous challenge in attempting to carve out its own sphere of influence without shattering its economic stability. Hence Beijing needs to slow the pace of confrontation with the West while pursuing the same strategic aims. Xi Stays, But Policy Uncertainty Still High In 2022  2022 is a critical political juncture for China. Xi was supposed to step down and hand the baton to a successor chosen by his predecessor Hu Jintao. Instead he has spent the past decade arranging to remain in power until at least 2032. He took a big stride toward this goal at the nineteenth national party congress in 2017, when he assumed the title of “core leader” of the Communist Party and removed term limits from its constitution. This year’s Omicron outbreak and abrupt economic slowdown have raised speculation about whether Xi’s position is secure. Some of this speculation is wild – but China is far less stable than it appears. Structurally, inequality is high, social mobility is low, and growth is slowing, forcing the new middle class to compromise its aspirations. Cyclically, unemployment is rising and the Misery Index is higher than it appears if one focuses on youth employment and fuel inflation (Chart 3). The risk of sociopolitical upheaval is underrated among global investors. Chart 3AStructurally China Is Vulnerable To Social Unrest Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. Chart 3BCyclically China Is Vulnerable To Social Unrest Cyclically China Is Vulnerable To Social Unrest Cyclically China Is Vulnerable To Social Unrest Yet even assuming that social unrest and political dissent flare up, Xi is highly likely to clinch another five-to-ten years in power. Consider the following points: The top leaders control personnel decisions. The national party congress is often called an “election,” but that is a misnomer. The Communist Party’s top posts will be ratified, not elected. The Politburo and Politburo Standing Committee select the members of the Central Committee; the national party congress convenes to ratify these new members. The Central Committee then ratifies the line-up of the new Politburo and Politburo Standing Committee, which is orchestrated by Xi along with the existing Politburo Standing Committee (Diagram 1). Xi is the most important figure in deciding the new leadership. Diagram 1Mechanics Of The Chinese Communist Party’s National Congress Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. There is no history of surprise votes. The party congress ratifies approximately 90% of the candidates put forward. Outcomes closely conform to predictions of external analysts, meaning that the leadership selection is not a spontaneous, grassroots process but rather a mechanical, elite-driven process with minimal influence from low-level party members, not to mention the population at large.2  The party and state control the levers of power: The Communist Party has control over the military, state bureaucracy, and “commanding heights” of the economy. This includes domestic security forces, energy, communications, transportation, and the financial system. Whoever controls the Communist Party and central government exerts heavy influence over provincial governments and non-government institutions. The state bureaucracy is not in a position to oppose the party leadership. Xi has conducted a decade-long political purge (“anti-corruption campaign”). Upon coming to power in 2012, Xi initiated a neo-Maoist campaign to re-centralize power in his own person, in the Communist Party, and in the central government. He has purged foreign influence along with rivals in the party, state, military, business, civil society, and Big Tech. He personally controls the military, the police, the paramilitary forces, the intelligence and security agencies, and the top Communist Party organs. There may be opposition but it is not organized or capable. Chart 4China: Big Tech Gets Relief ... For Now China: Big Tech Gets Relief ... For Now China: Big Tech Gets Relief ... For Now There are no serious alternatives to Xi’s leadership. Xi is widely recognized within China as the “core” of the fifth generation of Chinese leaders. The other leaders and their factions have been repressed. Xi imprisoned his top rivals, Bo Xilai and Zhou Yongkang, a decade ago. He has since neutralized their followers and the factions of previous leaders Hu Jintao and Jiang Zemin. Premier Li Keqiang has never exercised any influence and will retire at the end of this year. None of the ousted figures have reemerged to challenge Xi, but potential rivals have been imprisoned or disciplined, as have prominent figures that pose no direct political threat, such as tech entrepreneur Jack Ma (Chart 4).  Additional high-level sackings are likely before the party congress. China’s reversion to autocracy grew from Communist Party elites, not Xi alone. China’s slowing potential GDP growth and changing economic model raise an existential threat to the Communist Party over the long run. The party recognized its potential loss of legitimacy back in 2012, the year Xi was slated to take the helm. The solution was to concentrate power in the center, promoting Maoist nostalgia and strongman rule. In essence, the party needed a new Mao; Xi was all too willing to play the part. Hence Xi’s current position does not rest on his personal maneuvers alone. The party has invested heavily in Xi and will continue to do so. Characteristics of the political elite underpin the autocratic shift. Statistics on the evolving character traits of Politburo members show the trend toward leaders that are more rural, more bureaucratic, and more ideologically orthodox, i.e. more nationalist and communist (Chart 5). This trend underpins the party’s behavior and Xi’s personal rule. Chart 5China: From Technocracy To Autocracy Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. Chart 6China: De-Industrialization Undermines Stability China: De-Industrialization Undermines Stability China: De-Industrialization Undermines Stability Xi has guarded his left flank. By cornering the hard left of the political spectrum Xi has positioned himself as the champion of poor people, workers, farmers, soldiers, and common folk. This is the political base of the Communist Party, as opposed to the rich coastal elites and westernizing capitalists, who stand to suffer from Xi’s policies. Ultimately de-industrialization – e.g. the sharp decline in manufacturing and construction sectors (Chart 6) – poses a major challenge to this narrative. But social unrest will be repressed and will not overturn Xi or the regime anytime soon. Xi still retains political capital. After centuries of instability, Chinese households are averse to upheaval, civil war, and chaos. They support the current regime because it has stabilized China and made it prosperous. Of course, relative to the Hu Jintao era, Xi’s policies have produced slower growth and productivity and a tarnished international image (Chart 7). But they have not yet led to massive instability that would alienate the people in general. If Chinese citizens look abroad, they see that Xi has already outlasted US Presidents Obama and Trump, is likely to outlast Biden, and that US politics are in turmoil. The same goes for Europe, Japan, and Russia – Xi’s leadership does not suffer by comparison.  Chart 7China’s Declining International Image Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. External actors are neither willing nor able to topple Xi. Any outside attempt to interfere with China’s leadership or political system would be unwarranted and would provoke an aggressive response. The US is internally divided and has not developed a consistent China policy. This year the Biden administration has its hands full with midterm elections, Russia, and Iran, where it must also accept the current leadership as a fact of life. It has no ability to prevent Xi’s power consolidation, though it will impose punitive economic measures. Japan and other US allies have an interest in undermining Xi’s administration, but they follow the US’s lead in foreign policy. They also lack influence over the political rotation within the Communist Party. The Europeans will keep their distance but will not try to antagonize China given their more pressing conflict with Russia. Russia needs China more than ever and will lend material support in the form of cheaper and more secure natural resources. North Korean and Iranian nuclear provocations will help Xi stay under the radar.  There is no reason to expect a new leader to take over in China. The Xi administration’s strategy, revealed over the past ten years, will remain intact for another five-to-ten years at least. The real question at the party congress is whether Xi will be forced to name a successor or compromise with the opposing faction on the personnel of the Politburo and Politburo Standing Committee. But even that remains to be seen – and either way he will remain the paramount leader. Bottom Line: Xi Jinping has the political capability to cement another five-to-ten years in power. Opposing factions have been weakened over the past decade by Xi’s domestic political purge and clash with the United States. China is ripe for social unrest and political dissent but these will be repressed as China goes further down the path of autocracy. Foreign powers have little influence over the process. Policy Uncertainty Falls In 2023 … Only To Rise Again What will Xi Jinping do once he consolidates power? Xi’s administration has weighed heavily on China’s economy, foreign relations, and financial markets. The situation has worsened dramatically this year as the economy struggles with “A Trifecta Of Economic Woes” – namely a rampant pandemic, waning demand for exports, and a faltering housing market (Chart 8). In response the administration is now easing a range of policies to stabilize expectations and try to meet the 5.5% annual growth target. The money impulse, and potentially the credit impulse, is turning less negative, heralding an eventual upturn in industrial activity and import volumes in 2023. These measures will give a boost to Chinese and global growth, although stimulus measures are losing effectiveness over time (Chart 9).  Chart 8China's Trifecta Of Economic Woes China's Trifecta Of Economic Woes China's Trifecta Of Economic Woes Chart 9More Stimulus, But Less Effectiveness More Stimulus, But Less Effectiveness More Stimulus, But Less Effectiveness This pro-growth policy pivot will continue through the year and into next year. After all, if Xi is going to stay in power, he does not want to bequeath himself a financial crisis or recession at the start of his third term. Still, investors should treat any rally in Chinese equity markets with skepticism. First, political risk and uncertainty will remain elevated until Xi completes his power grab, as China is highly susceptible to surprises and negative political incidents this year (Chart 10). For example, if social unrest emerges and is repressed, then the West will impose sanctions. If China increases its support of Russia, Iran, or North Korea, then the US will impose sanctions.     Chart 10China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 China: Policy Uncertainty And Geopolitical Risk To Stay High In 2022, Might Improve In 2023 Chart 11China Needs To Court Europe China Needs To Court Europe China Needs To Court Europe The regime will be extremely vigilant and overreact to any threats this year, real or perceived. Political objectives will remain paramount, above the economy and financial markets, and that means new economic policy initiatives will not be reliable. Investors cannot be confident about the country’s policy direction until the leadership rotation is complete and new policy guidance is revealed, particularly in December 2022 and March 2023. Second, after consolidating power, investors should interpret Xi’s policy shift as “letting 100 flowers bloom,” i.e., a temporary relaxation that aims to reboot the economy but does not change the country’s long-term policy trajectory. Economic reopening is inevitable after the pandemic response is downgraded – which is a political determination. Xi will also be forced to reduce foreign tensions for the sake of the economy, particularly by courting Europe, which is three times larger than Russia as a market (Chart 11). However, China’s declining labor force and high debt levels prevent its periodic credit stimulus from generating as much economic output as in the past. And the administration will not ultimately pursue liberal structural reforms and a more open economy. That is the path toward foreign encroachment – and regime insecurity. The US’s sanctions on Russia have shown the consequences of deep dependency on the West. China will continue diversifying away from the US. And, as we will see, the US cannot provide credible promises that it will reduce tensions. US-China: Re-Engagement Will Fail The Biden administration is focused on fighting inflation ahead of the midterm elections. But its confrontation with Russia – and likely failure to freeze Iran’s nuclear program – increases rather than decreases oil supply constraints. Hence some administration officials and outside observers argue that the administration should pursue a strategic re-engagement with China.3  Theoretically a US-China détente would buy both countries time to deal with their domestic politics by providing some international stability. Improved US-China relations could also isolate Russia and hasten a resolution to the war in Ukraine, potentially reducing commodity price pressures. In essence, a US-China détente would reprise President Richard Nixon’s outreach to China in 1972, benefiting both countries at the expense of Russia.4  This kind of Kissinger 2.0 maneuver could happen but there are good reasons to think it will not, or if it does that it will fall apart in one or two years. In 1972, China had nowhere near the capacity to deny the US access to the Asia Pacific region, expel US influence from neighboring countries, reconquer Taiwan, or project power elsewhere. Today, China is increasingly gaining these abilities. In fact it is the only power in the world capable of rivaling the US in both economic and military terms over the long run (Chart 12). Secretary of State Antony Blinken recently outlined the Biden administration’s China policy and declared that China poses “the most serious long-term challenge” to the US despite Russian aggression.5  Chart 12US-China Competition Sows Distrust, Drives Economic Divorce Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. While another decade of US engagement with China would benefit the US economy, it would be far more beneficial to China. Crucially, it would be beneficial in a strategic sense, not just an economic one. It could provide just the room for maneuver that China needs – at this critical juncture in its development – to achieve technological and productivity breakthroughs and escape the middle-income trap. Another ten-year reprieve from direct American competition would set China up to challenge the US on the global stage. That would be far too high of a strategic price for America to pay for a ceasefire in Ukraine. Ukraine has limited strategic value for the US and it does not steer US grand strategy, which aims to prevent regional empires from taking shape. In fact Washington is deliberately escalating and prolonging the war in Ukraine to drain Russia’s resources. Ending the war would do Russia a strategic favor, while re-engaging with China would do China a strategic favor. So why would the defense and intelligence community advise the Biden administration to pursue Kissinger 2.0? Chart 13US Unlikely To Revoke Trump Tariffs US Unlikely To Revoke Trump Tariffs US Unlikely To Revoke Trump Tariffs Biden could still pursue some degree of détente with China, namely by repealing President Trump’s trade tariffs, in order to relieve price pressures ahead of the midterm election. Yet even here the case is deeply flawed. Trump’s tariffs on China did not trigger the current inflationary bout. That was the combined Trump-Biden fiscal stimulus and Covid-era supply constraints. US import prices are rising faster from the rest of the world than they are from China (Chart 13). Tariff relief would not change China’s Zero Covid policy, which is the current driver of price spikes from China. And while lifting tariffs on China would not reduce inflation enough to attract voters, it would cost Biden some political credit among voters in swing states like Pennsylvania, and across the US, where China’s image has plummeted in the wake of Covid-19 (Chart 14).   Chart 14US Political Consensus Remains Hawkish On China Will China Let 100 Flowers Bloom? Only Briefly. Will China Let 100 Flowers Bloom? Only Briefly. If Biden did pursue détente, would China be able to reciprocate and offer trade concessions? Xi has the authority to do so but he is unlikely to make major trade concessions prior to the party congress. Economic self-sufficiency and resistance to American pressure have become pillars of his support. Promises will not ease inflation for US voters in November and Xi has no incentive to make binding concessions because the next US administration could intensify the trade war regardless.  Bottom Line: The US has no long-term interest, and a limited short-term interest, in easing pressure on China’s economy. Continued US pressure, combined with China’s internal difficulties, will reinforce Xi Jinping’s shift toward nationalism and hawkish foreign policy. Hence there is little basis for a substantial US-China re-engagement that improves the global macroeconomic environment over the coming years. Investment Takeaways Chart 15Autocracy Hurts Productivity Autocracy Hurts Productivity Autocracy Hurts Productivity Xi Jinping will clinch another five-to-ten years in power this fall. To stabilize the economy, he will “let 100 flowers bloom” and ease monetary, fiscal, regulatory, and social policy at home. He will also court the West, especially Europe, for the sake of economic growth. However, he will not go so far as to compromise his ultimate aims: self-sufficiency at home and a sphere of influence abroad. The result will be a relapse into conflict with the West within a year or two. Ultimately a closed Chinese economy in conflict with the West will result in lower productivity, a weaker currency, a high geopolitical risk premium, and low equity returns – just as it did for Russia (Chart 15). Any short-term improvement in China’s low equity multiples will ultimately be capped. Over the long run, western investors should hedge against Chinese geopolitical risk by preferring markets that benefit from China’s periodic stimulus yet do not suffer from the break-up of the US-China and EU-Russia economic relationships, such as key markets in Latin America and Southeast Asia (Charts 16 & 17). Chart 16China Stimulus Creates Opportunity For … Latin America China Stimulus Creates Opportunity For ... Latin America China Stimulus Creates Opportunity For ... Latin America Chart 17China Stimulus Creates Opportunity For … Southeast Asia China Stimulus Creates Opportunity For ... Southeast Asia China Stimulus Creates Opportunity For ... Southeast Asia     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1     Modern scholarship has shown that Mao intended to entrap the opposition through the 100 Flowers Campaign. For a harrowing account of this episode, see Jung Chang and Jon Halliday, Mao: The Unknown Story (New York: Anchor Books, 2006), pp. 409-17. 2     “At least 8% of CPC Central Committee nominees voted off,” Xinhua, October 24, 2017, english.www.gov.cn. 3    Christopher Condon, “Yellen Says Biden Team Is Looking To ‘Reconfigure’ China Tariffs,” June 8, 2022, www.bloomberg.com. 4       Niall Ferguson, “Dust Off That Dirty Word Détente And Engage With China,” Bloomberg, June 5, 2022, www.bloomberg.com. 5    See Antony J Blinken, Secretary of State, “The Administration’s Approach to the People’s Republic of China,” George Washington University, Washington D.C., May 26, 2022, state.gov. Additionally, see President Joe Biden’s third assertion of US willingness to defend Taiwan against China, in a joint press conference with Japan’s Prime Minister Kishida Fumio, “Remarks by President Biden and Prime Minister Kishida Fumio of Japan in Joint Press Conference,” Akasaka Palace, Tokyo, Japan, May 23, 2022, whitehouse.gov.

Listen to a short summary of this report.     Executive Summary Sentiment On Sterling Is Depressed Sentiment On Sterling Is Depressed Sentiment On Sterling Is Depressed The pound will suffer in the short term, setting the stage for a coiled-spring rebound. Cable is extremely cheap by most measures (Feature chart). The BoE could engineer a soft landing in the UK economy. If successful, it will annihilate sterling vigilantes, in a volte-face of the ERM crisis. We are cognizant of near-term risks. As such, we are long EUR/GBP with a target of 0.90, but will be buyers of cable at 1.20. Ultimately, the pound is undervalued on a longer-term basis. GBP/USD should touch 1.36 over the next 12-18 months. RECOMMENDATIONS INCEPTION LEVEL inception date RETURN long eur/gbp 0.846 2021-10-15 0.27 Bottom Line: The pound will likely face pressure in the near term, but will fare well over a cyclical horizon. Our 12-month target is 1.36. This target is based on a modest reversion towards PPP fair value, and some erosion in the “crisis” discount. Admittedly, sentiment on the pound is very depressed, and we could be wrong in our near-term assessment and cable has indeed bottomed. Feature Chart 1A Play On Cable Downside A Play On Cable Downside A Play On Cable Downside There has been much discussion around the premise that the pound could enter a capitulation phase, akin to an emerging market-style currency crisis. With inflation sitting at 9%, well above the Bank of England’s 2% target, the narrative is that interest rates need to rise substantially but will, at the same time, kill any recovery. The result will be a sharp fall in the pound. We began to highlight the near-term risks to cable in October of last year, going long EUR/GBP in the process, as a way to play sterling downside (Chart 1). That said, our longer-term view on the pound remained positive. In this report, we review what has changed since, and if a negative longer-term view is now warranted.   UK Balance Of Payments Almost all currency crises are rooted in a deterioration of the external balance, and this is certainly true for the UK. The trade deficit sits at 7.9% of GDP, the worst among G10 countries (Chart 2). As a result, the current account is also in deficit. That said, there are reasons for optimism. Related Report  Foreign Exchange StrategyAn Update On Sterling The Office for National Statistics (ONS) suggests that a change in methodology in January 2022 could be exarcebating the deterioration in the latest release of the trade balance. In our view, there are two key reasons why the UK’s balance of trade is worsening. The first is the oil shock – fuels constitute 11% of UK imports. Second, unprecedented fiscal stimulus led to an overshoot in goods imports. These negative forces are likely cyclical in nature, rather than structural. It is also noteworthy that most of the goods imported into the UK are machinery and transport equipment, which could go a long way in improving its productive capacity (Chart 3). Chart 2The UK Trade Balance Has Deteriorated The UK Trade Balance Has Deteriorated The UK Trade Balance Has Deteriorated Chart 3Goods Imports Have Been A Hit To The UK Trade Balance Goods Imports Have Been A Hit To The UK Trade Balance Goods Imports Have Been A Hit To The UK Trade Balance In parallel, there has been a structural improvement in the UK’s current account balance. This has mostly been driven by a rising primary income balance. In short, investments abroad are earning more, relative to domestic liabilities (Chart 4). The UK runs a large negative international investment position. Despite this, it has maintained the ability to issue debt bought by foreigners, while investing in high-return assets abroad. Secondary income has admittedly been in a structural deficit, but a falloff in transfer payments under the Brexit agreement will significantly improve this balance (Chart 5). Chart 4The UK Current Account Is Improving The UK Current Account Is Improving The UK Current Account Is Improving Chart 5A Fall In Brexit Payments Will Mend Secondary Income Is Sterling Facing Another Crisis? Is Sterling Facing Another Crisis? Finally, the pound’s share of global foreign exchange turnover is 12.8%, just behind the dollar, euro, and yen. That said, London dwarfs New York, Hong Kong, and Tokyo as a hub for foreign exchange trading (Chart 6). The pound also very much remains among the most desirable global currencies. Global allocation of FX reserves in sterling have been rising over the last decade (Chart 7). It currently stand at 4.8%, higher than the RMB at 2.8%, and all other emerging market currencies combined. Chart 6London Remains An Important Financial Center Is Sterling Facing Another Crisis? Is Sterling Facing Another Crisis? Chart 7The Pound Is Still A Reserve Currency The Pound Is Still A Reserve Currency The Pound Is Still A Reserve Currency It is noteworthy to revisit the period the pound experienced an EM-style crisis – under the European Exchange Rate Mechanism (ERM), when cable was effectively pegged to the German mark at an expensive level. At the time, UK inflation was running hot, while German inflation was more subdued. By importing monetary policy from the Bundesbank, the BoE was able to tame inflation, but at a high cost to growth. In Germany, the reunification boom warranted much higher interest rates, which was not appropriate for the UK . Cable eventually collapsed by 32.9% peak-to-trough, as the UK ran out of foreign currency reserves. Chart 8Cable Is Very Cheap Cable Is Very Cheap Cable Is Very Cheap There are three key differences between that episode and today: The pound is freely floating. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. A collapse in the pound seems unlikely, unless the UK faces a new large exogenous shock. Inflation is running hot in many countries, not just the UK. The pound is extremely cheap, and stimulative for the economy. On a real effective exchange rate basis, the pound is at record lows (Chart 8).     Will The BoE Make A Policy Mistake? Sterling is pricing in a policy mistake by the BoE. First, inflation is well above its 2% target. Second, the labor market has tightened significantly. The unemployment rate hit a 47-year low of 3.7%, and job vacancies are low, pushing wages higher. As such, either the BoE allows inflation expectations to become unmoored, destroying the purchasing power of the pound, or kills the recovery to maintain credibility (Chart 9). Chart 9The UK Labor Market Is Tight The UK Labor Market Is Tight The UK Labor Market Is Tight While difficult, there are reasons to believe the BoE can achieve a soft landing. According to an in-house study, only one-third of the rise in UK inflation has been driven by demand-side pull, with the balance related to supply factors.1 The latter have been the usual suspects – rising energy costs, supply shortages, and even legacies of the Brexit shock (Chart 10). UK electricity prices have cratered since the opening of the 1,400MW undersea cable with Norway (Chart 11). Chart 10Most Of The Increase To UK Prices Is Supply-Driven Is Sterling Facing Another Crisis? Is Sterling Facing Another Crisis? Chart 11A Sharp Drop In Electricity Prices A Sharp Drop In Electricity Prices A Sharp Drop In Electricity Prices Second, it is likely that the neutral rate of interest in the UK is lower in a post-Brexit, post-COVID-19 world. This is visible in trend productivity growth, but even the size of the labor force has shrunk significantly. The UK workforce is down by 560,000 people since the start of the pandemic. This has been partly due to less immigration and more retirees, but the vast majority has been due to health side-effects from the pandemic, and delays in getting adequate medical care. As a result, there has barely been a recovery in the UK participation rate (Chart 12). Chart 12AThe Participation Rate In The UK Is Below Trend The Participation Rate In The UK Is Below Trend The Participation Rate In The UK Is Below Trend Chart 12BA Low Participation Rate Across Many Regions A Low Participation Rate Across Many Regions A Low Participation Rate Across Many Regions In hindsight, a least-regrets strategy to policy tightening – lift rates faster now, and then back off if financial conditions tighten sufficiently – seems appropriate. Frontloading the pace of tightening will flatten the UK gilts curve further. With most borrowing costs in the UK tied to the longer end of the curve, refinancing costs might not edge up that much, while inflation expectations will be well contained. The real canaries in the coal mine from this strategy are the economies of Australia, New Zealand, and Canada, where household debt is much more elevated (Chart 13), and the percentage of variable rate mortgages  are higher. Chart 13Household Debt Is Not Alarming In The UK Household Debt Is Not Alarming In The UK Household Debt Is Not Alarming In The UK Larger fiscal stimulus will partially offset the near-term hit from tighter monetary policy. The additional £15 billion cost-of-living package announced last month is quite substantial at 0.7% of GDP. This gives the BoE breathing room to tighten policy in the near term. The redistributionist nature of the plan – taxing windfall profits from large energy companies, and using that to subsidize consumers most in need – could be what is required to achieve a soft landing, if the energy shock is temporary. Our Global Fixed Income colleagues upgraded UK gilts to overweight last month, on the basis that market pricing further out the SONIA curve was too aggressive. In our prior report on sterling, we also suggested that market expectations for interest rate increases may have overshot. Money markets are discounting a peak in the bank rate at 2.8%. The BoE’s new Market Participants survey suggests it will peak at 1.75%. While the BoE will deliver sufficient monetary tightening to lean against near-term inflationary pressures, it will be very wary to overdo it. This is especially true if the neutral rate in the economy is much lower. What Next For The Pound? Our view is that the pound faces near-term risks but is a buy longer term. There is an old adage that credibility is hard to earn, but easy to lose. For the UK in particular, this hits the mark. The Bank of England is the oldest central bank in the world, after the Riksbank. Yes, the BoE can make a policy mistake (as it has in the past), but treating the pound as an emerging market asset is a stretch (Chart 14). That said, our Chief European Strategist, Mathieu Savary, believes stagflation is not fully priced into UK assets. In the near term, he might be right. The UK’s large trade deficit puts the onus on foreigners to dictate movements in the pound. The pound does well when animal spirits are fervent. So far, markets have bid up a substantial safe-haven premium into the dollar (Chart 15). As a proxy, the pound has been sold. Northern Ireland could also return as a thorn in the side of sterling.  Chart 14The Pound Is A Risk-On Currency Cable And EM Stocks The Pound Is A Risk-On Currency Cable And EM Stocks The Pound Is A Risk-On Currency Cable And EM Stocks Chart 15The Dollar Has A Hefty Safe-Haven Premium The Dollar Has A Hefty Safe-Haven Premium The Dollar Has A Hefty Safe-Haven Premium From a bird’s eye view, three factors tend to drive currencies – the macroeconomic environment, valuation, and sentiment. For now, markets have latched on to the GBP’s vulnerability to an EM-style crisis. That said, cable is very cheap, even accounting for elevated UK inflation. Our in-house PPP model suggests the pound could appreciate by 4% per year, over the next 10 years, just to revert to fair value (Chart 16). Chart 16Cable Is Cheap Cable Is Cheap Cable Is Cheap Admittedly, the UK desperately needs an improvement in productivity growth for further currency gains. To encourage capital inflows that the pound depends on, the UK needs to be at the forefront of disruptive technologies such as electric cars, digital currencies, 3D printing, and even innovations in gene therapy. High finance and fashion will remain relevant for London, but the need for innovation is high.  Investment Conclusions Chart 17Sentiment On Sterling Is Depressed Sentiment On Sterling Is Depressed Sentiment On Sterling Is Depressed The pound will likely face pressure in the near term, but will fare well over a cyclical horizon. Our 12-month target is 1.36. This target is based on a modest reversion towards PPP fair value, and some erosion in the “crisis” discount. Admittedly, sentiment on the pound is very depressed, and we could be wrong in our near-term assessment if cable has indeed bottomed. Our intermediate-term timing model suggests that GBP is undervalued and has bottomed. Technical indicators also warn that cable is ripe for a fervent rebound (Chart 17). Particularly, our intermediate-term technical indicator is rebounding from oversold levels. The Aussie would outperform the pound in the long term, but AUD/GBP is vulnerable to a commodity relapse in the shorter term.   Housekeeping We were stopped out of our short EUR/JPY trade for a loss of -2.78%, as oil prices and bond yields rebounded. This trade is a hedge to our pro-cyclical portfolio, so we will look to reenter it at more attractive levels. We are also lowering the stop-loss on our short RUB trade. This is a speculative bet many clients will not be able to play, but we expect it to payoff over the longer term.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Michael Saunders, "The route back to 2% inflation," (Speech given at the Resolution Foundation), May 9, 2022.   Trades & Forecasts Strategic View Cyclical Holdings (6-18 months) Tactical Holdings (0-6 months) Limit Orders Forecast Summary

Executive Summary Investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023. High conviction recommendation: Overweight healthcare versus basic resources. In other words, tilt towards sectors that benefit the most from rising bond prices and that suffer the least from contracting profits. New high conviction recommendation: Go long the Japanese yen. As bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. Fractal trading watchlist: JPY/USD, GBP/USD, and Australian basic resources. If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market Bottom Line: The risk is that the valuation-driven sell-off morphs into a profits-driven sell-off. Feature In May, many stock markets reached the drawdown of 20 percent that defines a technical bear market. Yet what has caught many people off guard is that the bear market in stocks has happened during a bull market in profits. Since the start of 2022, US profits are up by 5 percent.1 The bear market in stocks has happened during a bull market in profits… so far. This shatters the shibboleth that bear markets only happen when there is a profits recession. The 2022 bear market has been a valuation-driven bear market. US profits rose 5 percent, but the multiple paid for those profits collapsed by 25 percent, taking the market into bear territory. None of this should come as any surprise to our regular readers. As we have pointed out many times, a stock market can be likened to a bond with a variable rather than a fixed income. So, just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like. It turns out that that long-duration US stock market has the same duration as a 30-year bond. This means that: The US stock market = (The 30-year T-bond price) multiplied by (US profits) It follows that if the 30-year bond price falls by more than profits rise, then the stock market will sell off. And if the 30-year bond price falls by much more than profits rise, then the stock market will enter a valuation-driven bear market. Therein lies the story of 2022 so far (Chart I-1). Chart I-1The Bear Market Is Valuation-Driven. Profits Are Up... For Now The Bear Market Is Valuation-Driven. Profits Are Up... For Now The Bear Market Is Valuation-Driven. Profits Are Up... For Now Just As In 1981-82, Will The Sell-Off Morph From Valuation-Driven To Profits-Driven? In Markets Echo 1981, When Stagflation Morphed Into Recession, we argued that a good template for what happens to the economy and the markets in 2022-23 is the experience of 1981-82. Does 2022-23 = 1981-82? Then, just as now, the world’s central banks were obsessed with ‘breaking the back’ of inflation, and piloting the economy to a ‘soft landing’. Then, just as now, the central banks were desperate to repair their badly damaged credibility in managing the economy. And then, just as now, an invasion-led war between two major commodity producers – Iran and Iraq – was disrupting commodity supplies and adding to inflationary pressures. In 1981, just as now, the equity market sell-off started as a valuation sell-off, driven by a declining 30-year T-bond price. Profits held up through most of 1981, just as they have so far in 2022. In September 1981, US core inflation finally peaked, with bond yields following soon after. In the current experience, March 2022 appears to have marked the equivalent peak in US core inflation (Chart I-2 and Chart I-3). Chart I-2Does September 1981... Does September 1981... Does September 1981... Chart I-3...Equal March 2022? ...Equal March 2022? ...Equal March 2022? In late 1981, when the 30-year T-bond price rebounded, the good news was that beaten-down equity valuations also reached their low point. The bad news was that just as the valuation-driven sell-off ended, profits keeled over, and the valuation-driven sell-off morphed into a profits-driven sell-off (Chart I-4). In 2022-23, could history repeat? Chart I-4In September 1981, The Sell-Off Morphed From Valuation-Driven To Profits-Driven In September 1981, The Sell-Off Morphed From Valuation-Driven To Profits-Driven In September 1981, The Sell-Off Morphed From Valuation-Driven To Profits-Driven Recession Or No Recession? That Is Not The Question History rhymes, it rarely repeats exactly. What if the 2022-23 experience can avoid the outright economic recession of the 1981-82 experience? This brings us to another shibboleth that needs to be shattered. You don’t need the economy to go into recession for profits to go into recession. To understand why, we need to visit the concept of operational leverage. Profits is a small number that comes from the difference of two large numbers: sales and the costs of generating those sales. As any company will tell you, sales can be volatile, but costs – which are dominated by wages – are sticky and much slower to change. The upshot is that if sales growth exceeds costs growth, there is a massively leveraged impact on profits growth. This is the magic of operational leverage. But if sales growth falls below sticky cost growth, the magic turns into a curse. The operational leverage goes into reverse, and profits collapse. Using US stock market profits as an example, the magic turns into a curse at real GDP growth of 1.25 percent, above which profits grow at six times the difference, and below which profits shrink at six times the difference (Chart I-5). Chart I-5A Model For US Profits Growth: (Real GDP Growth - 1.25) Times 6 A Model For US Profits Growth: (Real GDP Growth - 1.25) Times 6 A Model For US Profits Growth: (Real GDP Growth - 1.25) Times 6 Strictly speaking, we should compare US profits growth with world GDP growth because multinationals generate their sales globally rather than domestically. But to the extent that the US has both the world’s largest stock market and the world’s largest economy, it is a reasonable comparison. We should also compare both profits and sales in either nominal or real terms, rather than a mixture. But even with these tweaks, we would still find that the dominant driver of profit growth is operational leverage. ‘Recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Therefore, the conclusion still stands – ‘recession or no recession?’ is a somewhat moot question, because even non-recessionary low growth is enough to tip profits into contraction. Such a period of low growth is now likely. If 2022-23 = 1981-82, What Happens Next? To repeat: The US stock market = (The 30-year T-bond price) multiplied by (US profits) This means that investors face a dilemma. The faster that inflation comes down, the better it will be for valuations via a stronger rally in the bond price. But if a collapse in inflation requires a sharp deceleration in growth, the worse it will be for profits. This was the precise set-up in December 1981, the equivalent of June 2022 in our historical template. In which case, what can we expect next? 1. Bond yields are likely in a peaking process, but the sharpest declines may come a few months down the road, after an unambiguous roll-over in food and energy inflation (Chart I-6). Chart I-6If 2022-23 = 1981-82, Then This Is What Happens To The Bond Yield If 2022-23 = 1981-82, Then This Is What Happens To The Bond Yield If 2022-23 = 1981-82, Then This Is What Happens To The Bond Yield 2. The stock market’s valuation-driven sell-off is likely over, but the danger is that it morphs into a profits-driven sell-off. As such, the stock market will remain under pressure through 2022, though it is likely to be higher 12 months from now in June 2023 (Chart I-7). Chart I-7If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market If 2022-23 = 1981-82, Then This Is What Happens To The Stock Market 3. Long-duration defensive sectors will outperform short-duration cyclical sectors. In other words, tilt towards sectors that benefit the most from rising bond prices and suffer the least from contracting profits. As such, a high conviction recommendation is to overweight healthcare versus basic resources (Chart I-8). Chart I-8If 2022-23 = 1981-82, Then This Is What Happens To Healthcare Versus Resources If 2022-23 = 1981-82, Then This Is What Happens To Healthcare Versus Resources If 2022-23 = 1981-82, Then This Is What Happens To Healthcare Versus Resources 4. In foreign exchange, the setup is very bullish for the Japanese yen through the next 12 months. The yen’s recent sell-off is explained by bond yields rising outside Japan. As these bond yield differentials re-tighten, the yen will rally. Additionally, the yen will benefit from its haven status in a period of recessionary risk. A new high conviction recommendation is to go long the Japanese yen (Chart I-9). Chart I-9The Yen's Sell-Off Is Due To Bond Yields Rising Outside Japan The Yen's Sell-Off Is Due To Bond Yields Rising Outside Japan The Yen's Sell-Off Is Due To Bond Yields Rising Outside Japan Fractal Trading Watchlist Supporting our bullish fundamental case for the Japanese yen, the sell-off in JPY/USD has reached the point of fragility on its 260-day fractal structure that marked previous major turning points in 2013 and 2015 (Chart 10). Hence, a first new trade is long JPY/USD, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 5 percent. Chart I-10The Sell-Off In JPY/USD Has Reached A Potential Turning Point The Sell-Off In JPY/USD Has Reached A Potential Turning Point The Sell-Off In JPY/USD Has Reached A Potential Turning Point Supporting our bearish fundamental case for resources stocks, the outperformance of Australian basic resources has reached the point of fragility on its 130-day fractal structure that marked previous turning points in 2013, 2015, and 2021 (Chart I-11). Hence, a second new trade is short Australian basic resources versus the world market, setting the trade length at 6 months, and the profit target and symmetrical stop-loss at 10 percent. Chart I-11The Australian Basic Resources Sector Is Vulnerable To Reversal The Australian Basic Resources Sector Is Vulnerable To Reversal The Australian Basic Resources Sector Is Vulnerable To Reversal Finally, we are adding GBP/USD to our watchlist, given that its 260-day fractal structure is close to the point of fragility that marked major turns in 2014, 2015, and 2016. Our full watchlist of 29 investments that are at, or approaching turning points, is available on our website: cpt.bcaresearch.com Fractal Trading Watchlist: New Additions GBP/USD At A Turning Point GBP/USD At A Turning Point GBP/USD At A Turning Point Chart 1AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal AUD/KRW Is Vulnerable To Reversal   Chart 2Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Canada Versus Japan Is Reversing Chart 3Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Canada's TSX-60's Outperformance Might Be Over Chart 4US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal US Healthcare Providers Vs. Software At Risk of Reversal Chart 5BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point BRL/NZD At A Resistance Point Chart 6Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Homebuilders Versus Healthcare Services Has Turned Chart 7CNY/USD Has Reversed CNY/USD Has Reversed CNY/USD Has Reversed Chart 8CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started CAD/SEK Reversal Has Started Chart 9Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Financials Versus Industrials To Reverse Chart 10The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse The Outperformance Of Resources Versus Biotech Has Started To Reverse Chart 11The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal The Outperformance Of Resources Versus Healthcare Is Vulnerable To Reversal Chart 12FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing FTSE100 Outperformance Vs. Euro Stoxx 50 Is Reversing Chart 13Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Netherlands Underperformance Vs. Switzerland Has Been Exhausted Chart 14The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility The Sell-Off In The 30-Year T-Bond Is Approaching Fractal Fragility Chart 15The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility The Sell-Off In The NASDAQ Is Approaching Fractal Fragility Chart 16Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Food And Beverage Outperformance Has Been Exhausted Chart 17The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile The Strong Trend In The 18-Month-Out US Interest Rate Future Is Fragile Chart 18The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile The Strong Trend In The 3 Year T-Bond Is Fragile Chart 19A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis A Potential Switching Point From Tobacco Into Cannabis Chart 20Biotech Is A Major Buy Biotech Is A Major Buy Biotech Is A Major Buy Chart 21Norway's Outperformance Could End Norway's Outperformance Could End Norway's Outperformance Could End Chart 22Cotton Versus Platinum Is Reversing Cotton Versus Platinum Is Reversing Cotton Versus Platinum Is Reversing Chart 23Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Switzerland's Outperformance Vs. Germany Has Started To End Chart 24The Rally In USD/EUR Has Ended The Rally In USD/EUR Has Ended The Rally In USD/EUR Has Ended Chart 25The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal The Outperformance Of MSCI Hong Kong Versus China Is Vulnerable To Reversal Chart 26A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare A Potential New Entry Point Into Petcare Chart 27Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Czech Outperformance Near Exhaustion Chart 28US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities US REITS Are Oversold Versus Utilities Chart 29GBP/USD At A Turning Point GBP/USD At A Turning Point GBP/USD At A Turning Point   Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 Defined as 12-month forward earnings per share. Fractal Trading System More On 2022-23 = 1981-82, And The Danger Ahead More On 2022-23 = 1981-82, And The Danger Ahead More On 2022-23 = 1981-82, And The Danger Ahead More On 2022-23 = 1981-82, And The Danger Ahead 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Indicators To Watch - Bond Yields - Euro Area Chart II-2Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Indicators To Watch - Bond Yields - Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Indicators To Watch - Bond Yields - Asia Chart II-4Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed Indicators To Watch - Bond Yields - Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Executive Summary EU Embargoes Russian Oil Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) The EU imposed an embargo on 90% of Russian oil imports, which will provoke retaliation. Russia will squeeze Europe’s economy ahead of critical negotiations over the coming 6-12 months. Russian gains on the battlefield in Ukraine point to a ceasefire later, but not yet – and Russia will need to retaliate against NATO enlargement. The Middle East and North Africa face instability and oil disruptions due to US-Iran tensions and Russian interference. China’s autocratic shift is occurring amid an economic slowdown and pandemic. Social unrest and internal tensions will flare. China will export uncertainty and stagflation.  Inflation is causing disparate effects in South Asia – instability in Pakistan and Sri Lanka, and fiscal populism in India.   Asset Initiation Date Return Long Brazilian Financials / Indian Equities (Closed) Feb 10/22 22.5%  Bottom Line: Markets still face three geopolitical hurdles: Russian retaliation; Middle Eastern instability; Chinese uncertainty. Feature Global equities bounced back 6.1% from their trough on May 12 as investors cheered hints of weakening inflation and questioned the bearish consensus. BCA’s Global Investment Strategy correctly called the equity bounce. However, as BCA’s Geopolitical Strategy service, we see several sources of additional bad news. Throughout the Ukraine conflict we have highlighted two fundamental factors to ascertain regarding the ongoing macroeconomic impact: Will the war cut off the Russia-EU energy trade? Will the war broaden beyond Ukraine? Chart 1Russian-Exposed Assets Will Suffer More Russian-Exposed Assets Will Suffer More Russian-Exposed Assets Will Suffer More In this report we update our views on these two critical questions. The takeaway is that the geopolitical outlook is still flashing red. The US dollar will remain strong and currencies exposed to Russia and geopolitical risk will remain weak (Chart 1). In addition, China’s politics will continue to produce uncertainty and negative surprises this year. Taken together, investors should remain defensive for now but be ready to turn positive when the market clears the hurdles we identify. The fate of the business cycle hangs in the balance.  Energy Ties Eroding … Russia Will Retaliate Over Oil Embargo Chart 2AEU Embargoes Russian Oil Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Europe is diversifying from Russian oil and natural gas. The European Union adopted a partial oil embargo on Russia that will cut oil imports by 90% by the end of 2022. It also removed Sberbank from the SWIFT banking communications network and slapped sanctions on companies that insure shipments of Russian crude. The sanctions will cut off all of Europe’s seaborne oil imports from Russia as well as major pipeline imports, except the Southern Druzhba pipeline. The EU made an exception for landlocked eastern European countries heavily dependent on Russian pipeline imports – namely Hungary, Slovakia, the Czech Republic, and Bulgaria (Chart 2A).  Focus on the big picture. Germany changed its national policy to reduce Russian energy dependency for the sake of national security. From Chancellors Willy Brandt to Angela Merkel, Germany pursued energy cooperation and economic engagement as a means of lowering the risk of war with Russia. Ostpolitik worked in the Cold War, so when Russia seized Crimea in 2014, Merkel built the Nord Stream 2 pipeline. But Merkel’s policy failed to persuade Russia that economic cooperation is better than military confrontation – rather it emboldened President Putin, who viewed Europe as divided and corruptible. Chart 2BRussia Squeezes EU’s Natural Gas Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Russia’s regime is insecure and feels threatened by the US and NATO. Russia believed that if it invaded Ukraine, the Europeans would maintain energy relations for the sake of preserving overall strategic stability. Instead Germany and other European states began to view Russia as irrational and aggressive and hence a threat to their long-term security. They imposed a coal ban, now an oil ban the end of this year, and a natural gas ban by the end of 2027, all formalized under the recently announced RePowerEU program. Russia retaliated by declaring it would reduce natural gas exports to the Netherlands and probably Denmark, after having already cut off Finland, Poland, and Bulgaria (Chart 2B). As a pretext Russia points to its arbitrary March demand that states pay for gas in rubles rather than in currencies written in contracts. This ruble payment scheme is being enforced on a country-by-country basis against those Russia deems “unfriendly,” i.e. those that join NATO, adopt new sanctions, provide massive assistance to Ukraine, or are otherwise adverse. Chart 3Russia Actively Cutting Gas Flows Russia Actively Cutting Gas Flows Russia Actively Cutting Gas Flows Russia and Ukraine are already reducing natural gas exports through the Ukraine and Turkstream pipelines while the Yamal pipeline has been empty since May – and it is only a matter of time before flows begin to fall in the Nord Stream 1 pipeline to Germany (Chart 3). German government and industry are preparing to ration natural gas (to prioritize household needs) and revive 15 coal plants if necessary. Europe is attempting to rebuild stockpiles for the coming winter, when Russian willingness and capability to squeeze natural gas flows will reach a peak. The big picture is demonstrated by game theory in Diagram 1. The optimal situation for both Russia and the EU is to maintain energy exports for as long as possible, so that Russia has revenues to wage its war and Europe avoids a recession while transitioning away from Russian supplies (bottom right quadrant, each side receives four points). The problem is that this solution is not an equilibrium because either side can suffer a sudden shock if the other side betrays the tacit agreement and stops buying or selling (bottom left and top right quadrants). Diagram 1EU-Russia Standoff: What Does Game Theory Say? Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) The equilibrium – the decision sets in which both Russia and the EU are guaranteed to lose the least – is a situation in which both states reduce energy trade immediately. Europe needs to cut off the revenues that fuel the Russian war machine while Russia needs to punish and deter Europe now while it still has massive energy leverage (top left quadrant, circled). Once Europe diversifies away, Russia loses its leverage. If Europe does not diversify immediately, Russia can punish it severely by cutting off energy before it is prepared.   Russian energy weaponization is especially useful ahead of any ceasefire talks in Ukraine. Russia aims for Ukrainian military neutrality and a permanently weakened Ukrainian state. To that end it is seizing territory for the Luhansk and Donetsk People’s Republics, seizing the southern coastline and strategic buffer around Crimea, and controlling the mouth of the Dnieper river so that Ukraine is forever hobbled (Map 1). Once it achieves these aims it will want to settle a ceasefire that legitimizes its conquests. But Ukraine will wish to continue the fight. Map 1Russian Invasion Of Ukraine, 2022 Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Russia will need leverage over Europe to convince the EU to lean on Ukraine to agree to a ceasefire. Something similar occurred in 2014-15 when Russia collaborated with Germany and France to foist the Minsk Protocols onto Ukraine. If Russia keeps energy flowing to EU, the EU not only gets a smooth energy transition away from Russia but also gets to keep assisting Ukraine’s military effort. Whereas if Russia imposes pain on the EU ahead of ceasefire talks, the EU has greater interest in settling a ceasefire. Finally, given Russia’s difficulties on the battlefield, its loss of European patronage, and potential NATO enlargement on its borders, Moscow is highly likely to open a “new front” in its conflict with the West. Josef Stalin, for example, encouraged Kim Il Sung to invade South Korea in 1950. Today Russia’s options lie in the Middle East and North Africa – the regions where Europe turns for energy alternatives. Not only Libya and Algeria – which are both inherently fertile ground for Russia to sow instability –  but also Iran and the broader Middle East, where a tenuous geopolitical balance is already eroding due to a lack of strategic understanding between the US and Iran. Russia’s capabilities are limited but it likely retains enough influence to ignite existing powder kegs in these areas.   Bottom Line: Investors still face a few hurdles from the Ukraine war. First, the EU’s expanding energy embargo and Russian retaliation. Second, instability in the Middle East and North Africa. Hence energy price pressures will remain elevated in the short term and kill more demand, thus pushing the EU and the rest of the world toward stagflation or even recession. War Contained To Ukraine So Far … But Russia To Retaliate Over NATO Enlargement At present Russia is waging a full-scale assault on eastern and southern Ukraine, where about half of Donetsk awaits a decision (Map 2). If Russia emerges victorious over Donetsk in the summer or fall then it can declare victory and start negotiating a ceasefire. This timeline assumes that its economic circumstances are sufficiently straitened to prevent a campaign to the Moldovan border.1   Map 2Russia May Declare Victory If It Conquers The Rest Of Donetsk Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) There are still ways for the Ukraine war to spill over into neighboring areas. For example, the Black Sea is effectively a Russian lake at the moment, which prevents Ukrainian grain from reaching global markets where food prices are soaring. Eventually the western maritime powers will need to attempt to restore freedom of navigation. However, Russia is imposing a blockade on Ukraine, has more at stake there than other powers, and can take greater risks. The US and its allies will continue to provide Ukraine with targeting information against Russian ships but this assistance could eventually provoke a larger naval conflict. Separately, the US has agreed to provide Ukraine with the M142 High Mobility Artillery Rocket System (HIMARS), which could lead to attacks on Russian territory that would prompt a ferocious Russian reaction. Even assuming that the Ukraine war remains contained, Russia’s strategic conflict with the US and the West will remain unresolved and Moscow will be eager to save face. Russian retaliation will occur not only on account of European energy diversification but also on account of NATO enlargement. Finland and Sweden are attempting to join NATO and as such the West is directly repudiating the Putin regime’s chief strategic demand for 22 years. Finland shares an 830 mile border with Russia, adding insult to injury. The result will be another round of larger military tensions that go beyond Ukraine and prolong this year’s geopolitical risk and uncertainty. Russia’s initial response to Finland’s and Sweden’s joint application to NATO was to dismiss the threat they pose while drawing a new red line. Rather than forbidding NATO enlargement, Russia now demands that no NATO forces be deployed to these two states. This demand, which Putin and other officials expressed, may or may not amount to a genuine Russian policy change. Russia’s initial responses should be taken with a grain of salt because Turkey is temporarily blocking Finland’s and Sweden’s applications, so Russia has no need to respond to NATO enlargement yet. But the true test will come when and if the West satisfies Turkey’s grievances and Turkey moves to admit the new members. If enlargement becomes inevitable, Russia will respond. Russia will feel that its national security is fundamentally jeopardized by Sweden overturning two centuries of neutrality and Finland reversing the policy of “Finlandization” that went so far in preventing conflict during the Cold War. Chart 4Military Balances Stacking Up Against Russia Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Russia’s military options are limited. Russia has little ability to expand the war and fight on multiple fronts judging by the army’s recent performance in Ukraine and the Red Army’s performance in the Winter War of 1939. This point can be illustrated by taking the military balance of Russia and its most immediate adversaries, which add up to about half of Russian military strength even apart from NATO (Chart 4). Russian armed forces already demonstrated some pragmatism in April by withdrawing from Kyiv and focusing on more achievable war aims. Unless President Putin turns utterly reckless and the Russian state fails to restrain him, Russia will opt for defensive measures and strategic deterrence rather than a military offensive in the Baltics. Hence Russia’s military response will come in the form of threats rather than outright belligerence. However, these threats will probably include military and nuclear actions that will raise alarm bells across Europe and the United States. President Dmitri Medvedev has already warned of the permanent deployment of nuclear missiles in the Kaliningrad exclave.2 This statement points to only the most symbolic option of a range of options that will increase deterrence and elevate the fear of war. Otherwise Russia’s retaliation will consist of squeezing global energy supply, as discussed above, including by opening a new front in the Middle East and North Africa. Instability should be expected as a way of constraining Europe and distracting America. Higher energy prices may or may not convince the EU to negotiate better terms with Russia but they will sow divisions within and among the allies. Ultimately Russia is highly unlikely to sacrifice its credibility by failing to retaliate for the combination of energy embargo and NATO enlargement on its borders. Since its military options are becoming constrained (at least its rational ones), its economic and asymmetrical options will grow in importance. The result will be additional energy supply constraints. Bottom Line: Even assuming that the war does not spread beyond Ukraine – likely but not certain – global financial markets face at least one more period of military escalation with Russia. This will likely include significant energy cutoffs and saber-rattling – even nuclear threats – over NATO enlargement.   China’s Political Situation Has Not Normalized China continues to suffer from a historic confluence of internal and external political risk that will cause negative surprises for investors. Temporary improvements in government policy or investor sentiment – centered on a relaxation of “Zero Covid” lockdowns in major cities and a more dovish regulatory tone against the tech giants – will likely be frustrated, at least until after a more dovish government stance can be confirmed in the wake of the twentieth national party congress in October or November this year. At that event, Chinese President Xi Jinping is likely to clinch another ten years in power and complete the transformation of China’s governance from single-party rule to single-person rule. This reversion to autocracy will generate additional market-negative developments this year. It has already embedded a permanently higher risk premium in Chinese financial assets because it increases the odds of policy mistakes, international aggression, and ultimately succession crisis. The most successful Asian states chose to democratize and expand free markets and capitalism when they reached a similar point of economic development and faced the associated sociopolitical challenges. But China is choosing the opposite path for the sake of national security. Investors have seen the decay of Russia’s economy under Putin’s autocracy and would be remiss not to upgrade the odds of similarly negative outcomes in China over the long run as a result of Xi’s autocracy, despite the many differences between the two countries. China’s situation is more difficult than that of the democratic Asian states because of its reviving strategic rivalry with the United States. US Secretary of State Antony Blinken recently unveiled President Biden’s comprehensive China policy. He affirmed that the administration views China as the US’s top strategic competitor over the long run, despite the heightened confrontation with Russia.3 The Biden administration has not eased the Trump administration’s tariffs or punitive measures on China. It is unlikely to do so during a midterm election year when protectionist dynamics prevail – especially given that the Xi administration will be in the process of reestablishing autocracy, and possibly repressing social unrest, at the very moment Americans go to the polls. Re-engagement with China is also prohibited because China is strengthening its strategic bonds with Russia. President Biden has repeatedly implied that the US would defend Taiwan in any conflict with China. These statements are presented as gaffes or mistakes but they are in fact in keeping with historical US military actions threatening counter-attack during the three historic Taiwan Strait crises. The White House quickly walks back these comments to reassure China that the US does not support Taiwanese independence or intend to trigger a war with China. The result is that the US is using Biden’s gaffe-prone personality to reemphasize the hard edge (rather than the soft edge) of the US’s policy of “strategic ambiguity” on Taiwan. US policy is still ambiguous but ambiguity includes the possibility that a president might order military action to defend Taiwan. US attempts to increase deterrence and avoid a Ukraine scenario are threatening for China, which will view the US as altering the status quo and penalizing China for Russia’s actions. Beijing resumed overflights of Taiwan’s air defense identification zone in the wake of Biden’s remarks as well as the decision of the US to send Senator Tammy Duckworth to Taiwan to discuss deeper economic and defense ties. Consider the positioning of US aircraft carrier strike groups as an indicator of the high level of strategic tensions. On January 18, 2022, as Russia amassed military forces on the Ukrainian border – and the US and NATO rejected its strategic demands – the US had only one publicly acknowledged  aircraft carrier in the Mediterranean (the USS Harry Truman) whereas it had at least five US carriers in East Asia. On February 24, the day of Russia’s invasion of Ukraine, the US had at least four of these carriers in Asia. Even today the US has at least four carriers in the Pacific compared to at least two in Europe – one of which, notably, is in the Baltics to deter Russia from attacking Finland and Sweden (Map 3). The US is warning China not to take advantage of the Ukraine war by staging a surprise attack on Taiwan. Map 3Amid Ukraine War, US Deters China From Attacking Taiwan Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Of course, strategic tensions are perennial, whereas what investors are most concerned about is whether China can secure its economic recovery. The latest data are still disappointing. Credit growth continues to falter as the private sector struggles with a deteriorating demographic and macroeconomic outlook (Chart 5). The credit impulse has entered positive territory, when local government bonds are included, reflecting government stimulus efforts. But it is still negative when excluding local governments. And even the positive measure is unimpressive, having ticked back down in April (Chart 6). Chart 5Credit Growth Falters Amid Economic Transition Credit Growth Falters Amid Economic Transition Credit Growth Falters Amid Economic Transition Chart 6Silver Lining: Credit Impulse Less Negative Silver Lining: Credit Impulse Less Negative Silver Lining: Credit Impulse Less Negative Bottom Line: Further monetary and fiscal easing will come in China, a source of good news for global investors next year if coupled with a broader policy shift in favor of business, but the effects will be mixed this year due to Covid policy and domestic politics. Taken together with a European energy crunch and Middle Eastern oil supply disruptions, China’s stimulus is not a catalyst for a sustainable global equity market rally this year. South Asia: Inflation Hammers Sri Lanka And Pakistan Since 2020 we have argued that the global pandemic would result in a new wave of supply pressures and global social unrest. High inflation is blazing a trail of destruction in emerging markets, notably in South Asia, where per capita incomes are low and political institutions often fragile. Chart 7South Asia: Surging Inflation Energy Cutoff Continues (GeoRisk Update) Energy Cutoff Continues (GeoRisk Update) Sri Lanka has been worst affected (Chart 7). Inflation surged to an eye-watering 34% in April  and is expected to rise further. Surging inflation has affected Sri Lanka disproportionately because its macroeconomic and political fundamentals were weak to begin with. The tourism-dependent Sri Lankan economy suffered a body blow from terrorist attacks in 2019 and the pandemic in 2020-21. Then 2022 saw a power struggle between Sri Lanka’s President Gotabaya Rajapaksa and members of the national assembly including Prime Minister (PM) Mahinda Rajapaksa. The crisis hit a crescendo when the country defaulted on external debt obligations last month. These events weigh on Sri Lanka’s ability to transition from a long civil war (1983-2009) to a path of sustained economic development. While the political crisis has seemingly stabilized following the appointment of new Prime Minister Ranil Wickremesinghe, we remain bearish on a strategic time horizon. This is mainly because the new PM is unlikely to bring about structural solutions for Sri Lanka’s broken economy. Moreover, Sri Lanka holds more than $50 billion of foreign debt, or 62% of GDP. Another country that has been dealing with political instability alongside high inflation in South Asia is Pakistan, where inflation hit a three-year high in April (see Chart 7 above). The latest twist in Pakistan’s never-ending cycle of political uncertainty comes from the ousted Prime Minister Imran Khan. The former PM, who commands an unusual popular support group due to his fame as a cricketer prior to entering politics, is demanding fresh elections and otherwise threatening to hold mass protests. Pakistan’s new coalition government and Prime Minister Shehbaz Sharif, who came to power amid parliamentary intrigues, are refusing elections and ultimatums. From a structural perspective Pakistan is characterized by a weak economy and an unusually influential military. Now it faces high inflation and rising food prices – indeed it is one of the countries that is most dangerously exposed to the Russia-Ukraine war as it depends on these two for over 70% of its grain imports. Bottom Line: MSCI Sri Lanka has underperformed the MSCI EM index by 58.3% this year to date. Pakistan has underperformed the same index by 41.6% over the same period. Against this backdrop, we remain strategic sellers of both bourses. Instability in these countries is also one  of the factors behind our strategic assessment of India as a country with a growing domestic policy consensus. South Asia: India’s Fiscal Populism And Geopolitics Inflation is less rampant in India, although still troublesome. Consumer prices nearly jumped to an 8-year high in April (see Chart 7). With a loaded state election calendar due over the next 12-18 months, the jump in inflation naturally triggered a series of mitigating policy responses. Ban On Wheat Exports: India produces 14% of the world’s wheat and 11% of grains, and exports 5% and 7%, respectively. India’s exports could make a large profit in the context of global shortages. But Prime Minister Narendra Modi is entering into the political end of the business cycle, with key state elections due that will have an impact on the ruling party’s political standing two years before the next federal election. He fears political vulnerability if exports continue amid price pressures at home. The emphasis on food security is typical but also bespeaks a lack of commitment to economic reform. Chart 8India's Real Interest Rates Fall India's Real Interest Rates Fall India's Real Interest Rates Fall Surprise Rate Hikes: The Reserve Bank of India (RBI) increased the policy repo rate by 40 basis points at an unscheduled meeting on May 4, thereby implementing its first rate hike since August 2018. With real rates in India lower than those in China or Brazil (Chart 8), the RBI will be forced to expedite its planned rate hikes through 2022. Tax Cuts On Fuel: India’s central government also announced steep cuts in excise duty on fuel. This is another populist measure that reduces political pressures but fails to encourage the private sector to adjust.  These measures will help rein in inflation but the rate hikes will weigh on economic growth while the tax cuts will add to India’s fiscal deficit. Indeed, India is resorting to fiscal populism with key state elections looming. Geopolitical risk is less of a concern for India – indeed the Ukraine war has strengthened its bargaining position. In the short run, India benefits from the ability to buy arms and especially cheap oil from Russia while the EU imposes an embargo. But over the long run its economy and security can be strengthened by greater interest from the US and its allies, recently highlighted by the fourth meeting of the Quadrilateral Security Dialogue (Quad) and the launch of the US’s Indo-Pacific Economic Framework (IPEF). These initiatives are modest but they highlight the US’s need to replace China with India and ASEAN over time, a trend that no US administration can reverse now because of the emerging Russo-Chinese strategic alliance. At the same time, the Quad underscores India’s maritime interests and hence the security benefits India can gain from aligning its economy and navy with the other democracies. Bottom Line: Fiscal populism in the context of high commodity prices is negative for Indian equities. However, our views on Russia, the Middle East, and China all point to a sharper short-term spike in commodity prices that ultimately drives the world economy deeper into stagflation or recession. Therefore we are booking a 22.5% profit on our tactical decision to go long Brazilian financials relative to Indian equities.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Chart 9Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Chart 10Other Measures Of Russian Geopolitical Risk Other Measures Of Russian Geopolitical Risk Other Measures Of Russian Geopolitical Risk Chart 11China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator Chart 12United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator United Kingdom: GeoRisk Indicator Chart 13Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator Chart 14France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator Chart 15Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Chart 16Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Chart 17Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Chart 18Australia: GeoRisk Indicator Australia: GeoRisk Indicator Australia: GeoRisk Indicator Chart 19Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Chart 20Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Chart 21Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Chart 22South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Chart 23Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator   Footnotes 1     Recent diplomatic flaps between core European leaders and Ukrainian President Volodymyr Zelensky reflect Ukraine’s fear that Europe will negotiate a “separate peace” with Russia, i.e. accept Russian territorial conquests in exchange for economic relief. 2     Dmitri Medvedev explicitly states ‘there can be no more talk of any nuclear-free status for the Baltic - the balance must be restored’ in warning Finland and Sweden joining NATO. Medvedev is suggesting that nuclear weapons will be placed in this area where Russia has its Kaliningrad exclave sandwiched between Poland and Lithuania. Guy Faulconbridge, ‘Russia warns of nuclear, hypersonic deployment if Sweden and Finland join NATO’, April 14, 2022, Reuters. 3    See Antony J Blinken, Secretary of State, ‘The Administration’s Approach to the People’s Republic of China’, The George Washington University, Washington D.C., May 26, 2022, state.gov. Additionally, see President Joe Biden’s remarks on China and getting involved military to defend Taiwan in a joint press conference with Japan’s Prime Minister Kishida Fumio. ‘Remarks by President Biden and Prime Minister Kishida Fumio of Japan in Joint Press Conference’, Akasaka Palace, Tokyo, Japan, May 23, 2022, whitehouse.gov.   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar

Executive Summary Loss Of Russian Production Will Lift Brent Loss Of Russian Production Will Lift Brent Loss Of Russian Production Will Lift Brent With German imports of Russian oil close to 10% of its total requirements – following an impressive decline from 35% pre-invasion – we expect the EU to declare an embargo on Russian oil imports this week or next. Smaller states – e.g., Hungary and Slovokia – will be granted embargo waivers; their import volumes will not affect the EU effort. Russia will be forced to shut in ~ 1.6mm b/d of production, rising to 2mm b/d next year (vs. pre-invasion levels). Demand will fall as Brent prices surpass $120/bbl by 2H22, in our revised base case. Prices above $140/bbl are likely if Russia immediately halts EU oil exports. Our revised forecast calls for Brent to average $113/bbl this year, and $122/bbl next year. WTI will trade $3/bbl lower. Per earlier threats, Russia will cut EU natgas exports following the EU embargo. Benchmark euro natgas prices will go back above €225/MWh, and trigger an EU recession. Bottom Line: An EU embargo on Russian oil imports is close. Brent crude will rally above $120/bbl by 2H22, with $140/bbl or higher likely, depending on how quickly Russia reacts to the EU oil embargo. Eurozone natgas will trade above €225/MWh again. We remain long the S&P GSCI index, the COMT ETF, and the XOP and CRAK ETFs to retain exposure to higher prices. We are getting long 1Q23 ICE Brent futures and 4Q22 TTF futures at tonight's close. Feature Related Report  Commodity & Energy StrategyDie Cast By EU: Inflation, Recession Risks Rise The stage is set for the EU to announce an embargo on Russian oil imports this week or next. Odds of an EU embargo being declared sooner rather than later increased, in our view, in the wake of Germany's success in cutting Russian oil imports by more than half in a very short period – from ~ 35% prior to Russia's invasion of Ukraine on 24 February to ~ 12% earlier this month (Chart 1). Further reductions in Russian oil imports we expect from Germany will make it easier for the EU's largest economy to walk away from Russian crude and product imports sooner rather than later.1 Other EU member states already stand with Germany on the issue of an embargo on Russian imports. Those that do not – Hungary and Slovakia, e.g. – do not import Russian oil on a scale that can meaningfully derail EU solidarity on the embargo, which means waivers for these states can be expected to keep the embargo on track. In addition, four of the Five-Eyes states – the US, UK, Australia and Canada – already have imposed embargoes on Russian oil imports. Chart 1EU Energy Import Dependency (2021) EU Energy Import Dependency (2021) EU Energy Import Dependency (2021) Russian Shut-ins Will Tighten Supply The immediate fallout of the EU embargo will be to accelerate the rate at which Russia is forced to shut in production, as increasing volumes of its oil remain stranded on the water looking for a home. We reckon 1mm b/d or so of Russian crude oil output already has been cut. This will continue to increase. Russia will be forced to shut in ~ 1.6mm b/d of crude output this year, rising to 2mm b/d next year (averages vs. pre-invasion levels), in our modelling. This takes Russian oil production down to 8.4mm b/d this year, on average, and 8.0mm b/d next year.2 As more and more Russian crude is shut in, the pipelines carrying Urals and Eastern Siberia-Pacific Ocean (ESPO) crude from the Siberian oil fields to ports will fill, along with inventory in the ports where ships are loaded for export. When storage and pipelines fill, the only alternative Russian producers will have will be to shut in crude and condensate production. While some states obviously will benefit from the increasing availability of Russian crude on offer at 30% discounts or more – e.g., India and China – there is a limit as to how much surplus Russian output they can take in. China, in particular, will not want to jeopardize long-term contracts with key suppliers – e.g., the Kingdom of Saudi Arabia (KSA) – nor will India, which will limit the total volumes both are willing to take from Russia longer term. Security of supply becomes an increasingly important consideration as Russia's oil output continues a long-term decline going forward: Costs were rising prior to Russia's invasion of Ukraine from 2008 to 2019. Falling drilling efficiency and production, were accompanied by rising water cuts – i.e., the amount of water being produced drilling for oil – in Russia's largest fields, which rose to as high as 86%. Shutting production from these older fields will force hard choices as to whether these fields are ever revived.3 Demand Will Be Stressed Shortly after Russia invaded Ukraine, the country's Energy Ministry Alexander Novak warned the EU it would cut off natural gas pipeline supplies being sent to the continent, in retaliation for embargoing oil imports.4 Oil exports of close to 5mm b/d accounted for just under half of Russia's revenue from energy exports last year, with OECD Europe representing half of that amount.5 For Russia, oil exports are far more important than gas exports, which will incline it to immediately cut pipeline flows to Europe as soon as an oil embargo is announced. For the EU, natgas exports from Russia are critical to the economies of its member states (Chart 2). The EU imported ~ 155 bcm of natgas from Russia in 2021, or just over 40% of its total natgas consumption. Germany's share amounted to 45 bcm, or 45% of domestic gas use . If, as we expect, the EU is close to announcing its oil embargo on Russia, an immediate retaliation from Moscow in the form of a cutoff of pipeline exports to the EU most likely will follow. This will throw the EU into a recession, as natgas prices surge. Chart 2Losing Russia's Natgas Will Be Painful For EU Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge Revised Forecast Reflects Falling Russian Output We are revising our Brent forecast and crude oil balances in line with our expectation Russian oil output will decline meaningfully. As noted above, we now expect Russian crude oil output to fall to 8.4mm b/d this year and 8.0mm b/d in 2023. This pushes non-core OPEC 2.0 production – which now includes Russia – lower, as a result (Chart 3). We moved Russia out of the core OPEC 2.0 producer group, given the production declines we expect this year and next, and into the "Other Guys" group. Our base case demand reflects a shift in OECD vs. non-OECD consumption estimates, with the OECD gaining incrementally, while EM demand (via non-OECD consumption) falls incrementally (Chart 4). Chart 3Falling Russia Output Pushes Non-Core OPEC 2.0 Output Lower Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge Chart 4DM Demand Shifts Higher, EM Shifts Lower DM Demand Shifts Higher, EM Shifts Lower DM Demand Shifts Higher, EM Shifts Lower The lower EM demand growth reflects weaker China oil consumption resulting from the country's zero-COVID policy. In addition, because we expect Russia to act quickly on cutting off EU natgas exports, benchmark TTF natgas prices will move back above €225/MWh. Higher oil and natgas prices in the EU will lead to recession later this year. How quickly this shows up depends on how quickly Russia reacts to an EU oil embargo. In addition, a strong USD – bid higher by global economic uncertainty and safe-haven demand – will pushing the local-currency costs of refined products like gasoline, diesel and jet fuel higher, also will contribute to lower EM demand (Chart 5). Chart 5USD Remains Well Bid Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge In our base case, we expect a tighter market on balance (Chart 6). Oil inventories remain under pressure, owing to falling as Russian output and declines in production outside core OPEC 2.0 and the US (Chart 7). We cannot rule out additional SPR releases from the US or IEA to offset tightening global inventories. Chart 6Global Balances Tighten Global Balances Tighten Global Balances Tighten Chart 7Inventories Draw As Supply Tightens Inventories Draw As Supply Tightens Inventories Draw As Supply Tightens Our forecast for Brent this year has been lifted on the back of a much stronger expectation of an EU oil embargo against Russia. This will result in 2mm b/d of Russian production being shut in by next year, which will not be fully replaced (Table 1). We are lifting our Brent forecast to $110/bbl for 2022, and $115/bbl for next year as a result (Chart 8). Chart 8Loss Of Russian Production Will Lift Brent Loss Of Russian Production Will Lift Brent Loss Of Russian Production Will Lift Brent Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge Investment Implications An EU embargo on Russian oil imports is close at hand, in our view. Brent crude will rally above $120/bbl by 2H22, with $140/bbl or higher possible, depending on Russia's reaction to the EU oil embargo. We expect Brent prices to average $113/bbl this year, and $122/bbl in 2023. WTI will trade $3/bbl lower on average. Eurozone natgas will trade above €225/MWh again and stay at elevated levels, likely moving higher following a Russian cutoff of natgas supplies to the continent. This will throw the EU into recession. We remain long the S&P GSCI index, the COMT ETF, and the XOP and CRAK ETFs to retain exposure to higher prices. We are getting long 1Q23 ICE Brent futures and TTF natgas futures at tonight's close. A word of caution is in order: We are assuming Russia will follow through on its threat to shut off natgas exports to the EU in the event of an embargo against importing its oil is declared. This, we believe, is Russia's red line. If the EU fails to declare an embargo, or if Russia fails to follow through on its threat to cut off gas supplies in the wake of an EU oil embargo of its exports we will have to re-assess our outlook.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish European natural gas inventories are building at a rapid rate, as competition from Asia – typically led by Chinese demand – remains weaker than in previous seasons. EU natgas storage stood at ~446 MWh as of May 16, 2022, the latest available reports indicate (Chart 9). The EU has weathered two extremely difficult winters in 2020-21 and 2021-22. Natgas storage levels were drawn hard to meet space heating demand, which, owing to a winter energy crisis in China at the time, forced European buyers into a competition for liquified natural gas (LNG) during the former period. Following unexpected spring-summer demand in 2021 when cold weather lingered in Europe and wind power generation fell sharply, storage owners again were hard pressed to secure LNG to rebuild storage levels going into this past winter, which caused European TTF natgas prices to soar, as demand surged (Chart 10). With the threat of a cutoff of Russian natgas hanging over the EU, there is a singular focus right now on getting storage as full as possible ahead of next winter. The EU aims to replace two-thirds of Russian gas imports before yearend. Precious Metals: Bullish The Fed has adopted a more hawkish rhetoric, as it acts more aggressively to reduce US inflation. Interest rates have increased from near-zero levels in March to 0.75%, and BCA’s US Bond strategy service expects two more 50 bps rate hikes in June and July. Post July, rate hikes will depend on the Fed’s assessment of inflation, inflation expectations and financial conditions. The Fed faces the risk of either remaining behind the inflation curve or sparking a recession in case it’s either not hawkish enough, or too hawkish. Base Metals: Bullish High power prices in Europe will continue to plague refined base metals production in the continent and keep refined metal prices buoyed. LME Europe aluminum stocks are close to 17-year lows. In China – whose metal smelters were also hit by high power prices in 2021 – aluminum smelting has revived, with the country reportedly producing a record amount of primary aluminum in April. Lockdowns, however, have reduced economic activity, demand for the metal and its domestic price. China has taken advantage of this arbitrage opportunity, sending most of its primary aluminum exports to Europe. This aluminum price spread between the two states has contributed to China’s steady rise in primary aluminum exports this year, after having exported nearly none in 2020 and 2021. Chart 9 Oil, Natgas Prices Set To Surge Oil, Natgas Prices Set To Surge Chart 10Dutch Title Transfer Facility Going Down Dutch Title Transfer Facility Going Down Dutch Title Transfer Facility Going Down     Footnotes 1     German officials have stated the country will wind down all oil imports from Russia by year end, even if the rest of the EU does not join it in an embargo.  We highly doubt Germany will act alone, given the support an embargo already has received from EU member states.  Please see Germany to Stop Russian Oil Imports Regardless of EU Sanctions, published by bloomberg.com on May 15, 2022. 2     Our expectation for shut-in volumes is lower than the IEA's, which sees Russia being forced to shut in 3mm b/d of production by 2H22.  We continue to monitor this closely via satellite and reporting services and will adjust our estimates as needed.  Obviously, if the IEA is correct oil markets will tighten even more than we expect. 3    Please see "The Future of Russian Oil Production in the Short, Medium, and Long Term," published by the Oxford Institute for Energy Studies in September 2019.  The OIES study notes production in Russia's highest-producing area – the Khanty-Mansi Autonomous (KMA) district – actually fell 15% between 2008-19, even as drilling activity surged 66%.  While output in 2018 rose due to intensified oil recovery (IOR), the OIES noted that the water cut rose sharply in 2018 as well in the KMA district. 4    Please see Russia warns of $300 oil, threatens to cut off European gas if West bans energy imports, published by cnbc.com on March 8, 2022.  The article notes Novak threatened to close the Nord Stream 1 pipeline delivering gas to Germany in retaliation for an EU oil embargo.  Almost three-quarters of Russia's natgas exports were sent to Europe prior to its invasion of Ukraine.  Natgas export revenues accounted for $62 billion of the $242 billion funding Russia's budget last year, while crude oil revenues made up $180 billion (just under 75%). 5    Please see Die Cast By EU: Inflation, Recession Risks Rise, which we published on May 5, 2022.  It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Trades Closed in 2022

Dear Client, This week, the US Bond Strategy service is hosting its Quarterly Webcast (May 17 at 9:00 AM EDT, 14:00 PM BST, 15:00 PM CEST and May 18 at 9:00 HKT, 11:00 AEST). In addition, we are sending this Quarterly Chartpack that provides a recap of our key recommendations and some charts related to those recommendations and other areas of interest for US bond investors. Please tune in to the Webcast and browse the Chartpack at your leisure, and do let us know if you have any questions or other feedback. To view the Quarterly Chartpack PDF please click here. Best regards, Ryan Swift, US Bond Strategist