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Highlights Japan’s long-term weaknesses – a shrinking population, low productivity growth, excess indebtedness – are very well known. However, it still punches above its weight in the realm of geopolitics. Abenomics – sorry, Kishidanomics – can still deliver some positive surprises every now and then. As the global pandemic wanes, and China faces a historic confluence of internal and external risks, investors should begin buying the yen on weakness. Japanese industrials also are an attractive play in a global portfolio. While the yen will likely fare better than the dollar over the next 6-9 months, it will lag other procyclical currencies. Feature Japan has always been an “earthquake society,”  in which things seem never to change until suddenly everything changes at once. The good news for investors is that that change occurred in 2011 and the latest political events reinforce policy continuity. Why “Abenomics” Remains The Playbook Over ten years have passed since Japan suffered a triple crisis of earthquake, tsunami, and nuclear meltdown. In fact, the Fukushima nuclear crisis merely punctuated a long accumulation of national malaise: the country had suffered two “Lost Decades” and was in the thrall of the Great Recession, a rare period of domestic political change, and a rise in national security fears over a newly assertive China. The nuclear meltdown marked the nadir. The result of all these crises was a miniature policy revolution in 2012 – Prime Minister Shinzo Abe and the Liberal Democratic Party (LDP) returned to power and initiated a range of bolder policies to whip the country’s deflationary mindset and reboot its foreign and trade relations. The new economic program, “Abenomics,” consisted of easy money, soft budgets, and pro-growth reforms. It succeeded in changing Japan. Both private debt and inflation, which had fallen during the lost decades, bottomed after the 2011 crisis and began to rise under Abe (Chart 1). By the 2019 House of Councillors election, however,  Abe was running out of steam. Consumption tax hikes, the US-China trade war, and COVID-19 thwarted his plans of national revival. In particular, Abe hoped to capitalize on excitement over the 2020 Tokyo Olympics to hold a popular referendum on revising the constitution. Constitutional revision is necessary to legitimize the Self-Defense Forces and thus make Japan a “normal” nation again, i.e. one that can maintain armed forces. But the global pandemic interrupted. Until the next heavyweight prime minister comes along, Japan will relapse into its old pattern of a “revolving door” of prime ministers who come and go quickly. For example, the only purpose of Abe’s immediate successor, Yoshihide Suga, was to tie off loose ends and oversee the Olympics before passing the baton (Chart 2). Chart 1Abenomics Was Making Progress Abenomics Was Making Progress Abenomics Was Making Progress Chart 2 The next few Japanese prime ministers will almost inevitably lack Abe’s twin supermajority in parliament, which was exceptional in modern history (Chart 3). It will be hard for the LDP to expand its regional grip given that it holds a majority in all 11 of the regional blocks in which the political parties contend for seats based on their proportion of the popular vote (Table 1). Chart 3 Table 1LDP+ Komeito Regional Performance Japan: Foreign Threats, Domestic Reflation Japan: Foreign Threats, Domestic Reflation Short-lived, traditional prime ministers will not be able to create a superior vision for Japan and will largely follow in Abe’s footsteps.   In September Prime Minister Fumio Kishida replaced Suga – a badly needed facelift for the ruling Liberal Democrats ahead of the October 31 election. The LDP retained its single-party majority in the Diet, so Kishida is off to a tolerable start (Chart 4). But he is far from charismatic and will not last long if he fumbles in the upper house elections in July 2022. This gives him a little more than half a year to make a mark. Chart 4 Kishida will oversee a roughly 30-40 trillion yen stimulus package, or supplemental budget, by the end of this year. Japanese stimulus packages are almost always over-promised and under-delivered. However, given the electoral calendar, he will put together a large package that will not disappoint financial markets. His other goal will be to build on recent American efforts to cobble together a coalition of democracies to counter China and Russia. Japan’s Grand Strategy In Brief Chart 5Japan Exposed To China Trade Japan Exposed To China Trade Japan Exposed To China Trade Japan’s grand strategy over centuries consists of maintaining its independence from foreign powers, controlling its strategic geographic approaches to prevent invasion, and stopping any single power from dominating the eastern side of the Eurasian landmass. Originally the hardest part of this grand strategy was that it required establishing unitary political control over the far-flung Japanese archipelago. However, since the Meiji Restoration, Tokyo has maintained centralized government. Since then Japan has focused on controlling its strategic approaches and maintaining a balance among the Asian powers. During the imperialist period it tried to achieve these objectives on its own. After World War II, the United States became critical to Japan’s grand strategy. Through its broad alliance with Washington, Tokyo can maintain independence, make sure critical territories are not hostile (e.g. Taiwan and South Korea), and deter neighboring threats (North Korea, China, Russia). It can at least try to maintain a balance of power in Eurasia. Yet these constant national interests underscore Japan’s growing vulnerabilities today: China’s economy is now two-times larger than Japan’s and Japan is more dependent on China’s trade than vice versa (Chart 5). Under Xi Jinping, Beijing is actively converting its wealth into military and strategic capabilities that threaten Japan’s security. Rising tensions across the Taiwan Strait are fueling nationalism and re-armament in Japan.  Russia’s post-Soviet resurgence entails an ever-closer Russo-Chinese partnership. It also entails Russian conflicts with the US that periodically upset any attempts at Russo-Japanese détente. North Korea’s asymmetric war capabilities and nuclearization pose another security threat. South Korea’s attempts to engage with the North and China, and compete with Japan, are unhelpful.    All of these realities drive Japan closer to the United States. Even the US is increasingly unpredictable, though not yet to the point of causing serious doubts about the alliance. If the US were fundamentally weakened, or abandoned the alliance, Japan would either have to adopt nuclear weapons or accommodate itself to Chinese hegemony to meet its grand strategy. Nuclearization would be the more likely avenue. The stability of Asia depends greatly on American arbitration. Japan’s Strategy Since 1990 Beneath this grand strategy Japan’s ruling elites must pursue a more particular strategy suited to its immediate time and place. Ever since Japan’s working population and property bubble peaked in the early 1990s, the country’s relative economic heft has declined. To maintain stability and security, the central government in Tokyo has had to take on a very active role in the economy and society. The first step was to stabilize the domestic economy despite collapsing potential growth. This has been achieved through a public debt supercycle (Chart 6). Unorthodox monetary and fiscal policy largely stabilized demand, at the cost of the world’s highest net debt-to-GDP ratio. The economic adjustment was spread out over a long period of time so as to prevent a massive social and political backlash. Unemployment peaked in 2009 at 5.5% and never rose above this level. The ruling elite and the Liberal Democrats maintained control of institutions and government. The second step was to ensure continued alliance with the United States. Japan could deal with its economic problems – and the rise of China – if it maintained access to US consumers and protection from the US military. To maintain the alliance required making investments in the American economy, in US-led global institutions, and cooperating with the US on various initiatives, including controversial foreign policies. As in the 1950s-60s, Japan would bulk up its Self-Defense Forces to share the burden of global security with the United States, despite the US-written constitution’s prohibition on keeping armed forces. The third step was to invest abroad and put Japan’s excess savings to work, developing materials and export markets abroad while employing foreign workers and factories to become Japan’s new industrial base in lieu of the shrinking Japanese workforce (Chart 7).  Chart 6Japan's Public Debt Supercycle Japan's Public Debt Supercycle Japan's Public Debt Supercycle Chart 7 Japan’s post-1990 strategy has staying power because of the massive pressures on Japan listed above: China’s rise, Russo-Chinese partnership, North Korean threats, and American distractions. Investors tend to underrate the impact of these trends on Japan. Unless they fundamentally change, Japan’s strategy will remain intact regardless of prime minister or even ruling party. Russia’s role is less clear and could serve as a harbinger of any future change. President Vladimir Putin and Abe had the best chance in modern memory to resolve the two countries’ territorial disputes, build on mutual interests, and maybe even sign a peace treaty. But Russia’s clash with the West  proved an insurmountable obstacle. New opportunities could emerge at some later juncture, as Japan’s interest in preventing China from dominating Eurasia gives it a strong reason to normalize ties with Russia. Russia will at some point worry about overdependency on China. But this change is not on the immediate horizon.  Japan’s Tactics Since 2011 Chart 8 Japan is nearly a one-party state. Brief spells of opposition rule, in 1993 and 2009-11, are exceptions that prove the rule. The Liberal Democrats did not fall from power so much as suffer a short “time out” to reflect on their mistakes before voters put them right back into power. However, these timeouts have been important in forcing the ruling party to adjust its tactics for changing times, as with Abenomics. Kishida will not have enough political capital to change direction. The emphasis will still be on defeating deflation and rekindling animal spirits and corporate borrowing (as opposed to relying exclusively on public debt). Kishida has talked about a new type of capitalism and a more active redistribution of wealth, in keeping with the current zeitgeist among the global elite. However, Japan lacks the impetus for dramatic change. Wealth inequality is not extreme and political polarization is non-existent (Chart 8). The LDP is wary of losing votes to the populist Japan Innovation Party, or other regional movements, but populism does not have as fertile ground in countries with low inequality.  The desire to boost wages was a central plank of Abenomics (Chart 9) and an area of success. It will come through in Kishida’s policies as well. But the ultimate outcome will depend on how tight the labor market gets in the upcoming economic cycle. Similarly Kishida can be expected to encourage, or at least not roll back, women’s participation in the labor force, as labor markets tighten (Chart 10). As the pandemic wanes it is also likely that he will reignite Abe’s loose immigration policy, which saw the number of foreign workers triple between 2010 and 2020. This inflow is perhaps the surest sign of any that insular and xenophobic Japan is changing with the times to meet its economic needs.  Chart 9Kishidanomics To Build On Abe's Wage Growth Kishidanomics To Build On Abe's Wage Growth Kishidanomics To Build On Abe's Wage Growth Chart 10Women Off To Work But Fertility ##br##Relapsed Women Off To Work But Fertility Relapsed Women Off To Work But Fertility Relapsed The only substantial difference between Kishidanomics and Abenomics is that Abe compromised his reflationary fiscal efforts by insisting on going forward with periodic hikes to the consumption tax. Kishida is under no such expectation. Instead he is operating in a global political and geopolitical context in which ambitious public investments are positively encouraged even at the expense of larger budget deficits (Chart 11). Yet interest rates are still low enough to make such investments cheaply. The stage is set for fiscal largesse. Chart 11Fiscal Largesse To Continue Fiscal Largesse To Continue Fiscal Largesse To Continue Kishida can be expected to promote large new investments in supply-chain resilience, renewable energy, and military rearmament. The US and EU may exempt climate policies from traditional budget accounting – Japan may do the same. Even more so than China and Europe, Japan has a national interest in renewable energy since it is almost entirely dependent on foreign imports for its fossil fuels. The green transition in Japan is lagging that of Germany but the Japanese shift away from nuclear power has gone even faster, creating an import dependency that needs to be addressed for strategic reasons (Chart 12). Monetary-fiscal coordination began under Abe and can increase under Kishida. What is clear is that public investment is the top priority while fiscal consolidation is not. Military spending is finally starting to edge up as a share of GDP, as noted above. For many years Japanese leaders talked about military spending but it remained steady at 1% of GDP. Now, at the onset of the US-China cold war, the Japanese are spending more and say the ratio will rise to 2% of GDP (Chart 13). Tensions with China, especially over Taiwan, will continue to drive this shift, though North Korea’s weapons progress is not negligible. Chart 12 Chart 13 The Biden administration is prioritizing US allies and the competition with China, which makes the Japanese alliance top of mind. Tokyo’s various attempts to talk with Beijing in recent years have amounted to nothing, with the exception of the Regional Comprehensive Economic Partnership, which is far from ratification and implementation. Japan’s relations with China are driven by interests, not passing attitudes and emotions. If Biden proves too dovish toward China – a big “if” – then it will be Japan pushing the US to take a more hawkish line rather than vice versa. Japan will take various strategic, economic, technological, and military actions to defend itself from the range of external threats it faces. These actions will intimidate and provoke China and other neighbors, which will help to entrench the “security dilemma” between the US and China and their allies. For example, Japan will eagerly participate in US efforts to upgrade its military and its regional alliances and partnerships, including via the Quadrilateral Security Dialogue with India and Australia. The Biden administration might force Japan to play nice with South Korea and patch up their trade war. But that is a price Japan can pay since American involvement also precludes any shift by South Korea fully into China’s camp. If China should invade Taiwan – which we cannot rule out over the long run – Japan’s vital supply lines and national security would fall under permanent jeopardy. Japan would have an interest in defending Taiwan but its willingness to war with China may depend on the US response. However, both Japan and the US would have to draw a stark line in defense of Japanese territory, not least Okinawa, where US troops are based. Both powers would mobilize and seek to impose a strategic containment policy around China at that point. Until The Next Earthquake … For Japan to abandon its post-1990 strategy, it would need to see a series of shocks to domestic and international politics. If China’s economy collapsed, Korea unified, or the US abandoned the Asia Pacific region, then Tokyo would have to reassess its strategy. Until then the status quo will prevail. At home Japan would need to see a split within the Liberal Democrats, or a permanent break between the LDP and their junior partner Komeito, combined with a single, consolidated, and electorally viable opposition party and a charismatic opposition leader. This kind of change would follow from major exogenous shocks. Today it is nowhere in sight – the last two shocks, in 2011 and 2020, reinforced the LDP regime. Theoretically some future Japanese government could adopt a socialist platform that relies entirely on public debt rather than trying to reboot private debt. It could openly embrace debt monetization and modern monetary theory  rather than trying to raise taxes periodically to maintain the appearance of fiscal rectitude. But if it tried to distance itself from the United States and improve relations with Russia and China, such a strategy would not go very far. It would jeopardize Japan’s grand strategy. For the foreseeable future, Japan’s economic security and national security lie in maintaining the American alliance and continuing an outward investment strategy focused on emerging markets other than China. Macroeconomic Developments The key message from an economic context is that fiscal stimulus is likely to be larger in Japan than the market currently expects. The IMF is penciling in a fiscal deficit of around 2% of potential GDP next year, which will be a drag on growth (Chart 14). More likely, Kishida will cobble together a slightly larger package to implement most of the initiatives he has proposed on the campaign trail. Meanwhile, a large share of JGBs are about to mature over the next couple of years, providing room for more issuance, which the BoJ will be happy to assimilate (Chart 15). Chart 14More Fiscal Stimulus In Japan Likely More Fiscal Stimulus In Japan Likely More Fiscal Stimulus In Japan Likely Chart 15Lots Of JGBs Mature In The Next Few Years Lots Of JGBs Mature In The Next Few Years Lots Of JGBs Mature In The Next Few Years Real numbers on the size of the fiscal package have been scarce, but it should be around 30-40 trillion yen, spread over a few years. With Japan’s net interest expense at record lows (Chart 16), and a lot of the spending slated for worthwhile productivity-enhancing projects such as supply chains, green energy, education and some boost to the financial sector in the form of digital innovation and consolidation, we expect fiscal policy in Japan will remain moderately loose, with the BoJ staying accommodative. The timing of more fiscal stimulus is appropriate as Japan has managed to finally put the pandemic behind it. The number of new Covid-19 cases is at the lowest recorded level per capita, and Japan now  has more of its population vaccinated than the US. As a result, the manufacturing and services PMIs, which have been the lowest in the developed world, could stage a coiled-spring rebound. This will be a welcome fillip for Japanese assets (Chart 17). Chart 16Little Cost To Issuing More Debt Little Cost To Issuing More Debt Little Cost To Issuing More Debt Chart 17The Japanese Recovery Has Lagged The Japanese Recovery Has Lagged The Japanese Recovery Has Lagged Consumption could also surprise to the upside in Japan. With the consumption tax hike of 2019 and the 2020 pandemic now behind us, pent-up demand could finally be unleashed in the coming quarters. Rising wages and high savings underscore that Japan could see a vigorous rebound in consumption, as was witnessed in other developed economies. This will be particularly the case as inflation stays low. The big risk for Japan from a macro perspective is an external slowdown, driven by China. A boom in foreign demand has been a much welcome cushion for Japanese growth, especially amidst weak domestic demand. The risk is that this tailwind becomes a headwind as Chinese growth slows, especially as a big share of Japanese exports go to China. Our view has been that policy makers in China will be able to ring-fire the property crisis, preventing a “Lehman” moment. As such, while China’s slowdown is a reality and downside risks warrant monitoring, we also expect China to avoid a hard landing. Meanwhile, Japanese exports are also diversified, with other developed and emerging markets accounting for the lion’s share of total exports. For example, exports to the US account for 19% of sales while EU exports account for 9%. Both exports and foreign machinery orders remain quite robust, suggesting that the slowdown in China will not crush all external demand (globally, export growth remains very strong).  It is noteworthy that many countries now have “carte blanche” to boost infrastructure spending, especially in areas like renewable energy and supply chain resiliency. Japan continues to remain a big supplier of capital goods globally. This will ensure that an economic recovery around the world will buffer foreign machinery orders. Market Implications Japanese equities have underperformed the US over the last decade, and Kishidanomics is unlikely to change this trend. But to the extent that more fiscal stimulus helps lift aggregate demand, a few sectors could begin to see short-term outperformance. More importantly, the underperformance of certain Japanese equity sectors have not been fully justified by the improving earnings picture (Chart 18). This suggests some room for catch-up. Banks in particular could benefit from a steeper yield curve in Japan, rising global yields and proposed reform in the sector (Chart 19). We will view this as a tactical opportunity however, than a strategic call. Our colleagues in the Global Asset Allocation service have clearly outlined key reasons against overweighting Japan, and are currently neutral.  More importantly, industrials also look poised to see some pickup in relative EPS growth, as global industrial demand stays robust. An improvement in domestic demand should also favor small caps over large caps. Chart 18ADismal Earnings Explain Some Underperformance Of Japanese Equities Dismal Earnings Explain Some Underperformance Of Japanese Equities Dismal Earnings Explain Some Underperformance Of Japanese Equities Chart 18BDismal Earnings Explain Some Underperformance Of Japanese Equities Dismal Earnings Explain Some Underperformance Of Japanese Equities Dismal Earnings Explain Some Underperformance Of Japanese Equities Chart 19Japanese Banks Will Benefit From A Steeper Yield Curve Japanese Banks Will Benefit From A Steeper Yield Curve Japanese Banks Will Benefit From A Steeper Yield Curve Foreigners have huge sway over the performance of Japanese assets, especially equities. Foreign holders account for nearly 30% of the Japanese equity float. This is important not only for the equity call but for currency performance as well since portfolio flows dominate currency movements. Historically, the yen and the Japanese equity market have been negatively correlated. This was due to positive profit translation effects from a lower currency. However, it is possible that Japanese domestic profits are no longer driven only by translation effects, but rather by underlying productivity gains. This could result in less yen hedging by foreign equity investors, which would restore a positive relationship between the relative share price performance and the currency. As for the yen, the best environment for any currency is when the economy can generate non-inflationary growth. Japan may well be entering this paradigm. Historically, now has been the exact environment where the yen tends to do well, as the economy exits deflation and enters non-inflationary growth (Chart 20). Chart 20The Yen And Japanese Growth The Yen And Japanese Growth The Yen And Japanese Growth Markets have been wrongly focusing on nominal rather than real yields in Japan and the implication for the yen. Therefore the risk to a long yen view is that the Bank of Japan keeps rates low as global yields are rising. However, in an environment where global inflationary pressures normalize (say in the next 6-9 months) and temper the increase in global yields, this could provide room for short covering on the yen. In our view, the yen is already the most underappreciated currency in the G10, as rising global yields have led to a massive accumulation of short positions. Finally, from a valuation standpoint, the yen is the cheapest G10 currency according to our PPP models, and is also quite cheap according to our intermediate-term timing model (Chart 21). With the yen being a risk-off currency, it also tends to rise versus the dollar not only during recessions, but also during most episodes of broad-based dollar weakness. This low-beta nature of the currency makes it a good portfolio hedge in an uncertain world. Chart 21The Yen Is Undervalued The Yen Is Undervalued The Yen Is Undervalued Given the historic return of geopolitical risk to Japan’s neighborhood, as the US and Japan engage in active great power competition with China, the yen is an underrated hedge. Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Chester Ntonifor Vice President Foreign Exchange Strategy chestern@bcaresearch.com

Highlights The surge in energy prices going into the Northern Hemisphere winter – particularly coal and natgas prices in China and Europe – will push inflation and inflation expectations higher into the end of 1Q22 (Chart of the Week).  Over the medium-term, similar excursions into the far-right tails of price distributions will become more frequent if capex in hydrocarbon-based energy sources continues to be discouraged, and scalable back-up sources of energy are not developed for renewables. It is not clear China will continue selectively relaxing price caps for some large electricity buyers, which came close to bankrupting power utilities this year and contributed to power shortages.  The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF.  We remain long both. Higher energy and metals prices also will work in favor of long-only commodity index exposure over the medium term. Longer-term supply-chain issues will be sorted out. Still, higher costs will be needed to incentivize production of the base metals required to decarbonize electricity production globally, and  to keep sufficient supplies of fossil fuels on hand to back up renewable generation.  This will cause inflation to grind higher over time. Feature Back in February, we were getting increasingly bullish base metals on the back of surging demand from China. Most other analysts were looking for a slowdown.1 The metals rally earlier this year drew attention away from the fact that China had fundamentally altered its energy supply chain, when it unofficially banned imports of Australian thermal coal. It also altered global energy flows and will, over the winter, push inflation higher in the short run. Building new supply chains is difficult under the best of circumstances. But last winter had added dimensions of difficulty: A La Niña drawing arctic weather into the Northern Hemisphere and driving up space-heating demand; flooding in Indonesia, which limited coal shipments to China; and a manufacturing boom that pushed power supplies to the limit. Over the course of this year, Chinese coal inventories fell to rock-bottom levels and set off a scramble for liquified natural gas (LNG) to meet space-heating and manufacturing demand last winter (Chart 2).2 Chart of the WeekEnergy-Price Surge Will Lift Inflation Energy-Price Surge Will Lift Inflation Energy-Price Surge Will Lift Inflation Chart 2Coal Shortage China China Power Outages: Another Source Of Downside Risk Coal Shortage China China Power Outages: Another Source Of Downside Risk Coal Shortage China While this was evolving, the volume of manufactured exports from China was falling (Chart 3), even while the nominal value of these exports was rising in USD terms (Chart 4).  This is a classic inflationary set-up: More money chasing fewer goods.  This is occurring worldwide, as supply-chain bottlenecks, power rationing and shortages, and falling commodity inventories keep supplies of most industrial commodities tight.  China's export volumes peaked in February 2021, and moved lower since then.  This likely persists going forward, given the falloff of orders and orders in hand (Chart 5). Chart 3Volume Of China's Exports Falls … Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 4… But The Nominal USD Value Rises Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 5China's Official PMIs, Export And In-Hand Orders Weaken Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Space-heating and manufacturing in China are both heavily reliant on coal. Space-heating north of the Huai River is provided for free, or is heavily subsidized, from coal-fired boilers that pump heat to households and commercial establishments. This is a practice adopted from the Soviet Union in the 1950s and expanded until the 1980s, according to Fan et al (2020).3 Manufacturing pulls its electricity from a grid that produces 63% of its power from coal. China's coal output had been falling since December 2020, which complicated space heating and electricity markets, where prices were capped until this week. This meant electricity generators could not recover skyrocketing energy costs – coal in particular – and therefore ran the risk of bankruptcy.4 The loosening of price caps is now intended to relieve this pressure. Competition For Fuels Will Continue Europe was also hammered over the past year by a colder-than-normal winter brought on by a La Niña event, which sharply drew natgas inventories. The cold weather lingered into April-May, which slowed efforts to refill storage, and set off a scramble to buy up LNG cargoes (Chart 6). Chart 6The Scramble For Natgas Continues Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher This competition has lifted global LNG prices to record levels, and continues to drive prices higher. Longer-term, the logic of markets – higher prices beget higher supply, and vice versa – virtually assures supply chains will be sorted out. However, the cost of energy generally will have to increase to incentivize production of the base metals needed to pull off the decarbonization of electricity production globally, and to keep sufficient supplies of fossil fuels on hand to back up renewable generation. This will cause inflation to grind higher over time. Decarbonization is a strategic agenda for leading governments, especially China and the European Union. China is fully committed to renewables for fear of pollution causing social unrest at home and import dependency causing national insecurity abroad. In the EU, energy insecurity is also an argument for green policy, which is supported by popular opinion. The US has greater energy security than these two but does not want to be left behind in the renewable technology race – it is increasing government green subsidies. The current set of ruling parties will continue to prioritize decarbonization for the immediate future. Compromises will be necessary on a tactical basis when energy price pressures rise too fast, as with China’s latest measures to restart coal-fired power production. The strategic direction is unlikely to change for some time. Investment Implications Over time, a structural shift in forward price curves for oil, gas and coal – e.g., a parallel shift higher from current levels – will be required to incentivize production increases. This would provide hedging opportunities for the producers of the fuels used to generate electricity, and the metals required to build the infrastructure needed by the low-carbon economies of the future. We continue to expect markets to remain tight on the supply side, which will make backwardation – i.e., prices for prompt-delivery commodities trade higher than those for deferred delivery – a persistent feature of commodities for the foreseeable future.  This is because inventories will remain under pressure, making commodity buyers more willing to pay up for prompt delivery. The current market set-up favors long commodity index products like the S&P GSCI and the COMT ETF. We remain long both, given our expectation. Over the short term, inflation will be pushed higher by the rise in coal and gas prices.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com   Commodities Round-Up Energy: Bullish According to the Energy Information Administration (EIA), industrial consumption of natgas in the US is on track to surpass its five-year average this year. Over the January-July period, US natgas consumption average 22.4 BCF/d, putting it 0.2 BCF/d over its five-year average (2016-2020). US industrial consumption of natgas peaked in 2018-19 at just over 23 BCF/d, according to the EIA (Chart 7). The EIA expects full-year 2021 industrial consumption of natgas to be 23.1 BCF/d, which would tie it with the previous peak levels. Base Metals: Bullish Following a sharp increase in refined copper usage in China last year resulting from a surge in imports, the International Copper Study Group (ICSG) is expecting a 5% decline this year on the back of falling imports. Globally, the ICSG expects refined copper consumption to be unchanged this year, and rise 2.4% in 2022. Refined copper production is expected to be 25.9mm MT next year vs. 24.9mm MT this year. Consumption is forecast to grow to 25.6mm MT next year, up to 700k MT from the 24.96mm MT usage expected this year. Precious Metals: Bullish Lower-than-expected job growth in the US pushed gold prices higher at the end of last week on the back of expectations the Fed will continue to keep policy accessible as employment weakened. All the same, gold prices remain constrained by a well-bid USD, which continues to act as a headwind, and only minimal weakening of the 10-year US bond yield, which dipped slightly below the 1.61% level hit earlier in the week (Chart 8). Ags/Softs: Neutral This week's USDA World Agricultural Supply and Demand Estimates (WASDE) were mostly neutral for grains and bearish for soybeans. Global ending bean stocks are expected to rise almost 5.4% in the USDA's latest estimate for ending stocks in the current crop year, finishing at 104.6mm tons. Corn and rice ending stocks were projected to rise 1.4% and less than 1%, ending the crop year at 301.7mm tons and 183.6mm tons, respectively. According to the department, global wheat ending stocks are the lone standout, expected to fall 2.1% to 277.2mm tons, the lowest level since the 2016/17 crop year. Chart 7 Inflation Surges, Slows, Then Grinds Higher Inflation Surges, Slows, Then Grinds Higher Chart 8 Uncertainty Weighs On Gold Uncertainty Weighs On Gold   Footnotes 1     Please see Copper Surge Welcomes Metal Ox Year, which we published on February 11, 2021.  It is available at ces.bcaresearch.com. 2     China’s move to switch to Indonesian coal at the beginning of this year to replace Aussie coal was disruptive to global markets.  As argusmedia.com reported, this was compounded by weather-related disruptions in Indonesian exports earlier this year.  It is worthwhile noting, weather-related delays returned last month, with flooding in Indonesia's coal-producing regions again are disrupting coal shipments.  We expect these new trade flows in coal will take a few more months to sort out, but they will be sorted. 3    Please see Maoyong Fan, Guojun He, and Maigeng Zhou (2020), " The winter choke: Coal-Fired heating, air pollution, and mortality in China," Journal of Health Economics, 71: 1-17.  4    In August and September, the South China Morning Post reported coal-powered electric generators petitioned authorities to relax price caps, because they faced bankruptcy from not being able to recover the skyrocketing cost of coal. Please see China coal-fired power companies on the verge of bankruptcy petition Beijing to raise electricity prices, published by scmp.com on September 10, 2021. This month, Shanxi Province, which provides about a third of China's domestically produced coal, was battered by flooding, which forced authorities to shut dozens of mines, according to the BBC. Please see China floods: Coal price hits fresh high as mines shut published by bbc.co.uk on October 12, 2021. Power supplies also were lean because of the central government's so-called dual-circulation policies to reduce energy consumption and the energy intensity of manufacturing. This is meant to increase self-reliance of the state. Please see What is behind China’s Dual Circulation Strategy? Published by the European think tank Bruegel on September 7, 2021.   Investment Views and Themes Strategic Recommendations

Highlights Asian and European natural gas prices will remain well bid as the Northern Hemisphere winter approaches. An upgraded probability of a second La Niña event this winter will keep gas buyers scouring markets for supplies (Chart of the Week). The IEA is pressing Russia to make more gas available to European consumers going into winter. While Russia is meeting contractual commitments, it is also trying to rebuild its inventories. Gas from the now-complete Nord Stream 2 pipeline might not flow at all this year. High natgas prices will incentivize electric generators to switch to coal and oil. This will push the level and costs of CO2 emissions permits higher, including coal and oil prices. Supply pressures in fossil-fuel energy markets are spilling into other commodity markets, raising the cost of producing and shipping commodities and manufactures. Consumers – i.e., voters – experiencing these effects might be disinclined to support and fund the energy transition to a low-carbon economy. We were stopped out of our long Henry Hub natural gas call spread in 1Q22 – long $5.00/MMBtu calls vs short $5.50/MMBtu calls in Jan-Feb-Mar 2022 – and our long PICK ETF positions with returns of 4.58% and -10.61%. We will be getting long these positions again at tonight's close. Feature European natural gas inventories remain below their five-year average, which, in the event of another colder-than-normal winter in the Northern Hemisphere, will leave these markets ill-equipped to handle a back-to-back season of high prices and limited supply (Chart 2).1 The probability of a second La Niña event this winter was increased to 70-80% by the US Climate Prediction Center earlier this week.2 This raises the odds of another colder-than-average winter. As a result, markets will remain focused on inventories and flowing natgas supplies from the US, in the form of Liquified Natural Gas (LNG) cargoes, and Russian pipeline shipments to Europe as winter approaches. Chart of the WeekSurging Natural Gas Prices Intensify Competition For Supplies Natgas Markets Continue To Tighten Natgas Markets Continue To Tighten Chart 2Natgas Storage Remains Tight Natgas Markets Continue To Tighten Natgas Markets Continue To Tighten US LNG supplies are being contested by Asian buyers, where gas storage facilities are sparse, and European buyers looking for gas to inject into storage as they prepare for winter. US LNG suppliers also are finding ready bids in Brazil, where droughts are reducing hydropower availability. In the first six months of this year, US natgas exports averaged 9.5 bcf/d, a y/y increase of more than 40%. Although Russia's Nord Stream 2 pipeline has been completed, it still must be certified to carry natgas into Germany. This process could take months to finish, unless there is an exemption granted by EU officials. Like the US and Europe, Russia is in the process of rebuilding its natgas inventories, following a colder-than-normal La Niña winter last year.3 Earlier this week, the IEA called on Russia to increase natgas exports to Europe as winter approaches. The risk remains no gas will flow through Nord Stream 2 this year.4 Expect Higher Coal, Oil Consumption As other sources of energy become constrained – particularly UK wind power in the North Sea, where supplies went from 25% of UK power in 2020 to 7% in 2021 – natgas and coal-fired generation have to make up for the shortfall.5 Electricity producers are turning more towards coal as they face rising natural gas prices.6 Increasing coal-fired electric generation produces more CO2 and raises the cost of emission permits, particularly in the EU's Emissions Trading System (ETS), which is the largest such market in the world (Chart 3). Prices of December 2021 ETS permits, which represent the cost of CO2 emissions in the EU, hit an all-time high of €62.75/MT earlier this month and were trading just above €60.00/MT as we went to press. Chart 3Higher CO2 Emissions Follow Lower Renewables Output Higher CO2 Emissions Follow Lower Renewables Output Higher CO2 Emissions Follow Lower Renewables Output Going into winter, the likelihood of higher ETS permit prices increases if renewables output remains constrained and natgas inventories are pulled lower to meet space-heating needs in the EU. This will increase the price of power in the EU, where consumers are being particularly hard hit by higher prices (Chart 4). The European think tank Bruegel notes that even though natgas provides about 20% of Europe's electricity supply, it now is setting power prices on the margin.7 Chart 4EU Power Price Surge Is Inflationary Natgas Markets Continue To Tighten Natgas Markets Continue To Tighten Elevated natgas prices are inflationary, according to Bruegel: "On an annual basis, a doubling of wholesale electricity prices from about €50/megawatt hour to €100/MWh would imply that EU consumers pay up to €150 billion (€50/MWh*3bn MWh) more for their electricity. … Drastic increases in energy spending will shrink the disposable income of the poorest households with their high propensity to consume." This is true in other regions and states, as well. Is the Natgas Price Surge Transitory? The odds of higher natgas and CO2 permit prices increase as the likelihood of a colder-than-normal winter increases. Even a normal winter likely would tax Europe's gas supplies, given the level of inventories, and the need for Russia to replenish its stocks. However, at present, even with the odds of a second La Niña event this winter increasing, this is a probable event, not a certainty. The global natgas market is evolving along lines similar to the crude oil market. Fungible cargoes can be traded and moved to the market with the highest netback realization, after accounting for transportation. High prices now will incentivize higher production and a stronger inventory-injection season next year. That said, prices could stay elevated relative to historical levels as this is occurring. Europe is embarked on a planned phase-out of coal- and nuclear-powered electricity generation over the next couple of years, which highlights the risks associated with the energy transition to a low-carbon future. China also is attempting to phase out coal-fired generation in favor of natgas turbines, and also is pursuing a buildout of renewables and nuclear power. Given the extreme weather dependence on prices for power generated from whatever source, renewables will remain risky bets for modern economies as primary energy sources in the early stages of the energy transition. When the loss of wind, for example, must be made up with natgas generation and that market is tight owing to its own fundamental supply-demand imbalance, volatile price excursions to high levels could be required to destroy enough demand to provide heat in a cold winter. This would reduce support for renewables if it became too-frequent an event. This past summer and coming winter illustrate the risk of too-rapid a phase out of fossil-fueled power generation and space-heating fuels (i.e., gas and coal). Frequent volatile energy-price excursions, which put firms and households at risk of price spikes over an extended period of time, are, for many households, material events. We have little doubt the commodity-market effects will be dealt with in the most efficient manner. As the old commodity-market saw goes, "High prices are the best cure for high prices, and vice versa." All the same, the political effects of another very cold winter and high energy prices are not solely the result of economic forces. Inflation concerns aside, consumers – i.e., voters – may be disinclined to support a renewable-energy buildout if the hits to their wallets and lifestyles become higher than they have been led to expect. Investment Implications The price spike in natgas is highly likely to be a transitory event. Another surge in natgas prices likely would be inflationary while supplies are rebuilding – so, transitory.  Practically, this could stoke dissatisfaction among consumers, and add a political element to the transition to a low-carbon energy future. This would complicate capex decision-making for incumbent energy suppliers – i.e., the fossil-fuels industries – and for the metals suppliers, which will be relied upon to provide the literal building blocks for the renewables buildout.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Commodities Round-Up Energy: Bullish US crude oil inventories fell 3.5mm barrels in the week ended 17 September 2021, according to the US EIA. Product inventories built slightly, led by a 3.5mm-build in gasoline stocks, which was offset by a 2.6mm barrel draw in distillates (e.g., diesel fuel). Cumulative average daily crude oil production in the US was down 7% y/y, and stood at 10.9mm b/d. Cumulative average daily refined-product demand – what the EIA terms "Product Supplied" – was estimated at 19.92mm b/d, up almost 10% y/y. Brent prices recovered from an earlier sell-off this week and were supported by the latest inventory data (Chart 5). Base Metals: Bullish Iron ore prices have fallen -55.68% since hitting an all-time high of $230.58/MT in May 12, 2021 (Chart 6). This is due to sharply reduced steel output in China, as authorities push output lower to meet policy-mandated production goals and to conserve power. Even with the cuts in steel production, overall steel output in the first seven months of the year was up 8% on a y/y basis, or 48mm MT, according to S&P Global Platts. Supply constraints likely will be exacerbated as the upcoming Olympic Games hosted by China in early February approach. Authorities will want blue skies to showcase these events. Iron ore prices will remain closer to our earlier forecast of $90-$110/MT than not over this period.8 Precious Metals: Bullish The Federal Open Market Committee is set to publish the results of its meeting on Wednesday. In its last meeting in June, more hawkish than expected forecasts for interest rate hikes caused gold prices to drop and the yellow metal has been trading significantly lower since then. Our US Bond Strategy colleagues expect an announcement on asset purchase tapering in end-2021, and interest rate increases to begin by end-2022.9 Rate hikes are contingent on the Fed’s maximum employment criterion being reached, as expected and actual inflation are above the Fed criteria. Tapering asset purchases and increases in interest rates will be bearish for gold prices. Chart 5 BRENT PRICES BEING VOLATILE BRENT PRICES BEING VOLATILE Chart 6 BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI)RECOVERING BENCHMARK IRON ORE 62% FE, CFR CHINA (TSI)RECOVERING       Footnotes 1     Equinor, the Norwegian state-owned energy-supplier, estimates European natgas inventories will be 70-75% of their five-year average this winter.  Please see IR Gas Market Update, September 16, 2021. 2     Please see "ENSO: Recent Evolution, Current Status and Predictions," published by the US Climate Prediction Center 20 September 2021.  Earlier this month, the Center gave 70% odds to a second La Niña event in the Northern Hemisphere this winter.  Please see our report from September 9, 2021 entitled NatGas: Winter Is Coming for additional background. 3    Please see IEA calls on Russia to send more gas to Europe before winter published by theguardian.com, and Big Bounce: Russian gas amid market tightness.  Both were published on September 21, 2021. 4    Please see Nord Stream Two Construction Completed, but Gas Flows Unlikely in 2021 published 14 September 2021 by Jamestown.org. 5    Please see The U.K. went all in on wind power. Here’s what happens when it stops blowing, published by fortune.com on 16 September 2021.  Argus Media this week reported wind-power output fell 56% y/y in September 2021 to just over 2.5 TWh. 6    Please see UK power firms stop taking new customers amid escalating crisis, published by Aljazeera; Please see UK fires up coal power plant as gas prices soar, published by BBC. 7     Please see Is Europe’s gas and electricity price surge a one-off?, published by Bruegel 13 September 2021. 8    Please see China's Recovery Paces Iron Ore, Steel, which we published on November 5, 2020. 9    Please see 2022 Will Be All About Inflation and Talking About Tapering, published on September 22, 2021 and on August 10, 2021 respectively.     Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades

Highlights An Iran crisis is imminent. We still think a US-Iran détente is possible but our conviction is lower until Biden makes a successful show of force. Oil prices will be volatile. Fiscal drag is a risk to the cyclical global macro view. But developed markets are more fiscally proactive than they were after the global financial crisis. Elections will reinforce that, starting in Germany, Canada, and Japan. The Chinese and Russian spheres are still brimming with political and geopolitical risk. But China will ease monetary and fiscal policy on the margin over the coming 12 months. Afghanistan will not upset our outlook on the German and French elections, which is positive for the euro and European stocks. Feature Chart 1Bull Market In Iran Tensions Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Iran is now the most pressing geopolitical risk in the short term (Chart 1). The Biden administration has been chastened by the messy withdrawal from Afghanistan and will be exceedingly reactive if it is provoked by foreign powers. Nuclear weapons improve regime survivability. Survival is what the Islamic Republic wants. Iran is surrounded by enemies in its region and under constant pressure from the United States. Hence Iran will never ultimately give up its nuclear program, as we have maintained. Chart 2Biden Unlikely To Lift Iran Sanctions Unilaterally Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) However, Supreme Leader Ali Khamenei could still agree to a deal in which the US reduces economic sanctions while Iran allows some restrictions on uranium enrichment for a limited period of time (the 2015 nuclear deal’s key provisions expire from 2023 through 2030). This would be a stopgap measure to delay the march into war. The problem is that rejoining the 2015 deal requires the US to ease sanctions first, since the US walked away from the deal in 2018. Iran would need domestic political cover to rejoin it. Biden has the executive authority to ease sanctions unilaterally but after Afghanistan he lacks the political capital to do so (Chart 2). So Biden cannot ease sanctions until Iran pares back its nuclear activities. But Iran has no reason to pare back if the US does not ease sanctions. Iran is now enriching some uranium to a purity of 60%. Israeli Defense Minister Benny Gantz says it will reach “nuclear breakout” capability – enough fissile material to build a bomb – within 10 weeks, i.e. mid-October. Anonymous officials from the Biden administration told the Associated Press it will be “months or less,” which could mean September, October, or November (Table 1). Table 1Iran Nearing "Breakout" Nuclear Capability Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Meanwhile the new Iranian government of President Ebrahim Raisi, a hardliner who is tipped to take over as Supreme Leader once Ali Khamenei steps down, is implying that it will not rejoin negotiations until November. All of these timelines are blurry but the implication is that Iran will not resume talks until it has achieved nuclear breakout. Israel will continue its campaign of sabotage against the regime. It may be pressed to the point of launching air strikes, as it did against nuclear facilities in Iraq in 1981 and Syria in 2007 under what is known as the “Begin Doctrine.” Chart 3Israel Cannot Risk Losing US Security Guarantee Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) The constraint on Israel is that it cannot afford to lose America’s public support and defense alliance since it would find itself isolated and vulnerable in its region (Chart 3). But if Israeli intelligence concludes that the Iranians truly stand on the verge of achieving a deliverable nuclear weapon, the country will likely be driven to launch air strikes. Once the Iranians test and display a viable nuclear deterrent it will be too late. Four US presidents, including Biden, have declared that Iran will not be allowed to get nuclear weapons. Biden and the Democrats favor diplomacy, as Biden made clear in his bilateral summit with Israeli Prime Minister Naftali Bennett last week. But Biden also admitted that if diplomacy fails there are “other options.” The Israelis currently have a weak government but it is unified against a nuclear-armed Iran. At very least Bennett will underscore red lines to indicate that Israel’s vigilance has not declined despite hawkish Benjamin Netanyahu’s fall from power. Still, Iran may decide it has an historic opportunity to make a dash for the bomb if it thinks that the US will fail to support an Israeli attack. The US has lost leverage in negotiations since 2015. It no longer has troops stationed on Iran’s east and west flanks. It no longer has the same degree of Chinese and Russian cooperation. It is even more internally divided. Iran has no guarantee that the US will not undergo another paroxysm of nationalism in 2024 and try to attack it. The faction that opposed the deal all along is now in power and may believe it has the best chance in its lifetime to achieve nuclear breakout. The only reason a short-term deal is possible is because Khamenei may believe the Israelis will attack with full American support. He agreed to the 2015 deal. He also fears that the combination of economic sanctions and simmering social unrest will create a rift when he dies or passes the leadership to his successor. Iran has survived the Trump administration’s “maximum pressure” sanctions but it is still vulnerable (Chart 4). Chart 4Supreme Leader Focuses On Regime Survival Supreme Leader Focuses On Regime Survival Supreme Leader Focuses On Regime Survival Moreover Biden is offering Khamenei a deal that does not require abandoning the nuclear program and does not prevent Iran from enhancing its missile capabilities. By taking the deal he might prevent his enemies from unifying, forestall immediate war, and pave the way for a smooth succession, while still pursuing the ultimate goal of nuclear weaponization. Bringing it all together, the world today stands at a critical juncture with regard to Iran and the unfinished business of the US wars in the Middle East. Unless the US and Israel stage a unified and convincing show of force, whether preemptively or in response to Iranian provocations, the Iranians will be justified in concluding that they have a once-in-a-generation opportunity to pursue the bomb. They could sneak past the global powers and obtain a nuclear deterrent and regime security, like North Korea did. This could easily precipitate a war. Biden will probably continue to be reactive rather than proactive. If the Iranians are silent then it will be clear that Khamenei still sees the value in a short-term deal. But if they continue their march toward nuclear breakout, as is the case as we go to press, then Biden will have to make a massive show of force. The goal would be to underscore the US’s red lines and drive Iran back to negotiating table. If Biden blinks, he will incentivize Iran to make a dash for the bomb. Either way a crisis is imminent. Israel will continue to use sabotage and underscore red lines while the Iranians will continue to escalate their attacks on Israel via militant proxies and attacks on tankers (Map 1). Map 1Secret War Escalates In Middle East Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Bottom Line: After a crisis, either diplomacy will be restored, or the Middle East will be on a new war path. The war path points to a drastically different geopolitical backdrop for the global economy. If the US and Iran strike a short-term deal, Iranian oil will flow and the US will shift its strategic focus to pressuring China, which is negative for global growth and positive for the dollar. If the US and Iran start down the war path, oil supply disruptions will rise and the dollar will fall. Implications For Oil Prices And OPEC 2.0 The probability of a near-term conflict is clear from our decision tree, which remains the same as in June 2019 (Diagram 1). Diagram 1US-Iran Conflict: Critical Juncture In Our Decision Tree Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Shows of force and an escalation in the secret war will cause temporary but possibly sharp spikes in oil prices in the short term. OPEC 2.0 remains intact so far this year, as expected. The likelihood that the global economic recovery will continue should encourage the Saudis, Russians, Emiratis and others to maintain production discipline to drain inventories and keep Brent crude prices above $60 per barrel. OPEC 2.0 is a weak link in oil prices, however, because Russians are less oil-dependent than the Gulf Arab states and do not need as high of oil prices for their government budget to break even (Chart 5). Periodically this dynamic leads the cartel to break down. None of the petro-states want to push oil prices up so high that they hasten the global green energy transition. Chart 5OPEC 2.0 Keeps Price Within Fiscal Breakeven Oil Price Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 6Oil Price Risks Lie To Upside Until US-Iran Deal Occurs Oil Price Risks Lie To Upside Until US-Iran Deal Occurs Oil Price Risks Lie To Upside Until US-Iran Deal Occurs As long as OPEC 2.0 remains disciplined, average Brent crude oil prices will gradually rise to $80 barrels per day by the end of 2024, according to our Commodity & Energy Strategy (Chart 6). Imminent firefights will cause prices to spike at least temporarily when large amounts of capacity are taken offline. Global spare capacity is probably sufficient to handle one-off disruptions but an open-ended military conflict in the Persian Gulf or Strait of Hormuz would be a different story. After the next crisis, everything depends on whether the US and Israel establish a credible threat and thus restore diplomacy. Any US-Iran strategic détente would unleash Iranian production and could well motivate the Gulf Arabs to pump more oil and deny Iran market share. Bottom Line: Given that any US-Iran deal would also be short-term in nature, and may not even stabilize the region, some of the downside risks are fading at the moment. The US and China are also sucking in more commodities as they gear up for great power struggle. The geopolitical outlook is positive for oil prices in these respects. But OPEC 2.0 is the weak link in this expectation so we expect volatility. Global Fiscal Taps Will Stay Open Markets have wavered in recent months over softness in the global economic recovery, COVID-19 variants, and China’s policy tightening. The world faces a substantial fiscal drag in the coming years as government budgets correct from the giant deficits witnessed during the crisis. Nevertheless policymakers are still able to deliver some positive fiscal surprises on the margin. Developed markets have turned fiscally proactive over the past decade. They rejected austerity because it was seen as fueling populist political outcomes that threatened the established parties. Note that this change began with conservative governments (e.g. Japan, UK, US, Germany), implying that left-leaning governments will open the fiscal taps further whenever they come to power (e.g. Canada, the US, Italy, and likely Germany next). Chart 7Global Fiscal Taps Will Stay Open Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 7 updates the pandemic-era fiscal stimulus of major economies, with light-shaded bars highlighting new fiscal measures that are in development but have not yet been included in the IMF’s data set. The US remains at the top followed by Italy, which also saw populist electoral outcomes over the past decade. Chart 8US Fiscal Taps Open At Least Until 2023 US Fiscal Taps Open At Least Until 2023 US Fiscal Taps Open At Least Until 2023 The Biden administration is on the verge of passing a $550 billion bipartisan infrastructure bill. We maintain 80% subjective odds of passage – despite the messy pullout from Afghanistan. Assuming it passes, Democrats will proceed to their $3.5 trillion social welfare bill. This bill will inevitably be watered down – we expect a net deficit impact of around $1-$1.5 trillion for both bills – but it can pass via the partisan “budget reconciliation” process. We give 50% subjective odds today but will upgrade to 65% after infrastructure passes. The need to suspend the debt ceiling will raise volatility this fall but ultimately neither party has an interest in a national debt default. The US is expanding social spending even as geopolitical challenges prevent it from cutting defense spending, which might otherwise be expected after Afghanistan and Iraq. The US budget balance will contract after the crisis but then it will remain elevated, having taken a permanent step up as a result of populism. The impact should be a flat or falling dollar on a cyclical basis, even though we think geopolitical conflict will sustain the dollar as the leading reserve currency over the long run (Chart 8). So the dollar view remains neutral for now. Bottom Line: The US is facing a 5.9% contraction in the budget deficit in 2022 but the blow will be cushioned somewhat by two large spending bills, which will put budget deficits on a rising trajectory over the course of the decade. Big government is back. Developed Market Fiscal Moves (Outside The US) Chart 9German Opinion Favors New Left-Wing Coalition Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Fiscal drag is also a risk for other developed markets – but here too a substantial shift away from prudence has taken place, which is likely to be signaled to investors by the outperformance of left-wing parties in Germany’s upcoming election. Germany is only scheduled to add EUR 2.4 billion to the 25.6 billion it will receive under the EU’s pandemic recovery fund, but Berlin is likely to bring positive fiscal surprises due to the federal election on September 26. Germany will likely see a left-wing coalition replace Chancellor Angela Merkel and her long-ruling Christian Democrats (Chart 9). The platforms of the different parties can be viewed in Table 2. Our GeoRisk Indicator for Germany confirms that political risk is elevated but in this case the risk brings upside to risk assets (Appendix). Table 2German Party Platforms Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) While we expected the Greens to perform better than they are in current polling, the point is the high probability of a shift to a new left-wing government. The Social Democrats are reviving under the leadership of Olaf Scholz (Chart 10). Tellingly, Scholz led the charge for Germany to loosen its fiscal belt back in 2019, prior to the global pandemic. Chart 10Germany: Online Markets Betting On Scholz Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 11Canada: Trudeau Takes A Calculated Risk Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) In June, the cabinet approved a draft 2022 budget plan supported by Scholz that would contain new borrowing worth EUR 99.7 bn ($119 billion). This amount is not included in the chart above but it should be seen as the minimum to be passed under the new government. If a left-wing coalition is formed, as we expect, the amount will be larger, given that both the Social Democrats and the Greens have been restrained by Merkel’s party. Canada turned fiscally proactive in 2015, when the institutional ruling party, the Liberals, outflanked the more progressive New Democrats by calling for budget deficits instead of a balanced budget. The Liberals saw a drop in support in 2019 but are now calling a snap election. Prime Minister Trudeau is not as popular in general opinion as he is in the news media but his party still leads the polls (Chart 11). The Conservatives are geographically isolated and, more importantly, are out of step with the median voter on the key issues (Table 3). Table 3Canada: Liberal Agenda Lines Up With Top Voter Priorities Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Nevertheless it is a risky time to call an election – our GeoRisk Indicator for Canada is soaring (Appendix). Granting that the Liberals are very unlikely to fall from power, whatever their strength in parliament, the key point is that parliament already approved of CAD 100 billion in new spending over the coming three years. Any upside surprise would give Trudeau the ability to push for still more deficit spending, likely focused on climate change. Chart 12Japan: Suga Will Go, LDP Will Stimulate Japan: Suga Will Go, LDP Will Stimulate Japan: Suga Will Go, LDP Will Stimulate Japanese politics are heating up ahead of the Liberal Democrats’ leadership election on September 29 and the general election, due by November 28. Prime Minister Yoshihide Suga’s sole purpose in life was to stand in for Shinzo Abe in overseeing the Tokyo Olympics. Now they are done and Suga will likely be axed – if he somehow survives the election, he will not last long after, as his approval rating is in freefall. The Liberal Democrats are still the only game in town. They will try to minimize the downside risks they face in the general election by passing a new stimulus package (Chart 12). Rumor has it that the new package will nominally be worth JPY 10-15 trillion, though we expect the party to go bigger, and LDP heavyweight Toshihiro Nikai has proposed a 30 trillion headline number. It is extremely unlikely that the election will cause a hung parliament or any political shift that jeopardizes passage of the bill. Abenomics remains the policy setting – and consumption tax hikes are no longer on the horizon to impede the second arrow of Abenomics: fiscal policy. Not all countries are projecting new spending. A stronger-than-expected showing by the Christian Democrats would result in gridlock in Germany. Meanwhile the UK may signal belt-tightening in October. Bottom Line: Germany, Canada, and Japan are likely to take some of the edge off of expected fiscal drag next year. Emerging Market Fiscal Moves (And China Regulatory Update) Among the emerging markets, Russia and China are notable in Chart 7 above for having such a small fiscal stimulus during this crisis. Russia has announced some fiscal measures ahead of the September 19 Duma election but they are small: $5.2 billion in social spending, $10 billion in strategic goals over three years, and a possible $6.8 billion increase in payments to pensioners. Fiscal austerity in Russia is one reason we expect domestic political risk to remain elevated and hence for President Putin to stoke conflicts in his near abroad (see our Russian risk indicator in the Appendix). There are plenty of signs that Belarussian tensions with the Baltic states and Poland can escalate in the near term, as can fighting in Ukraine in the wake of Biden’s new defense agreement and second package of military aid. China’s actual stimulus was much larger than shown in Chart 7 above because it mostly consisted of a surge in state-controlled bank lending. China is likely to ease monetary and fiscal policy on the margin over the coming 12 months to secure the recovery in time for the national party congress in 2022. But China’s regulatory crackdown will continue during that time and our GeoRisk Indicator clearly shows the uptick in risk this year (Appendix). Chart 13China Expands Unionization? China Expands Unionization? China Expands Unionization? The regulatory crackdown is part of a cyclical consolidation of Xi Jinping’s power as well as a broader, secular trend of reasserting Communist Party and centralization in China. The latest developments underscore our view that investors should not play any technical rebound in Chinese equities. The increase in censorship of financial media is especially troubling. Just as the government struggles to deal with systemic financial problems (e.g. the failing property giant Evergrande, a possible “Lehman moment”), the lack of transparency and information asymmetry will get worse. The media is focusing on the government’s interventions into public morality, setting a “correct beauty standard” for entertainers and limiting kids to three hours of video games per week. But for investors what matters is that the regulatory crackdown is proceeding to the medical sector. High health costs (like high housing and education costs) are another target of the Xi administration in trying to increase popular support and legitimacy. Central government-mandated unionization in tech companies will hurt the tech sector without promoting social stability. Chinese unions do not operate like those in the West and are unlikely ever to do so. If they did, it would compound the preexisting structural problem of rising wages (Chart 13). Wages are forcing an economic transition onto Beijing, which raises systemic risks permanently across all sectors. Bottom Line: Political and geopolitical risk are still elevated in China and Russia. China will ease monetary and fiscal policy gradually over the coming year but the regulatory crackdown will persist at least until the 2022 political reshuffle. Afghanistan: The Refugee Fallout September 2021 will officially mark the beginning of Taliban’s second bout of power in Afghanistan. Will Afghanistan be the only country to spawn an outflux of refugees? Will the Taliban wresting power in Afghanistan trigger another refugee crisis for Europe? How is the rise of the Taliban likely to affect geopolitics in South Asia? Will Afghanistan Be The Last Major Country To Spawn Refugees? Absolutely not. We expect regime failures to affect the global economy over the next few years. The global growth engine functions asymmetrically and is powered only by a fistful of countries. As economic growth in poor countries fails to keep pace with that of top performers, institutional turmoil is bound to follow. This trend will only add to the growing problem of refugees that the world has seen in the post-WWII era. History suggests that the number of refugees in the world at any point in time is a function of economic prosperity (or the lack thereof) in poorer continents (Chart 14). For instance, the periods spanning 1980-90 and 2015-20 saw the world’s poorer continents lose their share in global GDP. Unsurprisingly these phases also saw a marked increase in the number of refugees. With the world’s poorer continents expected to lose share in global GDP again going forward, the number of refugees in the world will only rise. Chart 14Refugee Flows Rise When Growth Weak In Poor Continents Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Citizens of Syria, Venezuela, Afghanistan, South Sudan, and Myanmar today account for two-thirds of all refugees globally. To start with, these five countries’ share in global GDP was low at 0.8% in the 1980s. Now their share in global GDP is set to fall to 0.2% over the next five years (Chart 15). Chart 15Refugee Exporters Hit All-Time Low In Global GDP Share Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Per capita incomes in top refugee source countries tend to be very low. Whilst regime fractures appear to be the proximate cause of refugee outflux, an economic collapse is probably the root cause of the civil strife and waves of refugee movement seen out of the top refugee source countries. Another factor that could have a bearing is the rise of multipolarity. Shifting power structures in the global economy affect the stability of regimes with weak institutions. Instability in Afghanistan has been a direct result of the rise and the fall of the British and Russian empires. American imperial overreach is just the latest episode. If another Middle Eastern war erupts, the implications are obvious. But so too are the implications of US-China proxy wars in Southeast Asia or Russia-West proxy wars in eastern Europe. Bottom Line: With poorer continents’ economic prospects likely to remain weak and with multipolarity here to stay, the world’s refugee problem is here to stay too. Is A Repeat Of 2015 Refugee Crisis Likely In 2021? No. 2021 will not be a replica of 2015. This is owing to two key reasons. First, Afghanistan has long witnessed a steady outflow of refugees – especially at the end of the twentieth century but also throughout the US’s 20-year war there. The magnitude of the refugee problem in 2021 will be significantly smaller than that in 2015. Secondly, voters are now differentiating between immigrants and refugees with the latter entity gaining greater acceptance (Chart 16). Chart 16DM Attitudes Permissive Toward Refugees Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Chart 17Refugees Will Not Change Game In German/French Elections Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) Concerns about refugees will gain some political traction but it will reinforce rather than upset the current trajectory in the most important upcoming elections, in Germany in September and France next April. True, these countries feature in the list of top countries to which Afghan refugees flee and will see some political backlash (Chart 17). But the outcome may be counterintuitive. In the German election, any boost to the far-right will underscore the likely underperformance of the ruling Christian Democrats. So the German elections will produce a left-wing surprise – and yet, even if the Greens won the chancellorship (the true surprise scenario, looking much less likely now), investors will cheer the pro-Europe and pro-fiscal result. The French election is overcrowded with right-wing candidates, both center-right and far-right, giving President Macron the ability to pivot to the left to reinforce his incumbent advantage next spring. Again, the euro and the equity market will rise on the status quo despite the political risk shown in our indicator (Appendix). Of course, immigration and refugees will cause shocks to European politics in future, especially as more regime failures in the third world take place to add to Afghanistan and Ethiopia. But in the short run they are likely to reinforce the fact that European politics are an oasis of stability given what is happening in the US, China, Brazil, and even Russia and India. Bottom Line: 2021 will not see a repeat of the 2015 refugee crisis. Ironically Afghan refugees could reinforce European integration in both German and French elections. The magnitude of the Afghan crisis is smaller than in the past and most Afghan refugees are likely to migrate to Pakistan and Iran (Chart 17). But more regime failures will ensure that the flow of people becomes a political risk again sometime in the future. What Does The Rise Of Taliban Mean For India? The Taliban first held power in Afghanistan from 1996-2001. This was one of the most fraught geopolitical periods in South Asia since the 1970s. Now optimists argue that Taliban 2.0 is different. Taliban leaders are engaging in discussions with an ex-president who was backed by America and making positive overtures towards India. So, will this time be different? It is worth noting that Taliban 2.0 will have to function within two major constraints. First, Afghanistan is deeply divided and diverse. Afghanistan’s national anthem refers to fourteen ethnic groups. Running a stable government is inherently challenging in this mountainous country. With Taliban being dominated by one ethnic group and with limited financial resources at hand, the Taliban will continue to use brute force to keep competing political groups at bay. Chart 18Taliban In Line With Afghanis On Sharia Biden's Show Of Force (GeoRisk Update) Biden's Show Of Force (GeoRisk Update) At the same time, to maintain legitimacy and power, the Taliban will have to support aligned political groups operating in Afghanistan and neighboring Pakistan. Second, an overwhelming majority of Afghani citizens want Sharia law, i.e. a legal code based on Islamic scripture as the official law of the land (Chart 18). Hence if the Taliban enforces a Sharia-based legal system in Afghanistan then it will fall in line with what the broader population demands. It is against this backdrop that Taliban 2.0 is bound to have several similarities with the version that ruled from 1996-2001. Additionally, US withdrawal from Afghanistan will revive a range of latent terrorist movements in the region. This poses risks for outside countries, not least India, which has a long history of being targeted by Afghani terrorist groups. The US will remain engaged in counter-terrorism operations. To complicate matters, India’s North has an even more unfavorable view of Pakistan than the rest of India. With the northern voter’s importance rising, India’s administration may be forced to respond more aggressively to a terrorist event than would have been the case about a decade ago. It is also possible that terrorism will strike at China over time given its treatment of Uighur Muslims in Xinjiang. China’s economic footprint in Afghanistan could precipitate such a shift. Bottom Line: US withdrawal from Afghanistan is bound to add to geopolitical risks as latent terrorist forces will be activated. India has a long history of being targeted by Afghani terrorist movements. Incidentally, it will take time for transnational terrorism based in Afghanistan to mount successful attacks at the West once again, given that western intelligence services are more aware of the problem than they were in 2000. But non-state actors may regain the element of surprise over time, given that the western powers are increasingly focused on state-to-state struggle in a new era of great power competition.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Section II: GeoRisk Indicator China China: GeoRisk Indicator China: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Taiwan Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights Commodity markets will face growing supply challenges over the next decade as the US and China prepare for war, if only to deter war. Chinese President Xi Jinping's push for greater self-reliance at home and supply chain security abroad is reinforced by the West’s focus on the same interests. The erosion of a single rules-based global trade system increases the odds of economic and even military conflict. The competition for security is precipitating a reforging of global supply chains and a persistent willingness to use punitive measures, which can escalate into boycotts, embargoes, and even blockades (i.e. not only Huawei). The risk of military engagements will rise, particularly along global chokepoints and sea lanes needed to transport vital commodities. Import dependency and supply chain risk are powerful drivers of decarbonization efforts, especially in China. On net, geopolitical trends will keep the balance of commodity-price risks tilted to the upside. Commodity and Energy Strategy remains long commodity index exposure on a strategic basis via the S&P GSCI and the COMT ETF.  Note: Even in the short term, a higher geopolitical risk premium is warranted in oil prices due to US-Iran conflict. Feature The Chinese Communist Party (CCP) under President Xi Jinping has embarked on a drive toward autarky, or economic self-sufficiency, that has enormous implications, especially for global commodities. Beijing believes it can maintain central control, harness technology, enhance its manufacturing prowess, and grow at a reasonable rate, all while bulking up its national security. The challenge is to maintain social stability and supply security through the transition. China lives in desperate fear of the chaos that reigned throughout most of the twentieth and twenty-first centuries, which also enabled foreign domination (Chart 1). The problem for the rest of the world is that Chinese nationalism and assertive foreign policy are integral aspects of the new national strategy. They are needed to divert the public from social ills and deter foreign powers that might threaten China’s economy and supply security. Chart 1China Fears Any Risk Of Another ‘Century Of Humiliation’ US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand The chief obstacle for China is the United States, which remains the world leader even though its share of global power and wealth is declining over time. The US is formally adopting a policy of confrontation rather than engagement with China. For example, the Biden administration is co-opting much of the Trump administration's agenda. Infrastructure, industrial policy, trade protectionism, and the “pivot to Asia” are now signature policies of Biden as well as Trump (Table 1).1 Table 1US Strategic Competition Act Highlights Return Of Industrial Policy, Confrontation With China US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Many of these policies are explicitly related to the strategic aim of countering China’s rise, which is seen as vitiating the American economy and global leadership. Biden’s Trump-esque policies are a powerful indication of where the US median voter stands and hence of long-term significance (Chart 2). Thus competition between the US and China for global economic, military, and political leadership is entering a new phase. China’s drive for self-reliance threatens the US-led global trade system, while the US’s still-preeminent geopolitical power threatens China’s vital lines of supply. Chart 2US Public’s Fears Are China-Centric US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Re-Ordering Global Trade The US’s and China’s demonstrable willingness to use tariffs, non-tariff trade barriers, export controls, and sanctions cannot be expected to abate given that they are locked in great power competition (Chart 3). More than likely, the US and China will independently pursue trade relations with their respective allies and partners, which will replace the mostly ineffective World Trade Organization (WTO) framework. The WTO is the successor to the rules-based and market-oriented system known as the General Agreement on Tariffs and Trade (GATT), which was formed following World War II. The GATT’s founders shared a strong desire to avoid a repeat of the global economic instability brought on by World War I, the Great Crash of 1929, and the retreat into autarky and isolationism that led to WWII. Chart 3US and China Imposing Trade Restrictions US and China Imposing Trade Restrictions US and China Imposing Trade Restrictions This inter-war period saw domestically focused monetary policies and punishing tariffs that spawned ruinous bouts of inflation and deflation. Minimizing tariffs, leveling the playing field in trading markets, and reducing subsidization of state corporate champions were among the GATT's early successes. The WTO, like the GATT before it, has no authority to command a state to change its economy or the way it chooses to organize itself. At its inception the GATT's modus vivendi was directed at establishing a rules-based system free of excessive government intrusion and regulation. If governments agreed to reduce their domestic favoritism, they could all improve their economic efficiency while avoiding a relapse into autarky and the military tensions that go with it.2 The prime mover in the GATT's founding and early evolution – the USA – firmly believed that exclusive trading blocs had created the groundwork for economic collapse and war. These trading blocs had been created by European powers with their respective colonies. During the inter-war years the revival of protectionism killed global trade and exacerbated the Great Depression. After WWII, Washington was willing to use its power as the global hegemon to prevent a similar outcome. Policymakers believed that European and global economic integration would encourage inter-dependency and discourage protectionism and war. The fall of the Soviet Union reinforced this neoliberal Washington Consensus. Countries like India and China adopted market-oriented policies. The WTO was formed along with a range of global trade deals. Ultimately the US and the West cleared the way for China to join the trading bloc, hoping that the transition from communism to capitalism would eventually be coupled with social and even political liberalization. The world took a very different turn as the United States descended into a morass of domestic political divisions and foreign military adventures. China seized the advantage to expand its economy free of interference from the US or West. The West failed to insist that liberal economic reforms keep pace.3 Moreover, when China joined the WTO in 2001, the organization was in a state of "regulatory stalemate," which made it incapable of dealing with the direct challenges presented by China.4 Today President Xi has consolidated control over the Communist Party and directs its key economic, political, and military policymaking bodies. He has deepened party control down to the management level of SOEs – hiring and firing management. SOEs have benefited from Xi’s rule (Chart 4). But now the West is also reasserting the role of the state in the economy and trade, which means that punitive measures can be brought to bear on China’s SOEs. Chart 4State-Owned Enterprises Benefit From Xi Administration State-Owned Enterprises Benefit From Xi Administration State-Owned Enterprises Benefit From Xi Administration What Comes After The WTO? The CCP has shown no interest in coming around to the WTO's founding beliefs of government non-interference in the private sector. For example, it is doubling down on subsidization and party control of SOEs, which compete against firms in other WTO member states. Nor has the party shown any inclination to accept a trade system based on the GATT/WTO founding members' Western understanding of the rule of law. These states represent market-based economies with long histories of case law for settling disputes. Specifically, China’s fourteenth five-year plan and recent policies re-emphasize the need to upgrade the manufacturing sector rather than rebalancing the economy toward household consumption. The latter would reduce imbalances with trade deficit countries like the US but China is wary of the negative social consequences of too rapidly de-industrializing its economy. It wants to retain its strategic and economic advantage in global manufacturing and it fears the social and political consequences of fully adopting consumer culture (Chart 5). Chart 5China’s Economic Plans Re-Emphasize Manufacturing, Not Consumption US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand The US, EU, and Japan have proposed reform measures for the WTO aimed at addressing “severe excess capacity in key sectors exacerbated by government financed and supported capacity expansion, unfair competitive conditions caused by large market-distorting subsidies and state owned enterprises, forced technology transfer, and local content requirements and preferences.”5 But these measures are unlikely to succeed. China disagrees with the West’s characterization. In 2018-19, during the trade war with the US, Beijing contended that WTO members must “respect members’ development models.” China formally opposes “special and discriminatory disciplines against state-owned enterprises in the name of WTO reform.”6 In bilateral negotiations with the US this year, China’s first demand is that the US not to oppose its development model of “socialism with Chinese characteristics” (Table 2). Table 2China’s Three Diplomatic Demands Of The United States (2021) US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Yet it is hard for the US not to oppose this model because it involves Beijing using the state’s control of the economy to strengthen national security strategy, namely by the fusion of civil and military technology. Going forward, the Biden administration will violate the number one demand that Chinese diplomats have made: it will attempt to galvanize the democracies to put pressure on China’s development model. China’s demand itself reflects its violation of the US primary demand that China stop using the state to enhance its economy at the expense of competitors. If a breakdown in global trading rules is replaced by the US and China forming separate trading blocs with their allies and partners, the odds of repeating the mistakes of the inter-bellum years of 1918-39 will significantly increase. Tariff wars, subsidizing national champions, heavy taxation of foreign interests, non-tariff barriers to trade, domestic-focused monetary policies, and currency wars would become more likely. China’s Strategic Vulnerability The CCP has delivered remarkable prosperity and wealth to the average Chinese citizen in the 43 years since it undertook market reforms, and especially since its accession to the WTO in 2001 (Chart 6). China has transformed from an economic backwater into a $15.4 trillion (2020) economy and near-peer competitor to the US militarily and economically.7 This growth has propelled China to the top of commodity-importing and -consuming states globally for base metals and oil. We follow these markets closely, because they are critical to sustaining economic growth, regardless of how states are organized. Production of and access to these commodities, along with natural gas, will be critical over the next decade, as the world decarbonizes its energy sources, and as the US and China address their own growth and social agendas while vying for global hegemony. Decarbonization is part of the strategic race since all major powers now want to increase economic self-sufficiency and technological prowess. Chart 6CCPs Remarkable Success In Growing Chinas Economy CCPs Remarkable Success In Growing Chinas Economy CCPs Remarkable Success In Growing Chinas Economy Over recent decades China has become the largest importer of base metals ores (Chart 7) and the world's top refiner of many of these metals. In addition, it is the top consumer of refined metal (Chart 8). Chart 7China Is World’s Top Ore Importer US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Chart 8China Is Worlds Top Refined Metal Consumer China Is Worlds Top Refined Metal Consumer China Is Worlds Top Refined Metal Consumer By contrast, the US is not listed among ore importers or metals consumers in the Observatory of Economic Complexity (OEC) databases we used to map these commodities. This reflects not only domestic supplies but also the lack of investment and upgrades to the US's critical infrastructure over 2000-19.8 Going forward, the US is trying to invest in “nation building” at home. An enormous change has taken shape in strategic liabilities. In the oil market, the US went from being the world's largest importer of oil in 2000, accounting for more than 24% of imports globally, to being the largest oil and gas producer by 2019, even though it still accounted for more than 12% of the world's imports (Chart 9). In 2000, China accounted for ~ 3.5% of the world's oil imports and by 2019 it was responsible for nearly 21%. China is far behind per capita US energy consumption, given its large population, but it is gradually closing the gap (Chart 10). Overall energy consumption in China is much higher than in the US (Chart 11). Chart 9US Oil Imports Collapse As Shale Production Grows US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Chart 10Energy Use Per Capita In China Far From US Levels... Energy Use Per Capita In China Far From US Levels... Energy Use Per Capita In China Far From US Levels... Chart 11China Is World’s Largest Primary Energy Consumer US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand China's impressive GDP growth in the twenty-first century is primarily responsible for China's stunning growth in imports and consumption of oil (Chart 12) and copper (Chart 13), which we track closely as a proxy for the entire base-metals complex. Chart 12Global Oil Demand Forecast Remains Steady Chinas GDP Drives Oil Consumption, Imports Global Oil Demand Forecast Remains Steady Chinas GDP Drives Oil Consumption, Imports Global Oil Demand Forecast Remains Steady Chinas GDP Drives Oil Consumption, Imports Chart 13Global Oil Demand Forecast Remains Steady Chinas GDP Drives Refined Copper Consumption And Ore Imports Global Oil Demand Forecast Remains Steady Chinas GDP Drives Refined Copper Consumption And Ore Imports Global Oil Demand Forecast Remains Steady Chinas GDP Drives Refined Copper Consumption And Ore Imports China’s importance in these markets points to an underlying strategic weakness, which is its dependency on imports. This in turn points to the greatest danger of the breakdown in US-China relations and the global trade system. The Road To War? China is extremely anxious about maintaining supply security in light of these heavy import needs. Its pursuit of economic self-sufficiency, including decarbonization, is driven by its fear of the US’s ability to cut off its key supply lines. China’s first goal in modernizing its military in recent years was to develop a naval force capable of defending the country from foreign attack, particularly in its immediate maritime surroundings. Historically China suffered from invaders across the sea who took advantage of its weak naval power to force open its economy and exploit it. Today China is thought to have achieved this security objective. It is believed to have a high level of capability within the “first island chain” that surrounds the coast, from the Korean peninsula to the Spratly Islands, including southwest Japan and Taiwan (Map 1).9 China’s militarization of the South China Sea, suppression of Hong Kong, and intimidation of Taiwan shows its intention to dominate Greater China, which would put it in a better strategic position relative to other countries. Map 1China’s Navy Likely Achieved Superiority Within The First Island Chain US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand China’s capability can be illustrated by comparing its naval strength to that of the United States, the most powerful navy in the world. While the US is superior, China would be able to combine all three of its fleets within the first island China, while the US navy would be dispersed across the world and divided among a range of interests to defend (Table 3). China would also be able to bring its land-based air force and missile firepower to bear within the first island chain, as opposed to further abroad.10 Table 3China’s Naval Growth Enables Primacy Within First Island Chain US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand In this sense China is militarily capable of conquering Taiwan or other nearby islands. President Xi Jinping had in fact ordered China’s armed forces be capable of doing so by 2020.11 Taiwan continues to be the most significant source of insecurity for the regime. True, a military victory would likely be a pyrrhic victory, as Taiwan’s wealth and tech industry would be destroyed, but China probably has the raw military capability to defeat Taiwan and its allies within this defined space. However, this military capability needs to be weighed against economic capability. If China seized military control of Taiwan, or Okinawa or other neighboring territories, the US, Japan, and their allies would respond by cutting off China’s access to critical supplies. Most obviously oil and natural gas. China’s decarbonization has been impressive but the reliance on foreign oil is still a fatal strategic vulnerability over the next few years (Chart 14). China is rapidly pursuing a Eurasian strategy to diversify away from the Middle East in particular. But it still imports about half its oil from this volatile region (Chart 15). The US navy is capable of interdicting China’s critical oil flows, a major inhibition on China’s military ambitions within the first island chain. Chart 14Chinas Energy Diversification Still Leaves Vulnerabilities Chinas Energy Diversification Still Leaves Vulnerabilities Chinas Energy Diversification Still Leaves Vulnerabilities Of course, if the US and its allies ever blockaded China, or if China feared they would, Beijing could be driven to mount a desperate attack to prevent them from doing so, since its economic, military, and political survival would be on the line. Chart 15China Still Dependent On Middle East Energy Supplies China Still Dependent On Middle East Energy Supplies China Still Dependent On Middle East Energy Supplies The obvious historical analogy is the US-Japan conflict in WWII. Invasions that lead to blockades will lead to larger invasions, as the US and Japan learned.12 However, the lesson from WWII for China is that it should not engage the US navy until its own naval power has progressed much further. In the event of a conflict, the US would be imposing a blockade at a distance from China’s naval and missile forces. When it comes to the far seas, China’s naval capabilities are extremely limited. Military analysts highlight that China lacks a substantial naval presence in the Indian Ocean. China relies on commercial ports, where it has partial equity ownership, for ship supply and maintenance (Table 4). This is no substitute for naval basing, because dedicated military facilities are lacking and host countries may not wish to be drawn into a conflict. Table 4China’s Network Of Part-Owned Ports Across The World: Useful But Not A Substitute For Military Bases US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Further, Beijing lacks the sea-based air power necessary to defend its fleets should they stray too far. And it lacks the anti-submarine warfare capabilities necessary to defend its ships.13 These capabilities are constantly improving but at the moment they are insufficient to overthrow US naval control of the critical chokepoints like the Strait of Hormuz or Strait of Malacca. While China’s naval power is comparable to the US’s Asia Pacific fleet (the seventh fleet headquartered in Japan), it is much smaller than the US’s global fleet and at a much greater disadvantage when operating far from home. China’s navy is based at home and focused on its near seas, whereas US fleet is designed to operate in the far seas, especially the Persian Gulf, which is precisely the strategic area in question (Chart 16).14 China is gradually expanding its navy and operations around the world, so over time it may gain the ability to prevent the US from cutting off its critical supplies in the Persian Gulf. But not immediately. The implication is that China will have to avoid direct military conflict with the United States until its military and naval buildup has progressed a lot further. Chart 16China’s Navy At Huge Disadvantage In Distant Seas US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Meanwhile Beijing will continue diversifying its energy sources, decarbonizing, and forging supply chains across Eurasia via the Belt and Road Initiative. What could go wrong? We would highlight a few risks that could cause China to risk war even despite its vulnerability to blockade: Chart 17China’s Surplus Of Males Undergirds Rise In Nationalism US-China: War Preparation Pushes Commodity Demand US-China: War Preparation Pushes Commodity Demand Domestic demographic pressure. China is slated to experience a dramatic bulge in the male-to-female ratio over the coming decade (Chart 17).15 A surfeit of young men could lead to an overshoot of nationalism and revanchism. This trend is much more important than the symbolic political anniversaries of 2027, 2035, and 2049, which analysts use to predict when China’s military might launch a major campaign. Domestic economic pressure. China’s turn to nationalism reflects slowing income growth and associated social instability. An economic crisis in China would be worrisome for regional stability for many reasons, but such pressures can lead nations into foreign military adventures. Domestic political pressure. China has shifted from “consensus rule” to “personal rule” under Xi Jinping. This could lead to faulty decision-making or party divisions that affect national policy. A leadership that carefully weighs each strategic risk could decay into a leadership that lacks good information and perspective. The result could be hubris and belligerence abroad. Foreign aggression. Attempts by the US or other powers to arm China’s neighbors or sabotage China’s economy could lead to aggressive reaction. The US’s attempt to build a technological blockade shows that future embargoes and blockades are not impossible. These could prompt a war rather than deter it, as noted above. Foreign weakness. China’s capabilities are improving over time while the US and its allies lack coordination and resolution. An opportunity could arise that China’s strategists believe they cannot afford to miss. Afghanistan is not one of these opportunities, but a US-Iran war or another major conflict with Russia could be. The breakdown in global trade is concerning because without an economic buffer, states may resort to arms to resolve disputes. History shows that military threats intended to discourage aggressive behavior can create dilemmas that incentivize aggression. The behavior of the US and China suggests that they are preparing for war, even if we are generous and assume that they are doing so only to deter war. Both countries are nuclear powers so they face mutually assured destruction in a total war scenario. But they will seek to improve their security within that context, which can lead to naval skirmishes, proxy wars, and even limited wars with associated risks of going nuclear. Investment Takeaways The pursuit of the national interest today involves using fiscal means to create more self-sufficient domestic economies and reduce international supply risks. Both China and the West are engaged in major projects to this end, including high-tech industrialization, domestic manufacturing, and decarbonization. These trends are generally bullish for commodities, even though they include trends like military modernization and naval expansion that could well be a prelude to war. War itself leads to commodity shortages and commodity price inflation, but of course it is disastrous for the people and economies involved. Fortunately, strategic deterrence continues to operate for the time being. The underlying geopolitical trend will put commodity markets under continual pressure. A final urgent update on oil and the Middle East: The US attempt to conduct a strategic “pivot” to Asia Pacific faces a critical juncture. Not because of Afghanistan but because of Iran. The Biden administration will have trouble unilaterally lowering sanctions on Iran after the humiliating Afghanistan pullout. The new administrations in both Iran and Israel are likely to establish red lines and credible threats. A higher geopolitical risk premium is thus warranted immediately in global oil markets. Beyond short-term shows of force, everything depends on whether the US and Iran can find a temporary deal to avoid the path to a larger war. But for now short-term geopolitical risks are commodity-bullish as well as long-term risks.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1     There are also significant differences between Biden and Trump in other areas such as redistribution, immigration, and social policy. 2     See Ravenhill, John (2020), Regional Trade Agreements, Chapter 6 in Global Political Economy, which he edited for Oxford University Press, particularly pp. 156-9. 3    “As time went by, the United States realized that Communism not only did not retreat, but also further advanced in China, with the state-owned economy growing stronger and the rule of the Party further entrenched in the process." See Henry Gao, “WTO Reform and China Defining or Defiling the Multilateral Trading System?” Harvard International Law Journal 62 (2021), p. 28, harvardilj.org.  4    See Mavroidis, Petros C. and Andre Sapir (2021), China and the WTO, Why Multilateralism Still Matters (Princeton University Press) for discussion.  See also Confronting the Challenge of Chinese State Capitalism published by the Center for Strategic & International Studies 22 January 2021. 5    Gao (2021), p. 19. 6    Gao (2021), p. 24. 7     Please see China's GDP tops 100 trln yuan in 2020 published by Xinhuanet 18 January 2021. 8    We excluded 2020 because of the COVID-19 pandemic's effects on supply and demand for these ores, metals and crude oil. 9    See Captain James Fanell, “China’s Global Navy Strategy and Expanding Force Structure: Pathway To Hegemony,” Testimony to the US House of Representatives, May 17, 2018, docs.house.gov. 10   Fanell (2018), p. 13. 11    He has obliquely implied that his vision for national rejuvenation by 2035 would include reunification with Taiwan. Others suggest that the country’s second centenary of 2049 is the likely deadline, or the 100th anniversary of the People’s Liberation Army. 12    The US was a major supplier of oil to Japan, and in 1941 it froze Japan's assets in the US and shut down all oil exports, in response to Japan's military incursion into China in the Second Sino-Japanese War of 1937-45.  Please see Anderson, Irvine H. Jr. (1975), "The 1941 De Facto Embargo on Oil to Japan: A Bureaucratic Reflex," Pacific Historical Review, 44:2, pp. 201-231.  13   See Jeffrey Becker, “Securing China’s Lifelines Across the Indian Ocean,” China Maritime Report No. 11 (Dec 2020), China Maritime Studies Institute, digital-commons.usnwc.edu. 14   See Rear Admiral Michael McDevitt, “Becoming a Great ‘Maritime Power’: A Chinese Dream,” Center for Naval Analyses (June 2016), cna.org. 15   For discussion see Major Tiffany Werner, “China’s Demographic Disaster: Risk And Opportunity,” 2020, Defense Technical Information Center, discover.dtic.mil.  

Highlights China’s new plan for “common prosperity” is a long-term strategic plan to bulk up the middle class that will strengthen China – if it is implemented successfully. The record on implementing reforms is mixed. Large budget deficits to provide subsidies for households and key industries are inevitable. But fiscal reforms will be more difficult. Implementation will proceed gradually and some provinces will move faster than others. Cyclically, the common prosperity plan will not be allowed to interfere with the post-pandemic economic recovery. Beijing will have to ease monetary and fiscal policy to secure the recovery. But large debt levels create a limit on the ability to push through key reforms. Macro policy easing is beneficial for the rest of the world but Chinese investors must deal with a rise in uncertainty and an anti-business turn in the policy environment. Beijing has centralized political power to move rapidly on reforms. However, centralization creates new structural problems while antagonizing foreign nations. Feature Chinese President Xi Jinping laid out a plan on August 18 for “common prosperity” in China that will help guide national policy over the coming decades. The plan seeks to reduce social and economic imbalances and hence strengthen China and reinforce the Communist Party’s rule. The plan confirms our top key view for the year – China’s confluence of internal and external risks – as well as our long-running theme that Chinese domestic political risk is greater than it looks because of underlying problems like inequality and weak governance. The market has woken up to these views and themes (Chart 1). Now Beijing is turning to address these problems, which is positive if it follows through. But investors will have to cope with new policies and laws that reverse the pro-business context of recent decades. In this report we review the new plan and its implications in the context of overall Chinese economic policy. The chief investment takeaway is that while China will push forward various reforms, Beijing cannot afford to self-inflict an economic collapse. Monetary and fiscal policy will ease over the coming 12 months. As such China policy tightening will not short-circuit the global recovery. However, Chinese corporate earnings and the renminbi will not benefit from the country’s anti-business turn. Chart 1Market Wakes Up To China's Political Risk Market Wakes Up To China's Political Risk Market Wakes Up To China's Political Risk What Is In The Common Prosperity Plan? The first thing to understand about Beijing’s new plan for “common prosperity” is that it is aspirational: it contains few specific targets or concrete policies. It builds on existing policy goals set for 2049, the hundredth anniversary of the People’s Republic. Implementation will be gradual. The plan is consistent with the Xi administration’s previous emphasis on improving the country’s quality of life and tackling systemic risks. It takes aim at social immobility, income and wealth inequality, poor public services, a weak social safety net, and other problems that did not receive enough attention during China’s rapid growth phase over the past forty years. Left unattended, China’s socioeconomic imbalances could fester and eventually destabilize the regime. From the beginning, the Xi administration has tackled the most pressing popular concerns to try to rebuild the party’s legitimacy, increase public support, and avoid crises. Crackdowns on pollution and excessive debt are prime examples. China does indeed suffer from high income inequality and low social mobility, as we have highlighted in key reports. It is comparable to the United States as well as Italy, Argentina, and Chile, all of which have suffered from significant social and political upheaval in recent memory (Chart 2). By contrast, Japan, Germany, and Australia have been relatively politically stable. Chart 2China Risks Social Unrest Like The Americas China Spreads The Wealth Around China Spreads The Wealth Around Table 1 summarizes the common prosperity plan. The key takeaways are the long 2049 deadline, the emphasis on “mixed ownership” in the corporate sphere (retaining a big role for state control and state-owned enterprises but attracting private capital), the redistribution of household income (reform the tax code), the establishment of property rights, the censorship of media/discourse, and the need to reduce rural disparity. The most important point of all is that Beijing intends to grow the size and wellbeing of the middle class – the foundation of a country’s strength. Table 1China’s “Common Prosperity” Plan For 2049 China Spreads The Wealth Around China Spreads The Wealth Around Coastal China today has reached Taiwanese and Korean levels of per capita income and has slightly exceeded their levels of wealth inequality (Chart 3). These countries witnessed social unrest and regime change in the 1980s due to such problems. The urban-rural gap is even more problematic in China due to its large rural population and territory. The Chinese public is expected to become more demanding as it evolves. Hence Beijing is pledging to redistribute wealth, grow the middle class, speed up income growth among the poorest, reduce rural disparities, expand access to elderly care, medicine, and housing, and establish a better legal framework for business. These goals are positive in principle, especially for household sentiment, social stability, and political support for the administration. But they also entail a higher tax/wage/regulation environment for business and corporate earnings. The question for investors centers on implementation. Chart 3China's Wealth Disparities Outstrip Comparable Neighbors China's Wealth Disparities Outstrip Comparable Neighbors China's Wealth Disparities Outstrip Comparable Neighbors What About Vested Interests? Table 1 above shows that the super-committee that issued the common prosperity plan also addressed China’s ongoing battle against financial risk. The financial policy statement was neither new nor surprising but it highlights something important: “preventing risks” will have to be balanced with “ensuring stable growth.” This balancing of reform and growth is essential to Chinese government and will guide the implementation of the common prosperity plan just as it has guided President Xi’s crackdown on shadow banking. This is an especially pertinent point today, as Beijing runs the risk of overtightening monetary, fiscal, and regulatory policies. While Beijing’s vision of a better regulated, more heavily taxed, and higher-wage society should not be underrated, reform initiatives will be delayed if they threaten to derail the post-pandemic recovery. Time and again the Xi administration has ruled against a rapid, resolute, and disruptive approach to reform, such as the “assault phase of reform” spearheaded by Premier Zhu Rongji in the late 1990s. In the plan’s own words: “achieving common prosperity will be a long-term, arduous, and complicated task and it should be achieved in a gradual and progressive manner.” Having said that, the pattern of reform has been a vigorous launch, a market riot, and then backtracking or delay. This means markets face more volatility first before things settle down. An initial volley of policy actions should be expected between now and spring of 2023, when the National People’s Congress solidifies the plans of the twentieth National Party Congress in fall 2022. As with the ongoing regulatory crackdown on Big Tech, the market may experience a technical rebound but the political assessment suggests government pressure will be sustained for at least the next 12 months. We do not recommend bottom feeding in Chinese equities. Will the reforms be effective over time? When the Xi administration took power in 2012-13, it issued a visionary policy document calling for wide-ranging reforms to China’s economy (“Decision on Several Major Questions About Deepening Reform”).1 Over the past decade these reforms have had mixed success. Rhodium Group maintains a reform tracker to monitor progress – the results are lackluster (Table 2). Some core principles, such as the claim that China would make market forces “decisive” in allocating resources, have been totally reversed. Table 2China’s Progress On Reforms Over Past Decade China Spreads The Wealth Around China Spreads The Wealth Around While China’s government model is absolutist, there are still social and economic limits on what the government can achieve. Beijing cannot raise a nationwide property tax, estate tax, and capital gains tax overnight just to reduce inequality. In fact, the long saga of the property tax tells a very different story. Beijing is limited in how it can tax the bubbling property sector because Chinese households store their wealth in houses and because any sustained price deflation would lead to a national debt crisis. Officials have pledged to advance a nationwide property tax in the past three five-year plans with little progress. A serious effort to impose the tax in 2014 was only implemented in two provinces, notably Shanghai’s tax on second or third homes owned by the same household.2 The common prosperity plan entails that the government will revive the property tax but the rollout will still be gradual and step-by-step reform. The tax will focus on major urban areas, not minor ones where population decline could weigh on prices. The government work report in early 2023 will be a key watchpoint for where and when the property tax will be levied but there can be little doubt that it will gradually be levied for top-tier cities. Other aspects of the common prosperity plan will be implemented with provincial trial runs. It all begins with a “demonstration zone,” namely Zhejiang province, a wealthy coastal state where President Xi Jinping once served as party secretary and first army secretary. Zhejiang is expected to make some progress by 2025 and achieve most the goals by 2035 (in keeping with Xi’s 2035 strategic vision). The Zhejiang plan includes concrete numerical targets and as such sheds light on the broader national plan and how other provinces will implement it. The most important target is the desire to have 80% of the population earn an annual disposable income of CNY 100,000-500,000 ($15,400-77,000). The labor share of output should be greater than 50%, compared to a national average of 35%-40%. The urbanization rate should hit 75%, up from 72%. Urban incomes should be capped at just short of twice that of rural income. Enrollment rates in higher education will go up, life expectancy should reach above 80 years, pollution should be further controlled, and the unemployment rate should stay below 5.5%. A host of other goals, ranging from technology to fertility and the social safety net, are shown in Table 3. Table 3China: Zhejiang Province As Bellwether For “Common Prosperity” Plan China Spreads The Wealth Around China Spreads The Wealth Around Some of the plan’s intentions will be undermined by Chinese governance. It is difficult to improve social fairness and property rights in the context of autocracy because the central and local governments create distortions and cannot be held to account for their own mistakes and abuses. The immediate political context of the common prosperity plan should not be missed: the president is outlining a bright future to justify the fact that he will not step down from power as earlier term limits required in fall 2022. The president’s 2035 vision implies an important strategic window in which to accomplish ambitious goals but the lack of checks and balances suggests that the next 14 years could be very similar to the last 10 years, in which arbitrary and absolutist decisions govern policy. The problem is highlighted by China’s recent 10-point plan on government under rule of law, which is undercut by the arbitrary actions of regulators in the tech crackdown (see Appendix). In other words, while social stability may improve in many ways, the shift away from consensus rule, toward rule of a single person, will increase policy uncertainty and create new governance problems at the same time that could produce greater instability over the long run. Having said all that, it is essential to acknowledge that a comprehensive plan to grow the middle class and expand the social safety net could be very positive for China if implemented. A Global Social Justice Race? If investors are thinking that the Xi administration’s calls for “social fairness and justice” and big new investments in “elderly care, medical security, and housing supply” resemble those of US President Joe Biden in his American Families Plan, then they are right. But while the US is already at historic levels of social division after failing to deal with inequality, China is attempting to learn from the US’s problems and rebalance society before polarization, factionalization, and social unrest occur. The Communist Party tends to take major action in response to American crises. Beijing’s crackdown on extremism and domestic terrorism in the early 2000s followed from the September 11 attacks. Its crackdown on local government debt and shadow banking stemmed from the 2008 financial crisis. And its crackdown on Big Tech, social media, and inequality today responds to the rise of populism in the US and Europe. The fact that deindustrialization has led to political crises in the developed world, and that social media companies can both exacerbate social unrest and silence a sitting president, is not lost on the Chinese administration. Unfortunately, China’s approach will probably escalate conflict with the West. First, Beijing is coupling its new social agenda with an aggressive campaign of military modernization and technological acquisition. It is doubling down on advanced manufacturing as its future economic model. The liberal democracies will not only be forced to defend their own political systems and governance models but will also be pressured into more hawkish stances on foreign, trade, and defense policy toward China. So far China is still attractive to foreign investors but the combination of socialist policy, import substitution, and foreign protectionism should put a cap on investment flows over time (Chart 4). What is the net effect of social largesse at home and great power competition abroad? Larger budget deficits. Fiscal expansionism is the key mechanism for the US and China to reboot their economies, reduce social pressures, secure supply chains, and compete with other each other. And expansionary fiscal policies will boost inflation expectations on the margin. One thing is clear: China’s regime will be imperiled if instead of common prosperity and “national rejuvenation” it gets economic collapse. Beijing is already seeing capital outflows reminiscent of the crisis period in 2014-15 when aggressive reforms triggered a collapse in risk appetite and a stock market crash (Chart 5). The implication is that monetary and fiscal easing will accompany the reform agenda. Chart 4China's New Policies Will Deter Foreign Investment China's New Policies Will Deter Foreign Investment China's New Policies Will Deter Foreign Investment Chart 5Capital Flight And Capital Controls A Risk If Implementation Aggressive Capital Flight And Capital Controls A Risk If Implementation Aggressive Capital Flight And Capital Controls A Risk If Implementation Aggressive That would be marginally positive for global growth and EM countries that export to China. Investors in China, however, will have to deal with greater policy uncertainty as China attempts to redistribute wealth while waging a cold war abroad. Investment Takeaways None of Beijing’s social goals can be met if overall growth and job creation slow too much. Reforms are constantly subject to the ultimate constraint of maintaining overall stability. Already in 2021 Beijing is verging on excessive monetary and fiscal policy tightening (Chart 6). The Politburo signaled in July that it would take its foot off the brakes but policy uncertainty is still wreaking havoc in the equity market and overall animal spirits are downbeat. We expect policy to ease over the coming year to ensure stability ahead of the twentieth national party congress. This would be marginally good news for global growth, contingent on the effects of the global pandemic. Of course we cannot deny that more bad news for global risk assets may be necessary in the very near term to prompt the policy easing that we expect. Policymakers will backtrack on various policies when the market revolts or when the risk of debt-deflation rears its ugly head. Corporate and even household debt have expanded so much in recent years that Chinese policymakers have their hands tied when they try to push reforms too aggressively (Chart 7). A Japanese-style combination of a shrinking and graying population could create a feedback loop with debt deleveraging in the event of a sharp drop in asset prices. On the whole we maintain a pessimistic outlook on Chinese currency and assets. Chart 6China Runs Risk Of Overtightening Policy China Runs Risk Of Overtightening Policy China Runs Risk Of Overtightening Policy Chart 7Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative Debt Trap Must Be Avoided - Monetary/ Fiscal Policy Will Stay Accommodative   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com     Appendix Table A1China: 10-Point Guidelines On Government Under Rule Of Law (2021-25) China Spreads The Wealth Around China Spreads The Wealth Around Footnotes 1     See Arthur R. Kroeber, “Xi Jinping’s Ambitious Agenda for Economic Reform in China,” Brookings, November 17, 2013, brookings.edu. 2     Chongqing’s property tax only affects luxury houses. Shenzhen and Hainan are the next pilot projects.

Highlights Going into the new crop year, we expect the course of the broad trade-weighted USD to dictate the path taken by grain and bean prices (Chart of the Week). Higher corn stocks in the coming crop year, flat wheat stocks and lower rice stocks will leave grain markets mostly balanced vs the current crop year.  Soybean stocks and carryover estimates from the USDA and International Grains Council (IGC) are essentially unchanged year-on-year (y/y). In the IGC's estimates, changes in production, trade, and consumption for the major grains and beans largely offset each other, leaving carryovers unchanged. Supply-demand fundamentals leave our outlook for grains and beans neutral.  This does not weaken our conviction that continued global weather volatility will tip the balance of price risk in grains and beans over the coming year to the upside. Our strategically bearish USD view also tips the balance of price risk in grains – and commodities generally – to the upside. We believe positioning for higher-volatility weather events and a lower US dollar is best done with index products like the S&P GSCI and the COMT ETF, which tracks a version of the GSCI optimized for backwardation.  Feature Chart of the WeekUSD Will Drive Global Grain Markets USD Will Drive Global Grain Markets USD Will Drive Global Grain Markets Chart 2Opening, Closing Grain Stocks Will Be Largely Unchanged Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Going into the new crop year, opening and closing stocks are expected to remain flat overall vs the current crop years, with changes in production and consumption largely offsetting each other in grain and bean markets (Chart 2).1 This will leave overall prices a function of weather – which no one can predict – and the path taken by the USD over the coming year. The IGC's forecast calls for mostly unchanged production and consumption for grains and beans globally, with trade volumes mostly flat y/y. This leaves global end-of-crop-year carryover stocks essentially unchanged at 594mm tons. The USDA expects wheat ending stocks at the end of the '21/22 crop year up a slight 0.5%; rice down ~ 4.5%, and corn up ~ 4%. Below we go through each of the grain and bean fundamentals, and assess the impact of COVID-19 on global trade in these commodities. We then summarize our overall view for the grain and bean complex, and our positioning recommendations. Rice The IGC forecasts higher global rice production and consumption, and, since they expect both to change roughly by the same amount, ending stocks are projected to remain unchanged in the '21/22 crop year relative to the current year (Chart 3). The USDA, on the other hand, is expecting global production to increase by ~ 1mm MT in the new crop year, with consumption increasing by ~ 8mm MT. This leaves ending inventories for the new crop year just under 8mm MT below '20/21 ending stocks, or 4.5%. Chart 3Global Rice Balances Roughly Unchanged Global Rice Balances Roughly Unchanged Global Rice Balances Roughly Unchanged Corn The IGC forecasts global corn production will rise 6.5% to a record high in the '21/22 crop year, while global consumption is expected to increase 3.6%. Trade volumes are expected to fall ~ 4.2%, leaving global carryover stocks roughly unchanged (Chart 4). In the USDA's modelling, global production is expected to rise 6.6% in the '21/22 crop year to 1,195mm MT, while consumption is projected to rise ~ 2.4% to 1,172mm MT. The Department expects ending balances to increase ~ 11mm MT, ending next year at 291.2mm MT, or just over 4% higher. Chart 4Corn Balances Y/Y Remain Flat Corn Balances Y/Y Remain Flat Corn Balances Y/Y Remain Flat Wheat The IGC forecasts global wheat production in the current crop year will increase by ~ 16mm MT y/y, which will be a record if realized. Consumption is expected to rise 17mm MT, with trade roughly unchanged. This leaves expected carryover largely unchanged at ~ 280mm MT globally (Chart 5). The USDA's forecast largely agrees with the IGC's in its ending-stocks assessment for the new crop year. Global wheat production is expected to increase 16.6mm MT y/y in '21/22, and consumption will rise ~ 13mm MT, or 1.7% y/y. Ending stocks for the new crop year are expected to come in at just under 292mm MT, or 0.5% higher. Chart 5Ending Wheat Stocks Mostly Unchanged Ending Wheat Stocks Mostly Unchanged Ending Wheat Stocks Mostly Unchanged Soybeans Both the IGC and USDA expect increases in soybean ending stocks for the '21/22 crop year. However, the USDA’s estimates for ending stocks are nearly double the IGC projections.2 We use the IGC's estimates in Chart 6 to depicts balances. USDA - 2021/22 global soybean ending stocks are set to increase by ~3 mm MT to 94.5 mm MT, as higher stocks from Brazil and Argentina are partly offset by lower Chinese inventories. US production is expected to make up more than 30% of total production, rising 6% year-on-year. Chart 6Higher Bean Production Meets Higher Consumption Higher Bean Production Meets Higher Consumption Higher Bean Production Meets Higher Consumption Impact Of COVID-19 On Ags Trade Global agricultural trade was mostly stable throughout the COVID-19 pandemic. China was the main driver for this resilience, accounting for most of the increase in agricultural imports from 2019 to 2020. Ex-China, global agricultural trade growth was nearly zero. During this period, China was rebuilding its hog stocks after an outbreak of the African Swine Flu, which prompted the government to grant waivers on tariffs in key import sectors, which increased trade under the US-China Phase One agreement. As a result, apart from COVID-19, other factors were influencing trade. Arita et. al. (2021) attempted to isolate the impact of COVID on global agricultural trade.3 Their report found that COVID-19 – through infections and deaths – had a small impact on global agricultural trade. Government policy restrictions and reduced mobility in response to the pandemic were more detrimental to agricultural trade flows than the virus itself in terms of reducing aggregate demand. Policy restrictions and lower mobility reduced trade by ~ 10% and ~ 6% on average over the course of the year. Monthly USDA data shows that the pandemic was not as detrimental to agricultural trade as past events. Rates of decline in global merchandise trade were sharper during the Great Recession of 2007 – 2009 (Chart 7). Many agricultural commodities are necessities, which are income inelastic. Furthermore, shipping channels for these types of commodities did not require substantial human interactions, which reduced the chances of this trade being a transmission vector for the virus, when governments declared many industries using and producing agricultural commodities as necessities. This could explain why agricultural trade was spared by the pandemic. Amongst agricultural commodities, the impact of the pandemic was heterogenous. For necessities such as grains or oilseeds, there was a relatively small effect, and in few instances, trade actually grew. For example, trade in rice increased by ~4%. The value of trade in higher-end items, such as hides, Chart 7COVID-19 Spares Ag Trade Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Chart 8Grains Rallied During Pandemic Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices Global Grain, Bean Markets Balanced; USD Expected To Drive '21/22 Prices tobacco, wine, and beer fell during the pandemic. This was further proof of the income inelasticity of many agricultural products which kept global trade in this sector resilient. Indeed, the UNCTAD estimates global trade for agriculture foods increased 18% in 1Q21 relative to 1Q19. Over this period, Bloomberg's spot grains index was up 47.08% (Chart 8). Investment Implications We remain neutral grains and beans based on our assessment of the new crop-year fundamentals. That said, we have a strong-conviction view global weather volatility will tip the balance of price risk in grains over the coming year to the upside. Our strategically bearish USD view also tips the balance of price risk in grains – and commodities generally – to the upside. Weather-induced grain and bean prices volatility is supportive for our recommendations in the S&P GSCI and the COMT ETF, which tracks a version of the GSCI optimized for backwardation. These positions are up 5.8% and 7.9% since inception, and are strategic holdings for us.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish US natural gas prices remain well supported by increased power-generation demand due to heat waves rolling through East and West coasts, lower domestic production and rising exports. The US EIA estimates natgas demand for July rose 3.9 bcf/d vs June, taking demand for the month to 75.8 bcf/d. Exports – pipeline and LNG – rose 0.4 bcf/d to 18.2 bcf/d, while US domestic production fell to 92.7 bcf/d, down 0.2 bcf/d from June's levels. As US and European distribution companies and industrials continue to scramble for gas to fill inventories, we expect natgas to remain well bid as the storage-injection season winds down. We remain long 1Q22 call spreads, which are up ~214% since the position was recommended April 8, 2021 (Chart 9). Base Metals: Bullish Labor and management at BHP's Escondida copper mine – the largest in the world – have a tentative agreement to avoid a strike that would have crippled an already-tight market. The proposed contract likely will be voted on by workers over the next two days, according to reuters.com. Separately, the head of a trade group representing Chile's copper miners said prices likely will remain high over the next 2-3 years as demand from renewables and electric vehicles continues to grow. Diego Hernández, president of the National Society of Mining (SONAMI), urged caution against expecting a more extended period of higher prices, however, mining.com reported (Chart 10). We remain bullish base metals generally, copper in particular, which we expect to remain well-bid over the next five years. Precious Metals: Bullish US CPI for July rose 0.5% month-over-month, suggesting the inflation spike in June was transitory. While lower inflation may reduce demand for gold, it will allow the Fed to continue its expansionary monetary policy. The strong jobs report released on Friday prompted markets and some Fed officials to consider tapering asset purchases sooner than previously expected. The jobs report also boosted an increasing US dollar. A strong USD and an increase in employment were negative for gold prices on Monday. There also were media reports of a brief “flash crash” caused by an attempt to sell a large quantity of gold early in the Asian trading day, which swamped available liquidity at the time. This also was believed to trigger stops and algorithmic trading programs, which exacerbated the move. The potential economic impact of the COVID-19 Delta variant is the only unequivocally supportive development for gold prices. Not only will this increase safe-have demand for gold, but it will also prevent the Fed from being too hasty in tapering its asset purchases and subsequently raising interest rates. Chart 9 Natgas Prices Recovering Natgas Prices Recovering Chart 10 Copper Prices Going Down Copper Prices Going Down Footnotes 1     The wheat crop year in the US begins in June; the rice crop year begins this month; and the corn and bean crop years begin in September. 2     Historical data indicate this difference is persistent, suggesting different methods of calculating ending stocks.  The USDA estimates ending stocks for the '21/22 crop year will be 94.5mm tons, while the IGC is projecting a level of 53.8mm.  3    Please refer to ‘Has Global Agricultural Trade Been Resilient Under Coronavirus (COVID-19)? Findings from an Econometric Assessment. This is a working paper published by Shawn Arita, Jason Grant, Sharon Sydow, and Jayson Beckman in May 2021.   Investment Views and Themes Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2021 Summary of Closed Trades Image

Highlights The DXY index appears to be following the seasonal pattern of strengthening in the summer and weakening towards year-end. In this context, the most attractive vehicles to play a decline in the dollar are the Scandinavian currencies over the longer term, and the yen in the very near term. Our composite attractiveness model ranks the US dollar and the NZ kiwi as the least attractive currencies, particularly on the basis of valuation. Our limit buy on long AUD/NZD was triggered at 1.05. Pessimism on the Aussie is becoming overdone, while the economy could stage a coiled spring rebound once vaccination rates improve. Feature Chart I-1Was Dollar Strength Seasonal? Was Dollar Strength Seasonal? Was Dollar Strength Seasonal? Since July 20, the DXY index has been consolidating its gains, and appears to be following the general seasonal pattern of strengthening in the summer, and eventually weakening towards year-end (Chart I-1). With this as a backdrop, it is instructive to revisit our attractiveness ranking, and highlight which currencies might benefit most from a dollar decline. Our framework is based on three major vectors –   the macroeconomic environment, valuation, and sentiment. Our macro vector tracks relative economic strength as measured by relative PMIs and real interest rate differentials. Other factors such as a country’s basic balance and external vulnerability are also considered. In our valuation vector, we consider a swathe of models including PPP, more high-frequency indicators such as our intermediate-term timing model, as well as longer-term models based on relative productivity trends. Finally, we also consider positioning to gauge if our view is mainstream or out of consensus. Using this framework, the most attractive vehicles to play a decline in the dollar are the Scandinavian currencies over the longer term, and the yen more near term, if rates remain well behaved. Meanwhile, the US dollar and the kiwi rank as the least attractive currencies, particularly on the basis of valuation (Chart I-2). Chart I-2An Attractiveness Ranking Of Currencies Which Are The Most Attractive Currencies In The G10? Which Are The Most Attractive Currencies In The G10? Macroeconomic Environment: Real Interest Rates Chart I-3The US Sports A Very Negative Real Yield Which Are The Most Attractive Currencies In The G10? Which Are The Most Attractive Currencies In The G10? On the short tenors, the US is among those sporting  the most negative real rates (Chart I-3). But what is interesting is that we know that there is a divergence in how various central banks are treating their inflation overshoot relative to the Federal Reserve. For example, both Norway and New Zealand have negative 2-year real rates, but their central banks are on track to lift short rates this year. However, the telegraphed messages from the Fed are that there will be no interest rate increases until 2023. This will push US real rates towards becoming more negative vis-à-vis other G10 countries. In our report titled Which Rates Matter For Currencies, we suggested that the recent decline in US Treasury yields should curtail strong inflows into US fixed income. This should ease upward pressure on the dollar. Macroeconomic Environment: Basic Balance Chart I-4Basic Balances Across The G10 Which Are The Most Attractive Currencies In The G10? Which Are The Most Attractive Currencies In The G10? The basic balance is one of the most important determinants of a currency’s attractiveness, simply because it captures the ebb and flow of demand for a country’s domestic assets. In a nutshell, the basic balance is the sum of the current account surplus and long-term investments. Trade surpluses underpin underlying demand for a country’s goods and services, while capital account surpluses suggest a country’s assets are under high demand. As such, persistent basic balance surpluses are usually associated with an appreciating currency and vice versa. There has been a sea change in the basic balances across the G10, a fact we highlighted in our recent report titled On The Fed Shift, And Balance Of Payments. One of those shifts involves Australia  seeing tremendous improvement in its basic balance surplus. In terms of rankings, Sweden sports the best basic balance surplus in the G10, followed by Australia and the euro area (Chart I-4). Meanwhile, the US ranks the worst in terms of basic balances, a big vulnerability for the currency. Macroeconomic Environment: External Debt A country’s external debt situation tends to only matter during crises. Therefore, in the current context of global fiscal and monetary stimulus, as well as generous Fed swap lines to assuage any dollar funding pressures abroad, external (especially USD) debt does not pose a significant threat for currencies. In an absolute sense, external debt as a share of GDP is highest in the UK, Switzerland, and Sweden (Chart I-5). However, what matters most often for vulnerability are net external assets rather than gross liabilities. Based on this measure, Japan, Norway, Canada, Switzerland and Sweden are the most attractive countries, based on net external assets (Chart I-6). Chart I-5External Debt In The G10 Which Are The Most Attractive Currencies In The G10? Which Are The Most Attractive Currencies In The G10? Chart I-6Net International Investment In The G10 Which Are The Most Attractive Currencies In The G10? Which Are The Most Attractive Currencies In The G10? Valuation: Purchasing Power Parity (PPP) Our PPP valuation model is our default in terms of evaluating a currency’s fair value, since by definition, it reveals price arbitration between any two countries.  Chart I-7The Dollar Is Expensive Which Are The Most Attractive Currencies In The G10? Which Are The Most Attractive Currencies In The G10? As we have documented, our model offers unique insight into a true PPP fair value, since it accounts for the fact that consumer price baskets tend to differ in composition from one country to the next. In order to get closer to an apples-to-apples comparison across countries, two adjustments are necessary. First, categorizing the consumer price index (CPI) into five major groups. In most cases, this breakdown captures 90% of the national CPI basket. This includes food, restaurants, and hotels (1), shelter (2), health care (3), culture and recreation (4), and energy and transportation (5). The second adjustment is to test the significance of individual price ratios, with the exchange rate as the dependent variable. This allows us to observe the most influential price ratios that help explain variations in the exchange rate. As a control strategy, we use a weighted average combination of the five groups to form a synthetic relative price ratio. If, for example, shelter is 33% in the US CPI basket, but 19% in the Swedish CPI basket, relative shelter prices will represent 26% of the combined price ratio. This allows for a uniform cross-country comparison, as opposed to using the national CPI weights. The results show the US dollar as overvalued, especially versus the Scandinavian currencies and the yen (Chart I-7). The results are based on the synthetic relative price ratio. Valuation: Intermediate-Term Timing Model (ITTM) Our ITTM is our favored model in the short term, because it gives signals with much higher frequency. Back in 2016, when we developed this indicator, it proved useful in helping global portfolio managers increase their Sharpe ratio in managing currency exposure. The idea was quite simple: For every developed world country, there were three key variables that influenced the near-term path of its exchange rate versus the US dollar: Interest Rate Differentials: We have elaborated at length that interest rate differentials are a key driver for currencies. Given that we get interest rates in real time, they are great inputs into any high-frequency model. Inflation Differentials: Inflation destroys the purchasing power of a currency, both in theory and practice (Chart I-8).  Assuming no transactional costs, the price of a dishwasher cannot be relatively high and rising in New York versus Manila. Either the US dollar needs to fall, the Philippine peso needs to rise, or a combination of the two has to occur to equalize prices across borders. Risk Factor: Exchange rates are risk assets. Ergo, the ebb and flow of risk aversion will have an impact on currencies, which is particularly the case for commodity exporters. We will be releasing a revamped version of our trading model in the coming weeks, incorporating results from ITTM. In a nutshell, our ITTM models have been a very good timing tool. And the signal today is to overweight JPY, AUD, SEK, and NOK in the G10 space (Chart I-9). Chart I-8Inflations and Currencies Inflations and Currencies Inflations and Currencies Chart I-9The Dollar Is Expensive Shorter Term Which Are The Most Attractive Currencies In The G10? Which Are The Most Attractive Currencies In The G10? Valuation: Long-Term Fair Value Model Chart I-10The Dollar Is Not Attractive Longer Term Which Are The Most Attractive Currencies In The G10? Which Are The Most Attractive Currencies In The G10? Our long-term FX models try to capture the movement in exchange rates over a business cycle (3-5 years, let’s say). Included in these models are much slower-moving variables like productivity differentials, and cumulative changes in the current account and basic balance. These models cover 22 currencies, incorporating both G10 and emerging market FX markets. We did an overhaul in these models this year, to account for rising Chinese productivity. Similar to our ITTM models, the longer-term valuation indicator favors the Scandinavian currencies, the yen, and the Aussie dollar (Chart I-10). Sentiment: Speculative Positioning The final consideration in our ranking is sentiment. In general, the dollar is a momentum currency and as such, you want to be long when bullish consensus and/or net speculative positioning is low and rising. Chart I-11 shows that the dollar has failed to break above its major trendlines, at the same time when bullish consensus on the dollar is rising (Chart I-12). This warns that a powerful countertrend reversal could be underway. Chart I-11The Dollar And Momentum The Dollar And Momentum The Dollar And Momentum Chart I-12The Dollar And Sentiment The dollar and sentiment The dollar and sentiment   According to CFTC data, the most shorted currencies are the Australian dollar and Japanese yen (Chart I-13). In our framework, these are the currencies slated to stage very powerful countertrend reversals, given we put the pandemic behind us. Chart I-13Everyone Is Long The Greenback Which Are The Most Attractive Currencies In The G10? Which Are The Most Attractive Currencies In The G10? Housekeeping Chart I-14AUD/NZD and Relative Rates AUD/NZD and Relative Rates AUD/NZD and Relative Rates Our long AUD/NZD position was triggered this week at 1.05. The messaging from the RBA and the RBNZ have been vastly different, whereby the former is cautious about the rising Delta variant infection rate, and the latter is focused on financial stability admist a bubbly housing market. On a relative policy basis, our bias is that the likelihood of rates adjusting higher than market expectations is higher in Australia than in New Zealand (Chart I-14). As we are  eventually going to put the virus behind us, underappreciated currencies such as the AUD could stage a mean-reversion rally.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades