Russia

Executive Summary US Can Do Without Russia's Oil, EU, NATO … Not So Much US Will Ban Russian Oil Imports US Will Ban Russian Oil Imports The US will ban Russian oil imports shortly.  This is not as big a deal markets had feared over the weekend, when news of a possible ban of Russian oil and refined products into the US and Europe was telegraphed by US officials, powering prices to $140/bbl.1 The US imported a combined 400k b/d of Russian crude oil and refined products in December 2021, the EIA reports, which accounted for less than 5% of the 8.6mm b/d of imports. Europe is another story.  Roughly 60% of Russia's 11.3mm b/d of crude oil and refined-products output goes to OECD Europe, according to the IEA. Russia considers Western sanctions to be on an equal footing with a declaration of war.2  President Putin has threatened a nuclear response if the West interferes with invasion of Ukraine, which could elicit a similar response from the West.3  US shale producers will be highly incentivized to increase output given high prices.  Our view continues to include a production increase from core OPEC 2.0 – Saudi Arabia, UAE and Kuwait.  We also anticipate a return of 1mm b/d from Iran, following a nuclear deal with the US. Bottom Line: We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to oil and gas producers via the XOP ETF. Footnotes 1     Please see Crude price jumps on talk of US oil ban as Russia steps up shelling of civilian areas, published by the Financial Times on March 6, 2022. 2     Please see Putin says Western sanctions are akin to declaration of war, published on March 5, 2022. 3    Please see How likely is the use of nuclear weapons by Russia?, published by Chatham House on March 1, 2022.  The report notes, " If Russia were to attack Ukraine with nuclear weapons, NATO countries would most likely respond on the grounds that the impact of nuclear weapons crosses borders and affects the countries surrounding Ukraine. NATO could respond either by using conventional forces on Russian strategic assets, or respond in kind using nuclear weapons as it has several options available."

Executive Summary Nuclear Worries Take Center Stage Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Vladimir Putin has now committed himself to orchestrating a regime change in Kyiv. Anything less would be seen as a defeat for him. Assuming he succeeds, and it is far from obvious that he will, the resulting insurgency will drain Russian resources. Along with continued sanctions, this will lead to a further deterioration in Russian living standards and growing domestic discontent. If Putin concludes that he has no future, the risk is that he will decide that no one else should have a future either. Although there is a huge margin of error around any estimate, subjectively, we would assign an uncomfortably high 10% chance of a civilization-ending global nuclear war over the next 12 months. These odds place some credence on Brandon Carter’s highly controversial Doomsday Argument. Even if World War III is ultimately averted, markets could experience a freak-out moment over the next few weeks, similar to what happened at the outset of the pandemic. Google searches for nuclear war are already spiking. Despite the risk of nuclear war, it makes sense to stay constructive on stocks over the next 12 months. If an ICBM is heading your way, the size and composition of your portfolio becomes irrelevant. Thus, from a purely financial perspective, you should largely ignore existential risk, even if you do care about it greatly from a personal perspective. Bottom Line: The risk of Armageddon has risen dramatically. Stay bullish on stocks over a 12-month horizon. All In on Sanctions In the criminal justice system, there is a reason why the punishment for armed robbery is lower than for murder. If the punishment were the same, an armed robber would have a perverse incentive to kill his victim in order to better conceal his crime. The same logic applies, or at least used to apply, to geopolitics: You do not impose maximum sanctions from the get-go because that removes your ability to influence your enemy with the threat of further sanctions. Following Russia’s invasion of Ukraine, the West chose to go all in on sanctions, levying every type imaginable with the exception of those entailing a big cost to the West (such as cutting off Russian energy exports). Most notably, many Russian banks have been blocked from the SWIFT messaging system while the Russian central bank’s foreign exchange reserves have been frozen. Even FIFA has barred Russia from international competition, just weeks before it was set to participate in the qualifying rounds of the 2022 World Cup. At this point, there is not much more that can be done on the sanctions front. This leaves military intervention as the only avenue available to further pressure Russia. A growing chorus of Western pundits, some of whom could not have picked out Ukraine on a map two weeks ago, have begun clamoring for regime change… this time, in Moscow. As one might imagine, this is not something that sits well with Putin. Last week, he declared that “No matter who tries to stand in our way or … create threats for our country and our people, they must know that Russia will respond immediately, and the consequences will be such as you have never seen in your entire history.” To ensure there was no uncertainty about what he was talking about, he proceeded to place Russia’s nuclear forces on “special regime of combat duty.” Yes, It’s Possible The Putin regime has used nuclear weapons of a sort in the past. The FSB likely orchestrated the poisoning of Alexander Litvinenko with polonium-210 in 2006, leaving traces of the radioactive substance scattered in dozens of places across London. As former US presidential advisor and Putin biographer Fiona Hill said in a recent interview with Politico, “Every time you think, “No, he wouldn’t, would he?” Well, yes, he would.” Admittedly, there is a big difference between dropping polonium into a cup of tea at the Millennium hotel in Mayfair and dropping a 10-megaton nuclear bomb on London or any other major Western city. Still, if Putin feels that he has no future, he may try to take everyone down with him. The collapse in the ruble, and what is sure to be a major plunge of living standards across Russia, could foment internal opposition to Putin. A quiet retirement is not an option for him. Based on the latest exchange rates, Russia’s GDP is smaller than Mexico’s and barely higher than that of Illinois (Chart 1). While denying gas to Europe is a very real threat, it has a limited shelf life. Europe will aggressively build out infrastructure to process LNG imports. Chart 1Russia's Economic Power Has Faded Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse In a few years, the one viable weapon that Russia will have at its disposal is its nuclear arsenal. As Dutch historian Jolle Demmers has said, “It is precisely the decline and contraction of Russian power, coupled with the possession of nuclear weapons and a tormented repressive president, that poses great risks.” Some of the world’s most prominent strategic thinkers flagged these risks before the invasion, but with little effect. The Mother of All Risks In simulated war games, it is generally difficult to get participants to cross the nuclear threshold, but once they do, a full-blown nuclear exchange usually ensues.1 The idea of “limited” nuclear war is a mirage.  How high are the odds of such a full-blown war? I must confess that my own feelings on the matter are heavily colored by my writings on existential risk. As I argued in Section XII of my special report, “Life, Death, and Finance in the Cosmic Multiverse,” we are probably greatly understating existential risk, especially when we look prospectively into the future. Although there is a huge margin of error around any estimate, subjectively, we would assign an uncomfortably high 10% chance of a civilization-ending global nuclear war over the next 12 months. These odds place some credence on Brandon Carter’s highly controversial Doomsday argument (See Box 1). A Paradox for Investors For investors, existential risk represents a paradoxical concept. If an ICBM is heading your way, the question of whether you are overweight or underweight stocks would be pretty far down on your list of priorities. And even if you were inclined to think about your portfolio, how would you alter it? In a full-blown global nuclear war, most stocks would go to zero while governments would probably be forced to default or inflate away their debt. Gold might retain some value – provided that you kept it in your physical possession – but even then, you would still have trouble exchanging it for anything of value if nothing of value were available to purchase. This means that from a purely financial perspective, you should largely ignore existential risk, even if you do care greatly about it from a personal perspective. What, then, can we say about the current market environment? I touched on many of the key issues in Monday’s Special Alert, in which we tactically downgraded global equities from overweight to neutral. I encourage readers to consult that report for our latest market views. In the remainder of today’s report, allow me to elaborate on a couple of key themes. A Freak-Out Moment Is Coming Chart 2Nuclear Worries Take Center Stage Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse The market today reminds me of early 2020. We wrote a report on February 21 of that year entitled “Markets Too Complacent About The Coronavirus,” in which we noted that a full-blown pandemic “could lead to 20 million deaths worldwide,” and that “This would likely trigger a global downturn as deep as the Great Recession of 2008/09, with the only consolation being that the recovery would be much more rapid than the one following the financial crisis.” Many saw that report as alarmist, just as they saw our subsequent decision to upgrade stocks in March as cavalier.  Even if you knew in February 2020 that the S&P 500 would reach an all-time high later that year, you should have still shorted equities aggressively on a tactical basis. I feel the same way about the present. Google searches for nuclear war are spiking (Chart 2). A freak-out moment is coming, which will present a good buying opportunity for investors. Just to be on the safe side, I picked up a couple of bottles of Potassium Iodide earlier this week. When I checked the pharmacy again yesterday, all the bottles were sold out. They are now being hawked on Amazon for ten times the regular price. From Cold War to Hot Economy? The spike in commodity prices – especially energy prices – will have a negative near-term impact on global growth, while also limiting the ability of central banks to slow the pace of planned rate hikes (Chart 3). In general, inflation expectations and oil prices move together (Chart 4).   Chart 3Central Banks: Caught Between A Rock And A Hard Place Central Banks: Caught Between A Rock And A Hard Place Central Banks: Caught Between A Rock And A Hard Place   Chart 4Inflation Expectations And Oil Prices Go Hand-In-Hand Inflation Expectations And Oil Prices Go Hand-In-Hand Inflation Expectations And Oil Prices Go Hand-In-Hand Assuming the geopolitical situation stabilizes in a few months, oil prices should come down. The forward curve for oil is heavily backwardated now: The spot price for Brent is $111/bbl while the December 2022 price is $93/bbl (Chart 5). BCA’s commodity strategists expect the price of Brent oil to fall to $88/bbl by year-end. The decline in energy prices should provide some relief to global growth and risk assets in the back half of the year, which is one reason we are more constructive on equities over a 12-month horizon than a 3-month horizon. Looking out beyond the next year or two, the new cold war will lead to higher, not lower, interest rates. Increased spending on defense and alternative energy sources will prop up aggregate demand, especially in Europe where the need to diversify away from Russian gas is greatest. As Chart 6 shows, capex in the euro area cratered following the euro debt crisis. Capital spending via the Recovery Fund and other sources will rise significantly over the next few years. Chart 5The Brent Curve Is Heavily Backwardated Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Chart 6European Capex Is Poised To Increase European Capex Is Poised To Increase European Capex Is Poised To Increase In addition, the shift to a multipolar world will expedite the retreat from globalization. Rising globalization was an important force restraining inflation – and interest rates – over the past few decades. Lastly, the ever-present danger of war could prompt households to reduce savings. It does not make sense to save for a rainy day if that day never arrives. Lower savings implies a higher equilibrium rate of interest. As we discussed in our recent report entitled “A Two-Stage Fed Tightening Cycle,” after raising rates modesty this year, the Fed will resume hiking rates towards the end of 2023 or in 2024, as it becomes clear that the neutral rate in nominal terms is closer to 3%-to-4% rather than the 2% that the market assumes. The secular bull market in equities will likely end at that point. In summary, equity investors should be somewhat cautious over the next three months, more optimistic over a 12-month horizon, but more cautious again over a longer-term horizon of 2-to-5 years. Box 1The Doomsday Argument In A Nutshell Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1     For example, an article from the Center for Arms Control and Non-Proliferation discusses a Reagan administration war game called “Proud Prophet,” an exercise the Americans hatched to test the theory of limited nuclear strikes. The result of this exercise was that the “Soviet Union perceived even a low-yield nuclear strike as an attack, and responded with a massive missile salvo.” Global Investment Strategy View Matrix Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse Special Trade Recommendations Current MacroQuant Model Scores Rising Risk Of A Nuclear Apocalypse Rising Risk Of A Nuclear Apocalypse

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

Executive Summary Russian Stocks Are Breaking Below Their 2008 And 2015 Lows Russian Stocks Are Breaking Below Their 2008 And 2015 Lows Russian Stocks Are Breaking Below Their 2008 And 2015 Lows The Kremlin will not halt its military operations in Ukraine for now. The strategic objective of Putin is to bring Ukraine back into its geopolitical and economic orbit. His immediate goal is to unseat the current government in Kyiv and install a pro-Kremlin administration. Russia is embracing a long period of economic and financial isolation. Russian financial markets will remain uninvestable for an extended period. We are downgrading Central European equities and local currency bonds to underweight within their respective EM portfolios. As a new trade, we recommend shorting the Polish zloty versus the US dollar. Recommendation Inception Date Return Short PLN / Long USD Mar 02, 2022   Bottom Line: The security situation in Europe will continue to deteriorate, especially if the Russian army fails to secure a rapid military victory. This poses a risk to global and EM risk assets. Within a global equity portfolio, investors should overweight the US, and underweight EM and Europe. Feature Global macro has taken a back seat and geopolitics has become the dominant driver of financial markets. Still, we believe geopolitical risks are underappreciated by global financial markets. Will Western Sanctions Halt Russia’s Military Operation? While sanctions have started and will continue to hurt the Russian economy and its financial system, the Kremlin will not halt its military operations in Ukraine for now. The strategic objective of Putin is to bring Ukraine back into its geopolitical and economic orbit. His immediate goal is to unseat the current government in Kyiv and install a pro-Kremlin administration. In fact, having already incurred considerable economic and financial costs, Russia will not pull back its army anytime soon. If anything, Russia’s rhetoric and actions will get more aggressive in the coming weeks. For now, the Kremlin will not agree to anything short of the surrender of Ukraine’s government and its army. In turn, Ukraine authorities and its military intend to continue fighting with the support of arms supplies from the West. As a result, any peace talks will be futile. The situation will thus continue to escalate and the risk premium in global financial markets will rise further. The global political uncertainty index will be rising and, as a rule of thumb, it heralds a lower P/E ratio for global equities (Chart 1). Chart 1Rising Geopolitical Risks = Lower P/E Ratio Rising Geopolitical Risks = Lower P/E Ratio Rising Geopolitical Risks = Lower P/E Ratio The main question is, therefore, how bad could it get? We believe the conflict might take a turn for the worse. If the Russian military fails to achieve its goal to remove the current government in Kyiv, Putin will go all out. Losing this war is not an option for him. The failure of the Kremlin to secure a rapid military victory implies a massive escalation on two fronts: (1) the military actions of the Russian army in Ukraine will intensify and civilian infrastructure and potentially the population at large might be threatened; and (2) Russia will become more aggressive in its threats to the West. If and when Putin perceives that his military operation is failing or his power is threatened at home, he will resort to the extreme actions he has been warning about. Putin will bolster his military threats to Europe and to the US. In such a scenario, global risk assets will tank. Bottom Line: The security situation in Europe will continue to deteriorate, especially if the Russian army fails to secure a rapid military victory. Investors should position their portfolio to account for the fact that things will get worse before they improve. Russian Markets Are Uninvestable Chart 2No Buyers For Russian Bonds No Buyers For Russian Bonds No Buyers For Russian Bonds Russian markets have become uninvestable and will remain so for some time (Chart 2). The elevated odds of further military escalation in Ukraine entails more downside in Russian financial assets. Additional sanctions on the Russian economy cannot be ruled out at this point. These sanctions as well as the capital controls imposed by Russia on both residents and non-residents make Russian financial markets uninvestable. We downgraded Russian stocks to underweight within an EM equity portfolio on December 17, 2021, arguing that geopolitical tensions surrounding Ukraine would escalate. Chart 3 suggests that Russian share prices in USD terms are about to break below their 2008 and 2015 lows. Technically speaking, if this transpires, it will entail considerable downside. Similarly, the ruble versus an equally-weighted basket of the US dollar and euro on a total return basis has formed a technically bearish head-and-shoulders configuration (Chart 4, top panel). Notably, the ruble’s real effective exchange rate based on both CPI and PPI is not as cheap as it was in 1998 and 2015 (Chart 4, bottom panel). Chart 4More Downside In The Ruble More Downside In The Ruble More Downside In The Ruble Chart 3Russian Stocks Are Breaking Below Their 2008 And 2015 Lows Russian Stocks Are Breaking Below Their 2008 And 2015 Lows Russian Stocks Are Breaking Below Their 2008 And 2015 Lows The sanctions have effectively cut off the largest Russian commercial banks1 from the SWIFT electronic system and frozen the central bank of Russia’s (CBR) foreign exchange reserves deposited at foreign institutions. As of June 2021, roughly US$ 377 billion out of US$ 585 billion of Russian foreign exchange reserves were held in Western commercial banks or institutions, most of it in liquid financial securities. Meanwhile, the rest were held either in gold physical holdings (US$ 127 billion) or at Chinese institutions (US$ 80 billion). If all western countries freeze the CRB’s assets held at their banks, Russia’s effective foreign exchange reserves will be down to US$ 207 billion. This assumes the amount of international reserves at western banks has not changed since June 2021. As a result, the ratio of the central bank’s foreign reserves-to-broad money supply (all household and corporate local currency deposits) has dropped from 0.9 to 0.6 (Chart 5). This suggests that the central bank’s available amount of foreign exchange reserves coverage of broad money supply has been reduced dramatically in recent days due to economic and financial sanctions. This and a massive flight of capital out of the country has led the authorities to impose capital controls. Also, the government is compelling domestic exporting firms to sell 80% of their foreign generated revenues. Will the West lift sanctions right after the war in Ukraine ends? We doubt it. In our view, Russia is embracing a long period of economic and financial isolation. Besides, Russia lacks the manufacturing capabilities needed to mitigate the effects of these sanctions. Chart 6 shows that Russia has been investing little outside resource sectors and real estate. At 8-8.5% of GDP, investment in non-resource sectors excluding properties has been too low for too long. Chart 5Russia: FX Reserves' Coverage Of Money Supply Russia: FX Reserves' Coverage Of Money Supply Russia: FX Reserves' Coverage Of Money Supply Chart 6Russia Has Not Been Investing Much Russia Has Not Been Investing Much Russia Has Not Been Investing Much   This entails that Russia cannot become self-sufficient in many manufacturing sectors and technology. Trade with China will be the main channel that Russia can secure the manufacturing goods, machinery and technology it requires. Still, this will not allow the Russian economy to avoid a prolonged period of stagflation. Bottom Line: Odds are high that Russian financial markets will remain uninvestable for an extended period. The Russia economy is facing years of stagflation. Central European Financial Markets: Contagion Or An Existential Threat? Chart 7Central European Currencies Will Depreciate Central European Currencies Will Depreciate Central European Currencies Will Depreciate Although Central European countries are not at risk from Russia’s military attack, their financial markets will remain jittery for a while. We are downgrading Polish, Czech and Hungarian equities, currencies and domestic bonds to underweight (Chart 7). The likelihood of strikes on Poland, the Baltic states or any other neighboring NATO member country is very low. Attacking a NATO member would trigger Article V of NATO and force the organization to defend its member. Importantly, we do not think the Kremlin has the appetite for war against NATO. Even though Russia is unlikely to stage an attack on any NATO member, there could still be threats from Moscow and escalation involving central European countries. This will be especially so if Putin fails to secure the change of government in Kyiv in the coming weeks and starts threatening the West due to the latter’s support of Ukraine. As a result, Central European financial markets will continue selling off further in response to this potential escalation. Bottom Line: We are downgrading Central European equities and local currency bonds to underweight within a respective EM universe. We are maintaining the long CZK / short HUF trade. As a new trade, we recommend shorting the Polish zloty versus the US dollar. Investment Recommendations Global share prices will continue selling off. Our US equity capitulation indicator has fallen significantly but is not yet at 2010, 2011, 2015-16 and 2018 levels (Chart 8). It will at least reach this level before the S&P 500 bottoms. Chart 8The S&P 500 Selloff Is Not Over The S&P 500 Selloff Is Not Over The S&P 500 Selloff Is Not Over Our capitulation indicator for EM stocks is not low yet either (Chart 9). Hence, there is more downside. Investors should continue to take a defensive stance. Chart 9EM Stocks: Is There A Capitulation Phase Still Ahead? EM Stocks: Is There A Capitulation Phase Still Ahead? EM Stocks: Is There A Capitulation Phase Still Ahead? Chart 10US Stocks Are About To Resume Their Relative Outperformance US Stocks Are About To Resume Their Relative Outperformance US Stocks Are About To Resume Their Relative Outperformance Within a global equity portfolio, investors should overweight the US, and underweight EM and Europe. As US/global bond yields drop due to geopolitical jitters, the US stock market and growth stocks will resume their outperformance, at least for a period of time (Chart 10). Within an EM equity portfolio, we recommend overweighting Brazil, Mexico, Chinese A-shares, Singapore and Korea and underweighting Russia, Central Europe, South Africa, Indonesia, Turkey, Peru, Chinese Investable Stocks, Colombia and Chile. EM currencies and fixed-income markets remain vulnerable as the global risk off move causes the US dollar to spike. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes 1     Following the invasion of Ukraine on February 26, the US administration added the two largest Russian banks, Sberbank and VTB Bank, to the sanction lists. Both banks combined total assets represent close to 40% of total Russian banking system assets. ​​​​​​

Executive Summary Hopes of an imminent peace deal between Russia and Ukraine will be dashed. The conflict will worsen over the coming days. As was the case during the original Cold War, both sides will eventually forge an understanding that allows the pursuit of mutually beneficial arrangements. A stabilization in geopolitical relations, coupled with fading pandemic headwinds, should keep global growth above trend this year, helping to support corporate earnings. The era of hyperglobalization is over. While central banks will temper their plans to raise rates in the near term, increased spending on defense and energy independence will lead to higher interest rates down the road. How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis Bottom Line: The near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected.   Dear Client, Given the rapidly evolving situation in Ukraine, we are sending you our thoughts earlier than normal this week. We will continue to update you as events warrant it. Best regards, Peter Berezin Chief Global Strategist   False Dawn In the lead-up to the invasion, Vladimir Putin assumed that Ukrainian forces would fold just as quickly as US-backed Afghan forces did last summer. He also presumed that the rest of the world would reluctantly accept Russia’s takeover of Ukraine. Both assumptions appear to have been proven wrong. Even if Putin succeeds in installing a puppet government in Kyiv, a protracted insurgency is sure to follow. In the initial days of the invasion, Russian troops generally tried to avoid harming civilians, partly in the hope that Ukrainians would see the Russian military as liberators. Now that this hope has been dashed, a more brutal offensive could unfold. This would trigger even more sanctions, leading to a wider gulf between Russia and the West. It is highly doubtful that sanctions will dissuade Putin from trying to subdue Ukraine. Putin made a name for himself by staging a successful invasion of Chechnya in 1999, just three years after the Yeltsin government had suffered a major defeat there. To withdraw from Ukraine now, without having fomented a regime change in Kyiv, would be a humiliating outcome for him. In this light, BCA’s geopolitical team, led by Matt Gertken, has argued that ongoing peace talks taking place on the border of Ukraine and Belarus are unlikely to amount to much. The situation will get worse before it gets better. Market Implications It always feels a bit crass writing about finance during times like this, but as investment strategists, it is our job to do so. With that in mind, we would make the following observations: Global equities are likely to suffer another leg down in the near term as hopes of an imminent peace deal fizzle. Consequently, we are downgrading our view on global stocks from overweight to neutral on a 3-month horizon. Nimble investors with a low risk tolerance should consider going underweight equities. We are shifting our stance on US stocks from underweight to neutral on a 3-month horizon. Europe could face significant pressures from near-term disruptions to Russian gas supplies. It does not make much sense for Russia to export gas if it is effectively barred from accessing the proceeds of its sales. Central and Eastern Europe will be particularly hard hit (Chart 1). Chart 1Central and Eastern Europe Would Suffer The Most From A Russian Energy Blockade A New Cold War A New Cold War For now, we are maintaining an overweight to stocks on a 12-month horizon. While it will take a month or two, both sides will ultimately forge an understanding whereby Russia and the West continue to publicly bad-mouth each other while still pursuing mutually beneficial arrangements. Remember that during the Cold War, the Soviet Union continued to sell oil to the West. Even the Cuban Missile Crisis had only a fleeting impact on equities (Chart 2). Chart 2How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis How Stocks Fared During The Cuban Missile Crisis Chart 3European Fiscal Policy Will Remain Structurally Looser Over The Coming Years A New Cold War A New Cold War Assuming that any reduction in Russian energy exports is temporary, oil prices will eventually recede. BCA’s commodities team, led by Bob Ryan, expects Brent to settle to $88/bbl by the end of 2022 (down from the current spot price of $101/bbl and close to the forward price of $87/bbl). Like oil, gold prices have upside in the near term but should edge lower once the dust settles.    Global growth should remain solidly above trend in 2022 as pandemic-related headwinds fade and fiscal policy turns more expansionary. Even before the Ukraine invasion, the structural primary budget deficit in Europe was set to swing from a small surplus to a deficit (Chart 3). The emerging new world order will lead to sizable additional military spending, as well as increased outlays towards achieving energy independence (new LNG terminals, more investment in renewables, and perhaps even some steps towards restarting nuclear power programs). China will also step up credit easing and fiscal stimulus. This will not only benefit the Chinese economy, but it will also provide some much-needed support to European exporters (Chart 4). While credit spreads are apt to widen further in the near term, corporate bonds should benefit from stronger growth later this year. US high-yield bonds are pricing in a jump in the default rate from 1.3% over the past 12 months to 4.2% over the coming year, which seems somewhat excessive (Chart 5).  Chart 4Chinese Policy Will Be A Tailwind For Growth Chinese Policy Will Be A Tailwind For Growth Chinese Policy Will Be A Tailwind For Growth Chart 5Credit Markets Are Pricing In An Excessive Default Rate Credit Markets Are Pricing In An Excessive Default Rate Credit Markets Are Pricing In An Excessive Default Rate Central banks will temper their plans to raise rates in the near term. Investors and speculators are net short duration at the moment, which could amplify any downward move in bond yields (Chart 6). However, over a multi-year horizon, recent events will lead to both higher inflation and interest rates. Larger budget deficits will sap global savings. The retreat from globalization will also put upward pressure on wages and prices. As defensive currencies, the US dollar and the Japanese yen will strengthen in the near term as the conflict in Ukraine escalates. Looking beyond the next few months, the dollar will weaken. On a purchasing power parity basis, the dollar is amongst the most expensive currencies (Chart 7). For example, relative to the euro, the dollar is 22% overvalued (Chart 8). The US trade deficit has doubled since the start of the pandemic, even as equity inflows have dipped (Chart 9). Speculators are long the greenback, which raises the risk of an eventual reversal in dollar sentiment. Chart 6Short Duration Is A Crowded Trade Short Duration Is A Crowded Trade Short Duration Is A Crowded Trade Chart 7The US Dollar Is Overvalued… A New Cold War A New Cold War   Chart 8...Especially Against The Euro A New Cold War A New Cold War The freezing of Russia’s foreign exchange reserves will encourage China to diversify away from US dollars towards hard assets such as land and infrastructure in economies where they are less likely to be seized. It will also encourage the Chinese authorities to bolster domestic demand and permit a further modest appreciation of the RMB since these two steps will reduce the current account surpluses that make foreign exchange accumulation necessary. EM currencies will benefit from this trend. Chart 9The Trade Deficit Is A Headwind For The Dollar The Trade Deficit Is A Headwind For The Dollar The Trade Deficit Is A Headwind For The Dollar In summary, the near-term outlook for risk assets has deteriorated. We are downgrading global equities from overweight to neutral on a tactical 3-month horizon. We continue to expect stocks to outperform bonds on a 12-month horizon as the global economic recovery gains momentum. On an even longer 2-to-5-year horizon, equities are likely to struggle as interest rates rise more than expected. Trade Update: We closed our long Brent oil trade for a gain of 24% last week. Earlier today, we were stopped out of the trade we initiated on September 16, 2021 going long the Russian ruble and the Brazilian real. The BRL leg was up 6.2% at the time of termination while the RUB leg was down 23.1% (based on the Bloomberg RUB/USD Carry Return Index as of 4pm EST today). Peter Berezin Chief Global Strategist peterb@bcaresearch.com View Matrix A New Cold War A New Cold War Special Trade Recommendations A New Cold War A New Cold War Current MacroQuant Model Scores A New Cold War A New Cold War

Executive Summary Stronger Capex Than Last Decade Fallout From Ukraine Fallout From Ukraine The fog of war continues, but the worst potential outcome for the market—a freeze of Russian energy exports to Europe—has been avoided. Energy inflation is reaching its apex. Markets will remain volatile in the near term as uncertainty remains elevated in the coming days. Moreover, a transition from a recovery driven by consumer durable goods to services remains a hurdle against near-term European outperformance. Italian bonds and European banks are attractive, but it is not yet prudent to plunge headfirst into the euro. The longer-term consequences of the conflicts point toward greater capex and public deficits in Europe. This will boost the neutral rate of interest and European yields. Industrials and defense stocks are also key structural beneficiaries. Bottom Line: Keep hedges in place for the near term, as uncertainty remains rife. Buy Italian bonds and European banks, which will benefit from ECB support. Industrials still face near-term hurdles but should be a structural overweight position in European equity portfolios, along with financials and defense stocks. Feature The situation in Ukraine is reaching a climax. Following Russia’s recognition of the breakaway Luhansk and Donetsk People’s Republics (LPR and DPR) and its invasion of Ukraine, the S&P 500 entered correction territory. Importantly, the Dow Jones Euro Stoxx 50 is now down 10% since its January 5th high, which validates our repeated call over the past four weeks to hedge risk asset portfolios by selling EUR/CHF and EUR/JPY. An international conflict has begun and a human tragedy is unfolding; but, at the time of writing, it looks like the worst-case scenario for markets will be avoided. Germany is folding Nord Stream 2 indeterminably and Western allies have imposed painful economic sanctions on Russia. However, an expulsion of the SWIFT payment system is not in the cards. This is crucial because it greatly limits the risk that Russia will stop sending natural gas and oil to the EU. Ultimately, neither Russia nor the EU wants this outcome, since it imposes an enormous loss of revenues on the former (which needs hard currency to finance its war) and guarantees a recession for the latter (Chart 1). The war will still cost Europe. European natural gas prices surged again on Thursday, rising by more than 60% intraday. While a spike above EUR200/MWh is unlikely in the absence of an oil embargo, 20% of European natural gas imports pass through Ukraine. The conflict suggests that these flows will remain disrupted for now and that natural gas prices will remain between EUR80/MWh and EUR100/MWh for the next few months. This translates into elevated energy and electricity costs for the EU (Chart 2). Chart 1A European Recession Averted Fallout From Ukraine Fallout From Ukraine Chart 2Peaking But Elevated Fallout From Ukraine Fallout From Ukraine Chart 3Ebbing Energy Inflation Fallout From Ukraine Fallout From Ukraine Oil markets are set to peak soon. The run-up in Brent prices in recent weeks was largely driven by geopolitical concerns. With the odds of an oil embargo declining, the pressure on Brent will also recede. Bob Ryan, BCA’s commodity and energy strategist, believes that Saudi Arabia, the UAE, and Kuwait will increase their own production in coming weeks to burnish their credentials as reliable oil producers, especially if oil experiences more turmoil.  Bob expects crude prices to drop to $85/bbl by the second half of 2022. These dynamics are important because they imply that European headline inflation will soon peak. Yes, the recent spike in natural gas prices will keep energy inflation higher for a few more months, but, ultimately, ebbing base effects will bring down energy CPI. As Chart 3 highlights, even if Brent and natural gas prices stay at today’s levels for the remainder of the year, their year-on-year inflation rates will collapse, which will drive HICP lower. Near-Term Market Dynamics In this context, what to do with European assets? It is probably still too early to abandon our hedges, but we will likely do so next week or soon after. While the market has probably bottomed, prudence remains of prime consideration as a war is taking place and the situation on the ground may deteriorate. Chart 4A Buying Opportunity Fallout From Ukraine Fallout From Ukraine The clearest near-term investment implication comes for European peripheral bonds. Italian spreads have widened significantly in the wake of the hawkish pivot by the ECB (Chart 4). However, we argued that, when interest rate expectations priced in 50bps of the hike for 2022, the move was excessive and that only one ECB hike in the fourth quarter was likely this year. Now that the Ukrainian crisis is reaching a climax, even some of the ECB’s most hawkish members, such as Robert Holzmann, Governor of the Austrian National Bank, indicate that the removal of liquidity will be slower than originally anticipated. This means that the ECB is likely to continue to backstop the European peripheral bond markets. Italian and Greek bonds, which offer spreads of 165bps and 249bps over German bunds, are appealing in light of this explicit backstop. European financials are another attractive buy. Investors should buy banks outright. As Chart 5 highlights, all the major Eurozone countries’ banking stocks have suffered widespread selloffs. However, the exposure to Russian debt is limited at $67 billion (Chart 6). Additionally, the European yield curve slope is unlikely to flatten significantly from here. The ECB will limit the upside in the German 2-year yields by not hiking until Q4 2022, while the terminal rate proxy in Europe has significant upside from here. A steeper yield curve will boost the appeal of banks, especially in a context in which peripheral spreads are likely to narrow. Chart 5Too Much Of A Dive Fallout From Ukraine Fallout From Ukraine Chart 6Limited Russian Exposure Fallout From Ukraine Fallout From Ukraine The outlook for the euro is more complex. Narrower peripheral spreads would boost the euro’s appeal, a cheap currency currently trading at a 17% discount to its PPP fair value. EUR/USD also trades at a 5% discount to the BCA Intermediate-Term Timing Model, which suggests that considerable bad news is already embedded in the exchange rate (Chart 7). The fact that the EUR/USD did not close below its January 27th low in the face of a major war on European soil adds to the notion that the euro already embeds a significant risk premium. However, there are still ample reasons to worry about additional volatility in the coming week or so. The ECB is sounding less hawkish, while the Fed is not changing its tone. Meanwhile, 1-month and 3-month risk reversals are not at levels consistent with a bearish capitulation, which suggests that the euro could suffer one last wave of liquidation (Chart 8). Thus, we are not buying the euro yet and are willing to forego the first few cents of gains for a clearer signal. Chart 7EUR/USD Is Cheap Fallout From Ukraine Fallout From Ukraine Chart 8Sentiment Could Get More Negative Fallout From Ukraine Fallout From Ukraine Circling back to the equity front, European equities had become very oversold after the 14-day RSI fell below 30. The diminishing risk of an energy crisis will also help. However, global equities face more risks than just Ukraine. As we wrote earlier this week, the transition away from consumer durable goods as the driver of global growth to services will involve some adjustments for stocks, especially in an environment in which the Fed is allowing global monetary conditions to deteriorate (Chart 9). Thus, the window of volatility in stocks is unlikely to close in the near term. The relative performance of European equities vis-a-vis the US is complex as well. European equities have undone most of the relative gains accrued so far in 2022 (Chart 10). On the one hand, the global growth transition will hurt European equities more than US ones, as a result of their greater exposure to manufacturing activity. Additionally, high energy costs are more of a problem for Europe right now than the US. On the other hand, the continued hawkishness of the Fed is likely to limit the ability of tech stocks to extend the rebound that began last Thursday. As a result, the most likely pattern is for some churning in the relative performance of Europe and the US in the coming week. Chart 10Vanishing Outperformance Fallout From Ukraine Fallout From Ukraine Chart 9Tightening US Liquidity Conditions Fallout From Ukraine Fallout From Ukraine For the remainder of the year, we expect the European equity outperformance to re-establish itself in view of the favorable relative profits picture for 2022, a topic that we will explore more deeply in the coming weeks. Bottom Line: The near-term outlook for European assets remains extremely murky. Not only is a war in Ukraine a major threat that can hurt sentiment further, but European assets still have to handle the short-term implications of a change in global growth leadership away from goods consumption. Nonetheless, the dovish message of the ECB in the wake of the Ukrainian invasion suggests that the collapse in Italian bonds and European banks in recent weeks is overdone. European stocks will likely continue to churn against US stocks in the near term but outperform for the remainder of the year. The sell-off in the euro is advanced, but prudence prevents us from buying EUR/USD today. Keep short EUR/CHF and short EUR/JPY hedges in place for now. Longer-Term Implications The crisis in Ukraine heightens Europe’s need to diversify its energy sourcing away from Russia. However, this is not a transition that can be executed on a dime. It will take years. For now, Europe remains dependent on Russian energy, which greatly limits the EU’s options. However, time offers many more possibilities. First, kicking Russia out of SWIFT will become feasible, because it will increase the robustness of the SPFS payment system, allowing Russia to receive funds for its energy, even if it is out of SWIFT. Second, and most importantly, time will allow Europe to find new energy sources. For example, Qatari LNG is often mentioned as a potential replacement for Russian natural gas. Qatar currently does not have the capacity to service Europe extensively, while fulfilling its previous contractual obligations, but the expansion of the production in its North Field East will increase capacity to 126MTPA by 2027. The LNG export capacity of the US may also increase over the coming years. Even if Qatar and the US could send enough LNG to satisfy the hole left by Russia tomorrow, Europe would not be able to accept delivery, as it does not have enough terminals to accommodate these shipments. Thus, investments in that sector will expand. Chart 11The Renewables Envelope Will Expand Fallout From Ukraine Fallout From Ukraine Chart 12Nuclear Skepticism Remains Fallout From Ukraine Fallout From Ukraine Most importantly, Europe will accelerate its transition toward renewable energy. Renewables are already a major focus of the NGEU program (Chart 11). However, we expect that, for the remainder of the decade, the NGEU program will be enlarged to allow greater investments in that space. Not only does it fit European green goals, but this policy would also increase the region energy security. More investment in nuclear electricity production is also possible but lacks popular support (Chart 12). The main message of these observations is that European infrastructure spending is likely to remain elevated in the coming years. As a result, industrial stocks may face some near-term headwinds as the global economy transitions away from the consumer goods-buying binge of COVID-19, but they will ultimately benefit greatly from an expansion of the capital stock around the world. Another long-term theme derived from the current crisis is that European defense stocks will fare well on a structural basis. The current crisis will force greater European unity. The presence of a common enemy will incentivize European nations to increase military spending, especially as the US continues to pivot toward Asia. Investors should overweight these stocks. In terms of bond market developments, more military spending and investment in energy infrastructures means that European budget deficits will be wider than if the Ukrainian crisis had not emerged. More accommodative fiscal policy will support aggregate demand, which will feed through greater capex (Chart 13). Thus, the experience of the last decade, whereby aggregate demand was curtailed by unnecessarily stringent European fiscal policy, will not be repeated. This confirms our expectation that the neutral rate of interest will rise in Europe and that Europe will escape an environment of zero rates (Chart 14). Therefore, German bunds yields have upside, the yield curve can steepen, and the outlook for European financials is positive on a long-term basis, not just on a near-term one. Chart 13Stronger Capex Than Last Decade... Fallout From Ukraine Fallout From Ukraine Chart 14...Means Higher Yields And A steeper Curve Fallout From Ukraine Fallout From Ukraine Chart 15Ebbing Fixed-Income Outflows? Fallout From Ukraine Fallout From Ukraine Finally, the picture for the euro is murky. On the one hand, its inexpensiveness is a major advantage while a higher neutral rate of interest will limit the European fixed-income outflows that have plagues the Euro for the past decade (Chart 15). However, if we are correct that European capex will increase and that budget deficits will remain wider than in the last decade, this also means that the European current account surplus will narrow as excess savings recede. This implies that one of the key underpinnings of the euro will dissipate. In the end, productivity will be the long-term arbiter of the exchange rate. Europe still lags behind the US on this front, which augurs poorly for the performance of the euro (Chart 16). Reforms and capex may save the day, but it is too early to make this call. Chart 16The Productivity Handicap Fallout From Ukraine Fallout From Ukraine ​​​​​​​ Bottom Line: The events in Ukraine portend a structural shift in European capex. Europe will need to ween itself off its Russian energy dependency, which will require major investments in LNG facilities and renewable power. Moreover, European defense spending will rise. These will continue to support fiscal and infrastructure spending. As a result, industrials will benefit from a structural tailwind, as will European defense stocks. These same forces will put upward pressure on European risk-free yields, which will benefit beleaguered European financials and banks. The long-term outlook for the euro is murkier. More research must be conducted before making a definitive directional bet.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations

Executive Summary Risk Premium Abates, But Does Not Disappear Oil Risk Premium Abates, But Still Remains Oil Risk Premium Abates, But Still Remains The risk premium in crude oil and natural gas prices is abating, and we expect that to continue. In the immediate aftermath of Russia's invasion, Brent crude oil traded close to $105/bbl on Thursday. At the urging of China's Xi Jinping, Russian President Vladimir Putin suggested he is prepared to enter negotiations with Ukraine in Minsk to discuss the latter's neutrality. Whether Ukraine is amenable to negotiations framed in this manner remains to be seen. Nothing has changed in supply-demand balances for oil or natgas. Markets are tight, and more supply is needed. In this highly fluid situation, we project Brent crude oil will average $100.00/bbl in 1Q22; $90.30/bbl in 2Q22; $85.00/bbl in 3Q22; and $85.00/bbl in 4Q22 (see Chart). Our estimate for 2023 Brent averages $85.00/bbl. Upside risk dominates in the near term. We expect the Kingdom of Saudi Arabia (KSA), the United Arab Emirates (UAE), and Kuwait, the only members of OPEC 2.0 with the capacity to increase and sustain higher production, to lift output by 1.75mm b/d. The Iran nuclear deal likely gets a boost from the Russian invasion, which will hasten the return of ~ 1.0mm b/d of production in 2H22, perhaps sooner. We also expect the US, and possibly the OECD, to release strategic petroleum reserves, but, as typically is the case, this will have a fleeting impact on markets and pricing. These supply increases will return prices closer to our base case forecast, which we raise slightly to $85/bbl from 2H22 to end-2023. If we fail to see an increase in core-OPEC production, or the US shales, or if Iranian barrels are not returned to export markets, oil prices have a good chance of moving to $140/bbl, as can be seen in the accompanying Chart. Bottom Line: We remain long commodity-index exposure (S&P GSCI and the COMT ETF), along with equity exposure to oil and gas producers via the XOP ETF.  

Executive Summary From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi The geopolitical “big picture” of Russia’s invasion of Ukraine is the deepening of the Russo-Chinese strategic partnership. While Russia’s economic and military constraints did not prohibit military action in Ukraine, they are still relevant. Most likely they will prevent a broader war with NATO or a total energy embargo of Europe. Still, volatility will persist in the near term as saber-rattling, aftershocks, and spillover incidents will occur this year.  Russo-Chinese relations are well grounded. Russia needs investment capital and resource sales, while China needs overland supply routes and supply security. Both seek to undermine the US in a new game of Great Power competition that will prevent global politics and globalization from normalizing. Tactically we remain defensive but buying opportunities are emerging. We maintain a cyclically constructive view. Favor equity markets of US allies and partners that are geopolitically secure. Trade Recommendation Inception Date Return Long Gold (Strategic) 2019-12-06 32.7% Bottom Line: Tactically investors should remain defensive but cyclically they should look favorably on cheap, geopolitically secure equity markets like those of Australia, Canada, and Mexico. Feature To understand the Russian invasion of Ukraine and the likely consequences, investors need to consider three factors: 1.  Why Russia’s constraints did not prohibit war and how constraints must always be measured against political will. 2.  Why Russia’s constraints will grow more relevant going forward, as the costs of occupation and sanctions take hold, the economy weakens, and sociopolitical pressures build. 3.  Why the struggle of the Great Powers will drive a Russo-Chinese alliance, whose competition with the US-led alliance will further destabilize global trade and investment. Russia’s Geopolitical Will Perhaps the gravest national security threat that Russia can face, according to Russian history, is a western military power based in the Ukraine. Time and again Russia has staged dramatic national efforts at great cost of blood and treasure to defeat western forces that try to encroach on this broad, flat road to Moscow. Putin has been in power for 22 years and his national strategy is well-defined: he aims to resurrect Russian primacy within the former Soviet Union, carve out a regional sphere of influence, and reduce American military threats in Russia’s periphery. He has long aimed to prevent Ukraine from becoming a western defense partner. Chart 1Russia Structured For Conflict From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi While Moscow faced material limitations to military action in Ukraine, these were not prohibitive, as we have argued. Consider the following constraints and their mitigating factors: Costs of war: The first mistake lay in assuming that Russia was not willing to engage in war. Russia had already invaded Ukraine in 2014 and before that Georgia in 2008. The modern Russian economy is structured for conflict: it is heavily militarized (Chart 1). Military spending accounts for 4.3% of GDP, comparable to the United States, also known for waging gratuitous wars and preemptive invasions. Financial burdens: The second mistake was to think that Moscow would avoid conflict for fear of the collapse of the ruble or financial markets. Since Putin rose to power in 2000, the ruble has depreciated by 48% against the dollar and the benchmark stock index has fallen by 57% against EMs. Each new crackdown on domestic or foreign enemies has led to a new round of depreciation and yet Putin remains undeterred from his long-term strategy (Chart 2). Chart 2Putin Doesn't Eschew Conflict For Sake Of Ruble Or Stocks Putin Doesn't Eschew Conflict For Sake Of Ruble Or Stocks Putin Doesn't Eschew Conflict For Sake Of Ruble Or Stocks Economic health: Putin’s foreign policy is not constrained by the desire to make the Russian economy more open, complex, advanced, or productive. While China long practiced a foreign policy of lying low, so as to focus on generating wealth that could later be converted into strategic power (which it is doing now), Russia pursued a hawkish foreign policy for the past twenty years despite the blowback on the economy. Russia is still an undiversified petro-state and total factor productivity is approaching zero (Chart 3). Chart 3Putin Doesn't Eschew Conflict For Sake Of Productivity Putin Doesn't Eschew Conflict For Sake Of Productivity Putin Doesn't Eschew Conflict For Sake Of Productivity ​​​​​​ Chart 4Putin Doesn’t Eschew Conflict For Fear Of Sanctions From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi ​​​​​​ Western sanctions: Western sanctions never provided a powerful argument against Russian intervention into Ukraine. Russia knew all along that if it invaded Ukraine, the West would impose a new round of sanctions, as it has done periodically since 2014. The 2014 oil crash had a much greater impact on Russia than the sanctions. Of course, Russia’s overall economic competitiveness is suffering, although it is capable of gaining market share in exporting raw materials, especially as it depreciates its currency (Chart 4). Chart 5Putin Doesn't Eschew Conflict For Sake Of Popular Opinion Putin Doesn't Eschew Conflict For Sake Of Popular Opinion Putin Doesn't Eschew Conflict For Sake Of Popular Opinion Public opinion: Surely the average Russian is not interested in Ukraine and hence Putin lacks popular support for a new war? True. But Putin has a strong record of using foreign military adventures as a means of propping up domestic support. Of course, opinion polls, which confirm this pattern, are manipulated and massaged (Chart 5). Nevertheless Russians like all people are highly likely to side with their own country in a military confrontation with foreign countries, at least in the short run. Over the long haul, the public will come to rue the war. Moscow believes that it can manage the domestic fallout when that time comes because it has done so since 2014. We doubt it but that is a question for a later time. Investors also need to consider Putin’s position if he did not stage ever-escalating confrontations with the West. Russia is an autocracy with a weak economy – it cannot win over the hearts and minds of its neighboring nations in a fair, voluntary competition with the West, the EU, and NATO. Russia’s neighbors are made up of formerly repressed Soviet ethnic minorities who now have a chance at national self-determination. But to secure their nationhood, they need economic and military support, and if they receive that support, then they inherently threaten Russia and help the US keep Russia strategically contained. Russia traditionally fights against this risk. Bottom Line: Investors and the media focused on the obstacles to Russian military intervention without analyzing whether there was sufficient political will to surmount the hurdles. Constraints Eroded None of the above suggests that Putin can do whatever he wants. Economic and military constraints are significant. However, constraints erode over time – and they may not be effective when needed. Europe did not promise to cancel all energy trade if Russia invaded: Exports make up 27% of Russian GDP, and 51% of exports go to advanced economies, especially European. Russia is less exposed to trade than the EU but more exposed than the US or even China (Chart 6). However, Russia trades in essential goods, natural resources, and the Europeans cannot afford to cut off their own energy supply. When Russia first invaded Ukraine in 2014, the Germans responded by building the Nord Stream pipeline, basically increasing energy cooperation. Russia concluded that Europeans, not bound to defend Ukraine by any treaty, would continue to import energy in the event of a conflict limited to Ukraine. Chart 6Putin Limits Conflict For Sake Of EU Energy Trade From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi ​​​​​​ Chart 7Putin Limits Conflict For Sake Of Chinese Trade From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi ​​​​​​ Russia substitutes China for Europe: As trade with the West declines, Russia is shifting toward the Far East, especially China (Chart 7). China is unlikely to reduce any trade and investment for the sake of Ukraine – it desperately needs the resources and the import-security that strong relations with Russia can provide. It cannot replace Europe – but Russia does not expect to lose the European energy trade entirely. (Over time, of course, the EU/China shift to renewables will undermine Russia’s economy and capabilities.) Ukraine is right next door: Aside from active military personnel, the US advantage over Iraq in 2002-03 was greater than the Russian advantage over Ukraine in 2022 (Chart 8). And yet the US got sucked into a quagmire and ultimately suffered political unrest at home. However, Ukraine is not Afghanistan or Iraq. Russia wagers that it can seize strategic territory, including Kiev, without paying the full price that the Soviets paid in Afghanistan and the US paid in Afghanistan and Iraq. This is a very risky gamble. But the point is that the bar to invading Ukraine was lower than that of other recent invasions – it is not on the opposite side of the world. ​​​​​​​Chart 8Putin Limits Conflict For Fear Of Military Overreach From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi Chart 9Putin Limits Conflict For Fear Of Military Weakness From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi NATO faces mutually assured destruction: NATO’s conventional military weight far surpasses Russia’s. For example, Russia, with its Eurasian Union, does not have enough air superiority to engage in offensive initiatives against Europe, even assuming that the United States is not involved. Even if we assume that China joins Russia in a full-fledged military alliance under the Shanghai Cooperation Organization (SCO), NATO’s military budget is more than twice as large (Chart 9). However, this military constraint is not operable in the case of Ukraine, which is not a NATO member. Indeed, Russia’s aggression toward Ukraine stems from its fear that Ukraine will become a real or de facto member of NATO. It is the fear of NATO that prompted Russia to attack rather than deterring it, precisely because Ukraine was not a member but wanted to join. Bottom Line: Russia’s constraints did not prohibit military action because several of them had eroded over time. NATO was so threatening as to provoke rather than deter military action. Going forward, Russia’s economic and military constraints will prevent it from expanding the war beyond Ukraine.  Isn’t Russia Overreaching? Yes, Russia is overreaching – the military balances highlighted in Charts 8 and 9 above should make that plain. The Ukrainian insurgency will be fierce and Russia will pay steep costs in occupation and economic sanctions. These will vitiate the economy and popular support for Putin’s regime over the long run. Chart 10The West Is Politically Divided And Vulnerable From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi The West is also vulnerable, however, which has given rise to a fiscal and commodity cycle that helps to explain why Putin staged his risky invasion at this juncture in time: The US and West are politically divided. Western elites see themselves as surrounded by radical parties that threaten to throw them out and overturn the entire political establishment. Their tenuous grip on power is clear from the thin majorities they hold in their legislatures (Chart 10). Nowhere is this clearer than in the United States, where Democrats cannot spare a single seat in the Senate, five in the House of Representatives, in this fall’s midterm elections, yet are facing much bigger losses. Russia believes that its hawkish foreign policy can keep the democracies divided.​​​​​​​ Elites are turning to populist spending: Governments have adopted liberal fiscal policies in the wake of the global financial crisis and the pandemic. They are trying to grow their way out of populist unrest, debt, and various strategic challenges, from supply chains to cyber security to research and development (Chart 11). China is also part of this process, despite its mixed economic policies. The result is greater demand for commodities, which benefits Russia.    Elites are turning to climate change to justify public spending: Governments, particularly in Europe and China, are using fears of climate change to increase their political legitimacy and launch a new government “moonshot” that justifies more robust public investment and pump-priming. The long-term trend toward renewable energy is fundamentally threatening to Russia, although in the short term it makes Russian natural gas and metals all the more necessary. Germany especially envisions natural gas as the fossil-fuel bridge to a green future as it has turned against both nuclear power and coal (Chart 12). Russian aggression will provoke a rethink in some countries but Germany, as a manufacturing economy, is unlikely to abandon its goals for green industrial innovation. Chart 11Politically Vulnerable States Need Fiscal Stimulus Politically Vulnerable States Need Fiscal Stimulus Politically Vulnerable States Need Fiscal Stimulus ​​​​​​ Chart 12The West Reluctant To Abandon Climate Goals From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi ​​​​​​ Proactive fiscal and climate policy motivate new capex and commodity cycle: The West’s attempt to revive big government and strategic spending will require vast resource inputs – resources that Russia can sell at higher prices. The new commodity cycle gives Russia maximum leverage over Europe, especially Germany, at this point in time (Chart 13). Later, as inflation and fiscal fatigue halt this cycle, Russia will lose leverage. Chart 13Commodity Cycle Gives Russia Advantage (For Now) Commodity Cycle Gives Russia Advantage (For Now) Commodity Cycle Gives Russia Advantage (For Now) Meanwhile Russia’s economic and hence strategic power will subside over time. Russia’s potential GDP growth has fallen since the Great Recession as productivity growth slows and the labor force shrinks (Chart 14). Chart 14Future Will Not Yield Strategic Opportunities For Russia Future Will Not Yield Strategic Opportunities For Russia Future Will Not Yield Strategic Opportunities For Russia ​​​​​​ Chart 15Younger Russians Not Calling The Shots (But Will Someday) From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi In short, the Kremlin has chosen the path of economic austerity and military aggression as a means of maintaining political legitimacy and achieving national security objectives. Western divisions, de-carbonization, the commodity cycle, and Russia’s bleak economic outlook indicated that 2022 was the opportunity to achieve a pressing national security objective, rather than some future date when Russia will be less capable relative to its opponents. In the worst-case scenario – not our base case – the invasion of Ukraine will trigger an escalation of European sanctions that will lead to Russia cutting off Europe’s energy and producing a global energy price shock. And yet that outcome would upset US and European politics in Russia’s favor, while Putin would maintain absolute control at home in a society that is already used to economic austerity and that benefits from high commodity prices. Note that Putin’s strategy will not last forever. Ukraine will mark another case of Russian strategic overreach that will generate a social and political backlash in coming years. While Putin has sufficient support among older, more Soviet-minded Russians for his Ukraine adventure, he lacks support among the younger and middle-aged cohorts who will have to live with the negative economic consequences (Chart 15). The entire former Soviet Union is vulnerable to social unrest and revolution in the coming decade and Russia is no exception. The Russo-Chinese Geopolitical Realignment Chart 16From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi From Nixon-Mao To Putin-Xi From a broader, geopolitical point of view, Russia’s invasion of Ukraine drives another nail into the coffin of the post-Cold War system and hyper-globalization. Russia is further divorcing itself from the western economy, with even the linchpin European energy trade falling victim to renewables and diversification. The US and its allies are imposing export controls on critical technologies such as semiconductors against Russia to cripple any attempts at modernization. The US is already restricting China’s access to semiconductors and from now on is locked into a campaign to try to enforce these export controls via secondary sanctions, giving rise to proxy battles in countries that Russia and China use to circumvent the sanctions. Russia will be forced to link its austere, militarized, resource-driven economy to the Chinese economy. Hence a major new geopolitical realignment is taking place between the US, Russia, and China, on the order of previous realignments since World War II. When the Sino-Soviet communist bloc first arose it threatened to overwhelm the US in economic heft and dominate Eurasia. This communist threat drove the US to undertake vast expeditionary wars, such as in South Korea and Vietnam. These were too costly, so the US sought economic engagement with China in 1972, which isolated the Soviet Union and ultimately helped bring about its demise. Yet China’s economic boom predictably translated into a strategic rise that began to threaten US preeminence, especially since the Great Recession. Today Russia and China have no option other than to cooperate in the face of the US’s increasingly frantic attempts to preserve its global status – and China’s economic growth and technological potential makes this alliance formidable (Chart 16). In short, the last vestiges of the “Nixon-Mao” moment are fading and the “Putin-Xi” alignment is already well-established. Russia cannot accept vassalage to China but it can make many compromises for the sake of strategic security. Their economies are much more complimentary today than they were at the time of the Sino-Soviet split. And Russia’s austere economy will not collapse as long as it retains some energy trade with Europe throughout the pivot to China. In turn the US will attempt to exploit Russian and Chinese regional aggression as a basis for a revitalization of its alliances. But Europe will dampen US enthusiasm by preserving economic engagement with Russia and China. The EU is increasingly an independent geopolitical actor and a neutral one at that. This environment of multipolarity – or Great Power Struggle – will define the coming decades. It will ensure not only periodic shocks, like the Ukraine war, but also a steady undercurrent of growing government involvement in the global economy in pursuit of supply security, energy security, and national security. Competition for security is not stabilizing but destabilizing. Hyper-globalization has given way to hypo-globalization, as regional geopolitical blocs take the place of what once promised to be a highly efficient and thoroughly interconnected global economy. Investment Takeaways Tactically, Geopolitical Strategy believes it is too soon to go long emerging markets. Russia is at war, China is reverting to autocracy, and Brazil is still on the path to debt crisis. Multiples have compressed sharply but the bad news is not fully priced (Chart 17). The dollar is likely to be resilient as the Fed hikes rates and a major European war rages. Europe’s geopolitical and energy insecurity will weigh on investment appetite and corporate earnings. American equities are likely to outperform in the short run. Chart 17Investors Should Not Bet On Russian And European Equities In This Context Investors Should Not Bet On Russian And European Equities In This Context Investors Should Not Bet On Russian And European Equities In This Context ​​​​​ Chart 18Investors Find Value, Minimize Risk In Geopolitically Secure Equity Markets Investors Find Value, Minimize Risk In Geopolitically Secure Equity Markets Investors Find Value, Minimize Risk In Geopolitically Secure Equity Markets ​​​​​​ Cyclically, global equities outside the US, and pro-cyclical assets offer better value, as long as the war in Ukraine remains contained, a Europe-wide energy shock is averted, and China’s policy easing secures its economic recovery. While European equities will snap back, Europe still faces structural challenges and eastern European emerging markets face a permanent increase in geopolitical risk due to Russian geopolitical decline and aggression. Investors should seek markets that are both cheap and geopolitically secure – namely Australia, Canada, and Mexico (Chart 18). We are also bullish on India over the long run.    Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Executive Summary EU-Russia Energy Trade To Persist Russia Takes Ukraine: What Next? Russia Takes Ukraine: What Next? Russia invaded Ukraine to prevent it from becoming a defense partner of the US and its allies. It is not likely to attack NATO members, which share a mutual defense treaty, so the war is limited in scope. Spillovers can occur but the US and Russia have 73 years of experience avoiding direct war. The US and EU will levy sweeping sanctions but they will not halt Russian energy exports, as that would cause a recession in Europe. European political leaders would likely fall from power in the coming years if there were a full-scale energy crisis. European nations will leverage Russian aggression to strengthen their popular support at home, while diversifying away from Russian energy over the long run. Europe will impose tough sanctions on Russia’s non-energy sectors, including finance and technology, to hobble the regime. China will consolidate power at home and strengthen ties with Russia but a war over Taiwan is a medium-to-long term risk.   Bottom Line: Investors should be cautious over the very near term but should prepare to buy the dip of a geopolitical incident that is generally limited to Ukraine and the Black Sea area. Supply responses from oil producers will remove the risk premium from oil prices and send the price of Brent crude to $85 per barrel by the end of the year. EU-Russia energy flows are the key risk to monitor. Feature Russia launched an invasion of Ukraine on February 24. The invasion was not limited to the far eastern corner of the country but involved attacks in the capital Kiev and in the far west and the coastline. Hence investors should proceed on the assumption that Russia will invade all of Ukraine even if it ends up limiting its invasion, as we expect (Map 1). Map 1Russian Invasion Of Ukraine 2022 Russia Takes Ukraine: What Next? Russia Takes Ukraine: What Next? It is critical for investors to understand the cause of the war in order to gauge its scope and adjust their risk appetite accordingly. Consider: Ukraine does not have mutual defense treaties that automatically trigger a broader war. Russia is attacking Ukraine to prevent it from becoming a defense partner of the US and its allies. Russia does not have the military capacity to attack the North Atlantic Treaty Organization (NATO) members, which have a mutual defense pact. Russia is attacking Ukraine because it does not have a mutual defense pact but was seeking one. Russia aims to neutralize Ukraine. If Moscow sacks Kiev and sets up a puppet state, then Ukraine will not seek western defense cooperation for the foreseeable future. If Russia conquers key territories to strengthen its control over Ukraine, then future Ukrainian governments will limit relations with the West for fear of Russian absorption. Russia is likely to seize coastal territory to ensure the long-term ability to blockade Ukraine. Russia will not withdraw troops until it has changed the government and seized key territories. Russia and NATO have no interest in war with each other. In the immediate fog of war, global financial markets will experience uncertainty about whether fighting will expand into a broader war between Russia and NATO. Such an expansion is unlikely because of mutually assured destruction (MAD) due to nuclear weapons. The US and Europe have already pledged that they will not send troops to fight in Ukraine. They will send troops and arms to support neighboring NATO states in central Europe, such as the Baltic states, Poland, Slovakia, Hungary, and others. This will serve as a deterrent to Russia to keep its operations limited. Spillover incidents can and will occur, such as with Malaysian Airlines Flight 17 in 2014, but the US and Russia have 73 years of experience avoiding direct war, including when Russia invaded Hungary in 1956, Czechoslovakia in 1968, and Afghanistan in 1979. The US and EU will levy sweeping sanctions but the EU will not halt Russian energy exports. When Russia first invaded Ukraine and seized territory in 2014, Germany responded by working with Russia to build the Nord Stream II pipeline so as to import energy directly from Russia and circumvent Ukraine. This historical fact over the past eight years reveals Germany’s true interests. Thus energy cooperation increased as a result of Russian aggression. Of course, Germany has suspended the certification of that pipeline in light of today’s invasion, but it was not yet operating, so energy flows are not impeded, and it still physically exists for future operation when Germany finds it politically expedient. Hungary, Italy, Finland, the Czech Republic and others will also need to keep up Russian energy flows. Chart 1EU-Russia Energy Trade To Persist Russia Takes Ukraine: What Next? Russia Takes Ukraine: What Next? Nevertheless, a cessation of energy flows is still the most important risk for investors to monitor, whether triggered by European boycott or Russian embargo. That would cause a recession in Europe. Recession would cause European political leaders to fall from power in the coming years, which explains why they will not pursue that objective in face of Russian aggression. Even the US is vulnerable to a global price shock (during a midterm election year) and hence will allow the EU to keep importing Russian energy, whatever its sanctions package may contain. True, Russia may cut off natural gas flows via Ukraine, which account for nearly 20% of Europe’s imports (Chart 1). Moreover, Europe may threaten or claim that they will sanction the energy sector. But most flows will likely continue. Europe will diversify away from Russian energy over the long run. Instead of cutting off their own vital energy supplies, European nations will leverage Russian aggression to strengthen their popular support at home, while initiating emergency state-led efforts to diversify away from Russian energy over the long run through renewables and imports from the US and its allies. This will be advantageous to European democracies that were already struggling to increase political legitimacy amid nascent populism – they will now have a crusade with which to rally their people and maintain fiscal support for their economy: energy security. Europe will sanction Russia’s non-energy sector. Europe will impose tough sanctions on Russia’s non-energy sectors, including finance and technology, to hobble the regime. Russia will eventually be cut off from the SWIFT banking communications network, since it already has a rudimentary alternative that it developed in recent years, but Germany will not agree to cut it off until the payment alternate to continue energy flows can be arranged, which is ultimately possible. China will take advantage of the moment but is probably not ready to invade Taiwan. China could seize the opportunity to consolidate power at home and it may increase pressure on Taiwan through rhetoric, sanctions, or cyber-attacks, but it is not likely to invade Taiwan. An amphibious invasion of the globally critical territory of Taiwan is far riskier for China than a land invasion of the non-critical territory of Ukraine is for Russia. Russia’s strategic calculations and timing are separate from China’s, despite their growing de facto alliance. But a war in the Taiwan Strait is at risk over the long run, as the situation is geopolitically unsustainable, for reasons similar to that of Ukraine. The situation in Ukraine is likely to get worse before it gets better, implying that investors should expect further volatility in risk assets in the near term. Structurally, the shift to a less geopolitically stable multipolar world will favor defense and cybersecurity stocks. “Great Power Struggle” is our top geopolitical investment theme over the long run and Russia’s invasion of Ukraine highlights its continuing relevance. Bottom Line: A buying opportunity for heavily discounted, pro-cyclical or high-beta assets is emerging rapidly, given our assessment, and we will monitor events over the coming weeks to identify when such a shift is prudent. A wholesale energy cutoff to Europe is the chief risk, as it would justify downgrading global equities relative to long-maturity bonds on a six-to-12 month horizon. Investment Takeaways Global Investment Strategy: With real rates coming down, owning gold remains an attractive hedge. As a fairly cheap and defensive currency, a long yen position is advisable. Assuming the conflict remains contained to Ukraine, equities and other risk assets should recover over the remainder of the year. The geopolitical premium in oil prices should also come down. Consistent with our Commodity & Energy Strategy views, our Global Investment Strategy service is closing its long Brent trade recommendation today for a gain of 24.0%. Commodities & Energy Strategy: While oil exports from Russia are not expected to diminish as a result of the invasion, it will prompt increased production from core OPEC producers – Saudi Arabia, the UAE, and Kuwait – to take the elevated risk premium out of Brent crude oil prices and allow refiners to rebuild inventories. The US and Iran may rejoin the 2015 nuclear deal, which would add about 1.0mm b/d of production to the market – Russia’s 2014 invasion of Crimea did not prevent the original nuclear deal. These production increases would take prices from the current $105 per barrel level to $85 per barrel by the second half of 2022 and keep it there throughout 2023, according to our base case view. This change marks an increase on our earlier expectation of an average $79.75 per barrel in 2023 in our previous forecast. European Investment Strategy: European equities are likely to continue to underperform in the near-term. Even if Russia and Europe avoid a full embargo of Russian energy shipments to the West, the disruption caused by a rupture of natural gas flows via Ukraine will keep European gas prices at elevated levels. Additionally, investors will continue to handicap the needed risk premia to compensate for the low but real threat of an energy crisis, which would prove particularly debilitating for Hungary, Poland, Germany, Czechia and Italy (Chart 2). Moreover, European equities sport a strong value and cyclical profile with significant overweight positions in financial and industrial equities. Industrials will suffer from higher input costs. European financials will suffer from a decline in yields as hawks in the European Central Bank are already softening their rhetoric on the need to tighten policy. However, due to the likely temporary nature of the dislocation, we do not recommend selling Europe outright and instead will stick with our current hedges, such as selling EUR/JPY and EUR/CHF. The evolution of the military situation on the ground will warrant a re-valuation of this hedging strategy next week. The euro will soon become a buy. Chart 2EU Economy Highly Vulnerable To Any Large Energy Cutoff Risk Premium Will Fade From Oil Price Risk Premium Will Fade From Oil Price Foreign Exchange Strategy: The Ukraine crisis will lead to a period of strength for the US dollar (DXY). Countries requiring foreign capital will be most at risk from an escalation in tensions. We still suspect the DXY will peak near 98-100, but volatility will swamp fundamental biases. Geopolitical Strategy: On a strategic basis, stick with our long trades in gold, arms manufacturers, UK equities relative to EU equities, and the Japanese yen. On a tactical basis, stick with long defensive sectors, large caps, Japanese equities relative to German, and Mexican equities relative to emerging markets. We will revisit these trades next week, after the European energy question becomes clearer, to determine whether to book profits on our bearish tactical trades.   – The BCA Research Team  

Executive Summary Russian Invasion Scenarios And Likely Equity Impact Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree The Ukraine crisis is escalating as predicted. We maintain our odds: 65% limited incursion, 10% full-scale invasion, 25% diplomatic de-escalation. Russia says it will take “military-technical” measures as its demands remain unmet, while the US says an invasion is imminent. Fighting has picked up in the Donbas region. Our Ukraine decision tree highlights that the key to a last-minute diplomatic resolution is a western renunciation of defense cooperation with Ukraine after a verified Russian troop withdrawal. The opposite is occurring as we go to press. Stay long gold, defensives over cyclicals, and large caps over small caps. Stay long cyber security stocks and aerospace/defense stocks relative to the broad market. Trade Recommendation Inception Date Return LONG GOLD (STRATEGIC) 2019-12-06 27.6% Bottom Line: Our 75% subjective odds of a partial Russian re-invasion of Ukraine appear to be materializing. At the same time, we are not as optimistic about an imminent solution to the US-Iran nuclear problem. A near-term energy price spike is negative for global growth so we recommend sticking with our defensive tactical trades. Feature Chart 1Ukraine: Don't Be Complacent Ukraine: Don't Be Complacent Ukraine: Don't Be Complacent Fears about a heightened war in Ukraine fell back briefly this week before redoubling. Russian President Vladimir Putin showed a willingness to pursue diplomacy but then western officials refuted Russian claims that it was reducing troops around Ukraine. US President Biden said Russia is highly likely to invade Ukraine in the next few days. The Russian foreign ministry sent a letter reiterating Russia’s earlier threat that it will take unspecified “military-technical” actions given that its chief demands have not been met by the United States. A worsening security outlook as we go to press will push the dollar up against the euro, the euro up against the ruble, will lead to global equities falling (with US not falling as much as ex-US), and global bond yields falling (Chart 1). To assess the situation we need to weigh the signs of escalation against those of de-escalation. What were the signs of de-escalation? First, the Russian Defense Ministry claimed it is reducing troop levels near Ukraine, although NATO and the western powers have not verified any drawdown. An unspecified number of troops were said to return to their barracks in the Western and Southern Military Regions, according to Russian Defense Ministry spokesman General Igor Konashenkov. A video showed military units and hardware pulling back from Crimea. Officials claimed all troops would leave Belarus after military drills ended on February 20.1 Second, the Kremlin signaled that diplomacy has not been exhausted. In a video released to the public, Putin met with Foreign Minister Sergei Lavrov. He asked whether there was still a chance “to reach an agreement with our partners on key issues that cause our concern?” Lavrov replied, “there is always a chance.” Putin replied, “Okay.” Then, after speaking with German Chancellor Olaf Scholz in Moscow, Putin said: "We are ready to work further together. We are ready to go down the negotiations track.”2 Third, the Ukrainians are supposedly restarting efforts to implement the 2015 Russia-imposed ceasefire, under pressure from Germany and France. Ukraine’s ruling party is expected to introduce three bills to the Rada (parliament) that would result in implementing the terms of the Russian-imposed 2015 ceasefire, the so-called Minsk II Protocols. Ukraine is supposed to change its constitution to adopt a more federal system that grants autonomy to the two Russian separatist regions in the Donbas, Donetsk and Luhansk. Ukraine is also supposed to hold elections.3 The caveats to these three points are already clear: The US said Russia actually added 7,000 troops to the buildup on the Ukrainian border. Without Russia’s reducing troops, the US and its allies cannot offer major concessions. The US cannot allow itself to be blackmailed as that would encourage future hostage-taking and blackmail. Putin’s offer of talks is apparently separate from its “military-technical” response to the West’s failure to meet its three core demands on NATO. Russia’s three core demands are no further NATO enlargement, no intermediate-range missiles within threatening range, and withdrawal of NATO forces from eastern Europe to pre-1997 status. Putin reiterated that these three demands are inseparable from any negotiation and that Russia will not engage endlessly without resolution. Yet the West has consistently rejected these demands. Then came the Foreign Ministry statement pledging Russia’s military-technical response. So talks that focus on other issues – like missile defense and military transparency – are a sideshow. Ukraine is reiterating its desire to join NATO and will struggle to implement the Minsk Protocol. The Minsk format is not popular in Ukraine as it grants influence and recognition to the breakaway ethnic Russian regions. Ostensibly President Volodymyr Zelenskiy has sufficient strength in the Rada to change the constitution, given the possibility of assistance from opposition parties that oppose war or favor Russia. But passage or implementation could fail. The Russian Duma has also advised Putin to recognize the Donetsk and Luhansk People’s Republics as independent countries, which Putin is not yet ready to do, but could do if Ukraine balks, and would nullify the Minsk format.4 Of Russia’s three core demands, investors should bear in mind the following points: Ukraine is never going to join NATO. One of the thirty NATO members will veto its membership to prevent war with Russia. Therefore Russia is either making this demand knowing it will fail to justify military action, or driving at something else, such as NATO defense cooperation with Ukraine. Even if NATO membership is practically unrealistic, the US and NATO are providing Ukraine with arms and training, making it a de facto member. The quality and quantity of western defense cooperation is not sufficient to threaten Russia’s military balance so far but it could grow over time and Russia is insisting that it stop. While there is also a broader negotiation over Europe’s entire security system, immediate progress depends on whether the US and its allies stop trying to turn Ukraine into a de facto NATO ally. NATO is not going to sacrifice all of the strategic, territorial, and military-logistical gains it has made since 1997. Especially not when Russia is attempting to achieve such a dramatic pullback by military blackmail. But NATO could reduce some of the most threatening aspects of its stance if Russia reciprocates and there is more military transparency. Similarly, the US and Russia have a track record of negotiating missile defense deals so this kind of agreement is possible over time. The problem, again, hinges on whether agreement can be found over Ukraine. The opposite looks to be the case. Based on the above points, Diagram 1 provides a “Decision Tree” that outlines the various courses of action, our subjective probabilities, and the sum of the conditional probabilities for each final scenario. Diagram 1Russia-Ukraine Decision Tree, February 9, 2022 Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree We start with the view that there is a 55% chance that the status quo continues: the West will not rule out Ukraine’s right to join NATO and will not halt defense cooperation. If this is true, then the new round of talks will fail because Russia’s core security interests will not be met. However, we also give a 25% chance to the scenario in which Ukraine is effectively barred from NATO but not defense cooperation. This may be the emerging scenario, given Chancellor Scholz’s point that Ukrainian NATO membership is not on the agenda and the White House’s claim that it will not pressure states to join NATO. Basically, western leaders could provide informal assurances that Ukraine will never join. But then the matter of defense cooperation must be resolved in the next round of talks. Given that the US and others have increased arms transfers to Ukraine in recent months and years (with US providing lethal arms for the first time in 2018), it seems more likely (60/40) that they will continue with arms transfers. After all, if they halt arms, Russia can invade anyway, but Ukraine will have less ability to resist. We allot a 15% chance to a scenario in which the US and its allies halt defense cooperation, even if they officially maintain NATO’s “open door” policy. If the Russians withdraw troops in this scenario, then a lasting reduction of tensions will occur. Again, while allied defense cooperation has been limited so far, it is up to Russia whether it poses a long-term threat. Finally, we give a 5% chance that the US and NATO will bar Ukraine from membership and halt defense cooperation. This path would mark a total capitulation to Russia’s demands. So far the allies have done nothing like this. They have insisted on NATO’s open door policy and have continued to transfer arms. No one should be surprised that tensions are escalating. De-escalation could still conceivably occur if Russia verifiably withdraws troops, if Ukraine moves to implement the Minsk II protocol, and if the US and its allies pledge to halt defense cooperation with Ukraine. The first step is for Russia to reduce troops, since that enables the US and allies to make major concessions when they are not under duress. If the US and NATO guarantee they will halt defense cooperation, given that Ukraine is practically unlikely to join NATO, then Russia may not be as concerned with Ukraine’s implementation of Minsk. As we go to press, none of these conditions are falling into place. The security situation is deteriorating rapidly. Bottom Line: Russia is likely to stage a limited military intervention into Ukraine (75%). The odds of a diplomatic resolution at the last minute are the same (25%). A full-scale invasion of all of Ukraine remains unlikely (10%). Market Reaction To Re-Escalation Chart 2 highlights the global equity market response to the Russian invasion of Crimea in 2014, which should serve as the baseline for assessing the market reaction to any renewed attack today. Stocks fell and moved sideways relative to bonds for several months, cyclicals (except energy) underperformed defensives, small caps briefly rose then collapsed against large caps, and value stocks rose relative to growth stocks. The takeaway was to stay invested over the cyclical time frame, prefer large caps, and prefer value. The difference today is that cyclicals and small caps are already performing worse against defensives and large caps than in 2014, while value has vastly outstripped growth (Chart 3). The implication is that once war breaks out, cyclicals and small caps have less room to fall whereas value has limited near-term upside. Chart 2Market Response To Crimea Invasion, 2014 Market Response To Crimea Invasion, 2014 Market Response To Crimea Invasion, 2014 ​​​​​​ Chart 3Market Response 2022 Versus 2014 Market Response 2022 Versus 2014 Market Response 2022 Versus 2014 ​​​​​​ If we look closely at global equity gyrations over the past week – when the Ukraine story moved to front and center – we see that stocks are falling relative to bonds, cyclicals are flat relative to defensives, small caps are rising relative to large caps, and value is flat relative to growth but may have peaked (Chart 4). In the short term the geopolitical dynamic will move markets so we expect cyclicals, small caps, and value to underperform. Commodity prices and the energy sector are initially benefiting from tensions as expected – oil prices and energy equities spiked amid the tensions (Chart 5). But assuming war materializes, Russia will at least cut off natural gas flowing through Ukraine, cutting off about 20% of Europe’s natural gas supply and triggering a bigger price shock. Ultimately, however, this price shock will incentivize production, destroy global demand, and drive energy prices down. Chart 4Global Equities Just Woke Up To Ukraine Global Equities Just Woke Up To Ukraine Global Equities Just Woke Up To Ukraine ​​​​​​ Chart 5Global Energy Sector Just Woke Up To Ukraine Global Energy Sector Just Woke Up To Ukraine Global Energy Sector Just Woke Up To Ukraine ​​​​​ Thus we expect energy price volatility. Russia will keep shipping energy to Europe to finance its military adventures. Europe will be loath to slap sanctions on critical energy supplies, assuming Russia’s military action is limited. The Saudis may or may not increase production to prevent demand destruction – in past Russian invasions they have actually reduced production once prices started to fall. A temporary US-Iran nuclear deal could release Iranian oil to the market, though that is not what we expect in the short run (discussed below). Bottom Line: Tactically investors should favor bonds over stocks, the US dollar and US equities over global currencies and equities (especially European), defensive sectors over cyclicals, large caps over small caps, and growth over value stocks. Is Ukraine Already Priced? Not Yet. Chart 6Crisis Events And Peak-To-Trough Market Drawdown Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree The peak-to-trough equity drawdown – in geopolitical crises that are comparable to a Russian invasion of Ukraine – range from 11%-14% going back to 1931. The following research findings are derived from a list of select events, from the Japanese invasion of China to the German invasion of Poland to lesser invasions, all the way down to Russia’s seizure of Crimea in 2014. We used the S&P 500 as it is the most representative stock index over this long period of time. The fully updated and broader list of geopolitical crises can be found in Appendix 1. Geopolitical crises tend to trigger an average 10% equity decline, smaller than economic crises or major terrorist attacks (Chart 6). The biggest geopolitical shocks to the equity market occur when an event is a truly global event, as opposed to regional shocks. Interestingly Europe-only shocks have seen some of the smallest average drawdowns at around 8% (Chart 7). An expanded Ukraine war would be limited to Europe. The average equity selloff is largest, at 14%, if both the US and its allies are directly involved in the geopolitical event. But the range is 11%-14% regardless of whether the US or its allies are involved (Chart 8). Ukraine is not an official ally, which is one reason the markets will tend to play down a larger war there. However, the market is underrating the fact that Ukraine’s neighbors are NATO members and will have a powerful interest in supporting the Ukrainian militant insurgency, which could lead to unexpected conflicts that involve NATO member-state’s citizens. Chart 7Geopolitical Crises And Markets: Where Is The Crisis? Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree ​​​​​​ Chart 8Geopolitical Crises And Markets: Who Are The Players? Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree ​​​​​​ Chart 9Russian Invasion Scenarios And Likely Equity Impact Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree The Russians have as many as 150,000 troops on the border with Ukraine, according to President Biden’s latest speech. The Ukrainian active military numbers 215,000. This ratio is not at all favorable for a full-scale invasion. The Russians are contemplating a limited action directed at teaching Ukraine a lesson or encroaching further onto Ukrainian territory, especially coastal territory. History suggests that a limited incursion will produce a 10% total equity drawdown, whereas a full-scale invasion would produce 13% or more (Chart 9). Still, investors should view 11%-14% as the appropriate range for a geopolitically induced crisis. The S&P has fallen by 9% since its peak on January 3, 2022. But Russia has not invaded yet. If war breaks out, there is more downside, given high uncertainty. Markets could still be surprised by the initial force of any Russian military action. The US will impose sweeping sanctions immediately. The Europeans will modify their sanctions according to Russia’s actions, a key source of uncertainty. If a diplomatic resolution is confirmed – with Russia withdrawing troops and the US and its allies cutting defense cooperation with Ukraine – then the market may continue to rally. However, there are other reasons to be cautious: especially inflation and monetary policy normalization, with the Federal Reserve potentially lifting rates by 50 basis points in March. Bottom Line: Stocks can fall further given that investors do not yet know the magnitude of the Russian military action or the US and European sanctions response. However, a buying opportunity is around the corner once this significant source of global uncertainty is clarified. New Iran Deal Is Neither Guaranteed Nor Durable A short note is necessary on the situation with Iran, another major risk this year, which falls under our third 2022 key view: oil-producing states gain geopolitical leverage. The implication is that the Iran risk will not be resolved quickly or easily. The global economy could suffer a double whammy of energy supply shock from Ukraine and energy supply risk in the Middle East this year. The US-Russia showdown is connected to the US-Iran nuclear negotiation. Russia took Crimea in 2014 in part because it saw an opportunity to exact a price from the United States, which sought Russia’s assistance in negotiating the 2015 nuclear deal with Iran. Today a similar dynamic is playing out, in which Russian diplomats cooperate on Iranian talks while encroaching on Ukraine. The Russians do not have an interest in Iran achieving a deliverable nuclear weapon and thus will offer some limited cooperation to this end. Their pound of flesh is Ukraine. According to media reports, the Iranian negotiations have seen some positive developments over the past month. US interest in rejoining the 2015 deal: The Biden administration has an interest in preventing Iran from reaching “breakout” levels of uranium enrichment and triggering a conflict in the region that would drive up oil prices ahead of the midterm election. It is going to be hard for Biden to remove sanctions in the context of Russian aggression but it is likely he would do it if the Iranians recommit to complying with the 2015 restrictions on their nuclear program. Iranian interest in rejoining the 2015 deal: The Iranians have an interest in convincing President Biden to remove sanctions to improve their economy and reduce the risk of social unrest. They are demanding the removal of all sanctions, not only those levied by President Trump. They also know that rejoining the 2015 deal itself is not so bad, since it starts expiring in 2025 and does not limit their missile production or support of militant proxies in the region. However, note that the Iranian regime has suppressed domestic instability since Trump’s “maximum pressure” sanctions, and the economy is improving on oil prices, so the threat of social unrest is not forcing Iran to accept a deal today. Also note that Iran is making demands that cannot be met: Iranian Foreign Minister Hossein Amirabdollahian is asking the US to provide guarantees that the US will not renege on the deal again, for example if the Republicans return to the White House in 2025. President Biden cannot provide these guarantees. The voting margins are too thin for a “political statement,” promising that the US will not renege on a deal, to pass Congress. While House Speaker Nancy Pelosi might be willing to provide such a statement to the Iranians, Senate Majority Leader Chuck Schumer probably will not – he opposed the originally 2015 deal. Even if Congress gave Iran guarantees, the fact remains that the GOP could win the White House in 2025, so the current, hawkish Iranian leadership cannot be satisfied on this front. Furthermore, even if Biden pulls back sanctions and Iran complies with the 2015 deal for a brief reprieve, Iran’s underlying interest is to obtain a deliverable nuclear weapon to achieve regime survival in the future. Iran faces a clear distinction between Ukraine, which gave up nukes and is now being dismembered (like Libya and Iraq), and North Korea, which now has a deliverable nuclear arsenal and commands respect from the US on the national stage. Moreover if the Republicans take back power in 2025, Iran will want to have achieved or be close to achieving a deliverable nuclear weapon. The Biden administration is weak at home and facing a crisis with Russia, which may present a window of opportunity for Iran to make a dash for the nuclear deterrent. Still, we acknowledge the short-term risk to our pessimistic view: It is possible that Iran will rejoin the deal to gain sanctions relief. In this case about 1-1.2 million barrels per day of Iranian crude will hit the global market. The implication, depending on the size of the energy shock, is that Brent crude prices will fall back to the $80 per barrel average that our Commodity & Energy Strategy expects. We also agree with our Commodity & Energy Strategist that global oil production will pick up in the face of supply risks that threaten to destroy demand. Bottom Line: We doubt Iran will rejoin the 2015 nuclear deal quickly. We expect energy prices to continue spiking in the short term due to Ukraine and any setbacks in the Iran negotiations. Yet we also expect oil producers around the world to increase production, which will sow the seeds for an oil price drop. Our tactical trade recommendations rest on falling oil prices and bond yields in the short run. Investment Takeaways Stay long gold. Stay long global defensive equity sectors over cyclicals. Favor global large caps over small caps. Stay long cyber security stocks and aerospace/defense stocks relative to the broad market. Stay long Japanese industrials relative to German and long yen. Stay long British stocks relative to other developed markets excluding the US, and long GBP-CZK. Favor Latin American equities within emerging markets, namely Mexican stocks and Brazilian financials relative to Indian stocks.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com   Footnotes 1      See "Russia Announces Troop Withdrawal," Russia Today, February 15, 2022, rt.com; "Ukraine crisis: Russian claim of troop withdrawal false, says US," BBC, February 17, 2022, bbc.com. 2     David M. Herszenhorn, “On stage at the Kremlin: Putin and Lavrov’s de-escalation dance,” Politico, February 14, 2022, politico.eu. 3     "Scholz says Zelensky promised to submit bills on Donbass to Contact Group," Tass, February 15, 2022, tass.com; "Scholz in Kyiv confirms Germany won’t arm Ukraine, stays mum on Nord Stream 2," February 15, 2022, euromaidanpress.com. 4     "Kiev makes no secret Minsk-2 is not on its agenda — Russian Foreign Ministry," Tass, February 17, 2022, tass.com; Felix Light, "Russian Parliament Backs Plan To Recognize Breakaway Ukrainian Regions," Moscow Times, February 15, 2022, themoscowtimes.com. Appendix 1: Geopolitical Events And Equity Market Impact Ukraine Crisis Decision Tree Ukraine Crisis Decision Tree Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)