War/Conflict

Special Report

Executive Summary The Good: There are compelling reasons to believe the Ukraine war will not break out into a broader NATO-Russia war, i.e. World War III. The Bad: The 1945 peace settlement is breaking down and the world is fundamentally less stable. Even if the Ukraine war is contained, other wars are likely in the coming decade. The Ugly: Russia is not a rising power but a falling power and its attempt to latch onto China will jeopardize global stability for the foreseeable future. Secular Rise In Geopolitical Risk Is Empirical Trade Recommendation Inception Date Return LONG GOLD (STRATEGIC) 2019-12-06 32.3% Bottom Line: Within international equities, favor bourses that are least exposed to secular US geopolitical conflict with Russia and China, particularly in the Americas, Western Europe, and Oceania. Feature Two weeks ago our Global Investment Strategy service wrote a report called “The Economic And Financial Consequences Of The War In Ukraine,” arguing that while the war’s impact on commodity markets and financial conditions would be significant, the global economy would continue to grow and equity prices would rise over the coming 12 months. Related Report  Geopolitical Strategy2022 Key Views: The Gathering Storm This companion special report will consider the geopolitical consequences of the Ukraine war. The primary consequence is that “Great Power Struggle” will intensify, as the return of war to Europe will force even the most pacific countries like Germany and Japan to pursue their national security with fewer illusions about the capacity for global cooperation. Globalization will continue to decay into “Hypo-Globalization” or regionalism, as the US severs ties with Russia and China and encourages its allies to do the same. Specifically, Germany will ultimately cleave to the West, China will ultimately cleave to Russia, a new shatter-belt will emerge from East Europe to the Middle East to East Asia, and US domestic politics will fall short of civil war. Given that US financial assets are already richly priced, global investors should seek to diversify into cheaper international equities that are nevertheless geopolitically secure, especially those in the Americas, western Europe, and Oceania. Global Versus Regional Wars Russia’s invasion of Ukraine is a continuation of a regional war that started in 2014. The war has been contained within Ukraine since 2014 and the latest expansion of the war is also contained so far. The war broke out because Russia views a western-allied Ukraine as an intolerable threat to its national security. Its historic grand strategy calls for buffer space against western military forces. Moscow feared that time would only deepen Ukraine’s bonds with the West, making military intervention difficult now but impossible in the future. As long as Russia fails to neutralize Ukraine in a military-strategic sense, the war will continue. President Putin cannot accept defeat or the current stalemate and will likely intensify the war until he can declare victory, at least on the goal of “de-militarization” of Ukraine. So far Ukraine’s battlefield successes and military support from NATO make a Russian victory unlikely, portending further war. If Ukraine and Russia provide each other with acceptable security guarantees, an early ceasefire is possible. But up to now  Ukraine is unwilling to accept de-militarization and the loss of Crimea and the Donbass, which are core Russian demands (Map 1). Map 1Russian Invasion Of Ukraine, 2022 Russia’s invasion of Ukraine has caused a spike in the global geopolitical risk index, which is driven by international media discourse (Chart 1). The spike confirms that geopolitical risk is on a secular upward trend. The trough occurred after the fall of the Soviet Union when the world enjoyed relative peace and prosperity. The new trend began with the September 11, 2001 terrorist attacks and the US’s preemptive invasion of Iraq. This war initiated a fateful sequence in which the US became divided and distracted, Russia and China seized the opportunity to rebuild their spheres of influence, and international stability began to decline. Chart 1Secular Rise In Geopolitical Risk Is Empirical Now Russia’s invasion of Ukraine presents an opportunity for the US and its allies to rediscover their core national interests and the importance of collective security. This implies increasing strategic pressure not only on Russia but also on China and their ragtag group of allies, including Iran, Pakistan, and North Korea. The world will become even less stable in this context. Chart 2Russian War Aims Limited Still, Russia will not expand the Ukraine war to other states unless it faces regime collapse and grows desperate. The war is manifestly a stretch for Russia’s military capabilities and a larger war would weaken rather than strengthen Russia’s national security. NATO utterly overwhelms Russia’s military capacity, even if we are exceedingly generous and assume that China offers full military support along with the rest of the Shanghai Cooperation Organization (Chart 2). As things stand Russia still has the hope of reducing Ukraine without destroying its economic foundation, i.e. commodity exports. But an expansion of the war would destroy the regime – and possibly large swathes of the world given the risk of nuclear weapons in such a scenario. If Russia’s strategic aim were to rebuild the Soviet Union, then it would know that it would eventually need to fight a war with NATO and would have attacked critical NATO military bases first. At very least it would have cut off Europe’s energy supplies to induce a recession and hinder the Europeans from mounting a rapid military defense. It would have made deeper arrangements for China to buy its energy prior to any of these actions. At present, about three-fifths of Russian oil is seaborne and can be easily repurposed, but its natural gas exports are fixed by pipelines and the pipeline infrastructure to the Far East is woefully lacking (Chart 3). The evidence does not suggest that Russia aims for world war. Rather, it is planning on a war limited to eastern and southern Ukraine. Chart 3Russia Gas Cutoff Would Mean Desperation, Disaster None of the great powers are willing or forced to wage war with Russia directly. The US and UK are the most removed and hence most aggressive in arming Ukraine but they are still avoiding direct involvement: they have repeatedly renounced any intention of committing troops or imposing a no-fly zone over Ukraine and they are still limiting the quality of their defense aid for fear of Russian reprisals. The EU is even more keen to avoid a larger war. Germany and France are still attempting to maintain basic level of economic integration with Russia. China is not likely to enter the war on Russia’s behalf – it will assist Russia as far as it can without breaking economic relations with Europe. The war’s limitations are positive for global investors but only marginally. The law that governs the history of war is the law of unintended consequences. Investors should absolutely worry about unintended consequences, even as they strive to be clear-headed about Russia’s limited means and ends. If Russia fails or grows desperate, if it makes mistakes or miscalculates, if the US is unresponsive and aggressive, or if lesser powers attempt to provoke greater American or European security guarantees, then the war could spiral out of control. This risk should keep every investor alive to the need to maintain a reasonable allocation to safe-haven assets.  If not, the end-game is likely a deliberate or de facto partition of Ukraine, with Russia succeeding in stripping Crimea and the Donbass from Ukraine, destroying most of its formal military capacity, and possibly installing a pro-Russian government in Kyiv. Western Ukraine will become the seat of a government in exile as well as the source of arms and materiel for the militant insurgency that will burn in eastern Ukraine. Over the course of this year Russia is likely to redouble its efforts to achieve its aims – a summer or fall campaign is likely to try to break Ukraine’s resistance. But if and when commodity revenues dry up or Russia’s economic burden becomes unbearable, then it will most likely opt for ceasefire and use Ukrainian military losses as proof of its success in de-militarizing the country. Why Germany Will Play Both Sides But Ultimately Cleave To The West A critical factor in limiting the war to Ukraine is Europe’s continued energy trade with Russia. If either Russia or Europe cuts off energy flows then it will cause an economic crash that will destabilize the societies and increase the risk of military miscalculation. German Chancellor Olaf Scholz once again rejected a European boycott of Russian energy on March 23, while US President Joe Biden visited and urged Europe to intensify sanctions. Scholz argued that no sanctions can be adopted that would hurt European consumers more than the Kremlin. Scholz’s comments related to oil as well as natural gas, although Europe has greater ability to boycott oil, implying that further oil supply tightening should be expected. Germany is not the only European power that will refuse an outright boycott of Russian energy. Russia’s closest neighbors are highly reliant on Russian oil and gas (Chart 4). It only takes a single member to veto EU sanctions. While several western private companies are eschewing business with Russia, other companies will pick up the slack and charge a premium to trade in Russian goods. Chart 4Germany Will Diversify Energy But Not Boycott Russia Chart 5Economically, Germany Will Cleave To The West Germany’s insistence on maintaining a basic level of economic integration with Russia stems from its national interest. During the last Cold War, Germany got dismembered. Germany’s whole history consists of a quest for unification and continental European empire. Modern Germany is as close to that goal as possible. What could shatter this achievement would be a severe recession that would divide the European Union, or a war in Europe that would put Germans on the front lines. An expansion of the US sanction regime to cover all of Russia and China would initiate a new cold war and Germany’s economic model would collapse due to restrictions on both the import and export side. Germany’s strategy has been to maintain security through its alliance with America while retaining independence and prosperity through economic engagement with Russia and China. The Russia side of that equation has been curtailed since 2014 and will now be sharply curtailed. Germany has also been increasing military spending, in a historic shift that echoes Japan’s strategic reawakening over the past decade in face of Chinese security competition. Chart 6Strategically, Germany Will Cleave To The West But Germany will be extremely wary of doing anything to accelerate the process of economic disengagement with China. China does not pose a clear and present military threat to Germany, though its attempt to move up the manufacturing value chain poses an economic threat over time. As long as China does not provide outright military support for Russia’s efforts in Ukraine, and does not adopt Russia’s belligerence against neighboring democracies like Taiwan, Germany will avoid imposing sanctions. This stance will not be a major problem with the US under the Biden administration, which is prioritizing solidarity with the allies, but it could become a major problem in a future Republican administration, which will seek to ramp up the strategic pressure on China. Ultimately, however, Germany will cleave to the West. Germany is undertaking a revolution in fiscal policy to increase domestic demand and reduce export dependency. Meanwhile its export-driven economy is primarily geared toward other developed markets, which rake up 70% of German exports (78% of which go to other EU members). China and the former Soviet Union pale in comparison, at 8% and 3% respectively (Chart 5). From a national security perspective Germany will also be forced to cleave to the United States. NATO vastly outweighs Russia in the military balance. But Russia vastly outweighs Germany (Chart 6). The poor performance of Russia’s military in Ukraine will not console the Germans given Russian instability, belligerence, and nuclear status. Germany has no choice but to rely on the US and NATO for national security. If the US conflict with China escalates to the point that the US demands Germany carry a greater economic cost, then Germany will eventually be forced to yield. But this shift will not occur if driven by American whim – it will only occur if driven by Chinese aggression and alliance with Russia. Which brings us to our next point: China will also strive to retain its economic relationship with Germany and Europe. Why China Will Play Both Sides But Ultimately Cleave To Russia Chart 7China Will Delay Any Break With Europe The US cannot defeat China in a war, so it will continue to penalize China’s economy. Washington aims to erode the foundations of China’s military and technological might so that it cannot create a regional empire and someday challenge the US globally. Chinese cooperation with other US rivals will provide more occasions for the US to punish China. For example, Presidents Biden and Xi Jinping talked on March 18 and Biden formally threatened China with punitive measures if Beijing provides Russia with military aid or helps Russia bypass US sanctions. Since China will help Russia bypass sanctions, US sanctions on China are likely this year, sooner or later. Europe thus becomes all the more important to China as a strategic partner, an export market, and a source of high-quality imports and technology. China needs to retain close relations as long as possible to avoid a catastrophic economic adjustment. Europe is three times larger of an export market for China than Russia and the former Soviet Union (Chart 7). Chart 8China Cannot Reject Russia When push comes to shove, however, China cannot afford to reject Russia. Russia’s decision to break ties with Europe reflects the Putin regime’s assessment that the country cannot preserve its national security against the West without allying with China. Ultimately Russia offers many of the strategic benefits that China needs. Most obviously, if China is ever forced into a military confrontation with the West, say over the status of Taiwan, it will need Russian assistance, just as Russia needs its assistance today. China’s single greatest vulnerability is its reliance on oil imported from the Persian Gulf, which is susceptible to American naval interdiction in the event of conflict. Russia and Central Asia form the second largest source of food, energy, and metals for China (Chart 8). Russia provides an overland route to the supply security that China craves. Chart 9Russia Offers Key To China's Eurasian Strategy Russia also wields immense influence in Central Asia and significant influence in the Middle East. These are the critical regions for China’s Eurasian strategy, symbolized in the Belt and Road Initiative. Chinese investment in the former Soviet Union has lagged its investment in the Middle East and the rest of Asia but the Ukraine war will change that. China will have an historic opportunity to invest in the former Soviet Union, on favorable terms, to secure strategic access all the way to the Middle East (Chart 9). China will always prioritize its East Asian neighbors as investment destinations but it will also need alternatives as the US will inevitably seek to upgrade relations with Southeast Asia. Another reason China must accept Russia’s overtures is that China is aware that it would be strategically isolated if the West pulled off a “Reverse Kissinger” maneuver and allied with Russia. This option seems far-fetched today but when President Putin dies or is overthrown it will become a fear for the Chinese. There has never been deep trust between the Chinese and Russians and the future Russian elite may reject the idea of vassalage to China. Therefore just as Russia needs China today, China will need Russia in the future. Why The Middle East Will Rumble Again The Middle East is destabilizing once again and Russia’s invasion of Ukraine will reinforce this trajectory. Most directly, the reduction in grain exports from Russia and Ukraine will have a disproportionate impact on food supplies and prices in countries like Pakistan, Turkey, Egypt, Libya, and Lebanon (Chart 10).   A new shatter-belt will take shape not only in Russia’s and China’s neighborhood, as they seek to establish spheres of influence, but also in the Middle East, which becomes more important to Europe as Europe diversifies away from Russia. Part of the strategic purpose of Russia’s invasion is to gain greater naval access to the Black Sea and Mediterranean, and hence to expand its ability to project power across the Middle East and North Africa. This is both for general strategic purposes and to gain greater leverage over Europe via its non-Russian energy and supply sources. Chart 10A New Shatter-Belt Emerging The critical strategic factor in the Middle East is the US-Iran relationship. If the two sides arrange a strategic détente, then Iranian oil reserves will be developed, the risk of Iraqi civil war will decline, and the risk of general war in the Middle East will decline. This would be an important reduction of oil supply risk in the short and medium term (Chart 11). But our base case is the opposite: we expect either no deal, or a flimsy deal that does not truly reduce regional tensions. Chart 11Middle East Still Unstable, Still Essential A US-Iran nuclear deal might come together soon – we cannot rule it out. The Biden administration is willing to lift sanctions if Iran freezes its nuclear program and pledges to reduce its militant activities in the region. Biden has reportedly even provided Russia with guarantees that it can continue trading with Iran. Theoretically the US and Russia can cooperate to prevent Iran from getting nuclear weapons. Russia’s pound of flesh is that Ukraine be neutralized as a national security threat. However, any US-Iran deal will be a short-term, stop-gap measure that will fall short of a strategic détente. Iran is an impregnable mountain fortress and has a distinct national interest in obtaining deliverable nuclear weapons. Iran will not give up the pursuit of nuclear weapons because it cannot rely on other powers for its security. Iran obviously cannot rely on the United States, as any security guarantees could be overturned with the next party change in the White House. Tehran cannot rely on the US to prevent Israel from attacking it. Therefore Iran must pursue its own national survival and security through the same means as the North Koreans. It must avoid the predicaments of Ukraine, Libya, and Iraq, which never obtained nuclear weaponization and were ultimately invaded. Insofar as Iran wants to avoid isolation, it needs to ally with Russia and China, it cannot embark on a foreign policy revolution of engagement with the West. The Russians and Chinese are unreliable but at least they have an interest in undermining the United States. The more the US is undermined, the more of a chance Iran has to make progress toward nuclear weapons without being subject to a future US attack. Chart 12Iran’s Other Nuclear Option Of course, the US and Israel have declared that nuclear weaponization is a red line. Israel is willing to attack Iran whereas Japan was not willing to attack North Korea – and where there is a will there is a way. But Iran may also believe that Israel would be unsuccessful. It would be an extremely difficult operation. The US has not shown willingness to attack states to prevent them from going nuclear. A split between the US and Israel would be an excellent foreign policy achievement for Tehran. The US may desire to pivot away from the Middle East to focus on containing Russia and China. But the Middle East is critical territory for that same containment policy. If the US abandons the region, it will become less stable until a new security order emerges. If the US stays involved in the region, it will be to contain Iran aggressively or prevent it from acquiring nuclear weapons by force. Whatever happens, the region faces instability in the coming decade and the world faces oil supply disruptions as a result. Iran has significant leverage due to its ability to shutter the Strait of Hormuz, the world’s premier oil chokepoint (Chart 12). Why A Fourth Taiwan Strait Crisis Looms Chart 13US Cannot Deter China Without Triggering Crisis There is a valid analogy between Ukraine and Taiwan: both receive western military support, hence both pose a fundamental threat to the national security of Russia and China. Yet both lack a mutual defense treaty that obligates the US alliance to come to their defense. This predicament led to war in Ukraine and the odds of an eventual war in Taiwan will go up for the same reason. In the past, China could not prevent the US from arming Taiwan. But it is increasingly gaining the ability to take Taiwan by force and deter the US from military intervention. The US is slated to deliver at least $8.6 billion worth of arms by 2026, a substantial increase in arms sales reminiscent of the 1990s, when the Third Taiwan Strait Crisis occurred (Chart 13). The US will learn from Russian aggression that it needs to improve its vigilance and deterrence against China over Taiwan. China will view this American response as disproportionate and unfair given that China did nothing to Ukraine. Chart 14Taiwanese Opinion Hard To Reconcile With Mainland Rule China is probably just capable of defeating Taiwan in a war but Beijing has powerful economic and political incentives not to take such an enormous risk today, on Russia’s time frame. However, if the 2022-24 election cycle in Taiwan returns the nominally pro-independence Democratic Progressive Party to power, then China may begin to conclude that peaceful reunification will be politically unachievable. Already it is clear from the steady course of Taiwanese opinion since the Great Recession that China is failing to absorb Taiwan through economic attraction (Chart 14). As China’s trend economic growth falters, it will face greater sociopolitical instability at home and an even less compelling case for Taiwan to accept absorption. This will be a very dangerous strategic environment. Taiwan is the epicenter of the US-China strategic competition, which is the primary geopolitical competition of the century because China has stronger economic foundations than Russia. China will become even more of a threat to the US if fortified by Russian alliance – and China’s fears over US support for Taiwan necessitate that alliance. Why The US Will Avoid Civil War None of the headline geopolitical risks outlined above – NATO-Russia war, Israeli-Iranian war, or Sino-Taiwanese war – would be as great of risks if the United States could be relied on to play a stable and predictable role as the world’s leading power. The problem is that the US is divided internally, which has led to erratic and at times belligerent foreign policy, thus feeding the paranoia of US rivals and encouraging self-interested and hawkish foreign policies, and hence global instability. Chart 15True, A Second US Civil War Is Conceivable It seems likely that US political polarization will remain at historic peaks over the 2022-24 election cycle. The Ukraine war will probably feed polarization by adding to the Democratic Party’s woes. Inflation and energy prices have already generated high odds that Republicans will retake control of Congress. But midterm churn is standard political clockwork in the US. The bigger risk is stagflation or even recession, which could produce another diametric reversal of White House policy over a mere four-year period. Former President Donald Trump is favored to be the Republican presidential nominee in 2024 – he is anathema to the left wing and unorthodox and aggressive in his foreign and trade policies. If he is reelected, it will be destabilizing both at home and abroad. But even if Trump is not the candidate, the US is flirting with disaster due to polarization and uncertainties regarding the constitution and electoral system. Chart 16Yet US Polarization Is Peaking... Aided By Foreign Threats US polarization is rooted in ethnic, ideological, regional, and economic disparities that have congealed into pseudo-tribalism. The potential for domestic terrorism of whatever stripe is high. These divisions cannot said to be incapable of leading to widespread political violence, since Americans possess far more firearms per capita than other nations (Chart 15). In the event of a series of negative economic shocks and/or constitutional breakdown, US political instability could get much worse than what was witnessed in 2020-21, when the country saw large-scale social unrest, a contested election, and a rebellion at the Capitol. Yet we would take the other side of the bet. US polarization will likely peak in the coming decade, if it has not peaked already. The US has been extremely polarized since the election of 1800, but polarization collapsed during World War I, the Great Depression, and World War II. True, it rose during the Cold War, but it only really ignited during the Reagan revolution and economic boom of the 1980s, when wealth inequality soared and the Soviet Union collapsed (Chart 16). The return of proactive fiscal policy and serious national security threats will likely drive polarization down going forward. Investment Takeaways The good news is that the war in Ukraine is unlikely to spread to the rest of Europe and engender World War III. The bad news is that the risk of such a war has not been higher for decades. Investors should hedge against the tail risk by maintaining significant safe-haven assets such as gold, cash, Treasuries, and farmland. Chart 17Investment Takeaways Europe and China will strive to maintain their economic relationship, which will delay a total breakdown in East-West relations. However, Germany and Europe will ultimately cleave to the US, while China will ultimately cleave to Russia, and the pace of transition into a new bifurcated world will accelerate depending on events. If the energy shock escalates to the point of triggering a European or global economic crash, the pace of strategic confrontation will accelerate. The global peace that emerged in 1945 is encountering very significant strains comparable to the most precarious moments of the Cold War. The Cold War period was not peaceful everywhere but the US and USSR avoided World War III. They did so on the basis of the peace settlement of 1945. The reason the 1945 peace regime is decaying is because the US, the preponderant power, is capable of achieving global hegemony, which is threatening to other great powers. The US combines the greatest share of wealth and military power and no single power can resist it. Yet a number of powers are capable of challenging and undermining it, namely China, but also Russia in a military sense, as well as lesser powers. The US is internally divided and struggling to maintain its power and prestige. The result is a return to the normal, anarchic structure of international relations throughout history. Several powerful states are competing for national security in a world that lacks overarching law. Great Power struggle is here to stay. Investors must adjust their portfolios to keep them in tune with foreign policies – in addition to monetary and fiscal policies. Given that US and Indian equities are already richly valued, in great part reflecting this geopolitical dynamic, investors should look for opportunities in international markets that are relatively secure from geopolitical risk, such as in the Americas, Western Europe, and Oceania (Chart 17).   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

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

Special Report

Executive Summary Failure Of Iran Deal Tightens Oil Supply The US and Iran suspended their attempt to negotiate a nuclear deal on March 11. Countries often get cold feet before major agreements but there are good reasons to believe this suspension will be permanent. A confirmed failure to restore the US-Iran strategic détente will lead to Middle Eastern instability. Iran will be on a trajectory to achieve nuclear weapons in a few years while Israel and the US will have to underscore their red lines against weaponization. The Strait of Hormuz will come under threat again. The immediate impact on oil prices should be positive: sanctions will continue to hinder Iran’s exports, while Iranian conflict with its neighbors will sharply increase the odds of oil disruptions caused by militant actions. Not to mention the Russia-induced energy supply shock. However, a decisive move by the Gulf Arab states to boost crude production would counteract the effect of Iranian sanctions and drive oil down. The Gulf Arabs will be more inclined to coordinate with the Biden administration as long as the Iran deal is ruled out. Thus oil volatility is the main implication beyond any short term oil spike.     Trade Recommendation Inception Date Return Long Gold (Strategic) 2019-12-06 36.8% Bottom Line: Go long US equities relative to global; long US and Canadian stocks versus Saudi and UAE stocks. Stay long XOP ETF, S&P GSCI index, and COMT ETF for exposure to oil prices and backwardation in oil forward curves. Feature The current Iran talks would have restored Joint Comprehensive Plan of Action (JCPA), which created a strategic détente between the US and Iran. Iran froze its nuclear program while the US lifted sanctions. President Barack Obama negotiated the deal in 2015, without congressional approval, while President Donald Trump nullified it in 2018, arguing that it did not restrict Iran’s ballistic missile development or support for regional militant groups. Chart 1Bull Market In Iran Tensions Will Be Super-Charged Since then there has been a bull market in Iran tensions (Chart 1), a secret war in which sporadic militant attacks, assassinations, and acts of sabotage occurred but neither side pursued open confrontation. These attacks can be significant, as with the Iran-backed attack on the Abqaiq refinery in Saudi Arabia, which took 6mm b/d of oil-processing capacity offline briefly in September 2019. The implication of this trend is energy supply disruption. Now the trend will be super-charged in the context of a global energy shortage. If no US-Iran détente is achieved, the Middle East will be set on a new trajectory of conflict, or at least a nuclear arms race and aggressive containment strategy. Since Trump turned away from the US-Iran détente and reimposed sanctions on Iran we have given a 40% chance of large-scale military conflict, according to our June 2019 decision tree (Diagram 1). The basis for such a conflict is Iran’s likelihood of obtaining nuclear arms and the need of Israel, its Arab neighbors, and the US to prevent that from happening. Diagram 1US-Iran Conflict: Critical Juncture In Our Decision Tree Between now and then, tit-for-tat military exchanges will increase, posing risks to oil supply in the short and medium run. Without a major diplomatic breakthrough that halts Iran’s nuclear weaponization, a bombing campaign against Iran will be the likeliest long-term consequence, due to the fateful logic of Israel’s strategic predicament (Diagram 2). Diagram 2Over Medium Term, Unilateral Israeli Military Action Is Possible Why Rejoining The US-Iran Deal Was Unlikely Under the Biden administration’s new plan, Iran would have frozen its nuclear program once again while Biden would have relaxed US “maximum pressure” sanctions on Iran, opening the way for foreign investment and the development of Iran’s energy sector and economy. The basis for a deal was the belief among some US policymakers that engagement with Iran would open up its economy, reducing regional war risks (especially in Iraq), expanding global energy supply, and fomenting pro-democratic sentiment in Iran. Also the Washington military-industrial complex wanted to reduce the US’s commitment to the Middle East and arrange a grand strategic “pivot to Asia” so as to counter the rise of China. Up till August 2021, we viewed a deal as likely, but that view changed when Iran’s hawkish or hardline faction came back into the presidency. Biden had a very small window of opportunity to negotiate with outgoing Iranian President Hassan Rouhani, who negotiated the original 2015 deal and whose administration fell apart after President Trump withdrew from the deal. When the hawkish Iranian faction took back power, this opportunity slipped. Iran’s hawks were vindicated for having opposed détente with the US in the first place. Since then we have argued that strategic tensions would escalate, for the following reasons: The Iranians could not trust the Americans, since they knew that any new deal could be torn up as early as January 20, 2025 if the Republican Party took back the White House. Indeed, former Vice President Mike Pence recently confirmed this view explicitly. The Iranians were not compelled to agree to the deal because high oil prices ensured that they could export oil regardless of US sanctions (Chart 2). The US no longer has the diplomatic credibility to galvanize a coalition that includes the Russians and Chinese to isolate Iran, like it did back in 2014-15. Chart 2Iranians Not Compelled To A Deal, Can Circumvent Sanctions As for Iran’s weak economy spurring social unrest and forcing Supreme Leader Ayatollah Ali Khamenei to agree to a deal, the US has had maximum pressure sanctions in place since 2019 and it has not produced that effect. Yes, Iran is ripe for social unrest, but the regime is consolidating power under the hardliners rather than taking any risky course of opening up and reform that could foment pro-democratic and pro-western demands for change. With oil revenues flowing in, the regime will be more capable of suppressing domestic opposition. The Americans could not trust the Iranians because they knew that they would ultimately pursue nuclear weapons regardless of any short-term revival of the 2015 deal. The Iranians have a stark choice between North Korea, which achieved nuclear weaponization and now has a powerful guarantee of future regime survival, and countries like Ukraine and Libya, which gave up nuclear weapons or programs only to be invaded by foreign armies. Moreover the Iranian nuclear deal lacked popular support, even among Obama Democrats back in 2015, not to mention today in the wake of the deal’s cancellation. The deal’s provisions would have begun expiring in 2025 under any conditions. The Israelis and Gulf Arabs opposed the deal. The Russians also switched to opposing the deal and made new demands at the last minute as a result of the US sanctions imposed on Russia in the wake of its invasion of Ukraine. The Russians do not have an interest in Iran obtaining a nuclear weapon and they supported the 2015 deal and the 2021-22 renegotiation while demanding their pound of flesh in the form of Ukraine. But they also know that Israel and the US will use military force to prevent Iran from getting the bomb, so they are not compelled to join any agreement. Crippling US sanctions over Ukraine likely caused them to interfere with the deal. Our pessimistic view is now confirmed, with the suspension of talks. True, informal talks will continue, diplomacy could somehow revive, and it is still possible for a deal to come together. But given our fundamental points above, we would give any durable diplomatic solution a low probability, say 5%. That means that the US and Iran will not engage, which means Iran will re-activate its regional militant proxies and begin pursuing nuclear weaponization. Iran has a powerful incentive to increase regime security before the dangerous leadership succession that looms over the nearly 83 year-old Khamenei and the threatening possibility of a Republican’s reelection in 2024. At present, it is unknown which side of the Iran nuclear deal talks suspended them. While the Iranians were not compelled by an international coalition to join the deal as they were in 2015, we cannot ignore the possibility the suspension in talks arises from a deal being reached between the US and core OPEC 2.0 producers (Saudi Arabia, the UAE, and Kuwait). Very simply, such a deal would entail that the Arab states increase output, to ease the global shortage, in return for the US walking away from the flawed Iran deal and pledging to work with Israel and the Gulf Arabs to contain Iran. Israel and the Gulf Arabs are increasingly aligned in their goal of countering Iran under the Abraham Accords, negotiated in 2020 by the Trump administration. If the US and Gulf states agreed, then the Gulf states are likely to increase production to ease the global shortage and prolong the business cycle, meaning that oil prices could fall rather than rise as their next move. Either way they will remain volatile as a result of global developments. What Next? Escalation In The Middle East The Iranians have made substantial nuclear progress since 2018, despite Israeli attempts at sabotaging critical facilities. Today Iran stands on the brink of achieving “breakout” levels of highly enriched uranium – levels at which it is possible to construct a nuclear device (Table 1). Table 1Iran Will Reach ‘Breakout’ Nuclear Capability The suspension of talks means the Iranians will soon reach breakout capacity, which will splash across global headlines. This news will rattle global financial markets as it will point to a nuclear arms race in the most volatile of regions. There is a gap of one-to-two years between breakout uranium enrichment and deliverable nuclear weapon, according to most experts.1 However, it is much easier to monitor nuclear programs than missile programs, which means western intelligence will lose visibility when it comes to knowing precisely when Iran will obtain a functional nuclear warhead that it can mount on a ballistic missile. The Iranians are skillful at ballistic missiles. The clock will start ticking once nuclear breakout is achieved and the Israelis and Americans will be forced to respond by underscoring their red line against weaponization. Starting right away, Israel and the US will need to demonstrate publicly that they have a “military option” to prevent Iran from achieving nuclear weaponization. They will refrain from immediate military action but will seek to re-establish a credible threat through shows of force. They will also redouble their efforts to use special operations and cyber attacks to set back the Iranian programs. The Iranians will seek to deter them from attacking and will want to highlight the negative consequences. The US-Iran talks were not only about the nuclear program but also about a broader strategic détente. The Iranians will no longer rein in their regional militant proxies, whether the militias in Iraq or the Houthis in Yemen or Hezbollah in Lebanon. In effect we are now looking at a major escalation of militant attacks in the Middle East at a time when oil is already soaring. In many cases the express intent of the Iran-backed groups will be to threaten oil supply to demonstrate the leverage that they have to intimidate the US and its allies and discourage them from applying too much pressure too quickly. Bottom Line: On top of the current oil shock, we are about to have a higher risk premium injected into oil from Middle Eastern proxy conflict involving Iran. If OPEC does not act quickly to boost production then financial markets face additional commodity price pressures, on top of the existing Russia-induced supply shock. Commodity And Energy Implications Our Commodity & Energy Strategist, Bob Ryan, outlines the following implications for the oil market: In BCA Research's oil supply-demand balances, while we recognized the Geopolitical Strategy view that the US-Iran deal would not materialize, nevertheless we assumed that Iran would return up to 1.3mm b/d of production by 2H22, which would have been available for export markets. This would have given a significant boost to oil supply as the market continues to tighten. Chart 3Failure Of Iran Deal Tights Oil Supply The failure of these barrels to return to the market will result in an oil-price increase of about $15/bbl in 2023, based on our modeling (Chart 3). We can expect backwardations to increase in Brent and WTI, as demand for precautionary inventories increases. The modelled prices include the oil risk premium of ~USD 9/bbl in H2 2022 and USD 5/bbl in 2023. Relative to 2021, we expect core- OPEC - KSA, UAE and Kuwait – and total US crude supply to increase by 1.7 mmb/d and 0.65 mmb/d respectively in 2022. Compared to 2022, core-OPEC supply will level off in 2023, and will increase by 0.6 mmb/d for total US. If the US has a deal with core OPEC, then, based on the reference production levels agreed by OPEC 2.0 in July 2021, core OPEC’s production capacity could cover a large bit of the volumes markets are short (Table 2). This is due to lower monthly additions of output that was supposed to be returned to markets – now above 1mm b/d – and the lost Iranian output (Table 2). Table 2OPEC 2.0 Reference Production Levels Per the OPEC 2.0 reference production schedule released following the July 2021 meeting in Vienna, Saudi Arabia’s output is free to go to 11.5mm b/d by May, the UAE's to 3.5mm b/d, and Kuwait's to just under 3mm b/d. Iraq also could raise output, but its output is variable and it will lie at the center of the new escalation in military tensions, so we do not count it as core OPEC 2.0 production. Assuming these numbers are consistent with actual capacity for core OPEC 2.0, that means Saudi Arabia could lift production by ~ 1.1mm b/d, UAE by ~ 0.5m b/d, and Kuwait by close to 0.3mm b/d. That’s almost 2mm b/d. These reference-production levels might be on the high side of what core OPEC 2.0 is able or willing to do. But they would be close to covering most of the deficit resulting from less-than-anticipated return of 400k b/d from OPEC 2.0 producers beginning last August ( ~ 1.2mm b/d). Most of Iran’s lost output also would be covered. More than likely, these barrels will find their way to market "under the radar" (i.e., smuggled out of Iran) over the next year or so. This was one reason our geopolitical strategists did not view Iran as sufficiently pressured to sign a deal. US shale-oil output will be increasing above the 0.9 mm b/d that we forecast last month for 2022, and the 0.5mm b/d we expect next year, given the sharp price rally prompted by the Russian invasion of Ukraine. Our Commodity & Energy Strategy service will be updating our estimate next week when we publish new supply-demand balances and price forecasts. Releases from the Strategic Petroleum Reserves of the US and OECD are available to tide the market over for brief periods due to Middle East shocks or sanctions on Russian oil. Releases from the Strategic Petroleum Reserves of the US and OECD are available to tide the market over for brief periods due to Middle East shocks or sanctions on Russian oil. Over time, a significant share of these displaced Russian barrels will find their way to China, and the volumes being displaced will be re-routed to other Asian and western buyers. Investment Takeaways One of our key geopolitical views for 2022 is that oil producers have enormous strategic leverage, specifically Russia and Iran. The Ukraine war and now the suspension of US-Iran détente bears out this view. It is highly destabilizing for global politics and economy. One of our five black swans for 2022 is that Israel could attack Iran – this is a black swan because it is highly unlikely on such a short time frame. However, if the US-Iran deal cannot be salvaged, then the clock is ticking to a time when Israel and/or the US will have to decide whether to prevent Iran from going nuclear or instead choose containment strategy as with North Korea. Yet the Iran dilemma is less stable than the Korean dilemma because the Israelis are committed to preventing weaponization. The Israelis will not act unilaterally until the last possible moment, when all other options to prevent weaponization are exhausted, as the operation would be extremely difficult and they need American military assistance. If diplomacy fails on Iran, the two options for the future are a major war or a nuclear arms race in the Middle East. The latter would involve an aggressive containment strategy. The global economy faces a major new risk to energy supply as a result of this material increase in Middle East tensions. A stagflationary outcome is much more likely. Europe’s energy security will be far more vulnerable now as it tries to diversify away from Russia but faces a more volatile Middle East (Chart 4). Undoubtedly Russia and Iran recognize their tremendous leverage. China, India, and other resource imports face a larger energy shock if the Gulf Arabs do not boost production promptly. They certainly face greater volatility. China’s policy support for the economy will remain lackluster in an environment in which inflation continues to threaten economic stability. China’s internal stability was already at risk and now it will have to scramble to secure energy supplies amid a global price shock and looming Middle Eastern instability. China has no choice but to accept Russia’s decision to cut ties with the West and lash itself to China as a strategic ally for the foreseeable future (Chart 5). Chart 4The EU’s Two-Pronged Energy Insecurity​​​​​ Chart 5China's Energy Insecurity​​​​​ Chart 6AGo Long US And Canada / Short Saudi And UAE ​​​​​ Chart 6BGo Long US And Canada / Short Saudi And UAE ​​​​​ Geopolitical Strategy recommends investors go long US equities relative to global equities on a strategic basis. We also recommend long US / short UAE equities and long Canadian / short Saudi equities (Charts 6A and 6B). Chart 7Worst Case Oil Risk In Historical Context Unlike Ukraine, the onset of a new Middle East crisis may not come with “shock and awe.” Weeks or months may pass before Iran reaches nuclear breakout. But make no mistake, if diplomacy fails, Iran will ignite a nuclear race and activate its militant proxies, while its enemies will increase sabotage, rattle sabers, and review military options. The Iranians will not be afraid to threaten the Strait of Hormuz, their other nuclear option (Chart 7). A total blockage of Hormuz is not by any means imminent. But war becomes more likely if Iran achieves nuclear breakout and diplomacy continues to fail.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Footnotes 1      See Ariel Eli Levite, “Can a Credible Nuclear Breakout Time With Iran Be Restored?” Carnegie Endowment for International Peace, June 24, 2021, carnegieendowment.org. See also Simon Henderson, “Iranian Nuclear Breakout: What It Is and How to Calculate It,” Washington Institute for Near East Policy, Policy Watch 3457, March 24, 2021, washingtoninstitute.org.   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix

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

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

Executive Summary We look at the Ukraine crisis in the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. Our high-conviction view is that the Ukraine crisis will be net deflationary, because the economic and financial sanctions imposed on Russia will lead to a generalized demand destruction. Bond yields will be lower in the second half of the year. Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Stay structurally overweight the 30-year T-bond. The ultimate low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Fractal trading watchlist: We focus on banks, add alternative electricity, and review bitcoin. Every Shock Is Always Supplanted By A New Shock Bottom Line: The recent rise in bond yields and the associated outperformance of cyclical sectors such as banks, ‘value’, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move within a much bigger structural downtrend. This structural downtrend is now set to resume. Feature Suddenly, nobody is worried about Covid and everybody is worried about nuclear war. Or as Vladimir Putin warns, “such consequences that you have never experienced in your history.” The life lesson being that every shock is always supplanted by a new shock. Hence, in this report we look at the Ukraine crisis through a wider lens. We look at the broader context of shocks, what we can learn from them, and how we can incorporate them into our strategy for investment, and life in general. The Predictability Of Shocks Shocks are very predictable. This sounds like a contradiction, but we don’t mean the timing or nature of individual shocks. As specific events, Russia’s full-scale invasion of Ukraine and the global pandemic were ‘tail-events’ that did come as shocks. Yet the statistical distribution of such tail-events is very predictable. This predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term strategy for investment, or life in general. The predictability of shocks forms the bedrock of the world’s $5 trillion insurance industry, and should also form the bedrock of any long-term investment strategy. We define a shock as any event that causes the long-duration bond price in a major economy to rally or slump by at least 20 percent, albeit this is just one definition.1On this definition, the Ukraine crisis is not yet a far-reaching economic or financial shock, but it is certainly well-placed to become one. Applying this definition of a shock through the last 60 years, the statistical distribution of shocks over any long period is well-defined and very predictable. For example, over a ten-year period the number of shocks exhibits a Poisson distribution with parameter 3.33 (Chart I-1), while the time between shocks exhibits an Exponential distribution with parameter 3.33. Chart 1The Statistical Distribution Of Shocks Is Very Predictable Many economists and investment strategists present their long-term forecasts for the economy and financial markets, yet completely ignore this very predictable distribution of shocks – making their long-term forecasts worthless! The question to such economists and strategists is why are there no shocks over your forecasting horizon? Their typical answer is that it is not an economist’s job to predict ‘acts of god’ or ‘black swans.’ But if insurance companies can incorporate the very predictable distribution of acts of god and black swans, then why can’t economists and strategists? Over any ten-year period, the likelihood of suffering a shock is a near-certainty, at 95 percent; in any five-year period, it is an extremely high 80 percent; in a two-year period, it is a coin toss at 50 percent; and even in one year it is a significant 30 percent (Chart I-2). Chart I-2On A Multi-Year Horizon, Another Shock Is A Near-Certainty Witness that since just 2016 we have experienced Brexit, and the election of Donald Trump as US president. These were binary-outcome events where we could ‘visualise’ the tail-event in advance, but many dismissed it as implausible. Then we had a global pandemic, and now Russia’s full-scale invasion of Ukraine. Therefore, the crucial question is not whether we will experience shocks. We always will. The crucial question is, will the shock be net deflationary or net inflationary? Our high-conviction view is that the Ukraine crisis will be net deflationary. Meaning that even if it starts as inflationary, it will quickly morph into deflationary. The Danger From Higher Energy Prices: The Obvious And The Not So Obvious Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns – most recently, the 1999-2000 trebling of crude and the subsequent 2000-01 downturn, and the 2007-2008 trebling of crude and the subsequent 2008-09 global recession. Begging the question, should we be concerned that the Ukraine crisis has lifted the crude oil price to a near-trebling since October 2020, not to mention the massive spike in natural gas prices? Many people have noticed the suspicious proximity of oil price surges to subsequent economic downturns. Of course, we know that the root cause of both the 2000-01 downturn and the 2008-09 recession was not the oil price surge that preceded them. As their names make crystal clear, the 2001-01 downturn was the dot com bust and the 2008-09 recession was the global financial crisis. And yet, and yet… while the oil price surge was not the culprit, it was certainly the accessory to both murders. The obvious way that high energy prices hurt is that they are demand destructive to both energy and non-energy consumption. In this regard, the good news is that the economy is becoming much less energy-intensive – every unit of real output requires about 40 percent less energy than at the start of the millennium (Chart I-3). Nevertheless, even if the scope to hurt is lessening, higher energy prices are still demand destructive. Chart I-3The Economy Is Becoming Less Energy-Intensive The not so obvious way that high energy prices hurt is that they risk driving up the long-duration bond yield and thereby tipping more systemically important economic and financial fragilities over the brink. This was the where the greater pain came from in both 2000 and 2008 (Chart I-4 and Chart I-5). Chart I-4Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 1999 Chart I-5Fears Of Energy-Driven Inflation Drove Up The Bond Yield In 2008 Fortunately, the recent decline in the 30-year T-bond yield suggests that the bond market is looking through the short-term inflationary impulse of higher energy prices (Chart I-6). Instead, it is focussing on the deflationary impulse that will come from the demand destruction that the higher prices will trigger. Chart I-6Today, The Bond Market Is Looking Through The Inflationary Impulse From Higher Energy Prices The economic and financial sanctions imposed on Russia will only lead to additional demand destruction. Sanctions restrict trade and economic and financial activity – therefore they hurt both the side that is sanctioned and the side that is sanctioning. This mutuality of pain caused the West to balk at both the timing and severity of its sanctions. But absent an unlikely backdown from Russia, the sanctions noose will tighten, choking growth everywhere.   If bond yields were to re-focus on inflation and move higher, it would add a further headwind to the economy and markets, forcing the 30-year T-bond yield back down again from a ‘line in the sand’ at around 2.4-2.5 percent. So, the long-duration bond yield will go down directly or via a short detour higher. Either way, bond yields will be lower in the second half of the year. Given the very tight connection between bond yields and stock market sector, style, and country allocation, it will become clear that the recent outperformance of cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100 was just a short-lived countertrend move in a much bigger structural downtrend (Chart I-7). This structural downtrend is set to resume. Chart I-7When Bond Yields Decline, Banks Underperform Underweight cyclicals such as banks, ‘value’ sectors, and value-heavy stock markets such as the FTSE 100. Yet, the over-arching message from the anatomy of shocks is that the ultimate structural low in the 30-year T-bond yield is yet to come, and will be a long way below the current 2.1 percent. Stay structurally overweight the 30-year T-bond.   Fractal Trading Watchlist This week’s analysis focusses on banks, adds alternative electricity, and reviews bitcoin. Supporting the fundamental arguments in the main body of this report, the recent outperformance of banks has reached the point of fractal fragility that has signalled several important turning-points through the past decade (Chart 1-8). Accordingly, this week’s recommended trade is to go short world banks versus world consumer services, setting the profit target and symmetrical stop-loss at 12 percent.  Chart I-8The Recent Outperformance Of Banks May Soon End Alternative Electricity Is Rebounding From An Oversold Position Bitcoin's Support Is Holding Dhaval Joshi Chief Strategist dhaval@bcaresearch.com   Footnotes 1 As bond yields approach their lower limit, this definition of a shock will need to change as it will become impossible for long-duration bond prices to rally by 20 percent. 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-5 Indicators To Watch - Interest Rate Expectations Chart II-6 Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

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

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