Global

Executive Summary Investors Think The Fed Will Not Be Able To Raise Rates Much Above 2% The neutral rate of interest is 3%-to-4% in the United States. This is substantially higher than the market estimate of around 2%. It is also higher than the central tendency range for the Fed’s terminal interest rate dot, which remained at 2.3%-to-2.5% following this week’s FOMC meeting. If the neutral rate turns out to be higher than expected, this is arguably good news for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value equities using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. Bottom Line: Global equities will rise over the next 12 months as the situation in Ukraine stabilizes, commodity prices recede, and inflation temporarily declines. Stocks will peak in the second half of 2023 in advance of a second, and currently unexpected, round of Fed tightening beginning in late-2023 or 2024.   Dear Client, Instead of our regular report next week, we will be sending you a Special Report written by Matt Gertken, BCA Research’s Chief Geopolitical Strategist, discussing the geopolitical implications of the war in Ukraine. We will be back the following week with the GIS Quarterly Strategy Outlook, where we will explore the major trends that are set to drive financial markets in the rest of 2022 and beyond. As always, I will hold a webcast discussing the outlook the week after, on Thursday, April 7th. Best regards, Peter Berezin Chief Global Strategist https://www.linkedin.com/in/peter-berezin-1289b87/ https://twitter.com/BerezinPeter A Two-Stage Fed Tightening Cycle The FOMC raised rates by 25 basis points this week, the first of seven rate hikes that the Federal Reserve has telegraphed in its Summary of Economic Projections for the remainder of 2022. We expect the Fed to follow through on its planned rate hikes this year, but then go on pause in early-2023, as inflation temporarily comes down. However, the Fed will resume raising rates in late-2023 or 2024 once inflation begins to reaccelerate and it becomes clear that monetary policy is still too easy. This second round of monetary tightening is currently not anticipated by market participants. If anything, investors think the Fed is more likely to cut rates than raise rates towards the end of next year (Chart 1). The Fed’s own views are not that different from the markets’: The central tendency range for the Fed’s terminal interest rate dot remained at 2.3%-to-2.5% following this week’s FOMC meeting, with the median dot actually ticking lower to 2.4% from 2.5% (Chart 2). Chart 2The Fed Is Still In The Secular Stagnation Camp A Higher Neutral Rate Our higher-than-consensus view of where US rates will eventually end up reflects our conviction that the neutral rate of interest is somewhere between 3% and 4%. One can think of the neutral rate as the interest rate that equates the amount of investment a country wants to undertake at full employment with the amount of savings that it has at its disposal.1 Anything that reduces savings or increases investment would raise the neutral rate (Chart 3). As we discussed last month, a number of factors are likely to lower desired savings in the US over the next few years: Households will spend down their accumulated pandemic savings. US households are sitting on $2.3 trillion (10% of GDP) in excess savings, the result of both decreased spending on services during the pandemic and the receipt of generous government transfer payments (Chart 4). Household wealth has soared since the start of the pandemic (Chart 5). Conservatively assuming that households spend three cents of every additional dollar in wealth, the resulting wealth effect could boost consumption by nearly 4% of GDP. Chart 5Net Worth Has Soared Since The Pandemic The household deleveraging cycle has ended (Chart 6). Household balance sheets are in good shape. After falling during the initial stages of the pandemic, consumer credit has begun to rebound. Banks are easing lending standards on consumer loans across the board. Baby boomers are retiring. They hold over half of US household wealth, considerably more than younger generations (Chart 7). As baby boomers transition from savers to dissavers, national savings will decline. Chart 6US Household Deleveraging Pressures Have Abated Chart 7Baby Boomers Have Amassed A Lot Of Wealth Government budget deficits will stay elevated. Fiscal deficits subtract from national savings. While the US budget deficit will come down over the next few years, the IMF estimates that the structural budget deficit will still average 4.9% of GDP between 2022 and 2026 compared to 2.0% of GDP between 2014 and 2019 (Chart 8). On the investment front: The deceleration in trend GDP growth, which depressed investment spending, has largely run its course.2 According to the Congressional Budget Office, real potential GDP growth fell from over 3% in the early 1980s to about 1.9% today. The CBO expects potential growth to edge down only slightly to 1.7% over the next few decades (Chart 9). Chart 8Fiscal Policy: Tighter But Not Tight Chart 9Much Of The Deceleration In Potential Growth Has Already Happened After moving broadly sideways for two decades, core capital goods orders – a leading indicator for capital spending – have broken out to the upside (Chart 10). Capex intention surveys remain upbeat (Chart 11). The average age of the nonresidential capital stock currently stands at 16.3 years, the highest since 1965 (Chart 12). Chart 10Positive Signs For Capex (I) Similar to nonresidential investment, the US has been underinvesting in residential real estate (Chart 13). The average age of the housing stock has risen to a 71-year high of 31 years. The homeowner vacancy rate has plunged to the lowest level on record. The number of newly finished homes for sale is half of what it was prior to the pandemic. Chart 11Positive Signs For Capex (II) Chart 12An Aging Capital Stock Chart 13Housing Is In Short Supply The New ESG: Energy Security and Guns The war in Ukraine will put further pressure on the neutral rate, especially outside of the United States. Chart 14European Capex Should Recover After staging a plodding recovery following the euro debt crisis, European capital spending received a sizable boost from the launch of the NextGenerationEU Recovery Fund (Chart 14). Capital spending will rise further in the years ahead as European governments accelerate efforts to make their economies less reliant on Russian energy. Meanwhile, European governments are trying to ease the burden from rising energy costs. France has introduced a rebate on fuel starting on April 1st. It is part of a EUR 20 billion package aimed at cutting heating and electricity bills. Other countries are considering similar measures. European military spending will also rise. Germany has already announced that it will spend EUR 100 billion more on defense. European governments will also need to boost spending to accommodate potentially several million Ukrainian refugees. A Smaller Chinese Current Account Surplus? Chart 15Will China Be A Source Of Excess Savings? The difference between what a country saves and invests equals its current account balance. Historically, China has been a major exporter of savings, which has helped depress interest rates abroad. While China’s current account surplus has declined as a share of its own GDP, it has remained very large as a share of global ex-China GDP, reflecting China’s growing weight in the global economy (Chart 15). Many analysts assume that China will double down on efforts to boost exports in order to offset the drag from falling property investment. However, there is a major geopolitical snag with that thesis: A country that runs a current account surplus must, by definition, accumulate assets from the rest of the world. As the freezing of Russia’s foreign exchange reserves demonstrates, that is a risky proposition for a country such as China. Rather than increasing its current account surplus, China may seek to bolster its economy by raising domestic demand. This could be achieved by either boosting domestic investment on infrastructure and/or consumption. Notably, the IMF’s latest projections foresee China’s current account surplus falling by more than half between 2021 and 2026 as a share of global ex-China GDP. If this were to happen, the neutral rate in China and elsewhere would rise. The Path to Neutral: The Role of Inflation If one accepts the premise that the neutral rate in the US is higher than widely believed, what will the path to this higher rate look like? The answer hinges critically on the trajectory of inflation. If inflation remains stubbornly high, the Fed will be forced to hike rates by more than expected over the next 12 months. In contrast, if inflation comes down rapidly, then the Fed will be able to raise rates at a more leisurely pace. As late as early February, one could have made a strong case that US inflation was set to fall. The demand for goods was beginning to moderate as spending shifted back towards services. On the supply side, the bottlenecks that had impaired goods production were starting to ease. Chart 16 shows that the number of ships anchored off the coast of Los Angeles and Long Beach has been trending lower while the supplier delivery components of both the ISM manufacturing and nonmanufacturing indices had come off their highs. Since then, the outlook for inflation has become a lot murkier. As we discussed last week, the war in Ukraine is putting upward pressure on commodity prices, ranging from energy, to metals, to agriculture. BCA’s geopolitical team, led by Matt Gertken, expects the war to worsen before a truce of sorts is reached in a month or two. Meanwhile, a new Covid wave is gaining momentum. New daily cases are rising across Europe and have exploded higher in parts of Asia (Chart 17). In China, the number of new cases has reached a two-year high. The government has already locked down parts of the country encompassing 37 million people, including Shenzhen, a major high-tech hub adjoining Hong Kong. Chart 17Covid Cases Are On The Rise Again In Some Countries Most new cases in China and elsewhere stem from the BA.2 subvariant of Omicron, which appears to be at least 50% more contagious than Omicron Classic. Given its extreme contagiousness, China may be forced to rely on massive nationwide lockdowns in order to maintain its zero-Covid strategy. While such lockdowns may provide some relief in the form of lower oil prices, the overall effect will be to worsen supply-chain disruptions. Watch For Signs of a Wage-Price Spiral As the experience of the 1960s demonstrates, the relationship between inflation and unemployment is inherently non-linear: The labor market can tighten for a long time with little impact on prices and wages, only for a wage-price spiral to suddenly develop once unemployment falls below a certain threshold (Chart 18). Chart 18A Wage-Price Spiral Was Ignited By Very Low Unemployment Levels In The 1960s Chart 19Wage Growth Has Picked Up, But Mostly At The Bottom End Of The Income Distribution For the time being, a wage-price spiral does not appear imminent. While wage growth has picked up, most of the increase in wages has occurred at the bottom end of the income distribution (Chart 19). Chart 20More Low-Wage Employees Should Return To Work Low-wage workers have not returned to the labor force to the same extent as higher-wage workers (Chart 20). However, now that extended unemployment benefits have lapsed and savings deposits are being drawn down, the incentive to resume work will strengthen. An influx of workers back into the labor market will cap wage growth, at least for this year. Long-Term Inflation Expectations Still Contained A sudden increase in long-term inflation expectations can be a precursor to a wage-price spiral because the expectation of higher prices can induce consumers to shop now before prices rise further, while also incentivizing workers to demand higher wages. Reassuringly, long-term inflation expectations have not risen that much. Expected inflation 5-to-10 years out in the University of Michigan survey registered 3.0% in March, down a notch from 3.1% in February (Chart 21). While the widely followed 5-year, 5-year forward TIPS inflation breakeven rate has climbed to 2.32%, it is still at the bottom of the Fed’s comfort zone of 2.3%-to-2.5% (Chart 22).3 Chart 21Long-Term Inflation Expectations Remain Contained (I) Chart 22Long-Term Inflation Expectations Remain Contained (II) Chart 23The Magnitude Of Damage Depends On How Long The Commodity Price Shock Lasts Moreover, the jump in market-based inflation expectations since the start of the war in Ukraine has been fueled by rising oil prices. The forwards are pointing to a fairly pronounced decline in the price of crude and most other commodity prices over the next 12 months (Chart 23). If that happens, inflation expectations will dip anew. Investment Implications The neutral rate of interest is higher in the United States than widely believed. A higher neutral rate is arguably good for stocks over the short-to-medium term because it lowers the risk that the Fed will accidentally induce a recession this year by bringing rates into restrictive territory. Over a longer-term horizon of 2-to-5 years, however, a higher neutral rate is bad news for stocks because it means that investors will eventually need to value stocks using a higher discount rate. It also means that the Fed could find itself woefully behind the curve in normalizing monetary policy. While the war in Ukraine and yet another Covid wave could continue to unsettle markets for the next month or two, global equities will be higher in 12 months than they are now. With inflation in the US likely to temporarily come down in the second half of the year, bond yields probably will not rise much more this year. However, yields will start moving higher in the second half of next year as it becomes clear that policy rates still have further to rise. The bull market in stocks will end at that point.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1  These savings can either by generated domestically or imported from abroad via a current account deficit. 2  Theoretically, there is a close relationship between trend growth and the equilibrium investment-to-GDP ratio. For example, if real trend growth is 3% and the capital stock-to-GDP ratio is 200%, a country would need to invest 6% of GDP net of depreciation to maintain the existing capital stock-to-GDP ratio. In contrast, if trend growth were to fall to 2%, the country would only need to invest 4% of GDP. 3  The Federal Reserve targets an average inflation rate of 2% for the personal consumption expenditures (PCE) index. The TIPS breakeven is based on the CPI index. Due to compositional differences between the two indices, CPI inflation has historically averaged 30-to-50 basis points higher than PCE inflation. This is why the Fed effectively targets a CPI inflation rate of about 2.3%-to-2.5%. View Matrix Special Trade Recommendations Current MacroQuant Model Scores

Executive Summary On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally. But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. Fractal trading watchlist: Brent crude oil, and oil equities versus banks equities. The DAX Has Sold Off ##br##Because It Expects Profits To Plunge… …But The S&P 500 Has Sold Off ##br##Because The Long Bond Has Sold Off   Bottom Line: In the Ukraine crisis, the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market, before the cavalry of lower bond yields ultimately charges to the rescue. Feature Given the onset of the largest military conflict in Europe since the Second World War, with the potential to escalate to nuclear conflict, you would have thought that the global stock market would have crashed. Yet since Russia’s full-scale invasion of Ukraine on February 24 to the time of writing, the world stock market is down a modest 4 percent, while the US stock market is barely down at all. Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Is this the stock market’s ‘Wile E Coyote’ moment, in which it pedals hopelessly in thin air before plunging down the chasm? Admittedly, since the invasion, European bourses have fallen – for example, Germany’s DAX by 10 percent. And stock markets were already falling before the invasion, meaning that this year the DAX is down 20 percent while the S&P 500 is down 12 percent. But there is a crucial difference. While the DAX year-to-date plunge is due to an expected full-blooded profits recession that the Ukraine crisis will unleash, the S&P 500 year-to-date decline is due to the sell-off in the long-duration bond (Chart I-1 and Chart I-2). This difference in drivers will also explain the fate of these markets as the crisis evolves, just as in the pandemic.   Chart I-1The DAX Has Sold Off Because It Expects Profits To Plunge...   Chart I-2...But The S&P 500 Has Sold Off Because The Long Bond Has Sold Off During The Pandemic, Central Banks And Governments Saved The Day… We can think of a stock market as a real-time calculator of the profits ‘run-rate.’ In this regard, the real-time stock market is several weeks ahead of analysts, whose profits estimates take time to collect, collate, and record. For example, during the pandemic, the stock market had already discounted a collapse in profits six weeks before analysts’ official estimates (Chart I-3 and Chart I-4). Chart I-3The German Stock Market Is Several Weeks Ahead Of Analysts Chart I-4The US Stock Market Is Several Weeks Ahead ##br##Of Analysts We can also think of a stock market as a bond with a variable rather than a fixed income. Just as with a bond, every stock market has a ‘duration’ which establishes which bond it most behaves like when bond yields change. It turns out that the long-duration US stock market has the same duration as a 30-year bond, while the shorter-duration German stock market has the same duration as a 7-year bond. Pulling this together, and assuming no change to the very long-term structural growth story, we can say that: The US stock market = US profits multiplied by the 30-year bond price (Chart I-5 and Chart I-6). The German stock market = German profits multiplied by the 7-year bond price (Chart I-7 and Chart I-8). Chart I-5US Profits Multiplied By The 30-Year Bond Price... Chart I-6...Equals The US Stock Market Chart I-7German Profits Multiplied By The 7-Year Bond Price... Chart I-8...Equals The German Stock Market When bond yields rise – as happened through December and January – the greater scope for a price decline in the long-duration 30-year bond will hurt the US stock market both absolutely and relatively. But when bond yields decline – as happened at the start of the pandemic – this same high leverage to the 30-year bond price can protect the US stock market. When bond yields decline, the high leverage to the 30-year bond price can protect the US stock market. During the pandemic, the 30-year T-bond price surged by 35 percent, which more than neutralised the decline in US profits. Supported by this surge in the 30-year bond price combined with massive fiscal stimulus that underpinned demand, the pandemic bear market lasted barely a month. What’s more, the US stock market was back at an all-time high just four months later, much quicker than the German stock market. …But This Time The Cavalry May Take Longer To Arrive Unfortunately, this time the rescue act may take longer. One important difference is that during the pandemic, governments quickly unleashed tax cuts and stimulus payments to shore up demand. Whereas now, they are unleashing sanctions on Russia. This will choke Russia, but will also choke demand in the sanctioning economy. Another crucial difference is that as the pandemic took hold in March 2020, the Federal Reserve slashed the Fed funds rate by 1.5 percent. But at its March 2022 meeting, the Fed will almost certainly raise the interest rate (Chart I-9). Chart I-9As The Pandemic Took Hold, The Fed Could Slash Rates. Not Now. As the pandemic was unequivocally a deflationary shock at its outset, it was countered with a massive stimulatory response from both central banks and governments. In contrast, the Ukraine crisis has unleashed a new inflationary shock from soaring energy and food prices. And this on top of the pandemic’s second-round inflationary effects which have already dislocated inflation into uncomfortable territory. Our high conviction view is that this inflationary impulse combined with sanctions will be massively demand-destructive, and thereby ultimately morph into a deflationary shock. Yet the danger is that myopic policymakers and markets are not chess players who think several moves ahead. Instead, by fixating on the immediate inflationary impulse from soaring energy and food prices, they will make the wrong move. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. If anything, the fixation on inflation and sanctions may increase short-term pain for both the economy and the stock market. Compared with the pandemic, both the sell-off and the recovery will take longer to play out. In the Ukraine crisis, the big risk is that the protection from lower bond yields and fiscal loosening will not come as quickly and as powerfully as it did during the pandemic. One further thought. The Ukraine crisis has ‘cancelled’ Covid from the news and our fears, as if it were just a bad dream. Yet the virus has not disappeared and will continue to replicate and mutate freely. Probably even more so, now that we have dismissed it, and Europe’s largest refugee crisis in decades has given it a happy hunting ground. Hence, do not dismiss another wave of infections later this year. The Investment Conclusions Continuing our chess metaphor, a tactical investment should consider only the next one or two moves, a cyclical investment should be based on the next five moves, while a long-term structural investment (which we will not cover in this report) should visualise the board after twenty moves. All of which leads to several investment conclusions: On a tactical (3-month) horizon, the inflationary impulse from soaring energy and food prices combined with the choke on growth from sanctions will weigh on both the global economy and the global stock market. As such, bond yields could nudge higher, the global stock market has yet to reach its crisis bottom, and the US dollar will rally (Chart I-10). Chart I-10When Stock Markets Sell Off, The Dollar Rallies But on a cyclical (12-month) horizon, the short-term inflationary impulse combined with sanctions will be massively demand-destructive, at which point the cavalry of lower bond yields will charge to the rescue. Therefore: Overweight the 30-year T-bond and the 30-year Chinese bond, both in absolute terms and relative to other 30-year sovereign bonds. Overweight equities. Overweight long-duration US equities versus short-duration non-US equities. How Can Fractal Analysis Help In A Crisis? When prices are being driven by fundamentals, events and catalysts, as they are now, how can fractal analysis help investors? The answer is that it can identify when a small event or catalyst can have a massive effect in reversing a trend. In this regard, the extreme rally in crude oil has reached fragility on both its 65-day and 130-day fractal structures. Meaning that any event or catalyst that reduces fears of a supply constraint will cause an outsized reversal (Chart I-11). Chart I-11The Extreme Rally In Crude Oil Is Fractally Fragile Equally interesting, the huge outperformance of oil equities versus bank equities is reaching the point of fragility on its 260-day fractal structure that has reliably signalled major switching points between the sectors (Chart I-12). Given the fast-moving developments in the crisis, we are not initiating any new trades this week, but stay tuned. Chart I-12The Huge Outperformance Of Oil Equities Versus Banks Equities Is Approaching A Reversal Fractal Trading Watchlist Biotech To Rebound US Healthcare Vs. Software Approaching A Reversal Norway's Outperformance Could End Greece’s Brief Outperformance To End Dhaval Joshi Chief Strategist dhaval@bcaresearch.com Fractal Trading System Fractal Trades 6-Month Recommendations Structural Recommendations Closed Fractal Trades Indicators To Watch - Bond Yields Chart II-1Indicators To Watch - Bond Yields ##br##- Euro Area Chart II-2Indicators To Watch - Bond Yields ##br##- Europe Ex Euro Area Chart II-3Indicators To Watch - Bond Yields ##br##- Asia Chart II-4Indicators To Watch - Bond Yields ##br##- Other Developed   Indicators To Watch - Interest Rate Expectations Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

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

Executive Summary No Contagion Yet The risk of contagion into other FX pairs from the collapse of the RUB remains contained but is rising. The main transmission mechanism will be a global rush into dollars, should the crisis trigger a global recession. For now, European countries with big trade and financial relationships with Russia are the ones in the firing range of any escalation. The euro has already adjusted lower. As such, while the crisis could get worse before it gets better, the broad DXY index is unlikely to rally much beyond 100. Meanwhile, the Federal Reserve will be swift in addressing any offshore dollar funding crises, via facilities revived during the depths of the COVID-19 crisis. Crude prices could be near capitulation highs. A reversal in oil prices (as the forward curve suggests) will benefit oil consumers versus producers. Long EUR/CAD and short NOK/SEK positions are on our shopping list.   Recommendations Inception Level Inception Date Return Short NOK/SEK 1.11 Mar 3/2022 - Bottom Line: Bottom Line: If a further escalation in the crisis triggers a global recession, it will lead to another down leg in stocks, and a rally in the dollar. Meanwhile, a détente will allow the bull market in stocks to continue, and the dollar rally to reverse. As we argue below, while the crisis could get worse before it gets better, the broad DXY index is unlikely to rally much beyond 100. Feature The market is treating the Russo-Ukrainian conflict as a localized event that is unlikely to trigger a global recession. While the DXY index is fast approaching the psychological 100 level, other FX pairs forewarning a major risk-off event on the horizon remain rather sanguine. For example, the AUD/JPY cross is toppy but has tracked the mild correction in global stocks. The big losers in the DXY index have been the Swedish krona and the euro, currencies directly in the firing range of any escalation in the crisis (Chart 1). Chart 2Investors Have Bought FX Hedges Chart 1No Contagion Yet Specific to the euro, risk reversals — the difference in implied volatility between out-of-the-money calls versus puts — have collapsed below COVID-19 lows. Across a broad spectrum of currencies, investors have been building hedges against losses (Chart 2). The mirror image of this is near record-high net speculative positioning in the dollar. Given this market configuration, the key question is where next? Clearly, if a further escalation in the crisis triggers a global recession, it will lead to another down leg in stocks, and a rally in the dollar. Meanwhile, a détente will allow the bull market in stocks to continue, and the dollar rally to reverse. As we argue below, while the crisis could get worse before it gets better, the broad DXY index is unlikely to rally much beyond 100. A Review Of The Fed Put Chart 3The Fed And Liquidity Crises Both a global pandemic and fear of a global war are existential threats which have occurred throughout history. As such, should we survive an escalation in tensions, the DXY could behave as it did during the COVID-19 crisis. Specifically, the pandemic triggered a rush into dollars amidst a global shortage. This was a key reason why the DXY punched above 100. Fast forward to today, and a lot of the facilities that were tapped into during the COVID-19 crisis can be reactivated. A review of the sequence of events back then is instructive: The Fed began by offering unlimited funding through swap lines to five major central banks at the overnight index swap + 25 basis points.1 This was effective as of the week of March 16, 2020 (Chart 3). When this proved insufficient to satiate the demand for dollars, the swap lines were extended to nine more central banks, with a cap of US$60 billion and a maturity of 84 days.2 This was announced on March 19, 2020. Finally, FIMA account holders were allowed to temporarily exchange their Treasury securities held with the Fed for US dollars. This was announced on March 24, 2020. In hindsight, it turned out that the Fed’s actions on March 19 marked the peak in the dollar at 103, even though we continue to live with Covid-19 today. That peak was 5% above current levels. What ensued was a period of volatility, with periodic rallies towards 100, but these provided excellent shorting opportunities for the DXY. The behavior of the DXY today could be more sanguine, with the benefit of hindsight. Barometers Of Contagion Chart 4Defaults Less Likely Outside Russia No two crises are the same. It is likely that holders of Russian US dollar debt will never be made whole, with coupon payments already suspended. As a result, the risk is that investors liquidate other holdings of emerging market dollar bonds to cover margin calls. This will lead to a self-reinforcing spiral which will transform a localized liquidity crisis into a global solvency one. Credit default swaps in major EM economies are rising, as they blow out for Russian debt (Chart 4). That said, there are a few similarities with past Russian incursions: The selloff in Russian debt during the invasion of Crimea was a localized event. The invasion of Georgia took place at the heart of the global financial crisis of 2008. In the former, a self-reinforcing feedback loop of higher refinancing rates and defaults did not ensue. The reaction from other EM currencies and equity markets has been rather constructive, despite the wholesale liquidation in Russian assets (Chart 5). As adjustment mechanisms, currencies are good at sniffing out the risk of contagion. That is not the case yet. Finally, the DXY and the RUB have already decoupled, as they did in previous episodes of a Russian invasion (Chart 6). In the past, this was a good indication that the event was localized, even though the RUB only bottomed after falling 35% and 47% in 2008 and 2014, respectively. While the risk today can be characterized as much greater, this dynamic remains the same (the dollar is up only 1.6% since the incursion).  Chart 5Spot The Outlier Chart 6The Dollar And Rouble Have Already Decoupled What is clear is that the longer the conflict lasts, the less likely it is that the Fed will deliver the aggressive rate hikes originally priced by the market this year. This will keep US policy very accommodative, at a time when the real fed funds rate is still well below estimates of neutral (Chart 7). Chart 7The Fed Is Still Very Accomodative The message from the Bank of Canada this week could be a model for other central banks, where quantitative tightening (QT) and rate hikes complement each other. This could signal a slower pace of hikes than the market expects and, in turn, could help lead to a steeping of yield curves, especially as growth eventually recovers. Applying The Russian Template The bigger question for currency markets longer term is what happens to foreign holders of US assets when the dust settles. Russian holdings of US Treasurys peaked during the Georgian war and have since fallen to nearly 0% of total reserves (Chart 8). This has been replaced by gold, RMB assets, euro assets, and other currencies. With US geopolitical rivals having seen how vulnerable the Russian economy has been to a cut-off from the SWIFT messaging system, currency alliances outside the scope of the dollar are likely to solidify. China is the number one contributor to the US trade deficit, which is hitting record lows. It is also the largest holder of US Treasurys, which it continues to destock. This could be a subtle retaliation against past US policies, or perhaps a way to make room for the internationalization of the RMB (Chart 9). What is clear is that nations getting cutoff from the US financial system can only accelerate this trend. Chart 8Template For US Geopolitical Rivals? Chart 9China Has Stopped Recycling Surpluses Into Treasurys From a broader perspective, the process of reserve diversification out of US dollars, into other currencies has been accelerating in recent years. International Monetary Fund (IMF) data shows that the global allocation of foreign exchange reserves to the US dollar peaked at about 72% in the early 2000s and has been in a downtrend ever since. Meanwhile, allocations to other currencies as well as gold have been surging. Ever since the trend began to accelerate in 2015, the DXY has been unable to sustainably punch through the 100 level (Chart 10). Chart 10The DXY: 100 Is The Line In The Sand Portfolio Strategy Deflationary shocks tend to be bullish for US Treasurys and the dollar. An inflationary dislocation will push investors towards gold (and currencies that act as an inflation hedge such as the NOK, CAD, AUD, and NZD). So far, the market seems to be betting on stagflation, where both Treasury yields and gold rise in tandem (Chart 11). The response of the Federal Reserve will be the key arbiter. A growth slowdown arising from the pandemic will slow the pace of rate hikes. As such, rising inflation and low real yields will reduce the appeal of US Treasurys and boost the appeal of gold in the near term. Historically, this has been bearish for the US dollar (Chart 12). Chart 11Competing Safe-Haven Assets Have Diverged Chart 12The Bond-To-Gold Ratio And The Dollar In our portfolio, we have two trades: A short CHF/JPY position, as we believe the yen will be a better hedge than the franc given higher real rates in Japan; and a long EUR/GBP position, given that the euro is closer to pricing in a recession, compared to the pound (or even the Canadian dollar). We will adjust our positions accordingly as the crisis unfolds.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 These included the Bank of Canada, the Bank of Japan, the Bank of England, the European Central Bank, and the Swiss National Bank. 2 These include the Reserve Bank of Australia, the Banco Central do Brasil, the Danmarks Nationalbank (Denmark), the Bank of Korea, the Banco de Mexico, the Norges Bank, the Reserve Bank of New Zealand, the Monetary Authority of Singapore, and the Sveriges Riksbank. Trades & Forecasts Strategic View Tactical Holdings (0-6 months) Limit Orders Forecast Summary