Geopolitics

BCA Research is proud to announce a new feature to help clients get the most out of our research: an Executive Summary cover page on each of the BCA Research Reports. We created these summaries to help you quickly capture the main points of each report through an at-a-glance read of key insights, chart of the day, investment recommendations and a bottom line. For a deeper analysis, you may refer to the full BCA Research Report. Executive Summary The tensions between Russia and the West over Ukraine are boiling over, as the risk of a conflict escalates. Following Washington’s written response to Moscow’s demands, BCA’s Geopolitical Strategy team now assigns a 75% probability to a Russian invasion of its neighbor. Matt Gertken, the team’s Chief Strategist, sees only a 10% chance that Russia will aim to conquer the whole of Ukraine. European markets are vulnerable to a Russian retaliation, and so we recommend hedging exposure to Europe and cyclical assets until the situation clears up. The euro remains at risk as long as tensions fester. Who Is Most Vulnerable To A Russian Energy Embargo? Bottom Line: Buy hedges such as short EUR/JPY and short EUR/CHF to protect portfolios against the risk of a conflict in Ukraine. The euro has more downside from here. Feature Handicapping The Risk Of War On Wednesday, after weeks of tense discussions, the US sent back its formal written response to Russia’s demands. Upon analysis of the situation, our geopolitical team concluded that the Biden administration offered no significant concessions. The US will not stop providing weapons to Ukraine, which, from Russia’s perspective, implies that its largest occidental neighbor could become “Russia’s Taiwan, i.e. a foreign-backed military enemy on its door step.”  Matt Gertken, BCA’s Geopolitical Strategy team’s Chief Strategist, believes that the probability of a diplomatic solution has fallen to 25%, despite the joint statement made by Russia, Ukraine, France, and Germany on January 26, which reaffirms the ceasefire in the Donbass region of Ukraine. Any minor violation of the ceasefire’s terms by Ukraine will create an excuse for a Russian invasion. The nature of the eventual conflict will be crucial to the economic and market outlook for Europe. Matt argues that Europeans are hamstrung by their large dependence on Russian energy. Even switching to US LNG in case of a crisis this winter will not fill the full gap and cause major economic distress in Europe. As a result, European governments will try to avoid a war in order to limit sanctions so that Russia does not cut energy supply further. However, Europeans are also allied with the US, which will push for sanctions and which is not as afraid of the consequences of a conflict. Faced with this dichotomy, Matt argues that the most likely outcome is that Russia will ultimately concentrate on the Eastern Ukraine. He observes that “Russia, if waging war, will prefer to receive revenues from Europe, as long as Europe is still buying. Thus, Russia will keep its military aims limited so that Germany and other countries have a basis for watering down sanctions to keep the energy flowing and avoid a recession.” In terms of the breakdown of probabilities, he sees a 65% probability of a short conflict whereby the battle is to control Eastern Ukraine, a 10% probability of a Russian effort to conquer the entire country, and a 25% probability of a diplomatic solution. According to Matt, it is too soon to buy the dip. Even if the situation on the ground matches our base case scenario of a limited conflict, Russia will employ a shock-and-awe strategy, creating the first major conflict on European soil since World War II. This will surprise investors and cause a knee-jerk spike in European energy prices. It will produce downside in the euro and in the relative performance of European equities, especially as it could take a few weeks before it becomes clear whether Russian troops will permanently cross the Dnieper. Bottom Line: European markets should brace for some volatility caused by Ukrainian events in the coming weeks. BCA’s geopolitical strategy team assigns only a 25% probability to a diplomatic resolution to the current tensions, a 65% probability to a limited Russian incursion in Ukraine, and a 10% chance of a war for the entire Ukrainian nation. Economic Risks Chart 1A Large Energy Shock For A Recession The economic implications of our base case scenario – a limited conflict – are restricted. As we showed three months ago, energy consumption only represents roughly 2% of European GDP. It would require a durable shock associated with a drawn-out conflict – the 10% probability scenario – to push up this ratio to the levels reached before the GFC, when energy prices were squeezing Europe (Chart 1). Nonetheless, markets will price in this probability as the conflict starts. Thus, understanding which economy is more vulnerable will help assess the risks to the market. The first metric to gauge vulnerability is the role of fossil fuels in the energy mix of European countries. In the event that a conflict causes an increase in energy prices, countries that rely more heavily on fossil fuel will experience a greater shock. On this front, pre-pandemic data from Eurostat shows that the Netherlands, Ireland, Poland, Greece, and Germany are the most exposed nations (Chart 2). By contrast, Sweden, Finland, France, and Denmark are the least exposed as a result of the role of nuclear or wind power generation in these countries. Chart 2Who depends Most On Fossil Fuel? Another metric is the share of a nation’s energy needs fulfilled by imports (Chart 3). On this score, Belgium, Italy, Spain, Greece, and Portugal are the most vulnerable nations, whereas Sweden, the UK, Denmark, and Czechia are the least at risk. Chart 3Who Depends Most On Imported Energy? We can also concentrate on the impact of the risk of a Russian embargo on energy shipments to Western Europe. Chart 4 shows that, when it comes to crude oil, Finland, Poland, Hungary, and, to a lesser extent, Czechia are most vulnerable, whereas Austria, Spain, and Ireland are the least at risk. With respect to natural gas, which is crucial to electricity generation, Czechia, Finland, and Hungary are the three most vulnerable countries, whereas Sweden, Austria, Ireland, and Denmark are not (Chart 5). Chart 4Who Depends Most On Russian Oil? Chart 5Who Depends Most On Russian Natural Gas? We may also combine all these measures and approximate the share of the total energy needs of European countries fulfilled by Russia. Our Vulnerability Index shows that the most exposed nation is by far Hungary, followed by Poland, Germany, Czechia, and Italy (Chart 6). This ranking helps explain why the German government’s support for Ukraine remains somewhat tepid, and why Italian businessmen still held a video call with Russian president Vladimir Putin as recently as last Wednesday. Chart 6Who Is Most Vulnerable To A Russian Energy Embargo? Bottom Line: Hungary, Poland, Germany, Czechia, and Italy are the European nations most exposed to an energy crisis in the event of a drawn-out, all-out war in Ukraine, whereas Austria, Sweden, Denmark, Ireland, and the UK are the least exposed. This scenario carries only a 10% probability, but understanding its impact is important, since investors will have to adjust their expectations once a conflict begins in the Ukraine. The ECB Response The ECB response to a Ukrainian conflict will depend on the nature of the war. In our base case scenario involving a limited assault focused on Eastern Ukraine, the ECB will look at any energy shock and its impact on inflation as temporary. European wage gains remain limited (Chart 7), and the Governing Council will assume that any spike in energy prices will not last long enough to dislodge European inflation expectations. This picture will be very different if Russia tries to conquer Western Ukraine as well. While the potential energy embargo will most likely cause a European recession, it will also risk pushing up inflation expectations permanently. Because expectations are already close to the ECB’s objective (Chart 8), the ECB will respond by tightening policy, which many members of the GC will want. This action is likely to accentuate any recessionary pressures in Europe. Again, we cannot stress enough that this constitutes a tail risk and is not our base case scenario. Chart 7European Wage Growth Remains Tame Chart 8Inflation Expectations Could Become Unmoored Market Implications The Euro Three weeks ago, we wrote that the euro was not ready to bottom because the risks associated with a slowing Chinese economy, the continued economic impact of Omicron, and the volatility of the natural gas market were still too considerable. Chart 9Another Wave Of Euro Selling This is even more true after last week’s Fed press conference, when FOMC Chair Jerome Powell did not contest the aggressive market pricing in the OIS curve. As a result, the window remains open in the near-term for interest rate differentials to move in a euro-bearish fashion (Chart 9). Ukraine adds another near-term threat to the euro. First, the run-up to an invasion, whether total or partial, will create a risk-off wave in global markets. Geopolitically driven sell-offs are most often associated with a rise in the counter-cyclical dollar, which is euro-bearish. The Swiss franc too would benefit against the euro. Moreover, Europe is much more exposed than the US to the economic consequences of a Ukrainian crisis. Obviously, our base case scenario implies a shorter and shallower sell-off than what would happen if Russia tried to conquer the whole of Ukraine. Nonetheless, a move below EUR/USD 1.10 now carries a greater than 40% probability. Bunds In our base case scenario of a limited Russian incursion in Ukraine, we should see a temporary dip in German yields driven by risk aversion. However, larger economic forces continue to point toward higher yields around the world, including in Germany. In our tail risk scenario, the German yield curve is likely to invert. ECB rate hikes will not be enough to push up 10-year yields, as markets will reflect that these increases will be temporary because of the associated recession. Instead, German 10-year yields will regress toward their 2021 lows of -0.55%. Equities Chart 10European Stocks Are Now Cheap Since mid-December, European equities have been outperforming US equities on the back of rising yields. We expect European shares to continue to outperform US stocks over the remainder of the year. As we wrote two weeks ago, European stocks possess a more generous valuation cushion against higher yields than their US counterparts, especially now that forward multiples have fallen back to 15.4, their lowest levels since May 2020 (Chart 10). Moreover, the greater cyclicality of European stocks means that they will benefit from an eventual stabilization of the Chinese economy by the latter half of 2022. They also stand to gain from a gradual normalization of the terminal rate proxy over the coming years, which often coincides with an outperformance of value stocks over growth names. Despite this positive outlook, the Ukrainian crisis poses a considerable near-term risk, even in the base case scenario of a limited Russian military aim. The wave of risk aversion will hurt the euro, which arithmetically will weigh on the relative performance of European stocks in common currency terms. Moreover, the more pro-cyclical profile of European stocks will accentuate their vulnerability in a geopolitical crisis. However, the temporary nature of the risk-off wave means that the woes suffered by Europe will also be transitory. Under the tail risk scenario, European equities will not be capable of outperforming those of the US for many months because of the high recession risk that will engulf the region. High energy prices will destroy the profit margins of European companies, which will already suffer from a hit to their top line-growth. US equities will suffer too, but significantly less so. Chart 11European Cyclicals Are Exposed To A Crisis In Ukraine Sector wise, a Ukrainian crisis will also short circuit the outperformance of European cyclicals over defensive equities. For now, European cyclicals have managed to generate alpha, despite the market correction (Chart 11), but the risk of a recession will affect this trend. Under our base case scenario, the underperformance will be short-lived, even if it proves severe; however, under the tail risk scenario, the cyclicals-to-defensives ratio will plunge toward the bottom of its historical range. Within defensive sectors, utilities will likely underperform, especially if the tail risk scenario comes to fruition. European governments will not allow utilities to pass on the full increase in natural gas prices to consumers, which will create a major compression in utilities’ profit margins. For cyclical names, consumer discretionary will bear the brunt of any sell-off. They are relatively pricey and the combination of the potential shock to household disposable income and rising risk aversion will prove to be lethal. The sales and profit margins of industrials will be under stress. However, this shock will be transitory if the Ukrainian crisis remains contained in our base-case scenario. Chart 12The Russian Exposure Of European Banks Financials carry their own risk in the context of a drawn-out Ukrainian crisis. European banks have exposure to Russia equal to $106 billion, concentrated in France and Switzerland (Chart 12). In and of itself, this is small. However, if European nations impose large enough sanctions on Russia, not only will that country cut its energy shipments to Western Europe, but Russian firms will also likely default on their foreign obligations, emboldened by Russia’s robust FX reserves and balance of payments. In the context of a recession wherein the ECB also hikes rates, these defaults will add considerable stress to the European banking sector. Thus, under our tail risk scenario, financials could perform particularly poorly. In terms of the implications for countries, Germany is the most exposed of all the major European markets to a Ukrainian crisis because of its high energy dependence on Russia and fossil fuels. The recent underperformance of German equities when we correct for sectoral bias probably already reflects the recent rise in electricity costs in the country, which hurt German firms versus their European competitors (Chart 13). While we like the fundamentals of European small-cap stocks, we have remained on the sidelines because of the strong correlation between their relative performance and the trade-weighted euro (Chart 14). The risks surrounding Ukraine and their implications for both the euro and the European economy suggest it is still too dangerous to pull the trigger and overweight small-cap in Europe. However, if our base case scenario of a limited conflict comes true, then this will create the perfect opportunity to move into the European small-cap space. Chart 13German Suffers A Nat Gas Discount Chart 14Small-Caps Need A Euro Bottom Investment Implications Considering the probability distribution laid out by BCA’s Geopolitical Strategy team, whose base case scenario is a limited Russian incursion into Ukraine, we do not expect NATO countries to impose sanctions severe enough to force Russia to cut Western Europe’s energy supply. Nonetheless, the prospect of the most significant military conflict on European soil since World War II will have a significant impact on European asset prices, even if this effect is transitory. As a result, we still maintain our preference for cyclical equities in Europe and still expect European equities to outperform US stocks over the course of 2022. We also continue to anticipate that European stocks will outperform Bunds in 2022. Nonetheless, ahead of the conflict, we recommend investors buy some hedges, such as short EUR/CHF and EUR/JPY to protect against downside risk. Rapidly after the conflict begins, an opportunity to close those hedges will emerge. With respect to the euro, the combined stress from a hawkish Fed and Ukrainian risks means we will stay on the sidelines after having been stopped out of our long EUR/USD trade. If our base case of a limited conflict does come to fruition and Russia instead initiates a full invasion of Ukraine, we will shift our portfolio to a fully defensive stance. The euro could re-test parity or even drop below it.   Mathieu Savary, Chief European Strategist Mathieu@bcaresearch.com Tactical Recommendations Cyclical Recommendations Structural Recommendations Closed Trades Currency Performance Fixed Income Performance Equity Performance

HighlightsUpgrade odds of Russia invading Ukraine from 50% to 75%. The US and allies are transferring arms to Ukraine while seeking alternate energy supply for Europe.Of the 75% war risk, we give 10% odds to Russia conquering all of Ukraine, as discussed in our “Five Black Swans For 2022.” Russia’s limited war aims worked in 2014 and President Putin tends to take calculated military risks. Full-scale invasion would force the West to unify.The remaining 25% goes to diplomatic resolution. It appears that the US is not offering Russia sufficient security guarantees. Ukrainian leaders do not have a domestic mandate to surrender and have not done so for eight years. Russia cannot accept the  status quo now that it has made armed demands for big change.Our third key view for 2022 – that oil producing states have geopolitical leverage – is vividly on display.Tactically stay defensive. But cyclically stay invested. Book 10% gain on long DM Europe / short EM Europe. Book a 8.6% gain on long CAD-RUB.FeatureUkraine’s economy is small but investors rightly worry that an expansion of the still simmering 2014 war there will cause Europe’s energy supply to tighten, pushing up prices and dragging on European demand. Russia would cut off natural gas to Ukraine, which would cut off 6.6% of Europe’s natural gas imports, 18% of Germany’s, 77% of Hungary’s, and 38% of Italy’s (Chart 1). Chart 1Ukraine Hinges On Germany If Europe retaliates against Russia with crippling sanctions, Russia and Belarus could conceivably cut off another 20% of Europe’s imports and 60% of Germany’s imports. The Czech Republic, Finland, and Hungary get almost 100% of their natural gas from Ukraine and Russia, while Finland, Poland, and Hungary get more than half of their oil from Russia. In other words, Europe will try to avoid war and try to limit sanctions so that Russia does not further reduce supply.Yet Russia, if waging war, will prefer to receive revenues from Europe, as long as Europe is still buying. Thus Russia will keep its military aims limited so that Germany and other countries have a basis for watering down sanctions to keep the energy flowing and avoid a recession. The US has already committed to sweeping sanctions against Russia and is much more likely to follow through (though President Biden also wants to avoid an energy shock ahead of midterm elections).Energy consumption amounts to only 2% of European GDP, though it could rise to 5% in the event of a shock, as our European Investment Strategist Mathieu Savary has shown. This number would not be far from the 7% reached in 2008, which coincided with financial crisis and recession. All of Europe will suffer from high prices, not only those that import via Ukraine, and Europe’s supply squeeze would push up global prices as well. So the risk of a recession in Europe will rise if the energy squeeze worsens, even if a recession is ultimately avoided.Whatever Russia ends up doing with its military, it may start off with shock and awe. Europe might see its first major war since World War II. Global investors will react very negatively, at least until they can be assured that the conflict will remain contained in Ukraine. According to our market-based quantitative indicators of Russian geopolitical risk, there is still complacency – the ruble has not fallen as far as one would expect based on key macro variables (Chart 2). Chart 2Russia Geopolitical Risk: Two Quantitative Indicators  Chart 3Russian Market Reaction Amid Ukraine Crisis Investors will sell European – especially eastern European – equities and currencies even more rapidly if a war breaks out (Chart 3). It is too soon to buy the dip. What is needed is a Russian decision and then clarity on the scope of the western reaction. Even then, developed Europe and non-European emerging markets will be more attractive.Looking at global equities: How did the market respond to previous Russian invasions?Few conclusions can be drawn from Russia’s invasion of Georgia in 2008, given Georgia’s lack of systemic importance and the simultaneous global financial crisis (Chart 4). Stocks underperformed bonds and cyclicals underperformed defensives, but value caught a bid relative to growth.Russia’s initial invasion of Ukraine in 2014 occurred in a different macroeconomic context but saw stocks flat relative to bonds, cyclicals fall relative to defensives (except energy stocks), and small caps roll over relative to large caps (Chart 5). Value stocks, however, outperformed growth stocks. Chart 4Market Reaction To Russian Invasion Of Georgia​​​​​  Chart 5Market Reaction To Russian Invasion Of Crimea​​​​​  Chart 6Ukraine Crisis And Energy: 2022 Versus 2014 However, in today’s context, these cyclical trends are looking stretched, so a temporary pullback from these trends should be expected. Value stocks, especially energy stocks, have skyrocketed relative to growth and defensives and are likely to pull back in a global risk-off move (Chart 6). Tactically we recommend American over European assets, defensives over cyclicals, large caps over small caps, and safe-haven assets like gold and the Japanese yen.Washington Offers “No Change” To MoscowWhy is a diplomatic solution less likely than before?The US offered no concessions to Russia in its formal written response to Russia’s demands on January 26. “No change, and there will be no change” in longstanding policies, according to Secretary of State Antony Blinken.1 The relevant policies are not about NATO membership – Ukraine is never going to join NATO – but rather about the US and NATO making Ukraine a de facto member by providing arms and defense cooperation. Russia obviously sees a US-armed Ukraine as a threat to its national security.One of the few realistic demands of Russia’s – that the US and NATO stop providing arms – has been flung back in Russia’s face. Blinken pointed out in his press conference that the US has given more defense aid to Ukraine in the past year than in any previous year. He said the US will continue to provide arms while pursuing diplomacy, including five MI-17 helicopters on the way. He also noted that the US has authorized allies to transfer American-origin arms to Ukraine.2The importance of the defense cooperation is not the quality of the arms being transferred (so far) but the long-term potential for the US to turn Ukraine into Russia’s Taiwan, i.e. a foreign-backed military enemy on its doorstep. The costs of inaction today could be checkmate from Russia’s long-term strategic point of view. Russia has warned for 14 years that it saw Ukraine as a red line and yet the US and NATO have increased defense cooperation. It is a moot point whether the US provides arms because it does not empathize with Russia’s security interests or because it believes Russia will attack Ukraine regardless.A diplomatic solution could still come from the US, if more information comes to light, or from Ukraine itself, under French and German pressure. Ukraine could make promises to respect Russia’s national security interests and implement the Minsk Protocols it was forced into after Russia seized Crimea in 2014.3If Ukraine surrenders, Russia can claim victory and reduce the threat of war, at least temporarily. But it would not eliminate the long-term risk of war since Ukraine’s government may not be willing or able to implement any such agreement. Ukraine views the Minsk agreement as a Russian imposition and it has rejected key parts of it (such as federalization and granting rights and privileges to Russian separatists in Donbass) for eight years already.4The joint statement from Russia, Ukraine, France, and Germany on January 26 reaffirms the ceasefire in the Donbass.5 It is unlikely that Russia can walk away with this ceasefire alone, having made fundamental demands regarding Russia’s long-term security and the European order. It is more likely that any Ukrainian violation of the ceasefire will now offer a pretext for Russia to respond with military force.Russia’s military advantage is immediate whereas diplomatic attempts by Ukraine to buy time could help it stage a more formidable defense against Russia in future, given ongoing US and NATO defense cooperation. This is why the continuation of arms transfers is the signal. Russia is incentivized to take action sooner rather than later now that the western willingness and urgency to provide arms has increased.Putin has succeeded with his “small war” and “hybrid war” strategy thus far. Russian forex and gold reserves at $630 billion (38% of GDP), gradual diversification away from the dollar (16% of forex reserves), low short-term external debt (5% of GDP), an alternative bank communication system, a special economic relationship with China, a Eurasian Economic Union that can help circumvent sanctions, all provide Russia with some buffer against US sanctions.GeoRisk Indicators: Europe Chart 7European GeoRisk Indicator Amid Ukraine Crisis In our Q3 2021 outlook, we argued that European political risk had bottomed due to Russia. Our geopolitical risk indicators show that financial markets tend to price European political risks in line with the USD-EUR exchange rate. The dollar rallied in 2021 and has since fallen back but a war and energy squeeze in Europe should help the dollar stay resilient, as should Federal Reserve rate hikes (Chart 7).If Russia attacks, the Ukrainians will fall back and then mount an insurgency. This will make the war more difficult than its planners initially believe. It will also raise the risk that war will spill over. Neighbors that provide economic aid – not to mention military aid – will eventually make themselves vulnerable to Russian attack, either to destroy commerce or cut insurgency supply lines.NATO will fortify its borders with troops but then tensions will grow on those borders, reducing security and raising uncertainty in the Baltics, Poland, Slovakia, and the Czech Republic. Ukraine could become a war zone like Libya or Syria except that this time the US and Russia would truly be fighting a proxy war against each other.Other European Risks Pale In ComparisonWe will monitor the French election in case the Ukraine conflict causes dynamics to shift against President Emmanuel Macron. Most likely Macron’s diplomatic flourishes, combined with France’s insulation from Russia and Ukraine, will benefit him at the ballot box.In the UK, Prime Minister Boris Johnson faces a leadership challenge. He will probably survive but the Conservative Party faces a serious challenge over the coming years. Labour’s comeback will build ahead of the next election, given that the pandemic has dealt a powerful blow against the Tories, who have been in power since 2010 and are therefore becoming stale. Labour has gotten over the Jeremy Corbyn problem.What matters is whether the UK rejoins the EU, whether Scotland leaves the UK, and whether the next government has a strong majority with which to lead. So far there have not been major changes on these issues:The Tories still have a 75-seat majority through 2024.Support for Scottish independence is stuck at 45% where it has been since 2014.Polling is still evenly divided on Brexit. Labour taking power is a prerequisite to any reunion with the EU, Labour does not want to campaign on re-opening the Brexit issue. While Labour will want to run against inflation, and win back the middle class, rather than for the EU.Thus political risk will be flat, not returning to Brexit highs anytime soon, which is marginally good news for pound sterling over a cyclical horizon (Chart 8). Chart 8UK GeoRisk Indicator And Boris Johnson's Troubles India Enters Populist Phase Of Election Cycle2022 will mark the beginning of India’s election season in full earnest, even though general elections are not due until 2024. This is because within the five-year election cycle spanning from 2019-2024, this year will see elections in some of India’s largest states (Chart 9).More importantly 2022 will see elections take place in most of India’s northern region (Chart 10), which is a key constituency for the ruling Bhartiya Janata Party (BJP). Chart 9India: Major State Elections This Year​​​​​  Chart 10North India In Focus With State Elections​​​​​ Of all the state elections due this year, the most critical will be those in Uttar Pradesh, where voting will begin on February 10, 2022. Final results will be declared a month later on March 10, 2022.Uttar Pradesh Will Disappoint BJPAt the last state elections held in Uttar Pradesh in 2017, BJP stormed into power with one of the strongest mandates ever seen in this sprawling and heterogenous state. The BJP boosted its seat share to an extraordinary 77%, leaving competitors far behind (Chart 11). Chart 11Bhartiya Janata Party (BJP) Stormed Into Power In Uttar Pradesh (UP) In 2017 Cut to 2022, the BJP appears likely to cross the 50% majority threshold but will cede seat share to a regional party called the Samajwadi Party (SP).What will drive this reduction in seats? The reduction will be driven by a degree of anti-incumbency sentiment and some adverse socio-political arithmetic. In a state where voting is still driven to a large extent by identity politics, it is worth recalling that the BJP was able to win the 2017 elections by pulling votes from three distinct communities:BJP’s core constituency of upper caste Hindus.A subset of Other Backward Classes (OBCs).A subset of a community belonging historically to one of the lowest social levels in India called Dalits.This winning formula of 2017 may not work in 2022 as the BJP faces resentment from parts of each of these three communities as well as from farmers (who were against farm law reforms that the BJP tried to pass).There is a chance that these groups may flock to the regional Samajwadi Party in 2022. The latter is in a position of strength as it is expected to retain support from its core constituency of Muslims and upper-caste OBCs too.Yet the risk is to the downside for the ruling party. Modi and the BJP have suffered a hit to their popular support from the global pandemic and recession, like other world leaders.Reading The Tea Leaves For 2024The pro-Modi wave that began in 2014, and gained steam in Uttar Pradesh in 2017, became a tsunami by 2019, causing the BJP to win a decisive 56% of seats in the national assembly. So, if the BJP loses seats in Uttar Pradesh this year, what will be the implications for the general elections of 2024?In a base case scenario, the Modi-led BJP appears set to emerge as the single largest party in the 2024 elections (albeit with a lower seat share than the 62 of 80 seats that the BJP managed in 2019). As the BJP administration ages, it is expected to lose a degree of seat share in its core constituency of north India. But these losses should be partially offset by gains in regions like east India where the BJP continues to make inroads. Also, national parties tend to attract higher vote share at general elections as compared to state elections, and this is true for the BJP. Most likely the pandemic will have fallen away by 2024 and the economy will be expanding.However, a lot can change in two years, and a major disappointment at Uttar Pradesh would sound alarm bells. By 2024, the BJP will have been in power for ten years. So it is not a foregone conclusion that the BJP will win a single-party majority for a third time, even if it does remain the biggest party.Regional parties like the Samajwadi Party (from Uttar Pradesh), Trinamool Congress (from West Bengal), Shiv Sena (from Maharashtra) and Aam Aadmi Party (from New Delhi) are small but rising and may incrementally eat into the BJP’s national seat share.Policy Implications For 2022 Chart 12India’s Fiscal Report Card May Worsen With Populism India’s central government will unveil its budget for FY23 on Feb 1, 2022 in the Indian parliament. We expect the government to announce a fiscal deficit of 6.6% of GDP which will be marginally lower than the FY22 target of 6.8% of GDP. However, with key elections around the corner, we allocate a high probability to the government announcing a big-bang pro-farmer or pro-poor scheme from this pulpit. This high focus on populism and inadequate focus on capital expenditure could lead markets to question India’s fiscal well-being at a time when its debt levels are high (Chart 12).Distinct from policy risks in the short run, geopolitical risks confronting India are elevated too. India’s relationship with China continues to fester. Sino-Indian frictions could easily take a turn for the worst in 2022 as India enters the business end of its five-year election cycle on one hand and China’s all-important 20th National Congress of the Chinese Communist Party (NCCCP) is due in the fall of 2022. China could take advantage of US distraction in Ukraine to flex its muscles in Asia. A geopolitical showdown with China would likely only cause a temporary drop in Indian equities, but taken with other factors, now is not the time to buy.Bottom Line: We remain positive on India on a strategic horizon. However, in view of India approaching the business-end of its five-year election cycle, when policy risks tend to become elevated, we reiterate our tactical sell on India.GeoRisk Indicators: Rest Of WorldNeutral China: China’s performance relative to emerging markets may be starting to bottom but we do not recommend buying it. Domestic political risk is still rising according to our indicator and we expect it to keep rising (Chart 13). Negative political surprises will occur in the lead up to the twentieth national party congress and the March 2023 implementation of the “Common Prosperity” plan. Any Russian conflict will distract the US and enable General Secretary Xi Jinping to cement his second ten-year term in office – and China’s reversion to autocracy – with minimal foreign opposition. The US’s conflict with China is one reason Russia believes it has a window of opportunity. Chart 13CHINA GEORISK INDICATOR Short Taiwan: Taiwan’s geopolitical risk has paused far short of previous peaks as the country’s currency and stock market benefit from the ongoing semiconductor shortage. But a peak may be starting to form in relative equity performance (Chart 14). We doubt that China will see any Russian attack on Ukraine in 2022 as an opportunity to invade Taiwan, although economic sanctions and cyber-attacks are an option that we fully anticipate. Invading Taiwan is far more difficult militarily than invading Ukraine and China is less ready than Russia for such an operation. However, China might be able to exploit a Russian attack as soon as 2024. Chart 14TAIWAN TERRITORY GEORISK INDICATOR Long South Korea: South Korea’s presidential election is approaching on March 9 and this event combined with North Korea’s new cycle of missile provocations will keep political risk elevated (Chart 15). The conservative People Power party has pulled ahead in opinion polling and the incumbent Democratic Party has been weakened by the pandemic. But the race is still fairly tight and a viable third party candidate could make a comeback. China’s policy easing should eventually benefit South Korea. Chart 15SOUTH KOREA GEORISK INDICATOR Long Australia: Australia’s federal election must be held by May 21 and anti-incumbency feeling has taken hold, with the Liberal-National coalition collapsing in opinion polls relative to the Australian Labor Party. Australia still faces shockwaves from the pandemic and China’s secular slowdown, reversion to autocracy, and conflict with the US, especially if the US gets distracted in Europe. Political risk is high and rising (Chart 16). However, Australia benefits from rising commodity prices and we favor developed markets outside the United States. Chart 16AUSTRALIA GEORISK INDICATOR Long Canada: Canada’s recapitalized its political system with last year’s general election and political risk is subsiding (Chart 17). Canada benefits from rising oil and commodity prices and close proximity to the hyper-stimulated US economy. Chart 17CANADA GEORISK INDICATOR Neutral Turkey: Turkey is one of our perennial candidates for a “black swan” event as the country’s political stability continues to suffer under strongman rule, unorthodox monetary and fiscal policy, military adventures in North Africa and Syria, and now a Russian bid to dominate the Black Sea. Elections looming in 2023 will provoke turmoil as the Erdogan administration is extremely vulnerable and yet has many ways to try to cling to power (Chart 18). Chart 18TURKEY GEORISK INDICATOR Neutral Brazil: Brazilian political risk is subsiding as the market expects former President Lula da Silva to return to power in this October’s presidential election and replace current populist President Jair Bolsonaro. Relative equity performance always appears as if it has bottomed only to inch lower in the next selloff. China’s policy easing is a boon for Brazil but China is not providing massive stimulus, the election will be tumultuous, and even a Lula victory will need to see a market riot to ensure that structural reforms are pursued (Chart 19). Chart 19BRAZIL GEORISK INDICATOR Long South Africa: South Africa still faces elevated political risk despite the conclusion of the 2021 municipal elections. However, the ruling African National Congress, which is pursuing an anti-corruption drive, is likely to stay in power, lending policy continuity. Equities have bottomed and are rebounding relative to emerging markets (Chart 20). The danger is that structural reforms will slip ahead of the spring 2024 election. Chart 20SOUTH AFRICA GEORISK INDICATOR Investment TakeawaysTactically stay long gold, defensives over cyclicals, large caps over small caps, Japanese industrials versus German, GBP-CZK, and JPY-KRW.Book a 10% gain on long DM Europe / short EM Europe. Book a 8.6% gain on long CAD-RUB.   Matt Gertken Vice PresidentGeopolitical Strategymattg@bcaresearch.com Ritika Mankar, CFAEditor/Strategistritika.mankar@bcaresearch.comFootnotes1      For Blinken’s press conference on the US formal response to Russia, see US Department of State, "Secretary Antony J. Blinken at a Press Availability," January 26, 2022, state.gov.2     For Ukraine’s criticism that Germany should offer pillows in addition to helmets, see Humeyra Pamuk and Dmitry Antonov, "U.S. responds to Russia security demands as Ukraine tensions mount," Reuters, January 26, 2022, reuters.com. For the US’s $2.5 billion in defense aid to Ukraine since 2014, see Elias Yousif, "U.S. Military Assistance to Ukraine," January 26, 2022, stimson.org. For purpose and significance, see Samuel Charap and Scott Boston, "U.S. Military Aid to Ukraine: A Silver Bullet?" Rand Blog, rand.org.3     Michael Kofman, "Putin’s Wager in Russia’s Standoff with the West," War on the Rocks, January 24, 2022, warontherocks.com.4     In 2021 the US apparently moved to embrace the Minsk Protocols for the first time, but since then it has not joined the talks. See National Security Adviser Jack Sullivan, "White House Daily Briefing," December 7, 2021, c-span.org. 5             Élysée, "Declaration of the advisors to the N4 Heads of States and Governments," January 26, 2022, elysee.fr. See also "Russia, Ukraine agree to uphold cease-fire in Normandy talks," DW, January 26, 2022, dw.com.Geopolitical CalendarStrategic ThemesOpen Tactical Positions (0-6 Months)Open Cyclical Recommendations (6-18 Months)

Highlights The Biden administration faces significant risks from outside the US economy – our third “key view” for 2022. The Ukraine conflict brings one external risk to the forefront. These external risks would exacerbate the global supply squeeze, potentially pushing up commodity prices until they start to kill demand. Investors should prepare for oil price overshoots.  Exogenous risks – such as foreign policy crises – rarely help the president’s party in the midterm election. Any crisis that adds to short-term inflation will hurt the ruling party. Tactically we continue to prefer defensive equities. Close our tactical long industrials / short consumer discretionary trade for a gain of 11.6%. Close long energy stocks for a 15.6% gain and convert to long energy small caps versus large caps. Buy the dip in cyber security stocks. Feature Stock market volatility is back, thanks in no small part to external risks such as Europe’s energy shortage and Russia’s conflict with the West over Ukraine. In our forecast for 2022, we highlighted the Biden administration’s external risks as our third key view. The rapidly deteriorating geopolitical situation was one of several reasons behind this view and it has now clearly moved to the forefront. In this report we highlight the consequences for domestic-oriented US investors. Biden’s immediate external risks, if they materialize, will increase the likelihood that Democrats will lose control of Congress, causing US fiscal policy to freeze and driving policy uncertainty and the dollar upward. For detailed coverage of the Ukraine conflict and its global geopolitical, macro, and market implications please refer to our Geopolitical Strategy reports. Why Is Biden Vulnerable To External Risks The Biden administration and the Democratic Party face serious external risks in 2022. The Omicron variant and global supply constraints are a major factor. Also the US’s domestic political divisions invite challenges from abroad. President Biden is politically weak ahead of midterm elections on November 8. His net approval rating is under water at -10 percentage points. Republicans are now leading the generic congressional ballot with 45.5% support against Democrats’ 41.8%. On a deeper level, Democrats are beset by a socialist fringe on their left wing, making it difficult to pass legislation, and an enthusiastic nationalist opposition movement with a viable challenger for the presidency in 2024 (former President Trump). At best they will pass one more major bill this year before Congress gets gridlocked. Foreign rivals have an advantage in this context. America’s chief rivals face limited political constraints at home (no midterm elections) but they can make low-cost, high-impact threats against the Biden administration through their leverage over the global supply chain and hence voters’ pocketbooks. External Risks Are Inflationary (At Least At First) External risks begin with inflation. The US’s large imbalance of investment over savings is evident in a current account deficit of 3.3% and deteriorating terms of trade. American demand is exceedingly strong due to accumulated household savings, a new capex cycle, and lingering effects of monetary and fiscal stimulus. Yet global supply is impeded. Import prices are rising at a 5.7% rate, the fastest since the BLS started the series in 2010, while imports from China are rising at a 4.7% clip. China’s “zero Covid” policy implies that supply disruptions will keep up the inflationary pressure this year (Chart 1, first panel). The US is also importing inflation from rising commodity prices. West Texas Intermediate crude oil prices have risen to $83 per barrel and average gasoline prices stand at $3.3. With global supply-demand balances tight, WTI prices should average $77 per barrel this year and $78 next year, according to our Commodity & Energy Strategy. In this context, unplanned supply disruptions are likely and will put more pressure on the supply side. Any conflicts with oil producers such as Russia and Iran will backfire in the form of higher prices at the pump (Chart 1, second panel). Yet geopolitical competitors (Russia, Iran, China) have unfinished business with the US stemming from the Trump administration. It is also possible that Biden could negotiate diplomatic solutions, reducing the risk of an oil price spike, but that is not the current trajectory. Chart 1Biden's External Risks Are Inflationary For Now Interest rate hikes from the Federal Reserve will not easily control inflation derived from external sources and supply constraints. They will take time to dampen domestic demand. Yet voters usually solidify their opinions by mid-summer. Inflation may not have come down much by that time. Biden and the Democratic Party are at the mercy of the global supply chain. In this context Russia deliberately forced its way to the top of the US and global agenda by demanding that the West renounce any attempt to threaten its national security via Ukraine or the former Soviet Union. Energy Shock From Russia? The Ukraine crisis threatens an increase in global energy prices. Russia provides 8% of Europe’s commodity imports, 18% of its energy imports, and 16% of its natural gas imports (Chart 2). Russia is already withholding energy supplies from Europe, helping push natural gas prices up by 122% since last August. If war ignites, Russia could reduce energy flows to Ukraine and hence to the rest of Europe. Europe would not be willing to impose as harsh of sanctions as the US because its energy supply depends on it. The US can increase exports to Europe but it cannot replace Russia without depriving its other allies and partners, including India, Japan, and South Korea (Chart 3). The squeeze will cause prices to rise at first but if it is not addressed by higher output from the US and OPEC 2.0, then demand will be destroyed. Note that in 1979, 2008, and 2014, Russian military invasions coincided with a peak in global oil prices. Chart 2Geopolitical Risks Cause Resource Squeeze Chart 3Can US Replace Russia For Europe? Not Really. If other supply problems emerged simultaneously, the slowdown could be especially disruptive. If US-Iran negotiations fail, then another energy supply risk will emerge immediately this spring. The implication is not only a rise in oil prices but also a resilient dollar, which is also the implication of the Fed’s looming rate hikes. Defensive plays would tend to beat cyclical plays, at least in the short run until the crisis abates. But it is important to look at previous examples of Russian aggression to test this hypothesis. US Market Response To Russian Belligerence When Russia invaded Georgia in August 2008, the attack had limited impact on global financial markets, which were focused on the subprime mortgage crisis unfolding on Wall Street. Naturally stocks underperformed bonds, cyclicals underperformed defensives, and value went sideways against growth. Small caps rallied at first versus large caps but then hit a turning point from outperformance to underperformance (Chart 4). Note that the invasion began while President Putin watched the summer Olympics live in Beijing. So one cannot rule out a limited military action against Ukraine in the near term just because Putin is also headed to Beijing for this winter’s Olympics. When Russia invaded Ukraine in February 2014, seizing the Crimean peninsula in the Black Sea, the attack had a greater impact on global financial markets than with Georgia, although Ukraine’s relevance to the global economy was (and is) still limited. Chart 4Market Reaction To Russia Invasion Of Georgia, 2008 Chart 5Market Reaction To Russia Invasion Of Ukraine, 2014 Bonds outperformed stocks, cyclicals were flat-to-up against defensives (energy clearly outperformed defensives), and small caps stumbled but then beat out large caps (Chart 5). Energy stocks theoretically stood to benefit but crashed later that year due to supply glut and China policy tightening. In 2022 the situation is different from these previous Russian invasions in that the world is already in the thrall of an energy supply squeeze brought on by various factors. China’s economy is growing slowly but authorities are easing policy. A comparison of the winter of 2021-22 with that of 2013-14, when Russia invaded Crimea, suggests that energy stocks have already far outpaced growth and defensives (Chart 6). Energy small caps, however, could rally substantially against large cap peers. Tactically US investors should maintain a risk-averse positioning until the Russians make a military decision and the West announces its retaliatory measures. This analysis suggests that cyclicals and small caps face volatility but can ultimately grind higher after the onset of any new war in Ukraine. The magnitude of the war will obviously matter, which is why we maintain a defensive tactical positioning. The next question centers on the medium-term policy impact of Biden’s external risks. Chart 6Market Context: 2022 Versus 2014 Implications For US Midterms And Policy It is possible that Biden’s external risks will play a role in the 2022 midterms. It depends on which risks materialize. Most likely a Russian re-invasion of Ukraine would have a negative effect on the Democrats, especially if it adds to voters’ inflation woes. Major foreign policy successes or failures have a substantial impact on a president’s re-election chances but midterms are less obvious. Midterms almost always go against the president’s party because the previous election’s losers turn out in droves while winners sit home in complacency or disillusionment. The midterm electorate tends to be older, whiter, and more educated than the presidential electorate. Chart 7 shows only midterm elections in which external risks – such as foreign policy – played a major role. In the House, the only time the president’s party gained seats was in 2002, though it only lost four seats in 1962. In the Senate, the president’s party gained seats in 1962, 2002, and 2018 and only lost 2 seats in 1954. From these points we can draw the following conclusions: Chart 7US Midterm Elections: Ruling Party Performance Amid Foreign Policy Crises Foreign policy crises do not generally help the president’s party. While major crises like 9/11 helped the Republicans, and the 1962 Cuban Missile Crisis minimized Democrats’ losses, nevertheless the 1942 midterm occurred after Pearl Harbor and the Democrats lost seats. Minor crises like the 1958 “Lebanon Crisis” also do not help. Russia’s invasion of Ukraine in 2014 falls under this category and did not help President Obama’s Democrats. A major threat to the homeland can help the president’s party on the margin. This is the significance of 1962 and 2002. The ruling party either minimized losses or made absolute gains in the House, while gaining seats in the Senate. (The 2018 midterm is the other case in which the president’s party gained Senate seats, amid President Trump’s trade war with China, but Republicans suffered heavily in the House.) Wartime escalation and entanglement hurt the president’s party. President Johnson’s Democrats suffered deep losses in 1966, as did President George W. Bush’s Republicans in 2006. Obama’s troop surge in Afghanistan was not the main issue but did not help his party in 2010. Ceasefires and peace treaties do not help the president’s party, even when the end of the war is seen as a victory. World War I was drawing to a close in 1918 but Democrats suffered for having gotten the US involved. Democrats also lost in 1946, despite US triumph in WWII. The Korean war ended on a far more ambivalent note and Republicans suffered at the ballot box. Vietnam was drawing to an ignominious close in 1974, which also occurred in the aftermath of the Arab oil embargo, recession, and Watergate scandal, so no surprise Republicans lost seats. If there is a foreign policy crisis this year, the “best case” for Biden’s Democrats – in crass political terms – would be one that engenders a patriotic rally, like happened with the Cuban Missile Crisis or 9/11. If Democrats only lose four seats in 2022, like Kennedy in 1962, they will have a one-seat majority in the House. However, this best-case scenario is unlikely. As noted, 1962 and 2002 consisted of direct threats to the US homeland. All other crises either hurt or did not help the president’s party. In 2014, while voters had other things on their minds that year, Russia’s invasion of Crimea reinforced criticisms of Obama’s foreign policy already centered on Libya, Syria, and Iran. Obama responded with sanctions and aid to Ukraine, as Biden threatens to do today. Democrats lost 13 seats in the House and 9 seats in the Senate. A similar negative impact should be expected if Russia re-invades in 2022. Biden is already vulnerable: his approval rating collapsed after his messy withdrawal from Afghanistan (reinforcing the fourth bullet about ending wars above). A new foreign policy crisis could cement the narrative of foreign policy incompetence. It matters a great deal whether an exogenous crisis automatically hurts the voter’s pocketbook. If it does, then any initial rally around the flag will fade over time, leaving the negative material impact behind and angering voters. In 1974, President Ford’s approval rating shot up above 50% as he took over from Nixon, yet his party still suffered from the inflationary economic backdrop and dour foreign policy backdrop. In 1978, President Carter’s approval rating also recovered to nearly 50% in time for the vote but it was not enough to overcome inflationary malaise – and Iranian oil strikes began in September (Chart 8). If we subtract the Misery Index (unemployment plus inflation) from the president’s approval rating, we see that Kennedy had a 70% approval during the Cuban Missile Crisis, and Bush had a 62% approval in 2002. But Johnson and Carter were sinking toward 35% during their first midterms, which is where Biden stands today (Chart 9). Chart 8Different Reactions For Different Crises Chart 9Best And Worst Case Scenarios Of Foreign Policy Crisis For Democrats Thus Biden’s external risks, depending on which ones materialize, suggest that the Democratic Party will face another headwind in November. Democrats are very likely to lose the House and somewhat likely to lose the Senate. Gridlock is already setting in – as will be apparent with the potential government shutdown over the February 18 deadline to pass spending bills. But the midterm will formalize it. Policy uncertainty will continue to creep up and weigh on investor risk appetite this year. In other words, even if cyclicals rally through a Ukraine conflict, they may not outperform defensives later this year. Investment Takeaways Cyclically we are booking an 15.6% gain on our long energy trade and will convert it to a long US energy small caps relative to large caps trade. The external risks highlighted in this report would push up oil prices at least initially (Chart 10). However, volatility will pick up from here. OPEC 2.0 will want to keep Brent crude prices from settling above the $90 per barrel that starts to crimp demand, as our Commodity & Energy Strategy argues. Higher prices will also encourage new production, including from the US shale patch (Chart 11). Note that energy stocks, like other cyclicals, tend to underperform during midterm election years as policy uncertainty affects markets. Chart 10Book Gains On Tactical Long Energy Equities Trade Chart 11US Oil Producers Will Step Up  Tactically we recommend closing our long industrials / short consumer discretionary for a gain of 11.6%. Normally, consumer discretionary stocks are the best performing sector during midterm election years while industrials are the worst. But because of China’s policy easing, we took a tactical bet that the opposite would occur at the start of the year. However, external risks should now cause this situation to reverse by pushing up the dollar, penalizing industrials, without hurting the American consumer too much (Chart 12). Industrial equities are pricing in strong capex intentions but geopolitical conflicts would weigh on those intentions, while new orders and core durable goods orders could suffer a bit (Chart 13). The midterms will come into focus later this year and weigh on industrials as well. Chart 12Close Long Industrials Trade For Now Chart 13Industrials Still Attractive On Cyclical Basis Cyclically stick with cyber security stocks. They have sold off along with the tech sector as interest rates rise. But long cyber security is a secular investment thesis based on digitization of the economy, rising cyber crime, and geopolitical risk. Tensions with Russia, proxied by the fall in the ruble and rise in aerospace/defense stocks, point to the fact that investors recognize international tensions will remain high (Chart 14). Cyber space will remain an area of conflict even if physical conflict does not materialize. Growth stocks should also revive later as midterm policy uncertainty picks up. Chart 14Cyber Security Is A Secular Trade ... Buy The Dip Chart 15Overweight Health Care Amid Political Risk Tactically stick with overweight health care on rising uncertainty and expectations that the dollar will pick up (Chart 15). Defensives, especially health, should also outperform as the year goes on and midterms approach. Pricing power is returning to the sector but the Biden administration only has a little legislative ammunition left and its regulatory focus lies elsewhere for now.     Matt Gertken Vice President US Political Strategist mattg@bcaresearch.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Table A2Political Risk Matrix Table A3US Political Capital Index Table A4APolitical Capital: White House And Congress Table A4BPolitical Capital: Household And Business Sentiment Table A4CPolitical Capital: The Economy And Markets

Highlights Our top five “black swan” risks for 2022: Social unrest in China; Russian invasion of all of Ukraine; unilateral Israeli strikes on Iran; a cyber attack that goes kinetic; and a failure of OPEC 2.0. Too early to buy the dip on Russian assets: President Biden says Putin will probably “move in” and re-invade Ukraine, Russian embassy staff have been evacuating Ukraine, the US and UK have been providing more arms to Ukraine, and the US is warning of a semiconductor embargo against Russia. Talks resume in Geneva on Friday. Tactically investors should take some risk off the table, especially if linked to Russia and Europe.  Stay short the Russian ruble and EM Europe; stay short the Chinese renminbi and Taiwanese dollar; stay long cyber security stocks; and be prepared for oil volatility. Convert tactical long equity trades to relative trades: long large caps versus small caps, long defensives versus cyclicals, and long Japanese industrials versus German industrials. Feature Chart 1Recession Probability And Yield Curve The 2/10-year yield curve is flattening and now stands at 79 bps, while the implied probability of a recession over the next 12 months troughed at 5.9% in April 2021, and as of December 2021 stood at 7.7% (Chart 1). Apparently stagflation and recession are too high of a probability to constitute a “black swan” risk for this year. Black swans are not only high impact but also low probability. In this year’s annual “Five Black Swan” report, the last of our 2022 outlook series, we concentrate on impactful but unlikely events. These black swans emerge directly from the existing themes and trends in our research – they are not plucked at random. The key regions are highlighted in Map 1. Black Swan #1: Major Social Unrest Erupts In China China’s financial problems are front and center risks for investors this year. They qualify as a “Gray Rhino” rather than “Black Swan” risk.1 It is entirely probable that China’s financial and property sector distress will negatively impact Chinese and global financial markets in 2022. What investors are not expecting is an eruption of social unrest in China that fouls up the twentieth national party congress this fall and calls into question the Communist Party’s official narrative that it is handling the pandemic and the underlying economic transition smoothly. Social unrest is a major risk around the world in the face of the new bout of inflation. Most of the democracies have already changed governments since the pandemic began, recapitalizing their political systems, but major emerging markets – Russia, India, Turkey, Brazil – have not done so. They have seen steep losses of popular support for both political leaders and ruling parties. There is little opinion polling from China and people who are surveyed cannot speak openly. It is possible that the government’s support has risen given its minimization of deaths from the pandemic. But it is also possible that it has not. Beijing’s policies over the past few years have had a negative impact on the country’s business elite and foreign relations. There are disgruntled factions within China, though the current administration has a tight grip over the main organs of power. Since President Xi is trying to clinch his personal rule this fall, sending China down a path of autocracy that proved disastrous under Chairman Mao Zedong, it is possible he will face surprise resistance. China’s economic growth is decelerating, clocking in at a 4.0% quarter-on-quarter growth rate at the end of last year. While authorities are easing policy to secure the recovery, there is a danger of insufficient support. Private sentiment will remain gloomy, as reflected by weak money velocity and a low propensity to spend among both businesses and households (Chart 2). The government will continue to be repressive in the lead up to the political reshuffle. At least for the first half of the year the economy will remain troubled. Structurally China is ripe for social unrest. It suffers from high income inequality and low social mobility, comparable to the US and Brazil, which are both struggling with political upheaval (Chart 3). Chart 2China's Private Sector Still Depressed​​​​​ ​​​​​​ In addition China is keeping a stranglehold over Covid-19. This “Zero Covid” policy minimizes deaths but suppresses economic activity. Strict policy has also left the population with a very low level of natural immunity and the new Omicron variant is even more contagious than other variants. Hence the regime is highly likely to double down to prevent an explosive outbreak. The service side of the economy will continue to suffer if strict lockdowns are maintained, exacerbating household and business financial difficulties (Chart 4). Yet in other countries around the world, government decisions to return to lockdowns have sparked unrest. Chart 4Zero Covid Policy: Not Sustainable Beyond 2022 China’s “Misery Index” (unemployment plus inflation) is rising sharply. While misery is ostensibly lower than that of other emerging markets, China’s unemployment data is widely known to be unreliable. If we take a worst-case scenario, looking at youth unemployment and fuel prices, misery is a lot higher (Chart 5). The youth, who are having the hardest time finding jobs, are also the most likely to protest if conditions become intolerable (Chart 6). Of course, if social unrest is limited to students, it will lack support among the wider populace. But it is inflation, not youth activism, that is the reason for China’s authorities to be concerned, as inflation is a generalized problem that affects workers as well as students. Chart 5China's Misery Index Is Higher Than It Looks​​​​​ Chart 6China's Troubled Youth Why would protesters stick their necks out knowing that the Communist Party will react ferociously to any sign of instability during President Xi Jinping’s political reshuffle? True, mainland Chinese do not have the propensity to political activism that flared up in protests in Hong Kong in recent years. Also the police state will move rapidly to repress any unrest. Yet the entire focus of Xi Jinping’s administration, since 2012, has been the restoration of political legitimacy and prevention of popular discontent. Xi has cracked down on corruption, pollution, housing prices, education prices, and has announced his “Common Prosperity” agenda to placate the low and middle classes.2 The regime has also cracked down on the media, social media, civil society, and ideological dissent to prevent political opposition from taking root. If the government were not concerned about social instability, it would not have been adopting these policies. Disease, often accompanied by famines or riots, has played a role in the downfall of six out of ten dynasties, so Beijing will not be taking risks for granted (Table 1). Table 1Disease And Downfall Of Chinese Dynasties Social instability would have a major impact as it would affect China’s stability and global investor sentiment toward China. Western democracies would penalize China for violations of human rights, leaving China even more isolated. Bottom Line: Investors should stay short the renminbi and neutral Chinese equities. Foreign investors should steer clear of Chinese bonds in the event of US sanctions. After the party congress this fall there will be an opportunity to reassess whether Xi Jinping will “let a hundred flowers bloom,” thus improving the internal and external political and investment environment, but this is not at all clear today. Black Swan #2: Russia Invades All (Not Just Part) Of Ukraine US-Russia relations are on the verge of total collapse and Russian equities have sold off, in line with our bearish recommendations in reports over the past two years. Russia’s threat of re-invading Ukraine is credible. Western nations are still wishy-washy about the counter-threat of economic sanctions, judging by German Chancellor Olaf Scholz’s latest comments, and none are claiming they will go to war to defend Ukraine.3 Russia is looking to remove the threat of Ukraine integrating militarily and economically with the West. The US and UK are providing Ukraine with defense weaponry even as Russia specifically demands that they cease to do so. President Putin may choose short-term economic pain for long-term security gain. The consensus view is that if Russia does invade, it will undertake a limited invasion. But what if Russia invades all of Ukraine? To be clear, a full invasion is unlikely because it would be far more difficult and costly for Russia. It would go against Putin’s strategy of calculated risk and limited conflict. Table 2 compares Russia and Ukraine in size and strength, alongside a comparison of the US and Iraq in 2002. This is not a bad comparison given that Ukraine’s and Iraq’s land area and active military personnel are comparable. Table 2Russia-Ukraine Balance Of Power 2022 Compared To US-Iraq 2002 Russia would be biting off a much bigger challenge than the US did. Ukraine’s prime age population is 2.5 times larger than Iraq’s in 2002, and its military expenditure is three times bigger. The US GDP and military spending were 150 and 250 times bigger than Iraq’s, while Russia’s GDP and military spending are about ten times bigger than Ukraine’s today. Iraq was not vital to American national security, whereas Ukraine is vital to Russia; Russia has more at stake and is willing to take greater risks. But Ukraine is in better shape to resist Russian occupation than Iraq was to resist American. The point is that the US invasion went smoothly at first, then got bogged down in insurgency, and ultimately backfired both in political and geopolitical terms. Russia would be undertaking a massive expense of blood and treasure that seems out of proportion with its goal, which is to neutralize Ukraine’s potential to become a western defense ally and host of “military infrastructure.” However, there are drawbacks to partial invasion. The remainder of the Ukrainian state would be unified and mobilized, capable of integrating with the western world, and willing to support a permanent insurgency against Russian troops in eastern Ukraine. Russia has forces in Belarus, Crimea, and the Black Sea, as well as on Ukraine’s eastern border, giving rise to fears that Russia could attempt a three-pronged invasion of the whole country. In short, it is conceivable that Russian leaders could make the Soviet mistake of overreaching in the military aims, or that a war in eastern Ukraine could inadvertently expand into the west. If Russia tries to conquer all of Ukraine, the global impact will be massive. A war of this size on the European continent for the first time since World War II would shake governments and populations to their bones. The borders with Poland, Romania, the Baltic states, Slovakia, Hungary, Finland and the Black Sea area would become militarized (Map 2). NATO actions to secure its members and fortify their borders would exacerbate tensions with Russia and fan fears of a wider war. Trade flows would become subject to commerce destruction, affecting even neutral nations, including in the Black Sea. Energy supplies would tighten further, sending Russia and probably Europe into recession. The disruption to business and travel across eastern Europe would be deep and lasting, not only due to sanctions but also due to a deep risk-aversion that would affect foreign investors in the former Soviet Union and former Warsaw Pact. Germany would be forced to quit sitting on the fence, as it would be pressured by the US and the rest of Europe to stand shoulder to shoulder in the face of such aggression. Finland and Sweden would be much more likely to join NATO, exacerbating Russia’s security fears. Russia would suffer a drastic loss of trade, resulting in recession, and its currency collapse would feed inflation (Chart 7). Chart 7Inflation Poses Long-Term Threat To Putin Regime Ultimately the consequences would be negative for the Putin regime and Russia as a result of recession and international isolation. But in the short run the Russian people would rally around the flag and support a war designed to prevent NATO from stationing missiles on their doorstep. And their isolation would not be total, as they would strengthen ties with China and conduct trade via proxy states in the former Soviet Union. Bottom Line: A full-scale invasion of all of Ukraine is highly unlikely because it would be so costly for Russia in military, economic, and political terms. But the probability is not zero, especially because a partial re-invasion could lead to a larger war. While global investors would react in a moderate risk-off matter to a limited war in eastern Ukraine, a full-scale war would trigger a massive global flight to safety as it would call into question the entire post-WWII peace regime in Europe. Black Swan #3: Israel Attacks Iran The “bull market in Iran tensions” continues as there is not yet a replacement for the 2015 nuclear deal that the US abrogated. Our 2022 forecast that the UAE would get caught in the crossfire was confirmed on January 17 when Iran-backed Houthi rebels expanded their range of operations and struck Abu Dhabi (Map 3). The secret war is escalating and US-led diplomacy is faltering. Iran is not going to give up its nuclear program. North Korea achieved nuclear arms and greater military security and is now developing first and second strike capabilities. Meanwhile Ukraine, which faces another Russian invasion, exemplifies what happens to regimes that give up nuclear arms (as do Libya and Iraq). Iran appears to be choosing the North Korean route. While we cannot rule out a minor agreement between President Biden and Iranian President Ebrahim Raisi, we can rule out a substantial deal that halts Iran’s nuclear and missile progress. Here’s why: Any day now Iran could reach nuclear “breakout capacity,” with enough highly enriched uranium to construct a nuclear device (Table 3).4 Table 3Iran’s Violations Of 2015 Nuclear Deal Since US Exit Within Iran’s government, the foreign policy doves have been humiliated and kicked out of office while the hawks are fully in control. No meaningful agreement can be reached before 2024 because of the risk that the US will change ruling parties again and renege on any promises. Iran is highly incentivized to make rapid progress on its nuclear program now. The US will not be able to lead the P5+1 coalition to force Iran to halt its program because of its ongoing struggles with Russia and China. China is striking long-term cooperation deals with Iran. Israel has a well-established record of taking unilateral action, specifically against regional nuclear programs, known as the “Begin Doctrine.”5 Israel’s threats are credible on this front, although Iran is a much greater operational challenge than Iraq or Syria. Iran’s timeline from nuclear breakout to deliverable nuclear weapon is 12-24 months.6 Iran’s missile program is advanced. Missile programs cannot be monitored as easily as nuclear activity, so foreign powers base the threshold on nuclear capability rather than missile capability. Iran had a strong incentive to move slowly on its nuclear and missile programs in earlier years, to prevent US and Israeli military interference. But as it approaches breakout capacity it has an incentive to accelerate its tempo to a mad dash to achieve nuclear weaponization before the US or Israel can stop it. Now that time may have come. The Biden administration is afraid of higher oil prices and Israeli domestic politics are more divided and risk-averse than before. And yet Iran’s window might close in 2025, as the US could turn aggressive again depending on the outcome of the 2024 election. Hence Iran has an incentive to make its dash now. The US and Israel will restate their red lines against Iranian nuclear weaponization and brandish their military options this year. But the Biden administration will be risk-averse since it does not want to instigate an oil shock in an election year. Israel is more likely than the US to react quickly and forcefully since it is in greatest danger if Iran surprises the world with rapid weaponization. Here are the known constraints on unilateral Israeli military action: Limited Israeli military capability: Israel would have to commit a large number of aircraft, leaving its home front exposed, and even with US “bunker buster” bombs it may not penetrate the underground Fordow nuclear facility.7 Limited Israeli domestic support: The Israeli public is divided on whether to attack Iran. The post-Netanyahu government recently came around to endorsing the US’s attempt to renegotiate the nuclear deal. Limited US support: Washington opposes Israeli unilateralism that could entangle the US into a war. Israel cannot afford to alienate the US, which is its primary security guarantor. Iranian instability: The Iranian regime is under economic distress due to “maximum pressure” sanctions. It is vulnerable to social unrest, not least because of its large youth population. These constraints have been vitiated in various ways, which is why we raise this Israeli unilateralism as a black swan risk: Where there’s a will, there’s a way: If Israel believes its existence will be threatened, it will be willing to take much greater operational risks. It has already shown some ability to set back Iran's centrifuge program beyond the expected.8 Israeli opinion will harden if Iran breaks out: If Iran reaches nuclear breakout or tests a nuclear device, Israeli opinion will harden in favor of military strikes. Prime Minister Naftali Bennett has an incentive to take hawkish actions before he hands the reins of government over to a partner in his ruling coalition as part of a power-sharing agreement. The ruling coalition is so weak that a collapse cannot be ruled out. US opposition could weaken: Biden will have to explore military options if talks fail and Iran reaches nuclear breakout capacity. Once the midterms are over, Israel may have even more freedom to act, while a gridlocked Biden may be looking to shift his focus to foreign policy. Iranian stability: Iran’s social instability has not resulted in massive unrest or regime fracture despite years of western sanctions and a global recession/pandemic. Yet now energy prices are rising and Iran has less reason to believe sanction regimes will be watertight. From Israeli’s point of view, even regime change in Iran would not remove the nuclear threat once nuclear weapons are obtained. Finally, while Israel cannot guarantee that military strikes would successfully cripple Iran’s nuclear program and prevent weaponization, Israel cannot afford not to try. It would be a worse outcome to stand idly by while Iran gets a nuclear weapon than to attack and fail to set that program back. Hence the likeliest outcome over the long run is that Iran pursues a nuclear weapon and Israel attacks to try to stop it, even if that attack is likely to fail (Diagram 1). Diagram 1Game Theory: Will Israel Attack Iran? Bottom Line: A unilateral Israeli strike is unlikely but would have a massive impact, as 21% of global oil and 26% of natural gas flows through the Strait of Hormuz, and conflict could disrupt regional energy production and/or block passage through the strait itself. Black Swan #4: Cyber Attacks Spill Into Real World Investors are very aware of cyber security risks – it holds a respectable though not commanding position in the ranks of likely crisis events (Table 4). Our concern is that a cyber attack could spill over into the real world, impairing critical infrastructure, supply chains, and/or prompting military retaliation. Table 4Cyber Events Underrated In Consensus View Of Global Risks Russian attacks on US critical infrastructure by means of ransomware gangs disrupted a US fuel pipeline, meat-packing plant, and other critical infrastructure in 2021. Since then the two countries have engaged in negotiations over cyber security. The Russian Federal Security Bureau has cracked down on one of the most prominent gangs, REvil, in a sign that the US and Russia are still negotiating despite the showdown over Ukraine.9 Yet a re-invasion of Ukraine would shatter any hope of cooperation in the cyber realm or elsewhere. Russia is already using cyberattacks against Ukraine and these activities could expand to Ukraine’s partners if the military conflict expands. Should the US and EU impose sweeping sanctions that damage Russia’s economy, Russia could retaliate, not only by tightening energy supply but also by cyber attacks. Any NATO partners or allies would be vulnerable, though some states will be more reactive than others. Interference in the French election, for example, would be incendiary. The key question is: if Russia strikes NATO states with damaging cyber attacks, at what point would it trigger Article V, the mutual defense clause? There are no established codes of conduct or red lines in cyber space, so the world will have to learn each nation’s limits via confrontation and retaliation. Similar cyber risks could emerge from other conflicts. China is probably not ready to invade Taiwan but it has an interest in imposing economic costs on the island ahead of this fall’s midterm elections. Taiwan’s critical role in the semiconductor supply chain means that disruptions to production would have a global impact. Israel and the US have already used cyber capabilities to attack Iran and set back its nuclear program. These capabilities will be necessary as Iran approaches breakout capacity. Yet Iran could retaliate in a way that disrupts oil supplies. North Korea began a new cycle of provocations last September, accelerated missile tests over the past four months, and is dissatisfied with the unfinished diplomatic business of the Trump administration. In the wake of the last global crisis, 2010, it staged multiple military attacks against South Korea. South Korea may be vulnerable due to its presidential elections in May. The semiconductor or electronics supply chain could be interrupted here as well as in Taiwan. Bottom Line: There is no code of conduct in cyber space. As geopolitical tensions rise, and nations test the limits of their cyber capabilities, there is potential for critical infrastructure to be impaired. This could exacerbate supply chain kinks or provoke kinetic responses from victim nations. Black Swan #5: OPEC 2.0 Falls Apart The basis of the OPEC 2.0 cartel is Russian cooperation with Saudi Arabia to control oil supply and manage the forward price curve. Backwardation, when short-term prices are higher than long-term, is ideal for these countries since they fear that long-term prices will fall. In a world where Moscow and Riyadh both face competition from US shale producers as well as the green energy revolution, cooperation makes sense. Yet the two sides do not trust each other. Cooperation broke down both in 2014 and 2020, sending oil prices plunging. Falling global demand ignited a scramble for market share. Interestingly, Russian military invasions have signaled peak oil price in 1979, 2008, and 2014. Russia, like other petro-states, has greater room for maneuver when oil revenues are pouring in. But high prices also incentivize production, disincentivize cartel discipline, and trigger reductions in global demand (Chart 8). Chart 8Russian Invasions And Oil Price Crashes Broadly speaking, Saudi oil production rose modestly during times of Russian military adventures, while overall OPEC production was flat or down, and Russian/Soviet production went up (Chart 9). Chart 9Saudi And OPEC Oil Production During Russian Military Adventures Since 2020, we have held that OPEC 2.0 would continue operating but that the biggest risk would come in the form of a renewed US-Iran nuclear deal that freed up Iranian oil exports. In 2014, the Saudis increased production in the face of the US shale threat as well as the Iranian threat. This scenario is still possible in 2022 but it has become a low-probability outcome. Even aside from the Iran dynamic, there is some probability that Russo-Saudi cooperation breaks down as global growth decelerates and new oil supply comes online. Bottom Line: The world’s inflation expectations are elevated and closely linked to oil prices. Yet oil prices hinge on an uneasy political agreement between Russia and Saudi Arabia that has fallen apart twice before. If Russia invades Ukraine, or if US withdraws sanctions on Iran, for example, then Saudi Arabia could make a bid to expand its market share and trigger price declines in the process. Two Bonus Black Swans: Turkey And Venezuela Turkey lashes out: Our Turkish Political Capital Index shows deterioration for President Recep Erdogan’s political capital across a range of variables (Table 5). With geopolitical pressures increasing, and domestic politics heating up ahead of the 2023 elections, Erdogan’s behavior will become even more erratic. His foreign policy could become aggressive, keeping the lira under pressure and/or weighing on European assets. Table 5Turkey: Erdogan’s Political Capital Wearing Thin Venezuela’s Maduro falls from power: Venezuelan regime changes often follow from military coups. These coups do not only happen when oil prices collapse – sometimes the army officers wait to be sure prices have recovered. Coup-throwers want strong oil revenues to support their new rule. An unexpected change of regimes would affect the oil market due to this country’s giant reserves. Bottom Line: Turkey’s political instability could result in foreign aggression, while Venezuela’s regime could collapse despite the oil price recovery. Investment Takeaways We are booking profits on our tactical long trades on large caps and defensive sectors. We will convert these to relative trades: long large caps over small caps, and long defensives over cyclicals. We also recommend converting our tactical long Japan trade into long Japanese industrials / short German industrials equities. If US-Russia diplomacy averts a war we will reconsider.     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      “Gray Rhino” is a term coined by author Michele Wucker to describe large and probable risks that people neglect or avoid. For more, see thegrayrhino.com. 2     Xi Jinping recently characterized the “common prosperity” agenda as follows: “China has made it clear that we strive for more visible and substantive progress in the well-rounded development of individuals and the common prosperity of the entire population. We are working hard on all fronts to deliver this goal. The common prosperity we desire is not egalitarianism. To use an analogy, we will first make the pie bigger, and then divide it properly through reasonable institutional arrangements. As a rising tide lifts all boats, everyone will get a fair share from development, and development gains will benefit all our people in a more substantial and equitable way.” See World Economic Forum, “President Xi Jinping’s message to The Davos Agenda in full,” January 17, 2022, weforum.org. 3     Chancellor Scholz, when asked whether Germany would avoid using the Nord Stream II pipeline if Russia re-invaded Ukraine, said, "it is clear that there will be a high cost and that all this will have to be discussed if there is a military intervention against Ukraine.” He was speaking with NATO Secretary-General Jens Stoltenberg. See Hans Von Der Burchard, “Scholz: Germany will discuss Nord Stream 2 penalties if Russia attacks Ukraine,” Politico, January 18, 2022, politico.eu. 4     For the Begin Doctrine, see Meir Y. Soloveichik, “The Miracle of Osirak,” Commentary, April 2021, commentary.org. 5     The estimate of 12-24 months to mount a nuclear warhead on a missile has been cited by various credible sources, including David Albright and Sarah Burkhard, “Highlights of Iran’s Perilous Pursuit of Nuclear Weapons,” Institute for Science and International Security, August 24, 2021, isis-online.org, and Eric Brewer and Nicholas L. Miller, “A Redline for Iran?” Foreign Affairs, December 23, 2021, foreignaffairs.com. 6     See Edieal J. Pinker, Joseph Szmerekovsky, and Vera Tilson, “Technical Note – Managing a Secret Project,” Operations Research, February 5, 2013, pubsonline.informs.org, as well as “What Can Game Theory Tell Us About Iran’s Nuclear Intentions?” Yale Insights, March 17, 2015, insights.som.yale.edu.  7     See Josef Joffe, “Increasingly Isolated, Israel Must Rely On Nuclear Deterrence,” Strategika 35 (September 2016), Hoover Institution, hoover.org. 8     The sabotage of the Iran Centrifuge Assembly Center at the Natanz nuclear facility in July 2020 “set back Iran’s centrifuge program significantly and continues to do so,” according to David Albright, Sarah Burkhard, and John Hannah, “Iran’s Natanz Tunnel Complex: Deeper, Larger Than Expected,” Institute for Science and International Security, January 13, 2022, isis-online.org. For a recent positive case regarding Israel’s capabilities, see Mitchell Bard, “Military Options Against Iran,” Jewish Virtual Library, American-Israeli Cooperative Enterprise, January 2022, jewishvirtuallibrary.org.  9     For the FSB and REvil, see Chris Galford, “Russian FSB arrests members of REvil ransomware gang following attacks on U.S. infrastructure,” Homeland Preparedness News, January 18, 2022, homelandprepnews.com. For the Colonial Pipeline and JBS attacks, and other ransomware attacks, see Jonathan W. Welburn and Quentin E. Hodgson, “How the United States Can Deter Ransomware Attacks,” RAND Blog, August 9, 2021, rand.org. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights This week we highlight key charts for US Political Strategy themes and views in the New Year. For H1 2022, we maintain a pro-cyclical, risk-on approach. We favor industrials, energy, infrastructure, and cyclicals. Foreign supply kinks will persist due to Omicron. The US Congress will pass one more spending bill as Democrats try to save their skin ahead of the midterm election. Yet other trends are not so inflationary: Fed rate hikes, an 8% of GDP fiscal drag, and a looming return to congressional gridlock. Midterm elections usually see defensive and growth stocks outperform cyclical and value stocks. This is a risk to our view and may require adjustments later this year. Feature This week we offer our updated US Political Strategy chart pack for the new year. Inflation and stagflation are the top concerns. But the Federal Reserve is kicking into gear, with the market now expecting three-to-four interest rate hikes in 2022 alone. We doubt that will come to pass but it is possible and there is no question that a 12-month core PCE print of 4.7% is forcing the Fed to move. Since the mega-stimulus of March 2020, markets have seen a 91% rally in the S&P 500 and a 114% rally in the tech sector. Ultra-low interest rates and stay-at-home policies created a paradise for tech stocks. But the 10-year Treasury yield surged from 1.45% in December, when Omicron emerged and the Fed turned hawkish, to 1.76% today. An inflation-induced pullback and rotation out of tech stocks was to be expected and has been our most consistent sectoral view. Long-term inflation expectations have not taken off, however. Many investors see secular stagnation over the long run – and even in the short run the resilient dollar should work against inflation. Not only will the Fed wind down asset purchases by $30bn a month starting January 2022 and start hiking rates in March, but also the budget deficit is contracting, making for an 8% of GDP fiscal drag in 2022. In addition the market no longer has any confidence that Congress will pass President Biden’s “Build Back Better” plan. We still think a reconciliation bill will pass, albeit in watered down form. But ultimately the looming midterm election will paralyze Congress, as we argued in our 2022 outlook report, “Gridlock Begins Before The Midterms.” Gridlock will ensure that whatever passes only modestly expands the long-term deficit and then that fiscal taps will be turned off in 2023. In the context of Fed hikes, this should reduce fears of inflation later in 2022, though we still see inflation as a persistent long-term problem. If history is any guide, stocks and bond yields will be flattish for most of the year due to election uncertainty. The difference between this year and other midterm years is that the US consumer is in better financial shape and yet foreign supply kinks will persist due to Omicron. The takeaway is to prefer industrials, energy, small caps, and cyclicals, even though we may not maintain these recommendations for the whole year. We are hedging by staying long health care stocks. Omicron: Less Relevant At Home, More Relevant Abroad American economic growth is declining but will likely settle at or above trend (Chart 1A). Money growth, a proxy for stimulus, is also coming off its peaks while credit growth is rising moderately. The long deleveraging of the American consumer since 2008 appears to have come to an end. But it is too soon to say how aggressively Americans will lever back up and whether a new private sector “debt super cycle” will begin (Chart 1B). Chart 1AEconomic Growth Peaked, Will Slow To Trend Chart 1BEconomic Growth Peaked, Will Slow To Trend The Omicron variant of COVID-19 will have a modest negative impact early in the year. Hospitalizations are picking up in the wake of a surge in new cases following Christmas gatherings. Only 61% of Americans are fully vaccinated and only 23% have received the booster shot that is most effective against Omicron (Chart 2A & Chart 2B). Yet new deaths from the disease remain subdued and only about a fifth of those hospitalized go to the intensive care unit today. Chart 2BCOVID-19 Continues But Relevance Wanes Pharmaceuticals, both vaccines and anti-viral medications, are saving the day and Americans are becoming resigned to the likelihood of getting the virus at some point. Social mobility has dropped off since summer 2021 but will boom in the springtime and consumer confidence is already picking back up (Chart 3A & Chart 3B). The Biden administration is not likely to impose unpopular social restrictions during an election year unless a variant is deadlier, more contagious, and resistant to vaccines, which is not the case with Omicron. Chart 3AOmicron Not A Major Setback For Recovery The resilience of the US will come with persistent inflation in goods given that Omicron will still cause supply disruptions abroad. Not all countries have as effective vaccines when it comes to Omicron – if they maintain tighter social restrictions, prices of imported goods will continue to rise. The Fed cannot resolve foreign bottlenecks. While manufacturing surveys show bottlenecks easing from last year’s highs, foreign supply constraints will remain a problem throughout the year. Chart 3BOmicron Not A Major Setback For Recovery Buy The Rumor, Sell The News Of “Build Back Better” The Biden administration and Democratic Party are still likely to pass one last blast of fiscal spending – the “Build Back Better” budget reconciliation act, a social welfare bill. The output gap is virtually closed and the economy does not need new demand stimulus. However, the Democratic Party needs a legislative win ahead of the midterm election. Thin majorities in both chambers of Congress enable a single senator to derail the bill. But the bill’s provisions are popular among political independents and especially the Democratic Party’s base, which is lacking in enthusiasm about the election as things stand (Charts 4A & 4B). Moderate Democrats in the Senate are still negotiating: their goal is to chop the plan down to size and pass only the most popular provisions, rather than to sink the president and their own party. This means the bill’s top-line spending will be further reduced. The final size should fall from the earlier range of $2.5-$4.7 trillion to $2.3 trillion or less. Add a few tax hikes, like the minimum corporate tax, and the deficit impact will be around $600 billion (Table 1). Table 1"You’ve Gotta Pass It To See What’s In It" Ultimately we cannot have high conviction on the BBB plan because we cannot predict what a single senator will do. That is a matter of intelligence, not macro analysis. But subjectively we still give 65% odds that the Democratic Party will circle the wagons and pass the bill. The party views itself as surrounded by populism on both its right and left flanks – a failure to compromise will whet the appetites of both the Sanderistas (left-wing populists) and the Trumpists (right-wing populists) (Chart 5A). The Republicans still have a better position in the states, and the states have constitutional control of elections, so establishment Democrats are more terrified than usual of flopping in the midterm elections (Chart 5B). Otherwise the midterms – which are already likely to be bad for the Democrats – will deal a devastating blow. Republicans are recovering in party affiliation and tentatively surpassing Democrats among independent voters (Chart 6A). Biden and the Democrats lashed out at former President Trump and the Republican Party on the anniversary of the January 6, 2020 rebellion, but this tactic will not lift their popularity in polls. Their current polling is not much better than that of Republicans in 2018, when the latter suffered a bruising defeat in the midterms (Chart 6B). Chart 6ADemocrats Need A Win Before The Midterm Biden’s legislation would reduce the fiscal drag marginally in fiscal year 2023 but overall the budget deficit will shrink and then lie flat over 2022-24 regardless of what Congress does (Chart 7). New spending would be marginally inflationary over the long run since the budget deficit is expected to expand again beyond fiscal year 2024. Republicans will not be able to slash the budget until they control both Congress and the White House, but in that case they are likely to prove big spenders as in the past. Populism will persist on all sides: the political establishment will keep trying to use fiscal profligacy to peel voters away from populists, who are even more fiscally profligate. Only an inflation-induced recession will restore some fiscal discipline – and that is a way off. Ultimately the significance of the BBB bill is to verify whether establishment politicians – fiscal authorities – are capable of moderating their spending plans according to the threat of inflation, as Modern Monetary Theory maintains. Otherwise the implication is that polarization and populism will produce fiscal overshoots regardless of near-term inflation, even with the narrowest of possible majorities in Congress. The latter, a BBB fiscal overshoot, is what we expect. If it happens it will probably be received negatively by the equity market, fearing faster Fed rate hikes, and it would add credibility to long-term concerns about inflation, because it would reveal that fiscal authorities are not good at adjusting in real time. The former, a BBB failure and a halt to fiscal spending, would suggest that fiscal extravagance remains a crisis-era phenomenon and will be reined in by Congress after a crisis passes, which is probably positive for equities. It would at least suggest that fiscal authorities will adjust when the facts change. Of course, how investors respond to any legislative outcome will depend on a range of factors. But the takeaway is this: Inflation fears may or may not peak in the short run but they will persist over the long run. The Fed: Focus On The Framework In the wake of the Great Recession the Federal Reserve as an institution – both the Federal Open Market Committee and the Board of Governors – shifted in a more accommodative or dovish direction (Chart 8). The shift culminated in the review of monetary policy strategy in August 2020, which produced average inflation targeting. In practice the dovish policy shift is apparent in a real Fed funds rate at -4%, the lowest level since the inflationary 1970s under Fed Chair Arthur Burns. But what is more remarkable is the simultaneous surge in the budget deficit, unlike anything since World War II, and unlike anything in peacetime (Chart 9). Chart 9Inflation And Stagflation Risks The massive increase in federal debt, from 34% of GDP in 2000 to 75% before COVID-19 and 106% today, acts as a constraint on any future Fed hawkishness (Chart 10). A Fed chair who drives interest rates too high amid high debt levels will cause a recession and force the debt-to-GDP ratio up even higher. Yet the result of low rates is to stimulate indebtedness. While the private debt super cycle has subsided, a public debt super cycle is thriving. Chart 10A Major Check On Fed Hawkishness This brings us to today’s predicament. The Fed’s criteria for raising interest rates have mostly been met: 12-month core PCE inflation is running at 4.7% while the inflation breakeven rate in the Treasury market suggests that inflation is well anchored and likely to persist above the 2% inflation target for some time (Chart 11A). The economy is virtually at “maximum employment” (Table 2) – the Fed has set aside concerns about low labor force participation to focus on the collapsing unemployment rate, which is now within the range at which it will feed inflation (Chart 11B). Chart 11AThe Fed's Criteria For Liftoff Table 2The Fed’s Criteria For Liftoff Chart 11BThe Fed's Criteria For Liftoff The takeaway is that the Fed is suddenly restoring the credibility of its 2% inflation target, with headline PCE rapidly coming up on the trajectory established in the wake of the Great Recession (Chart 12), as our US bond strategist Ryan Swift has demonstrated. Chart 12Lo And Behold: Debt Monetization Generates Inflation The explosion of fiscal spending played a critical role in generating this new trajectory. The combination of monetary and fiscal accommodation has worked wonders. Assuming the BBB passes, Chairman Powell will face even greater pressure to prevent this correction of the inflation trajectory from overshooting and turning into a wage-price spiral. The unexpected risk would be if the BBB bill fails, the Fed hikes aggressively, global growth sputters, the dollar surges, and Republicans retake Congress — then Powell may yet see disinflationary challenges in his term in office. Our sense is that the BBB will pass, reinforcing Powell’s less dovish pivot, and yet the Fed’s framework will not permit too hawkish of a stance, resulting in persistent inflation risks over the long run. Three Strategic Themes In our annual strategic outlook, we highlighted three structural or strategic themes that are not beholden to the 12-month forecasting period: 1.   Rise Of Millennials And Generation Z: The sharp drop in labor force participation will gradually mend in the wake of the crisis but the aging of the population ensures that the general trend will decline over time as the dependency ratio rises (Chart 13A). Chart 13AStrategic Theme #1: Rise Of Millennials/Gen Z Politically the millennials and younger generations are gaining clout over time, although their partisan identity will also evolve as they mature and gain a greater stake in the economy and become asset owners (Chart 13B). 2.   Peak Polarization: US political polarization stands at historic highs and will likely remain so over the 2022-24 political cycle (Chart 14A). Polarization coincides with the transformation of society amid falling bond yields and technological revolution (Chart 14B). Chart 14AStrategic Theme #2: Peak Polarization Chart 14BStrategic Theme #2: Peak Polarization The pandemic era has been especially polarized due to the 2020 election and controversies over vaccination (Chart 15). Domestic terrorism of whatever stripe is possible (Chart 16). But any historic incidents will generate a majority opposed to political violence. Chart 16Risk Of Domestic Terrorism True, former President Trump is still likely to run on the Republican ticket, which will ensure that polarization remains elevated (Diagram 1). However, US elections hinge on structural factors, not individuals. Diagram 1GOP 2024 Is Up To Trump So far structural factors point to policy continuity: not only are Democrats still slated to retain the White House, but President Biden has coopted many of Trump’s key policies, including infrastructure, protectionism, and big budget deficits (Chart 17). If Democrats falter, Trump’s policies will be reaffirmed. The implication is that a new national policy consensus is taking shape beneath the surface. 3.   Limited “Big Government”: Americans have been turning away from “small government” and toward “big government” since the 1990s. Voters no longer worry so much about budget discipline and instead look for the “visible hand” of government to support the economy (Charts 18A & 18B). Both domestic populism and geopolitical challenges encourage this shift. Industrial policy and domestic manufacturing are making a comeback (Table 3). Table 3Strategic Theme #3: Limited “Big Government” With extremely robust fiscal policy, the US has avoided the policy mistake of the period after the Global Financial Crisis, when premature fiscal tightening undermined the economic recovery (Chart 19). Policy uncertainty will increase as gridlock returns to Congress and fiscal policy will be frozen. But investors need not fear a slide back into deflation. The Republican Party’s populist base may prevent more Democratic social spending but they will not be able to repeal what is done.  Chart 19Even With Looming Gridlock, The US Is Far From Tightening Fiscal Policy Too Soon This Time Three Key Views For 2022 The key views for the 12-month period are connected with the above but of a more short-term or cyclical duration: 1.   From Single-Party Rule To Gridlock: Republicans are highly likely to win back control of the House of Representatives and likely the Senate (Charts 20A & 20B). President Biden’s approval rating suggests that Democrats could lose 40 seats in the House (Chart 21) and three in the Senate (Chart 22), whereas they only need to lose five and one to lose control. Our quantitative Senate election model shows an even split but the model’s trend favors Republicans, as does the political cycle and partisan enthusiasm (Chart 23). 2.   From Legislative To Executive Power: Biden may still pass one more spending bill but otherwise the legislature will be frozen. Democrats will not succeed in ramming legislation through by abolishing the Senate filibuster. Biden will turn to executive decree, where he is already on track to make a historic increase in regulation, which will increase concerns among small business (Chart 24A & Chart 24B). Anti-trust laws are unlikely to be overhauled and Democrats will struggle to bring back the tough anti-trust posture of the 1900s-1950s without new legislation, meaning that Big Tech faces a bigger threat from inflation than regulation (Table 4). The green transition will continue but primarily in the form of any subsidies passed in the reconciliation bill, rather than new taxes or any carbon pricing scheme (Chart 25A & Chart 25B). Chart 24AKey View #2: From Legislative To Executive Power Table 4Key View #2: From Legislative To Executive Power Chart 25BGreen Energy: Subsidies But No Carbon Tax   3.   From Domestic To Foreign Policy Risks: Biden faces a slew of foreign policy and external risks that could damage the Democrats in the midterms. The surge in illegal immigration on the southern border is truly historic and will have significant policy ramifications over the long run (Chart 26A & Chart 26B). The surge in inflation will force Biden to contend with foreign policy challenges with one hand tied behind his back, since energy supply disruptions could derail his party ahead of the midterm election (Chart 27). While Biden could ease some inflationary pressure via reduced trade tariffs, protectionist impulses will prevail during an election year (Chart 28). Chart 26AKey View #3: External Risks For Biden Chart 26BKey View #3: External Risks For Biden Chart 27Foreign Policy Could Hit Prices At Pump Chart 28Tariff Relief In 2022? Don't Bet On It Investment Takeaways The stock market tends to be flat, with risks skewed to the downside, during midterm election years due to policy uncertainty. The same is true for bond yields (Chart 29). Chart 29Stocks And Bond Yields Trend Lower Before Midterms ... When united or single-party governments approach midterms, stocks tend to perform worse than for divided governments in midterm years, while bond yields tend to be a bit higher (Chart 30). This trend is supercharged in 2022 due to the inflationary effects of the pandemic. Chart 30... But United Govts See Higher Bond Yields And Weaker Stocks ... Assuming Republicans regain at least the House, the US will transition from united to divided government (gridlock). In previous such transitions, stocks tend to perform in line with the average for a midterm election year, but bond yields skew higher – reinforcing the previous point (Chart 31). Chart 31... Shift From United To Divided Govt Implies Higher Bond Yields Than Otherwise We will update our US Sector Political Risk Matrix to bring it better into line with our views, particularly in light of Table 5 below regarding sector relative performance during midterm election years. Normally defensives and growth stocks outperform in midterm years, Table 5ConDisc, Tech, Health Do Best During Midterms …But Waning Pandemic Makes An Exception while cyclicals and value stocks underperform, but 2022 looks to be different due to inflation. Still over the course of the year we would expect the historic trend to reassert itself. Investors should favor cyclicals even though they probably cannot outperform defensives for much longer (Chart 32A). We recommend health care stocks as a hedge given that the dollar should still be resilient this year, Fed hikes should moderate inflation expectations, and midterm policy uncertainty will eventually weigh on risk appetite (Chart 32B). Chart 32AFavor Cyclicals, Though They May Not Outperform Defensives Much Longer Chart 32BLong Health Care As Hedge Value stocks are forming a bottom relative to growth stocks, although this trend is less clear in the US, especially among US large caps, than it is abroad (Chart 33). We favor value over growth on a cyclical basis but midterm election uncertainties will pull the other way, making for a choppy bottom. Chart 33Favor Value And Small Caps, Though Bottom Formation Remains Choppy The same process is visible on a sector basis, where energy and materials continue to outperform tech (Chart 34A). We recommend staying long energy on a cyclical basis, though its outperformance against tech could abate later in 2022. Infrastructure stocks – such as building and construction materials – also continue to outperform. Since Biden’s honeymoon period ended, the outperformance is largely relative to tech rather than the S&P as a whole. We still favor infrastructure stocks as the fiscal policy theme will continue even beyond the current legislation, which will barely start to be implemented in 2022 (Chart 34B). Chart 34AFavor Energy, Materials, And Infrastructure Versus Tech Chart 34BFavor Energy, Materials, And Infrastructure Versus Tech   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)