War/Conflict

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

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

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

Highlights Our three strategic themes over the long run: (1) great power rivalry (2) hypo-globalization (3) populism and nationalism. The implications are inflationary over the long run. Nations that gear up for potential conflict and expand the social safety net to appease popular discontent will consume a lot of resources. Our three key views for 2022: (1) China’s reversion to autocracy (2) America’s policy insularity (3) petro-state leverage. The implications are mostly but not entirely inflationary: China will ease policy, the US will pass more stimulus, and energy supply may suffer major disruptions. Stay long gold, neutral US dollar, short renminbi, and short Taiwanese dollar. Stay tactically long global large caps and defensives. Buy aerospace/defense and cyber-security stocks. Go long Japanese and Mexican equities – both are tied to the US in an era of great power rivalry. Feature Chart 1US Resilience Global investors have not yet found a substitute for the United States. Despite a bout of exuberance around cyclical non-US assets at the beginning of 2021, the year draws to a close with King Dollar rallying, US equities rising to 61% of global equity capitalization, and the US 30-year Treasury yield unfazed by inflation fears (Chart 1). American outperformance is only partly explained by its handling of the lingering Covid-19 pandemic. The US population was clearly less restricted by the virus (Chart 2). But more to the point, the US stimulated its economy by 25% of GDP over the course of the crisis, while the average across major countries was 13% of GDP. Americans are still more eager to go outdoors and the government has been less stringent in preventing them (Chart 3). ​​​​​ Chart 3Social Restrictions Short Of Lockdown​​​​​​ Going forward, the pandemic should decline in relevance, though it is still possible that a vaccine-resistant mutation will arise that is deadlier for younger people, causing a new round of the crisis. The rotation into assets outside the US will be cautious. Across the world, monetary and credit growth peaked and rolled over this year, after the extraordinary effusion of stimulus to offset the social lockdowns of 2020 (Chart 4). Government budget deficits started to normalize while central banks began winding down emergency lending and bond-buying. More widespread and significant policy normalization will get under way in 2022 in the face of high core inflation. Tightening will favor the US dollar, especially if global growth disappoints expectations. Chart 4Waning Monetary And Credit Stimulus Chart 5Global Growth Stabilization Global manufacturing activity fell off its peak, especially in China, where authorities tightened monetary, fiscal, and regulatory policy aggressively to prevent asset bubbles from blowing up (Chart 5). Now China is easing policy on the margin, which should shore up activity ahead of an important Communist Party reshuffle in fall 2022. The rest of the world’s manufacturing activity is expected to continue expanding in 2022, albeit less rapidly. This trend cuts against US outperformance but still faces a range of hurdles, beginning with China. In this context, we outline three geopolitical themes for the long run as well as three key views for the coming 12 months. Our title, “The Gathering Storm,” refers to the strategic challenge that China and Russia pose to the United States, which is attempting to form a balance-of-power coalition to contain these autocratic rivals. This is the central global geopolitical dynamic in 2022 and it is ultimately inflationary. Three Strategic Themes For The Long Run The international system will remain unstable in the coming years. Global multipolarity – or the existence of multiple, competing poles of political power – is the chief destabilizing factor. This is the first of our three strategic themes that will persist next year and beyond (Table 1). Our key views for 2022, discussed below, flow from these three strategic themes. Table 1Strategic Themes For 2022 And Beyond 1. Great Power Rivalry Multipolarity – or great power rivalry – can be illustrated by the falling share of US economic clout relative to the rest of the world, including but not limited to strategic rivals like China. The US’s decline is often exaggerated but the picture is clear if one looks at the combined geopolitical influence of the US and its closest allies to that of the EU, China, and Russia (Chart 6). China’s rise is the most destabilizing factor because it comes with economic, military, and technological prowess that could someday rival the US for global supremacy. China’s GDP has surpassed that of the US in purchasing power terms and will do so in nominal terms in around five years (Chart 7). True, China’s potential growth is slowing and Chinese financial instability will be a recurring theme. But that very fact is driving Beijing to try to convert the past 40 years of economic success into broader strategic security. Chart 8America's Global Role Persists (If Lessened)​​​​​ Since China is capable of creating an alternative political order in Asia Pacific, and ultimately globally, the United States is reacting. It is penalizing China’s economy and seeking to refurbish alliances in pursuit of a containment policy. The American reaction to the loss of influence has been unpredictable, contradictory, and occasionally belligerent. New isolationist impulses have emerged among an angry populace in reaction to gratuitous wars abroad and de-industrialization. These impulses appeared in both the Obama and Trump administrations. The Biden administration is attempting to manage these impulses while also reinforcing America’s global role. The pandemic-era stimulus has enabled the US to maintain its massive trade deficit and aggressive defense spending. But US defense spending is declining relative to the US and global economy over time, encouraging rival nations to carve out spheres of influence in their own neighborhoods (Chart 8). Russia’s overall geopolitical power has declined but it punches above its weight in military affairs and energy markets, a fact which is vividly on display in Ukraine as we go to press. The result is to exacerbate differences in the trans-Atlantic alliance between the US and the European Union, particularly Germany. The EU’s attempt to act as an independent great power is another sign of multipolarity, as well as the UK’s decision to distance itself from the continent and strengthen the Anglo-American alliance. If the US and EU do not manage their differences over how to handle Russia, China, and Iran then the trans-Atlantic relationship will weaken and great power rivalry will become even more dangerous. 2. Hypo-Globalization The second strategic theme is hypo-globalization, in which the ancient process of globalization continues but falls short of its twenty-first century potential, given advances in technology and governance that should erode geographic and national boundaries. Hypo-globalization is the opposite of the “hyper-globalization” of the 1990s-2000s, when historic barriers to the free movement of people, goods, and capital seemed to collapse overnight. Chart 9From 'Hyper-Globalization' To Hypo-Globalization The volume of global trade relative to industrial production  peaked with the Great Recession in 2008-10 and has declined slowly but surely ever since (Chart 9). Many developed markets suffered the unwinding of private debt bubbles, while emerging economies suffered the unwinding of trade manufacturing. Periods of declining trade intensity – trade relative to global growth – suggest that nations are turning inward, distrustful of interdependency, and that the frictions and costs of trade are rising due to protectionism and mercantilism. Over the past two hundred years globalization intensified when a broad international peace was agreed (such as in 1815) and a leading imperial nation was capable of enforcing law and order on the seas (such as the British empire). Globalization fell back during times of “hegemonic instability,” when the peace settlement decayed while strategic and naval competition eroded the global trading system. Today a similar process is unfolding, with the 1945 peace decaying and the US facing the revival of Russia and China as regional empires capable of denying others access to their coastlines and strategic approaches (Chart 10).1 Chart 10Hypo-Globalization And Hegemonic Instability Chart 11Hypo-Globalization: Temporary Trade Rebound No doubt global trade is rebounding amid the stimulus-fueled recovery from Covid-19. But the upside for globalization will be limited by the negative geopolitical environment (Chart 11). Today governments are not behaving as if they will embark on a new era of ever-freer movement and ever-deepening international linkages. They are increasingly fearful of each other’s strategic intentions and using fiscal resources to increase economic self-sufficiency. The result is regionalization rather than globalization. Chinese and Russian attempts to revise the world order, and the US’s attempt to contain them, encourages regionalization. For example, the trade war between the US and China is morphing into a broader competition that limits cooperation to a few select areas, despite a change of administration in the United States. The further consolidation of President Xi Jinping’s strongman rule will exacerbate this dynamic of distrust and economic divorce. Emerging Asia and emerging Europe live on the fault lines of this shift from globalization to regionalism, with various risks and opportunities. Generally we are bullish EM Asia and bearish EM Europe. 3. Populism And Nationalism A third strategic theme consists of populism and nationalism, or anti-establishment political sentiment in general. These forces will flare up in various forms across the world in 2022 and beyond. Even as unemployment declines, the rise in food and fuel inflation will make it difficult for low wage earners to make ends meet. The “misery index,” which combines unemployment and inflation, spiked during the pandemic and today stands at 10.8% in the US and 11.4% in the EMU, up from 5.2% and 8.1% before the pandemic, respectively (Chart 12). Large budget deficits and trade deficits, especially in the US and UK, feed into this inflationary environment. Most of the major developed markets have elected new governments since the pandemic, with the notable exception of France and Spain. Thus they have recapitalized their political systems and allowed voters to vent some frustration. These governments now have some time to try to mitigate inflation before the next election. Hence policy continuity is not immediately in jeopardy, which reduces uncertainty for investors. By contrast, many of the emerging economies face higher inflation, weak growth, and are either coming upon elections or have undemocratic political systems. Either way the result will be a failure to address household grievances promptly. The misery index is trending upward and governments are continually forced to provide larger budget deficits to shore up growth, fanning inflation (Chart 13). Chart 12DM: Political Risk High But New Governments In Place​​​​​ Chart 13EM: Political Risk High But Governments Not Recapitalized​​​​​​ Chart 14EM Populism/Nationalism Threatens Negative Surprises In 2022 Just as social and political unrest erupted after the Great Recession, notably in the so-called “Arab Spring,” so will new movements destabilize various emerging markets in the wake of Covid-19. Regime instability and failure can lead to big changes in policies, large waves of emigration, wars, and other risks that impact markets. The risks are especially high unless and until Chinese imports revive. Investors should be on the lookout for buying opportunities in emerging markets once the bad news is fully priced. National and local elections in Brazil, India, South Korea, the Philippines, and Turkey will serve as market catalysts, with bad news likely to precede good news (Chart 14). Bottom Line: These three themes – great power rivalry, hypo-globalization, and populism/nationalism – are inflationary in theory, though their impact will vary based on specific events. Multipolarity means that governments will boost industrial and defense spending to gear up for international competition. Hypo-globalization means countries will attempt to put growth on a more reliable domestic foundation rather than accept dependency on an unreliable international scene, thus constraining supplies from abroad. Populism and nationalism will lead to a range of unorthodox policies, such as belligerence abroad or extravagant social spending at home. Of course, the inflationary bias of these themes can be upset if they manifest in ways that harm growth and/or inflation expectations, which is possible. But the general drift will be an inflationary policy setting. Inflation may subside in 2022 only to reemerge as a risk later. Three Key Views For 2022 Within this broader context, our three key views for 2022 are as follows: 1. China’s Reversion To Autocracy As President Xi Jinping leads China further down the road of strongman rule and centralization, the country faces a historic confluence of internal and external risks. This was our top view in 2021 and the same dynamic continues in 2022. The difference is that in 2021 the risk was excessive policy tightening whereas this coming year the risk is insufficient policy easing. Chart 15China Eases Fiscal Policy To Secure Recovery In 2022 China’s economy is witnessing a secular slowdown, a deterioration in governance, property market turmoil, and a rise in protectionism abroad. The long decline in corporate debt growth points to the structural slowdown. Animal spirits will not improve in 2022 so government spending will be necessary to try to shore up overall growth. The Politburo signaled that it will ease fiscal policy at the Central Economic Work Conference in early December, a vindication of our 2021 view. Neither the combined fiscal-and-credit impulse nor overall activity, indicated by the Li Keqiang Index, have shown the slightest uptick yet (Chart 15). Typically it takes six-to-nine months for policy easing to translate to an improvement in real economic activity. The first half of the year may still bring economic disappointments. But policymakers are adjusting to avoid a crash. Policy will grow increasingly accommodative as necessary in the first half of 2022. The key political constraint is the Communist Party’s all-important political reshuffle, the twentieth national party congress, to be held in fall 2022 (usually October). While Xi may not want the economy to surge in 2022, he cannot afford to let it go bust. The experience of previous party congresses shows that there is often a policy-driven increase in bank loans and fixed investment. Current conditions are so negative as to ensure that the government will provide at least some support, for instance by taking a “moderately proactive approach” to infrastructure investment (Chart 16). Otherwise a collapse of confidence would weaken Xi’s faction and give the opposition faction a chance to shore up its position within the Communist Party. Chart 16China Aims For Stability, Not Rapid Growth, Ahead Of 20th National Party Congress Party congresses happen every five years but the ten-year congresses, such as in 2022, are the most important for the country’s overall political leadership. The party congresses in 1992, 2002, and 2012 were instrumental in transferring power from one leader to the next, even though the transfer of power was never formalized. Back in 2017 Xi arranged to stay in power indefinitely but now he needs to clinch the deal, lest any unforeseen threat emerge from at home or abroad. Xi’s success in converting the Communist Party from “consensus rule” to his own “personal rule” will be measurable by his success in stacking the Politburo and Politburo Standing Committee with factional allies. He will also promote his faction across the Central Committee so as to shape the next generations of party leaders and leave his imprint on policy long after his departure. The government will be extremely sensitive to any hint of dissent or resistance and will move aggressively to quash it. Investors should not be surprised to see high-level sackings of public officials or private magnates and a steady stream of scandals and revelations that gain prominence in western media. The environment is also ripe for strange and unexpected incidents that reveal political differences beneath the veneer of unity in China: defections, protests, riots, terrorist acts, or foreign interference. Most incidents will be snuffed out quickly but investors should be wary of “black swans” from China in 2022. Chinese government policies will not be business friendly in 2022 aside from piecemeal fiscal easing. Everything Beijing does will be bent around securing Xi’s supremacy at all levels. Domestic politics will take precedence over economic concerns, especially over the interests of private businesses and foreign investors, as is clear when it comes to managing financial distress in the property sector. Negative regulatory surprises and arbitrary crackdowns on various industrial sectors will continue, though Beijing will do everything in its power to prevent the property bust from triggering contagion across the economic system. This will probably work, though the dam may burst after the party congress. Relations with the US and the West will remain poor, as the democracies cannot afford to endorse what they see as Xi’s power grab, the resurrection of a Maoist cult of personality, and the betrayal of past promises of cooperation and engagement. America’s midterm election politics will not be conducive to any broad thaw in US-China relations. While China will focus on domestic politics, its foreign policy actions will still prove relatively hawkish. Clashes with neighbors may be instigated by China to warn away any interference or by neighbors to try to embarrass Xi Jinping. The South and East China Seas are still ripe for territorial disputes to flare. Border conflicts with India are also possible. Taiwan remains the epicenter of global geopolitical risk. A fourth Taiwan Strait Crisis looms as China increases its military warnings to Taiwan not to attempt anything resembling independence (Chart 17A). China may use saber-rattling, economic sanctions, cyber war, disinformation, and other “gray zone” tactics to undermine the ruling party ahead of Taiwan’s midterm elections in November 2022 and presidential elections in January 2024. A full-scale invasion cannot be ruled out but is unlikely in the short run, as China still has non-military options to try to arrange a change of policy in Taiwan. ​​​​​​ Chart 17BMarket-Based Risk Indicators Say China/Taiwan Risk Has Not Peaked China has not yet responded to the US’s deployment of a small number of troops in Taiwan or to recent diplomatic overtures or arms sales. It could stage a major show of force against Taiwan to help consolidate power at home. China also has an interest in demonstrating to US allies and partners that their populations and economies will suffer if they side with Washington in any contingency. Given China’s historic confluence of risks, it is too soon for global investors to load up on cheap Chinese equities. Volatility will remain high. Weak animal spirits, limited policy easing, high levels of policy uncertainty, regulatory risk, ongoing trade tensions, and geopolitical risks suggest that investors should remain on the sidelines, and that a large risk premium can persist throughout 2022. Our market-based geopolitical risk indicators for both China and Taiwan are still trending upwards (Chart 17B). Global investors should capitalize on China’s policy easing indirectly by investing in commodities, cyclical equity sectors, and select emerging markets. 2. America’s Policy Insularity Our second view for 2022 centers on the United States, which will focus on domestic politics and will thus react or overreact to the many global challenges it faces. The US faces the first midterm election after the chaotic and contested 2020 presidential election. Political polarization remains at historically high levels, meaning that social unrest could flare up again and major domestic terrorist incidents cannot be ruled out. So far the Biden administration has focused on the domestic scene: mitigating the pandemic and rebooting the economy. Biden’s signature “Build Back Better” bill, $1.75 trillion investment in social programs, has passed the House of Representatives but not the Senate. The spike in inflation has shaken moderate Democratic senators who are now delaying the bill. We expect it to pass, since tax hikes were dropped, but our conviction is low (65% subjective odds), as a single defection would derail the bill. The implication would be inflationary since it would mark a sizable increase in government spending at a time when the output gap is already virtually closed. Spending would likely be much larger than the Congressional Budget Office estimate, shown in Chart 18, because the bill contains various gimmicks and hard-to-implement expiration clauses. Equity markets may not sell if the bill fails, since more fiscal stimulus would put pressure on the Federal Reserve to hike rates faster. Whether the bill passes or fails, Biden’s legislative agenda will be frozen thereafter. He will have to resort to executive powers and foreign policy to lift his approval rating and court the median voter ahead of the midterm elections. Currently Democrats are lined up to lose the House and probably also the Senate, where a single seat would cost them their majority (Chart 19). The Senate is still in play so Biden will be averse to taking big risks. For the same reason, Biden’s foreign policy goal will be to stave off various bubbling crises. Restoring the Iranian nuclear deal was his priority but Russia has now forced its way to the top of the agenda by threatening a partial reinvasion of Ukraine. In this context Biden will not have room for maneuver with China. Congress will be hawkish on China ahead of the midterms, and Xi Jinping will be reviving autocracy, so Biden will not be able to improve relations much. Biden’s domestic policy could fuel inflation, while his domestic-focused foreign policy will embolden strategic rivals, which increases geopolitical risks. 3. Petro-State Leverage A surge in gasoline prices at the pump ahead of the election would be disastrous for a Democratic Party that is already in disarray over inflation (Chart 20). Biden has already demonstrated that he can coordinate an international release of strategic oil reserves this year. Oil and natural gas producers gain leverage when the global economy rebounds, commodity prices rise, and supply/demand balances tighten. The frequency of global conflicts, especially those involving petro-states, tend to rise and fall in line with oil prices (Chart 21). Chart 20Inflation Constrains Biden Ahead Of Midterms Both Russia and Iran are vulnerable to social unrest at home and foreign strategic pressure abroad. Both have long-running conflicts with the US and West that are heating up for fundamental reasons, such as Russia’s fear of western influence in the former Soviet Union and Iran’s nuclear program. Both countries are demanding that the US make strategic concessions to atone for the Trump administration’s aggressive policies: selling lethal weapons to Ukraine and imposing “maximum pressure” sanctions on Iran. Biden is not capable of making credible long-term agreements since he could lose office as soon as 2025 and the next president could reverse whatever he agrees. But he must try to de-escalate these conflicts or else he faces energy shortages or price shocks, which would raise the odds of stagflation ahead of the election. The path of least resistance for Biden is to lift the sanctions on Iran to prevent an escalation of the secret war in the Middle East. If this unilateral concession should convince Iran to pause its nuclear activities before achieving breakout uranium enrichment capability, then Biden would reduce the odds of a military showdown erupting across the region. Opposition Republicans would accuse him of weakness but public opinion polls show that few Americans consider Iran a major threat. The problem is that this logic held throughout 2021 and yet Biden did not ease the sanctions. Given Iran’s nuclear progress and the US’s reliance on sanctions, we see a 40% chance of a military confrontation with Iran over the coming years. With regard to Ukraine, an American failure to give concessions to Russia will probably result in a partial reinvasion of Ukraine (50% subjective odds). This in turn will force the US and EU to impose sanctions on Russia, leading to a squeeze of natural gas prices in Europe and eventually price pressures in global energy markets. If Biden grants Russia’s main demands, he will avoid a larger war or energy shock but will make the US vulnerable to future blackmail. He will also demoralize Taiwan and other US partners who lack mutual defense treaties. But he may gain Russian cooperation on Iran. If Biden gives concessions to both Russia and Iran, his party will face criticism in the midterms but it will be far less vulnerable than if an energy shock occurs. This is the path of least resistance for Biden in 2022. It means that the petro-states may lose their leverage after using it, given that risk premiums would fall on Biden’s concessions. Of course, if energy shocks happen, Europe and China will suffer more than the US, which is relatively energy independent. For this reason Brussels and Beijing will try to keep diplomacy alive as long as possible. Enforcement of US sanctions on Iran may weaken, reducing Iran’s urgency to come into compliance. Germany may prevent a hardline threat of sanctions against Russia, reducing Russia’s fear of consequences. Again, petro-states have the leverage. Therefore investors should guard against geopolitically induced energy price spikes or shocks in 2022. What if other commodity producers, such as Saudi Arabia, crank up production and sink oil prices? This could happen. Yet the Saudis prefer elevated oil prices due to the host of national challenges they face in reforming their economy. If the US eases sanctions on Iran then the Saudis may make this decision. Thus downside energy price shocks are possible too. The takeaway is energy price volatility but for the most part we see the risk as lying to the upside. Investment Takeaways Traditional geopolitical risk, which focuses on war and conflict, is measurable and has slipped since 2015, although it has not broken down from the general uptrend since 2000. We expect the secular trend to be reaffirmed and for geopolitical risk to resume its rise due to the strategic themes and key views outlined above. The correlation of geopolitical risk with financial assets is debatable – namely because some geopolitical risks push up oil and commodity prices at the expense of the dollar, while others cause a safe-haven rally into the dollar (Chart 22).  Global economic policy uncertainty is also measurable. It is in a secular uptrend since the 2008 financial crisis. Here the correlation with the US dollar and relative equity performance is stronger, which makes sense. This trend should also pick up going forward, which is at least not negative for the dollar and relative US equity performance (Chart 23). Chart 22Geopolitical Risk Will Rise, Market Impacts Variable​​​​​​ Chart 23Economic Policy Uncertainty Will Rise, Not Bad For US Assets​​​​​​ We are neutral on the US dollar versus the euro and recommend holding either versus the Chinese renminbi. We are short the currencies of emerging markets that suffer from great power rivalry, namely the Taiwanese dollar versus the US dollar, the Korean won versus the Japanese yen, the Russian ruble versus the Canadian dollar, and the Czech koruna versus the British pound.     We remain long gold as a hedge against both geopolitical risk and inflation. We recommend staying long global equities. Tactically we prefer large caps and defensives. Within developed markets, we favor the UK and Japan. Japan in particular will benefit from Chinese policy easing yet remains more secure from China-centered geopolitical risks than emerging Asian economies. Within emerging markets, Mexico stands to benefit from US economic strength and divorce from China. We would buy Indian equities on weakness and sell Chinese and Russian equities on strength. We remain long aerospace and defense stocks and cyber-security stocks.   -The GPS Team We Read (And Liked) … Conspiracy U: A Case Study “Crazy, worthless, stupid, made-up tales bring out the demons in susceptible, unthinking people.” Thus the author’s father, a Holocaust survivor translated from Yiddish, on conspiracy theories and the real danger they present in the world. Scott A. Shay, author and chairman of Signature Bank, whose first book was a finalist for the National Jewish Book Award, has written an intriguing new book on the topic and graciously sent it our way.2 Shay is a regular reader of BCA Research’s Geopolitical Strategy and an astute observer of international affairs. He is also a controversialist who has written essays for several of America’s most prominent newspapers. Shay’s latest, Conspiracy U, is a bracing read that we think investors will benefit from. We say this not because of its topical focus, which is too confined, but because of its broader commentary on history, epistemology, the US higher education system – and the very timely and relevant problem of conspiracy theories, which have become a prevalent concern in twenty-first century politics and society. The author and the particular angle of the book will be controversial to some readers but this very quality makes the book well-suited to the problem of the conspiracy theory, since it is not the controversial nature of conspiracy theories but their non-falsifiability that makes them specious. As the title suggests, the book is a polemical broadside. The polemic arises from Shay’s unique set of moral, intellectual, and sociopolitical commitments. This is true of all political books but this one wears its topicality on its sleeve. The term “conspiracy” in the title refers to antisemitic, anti-Israel, and anti-Zionist conspiracy theories, particularly the denial of the Holocaust, coming from tenured academics on both the right and the left wings of American politics. The “U” in the title refers to universities, namely American universities, with a particular focus on the author’s beloved alma mater, Northwestern University in Chicago, Illinois. Clearly the book is a “case study” – one could even say the prosecution of a direct and extended public criticism of Northwestern University – and the polemical perspective is grounded in Shay’s Jewish identity and personal beliefs. Equally clearly Shay makes a series of verifiable observations and arguments about conspiracy theories as a contemporary phenomenon and their presence, as well as the presence of other weak and lazy modes of thought, in “academia writ large.” This generalization of the problem is where most readers will find the value of the book. The book does not expect one to share Shay’s identity, to be a Zionist or support Zionism, or to agree with Israel’s national policies on any issue, least of all Israeli relations with Arabs and Palestinians. Shay’s approach is rigorous and clinical. He is a genuine intellectual in that he considers the gravest matters of concern from various viewpoints, including viewpoints radically different from his own, and relies on close readings of the evidence. In other words, Shay did not write the book merely to convince people that two tenured professors at Northwestern are promoting conspiracy theories. That kind of aberration is sadly to be expected and at least partially the result of the tenure system, which has advantages as well, not within the scope of the book. Rather Shay wrote it to provide a case study for how it is that conspiracy theories can manage to be adopted by those who do not realize what they are and to proliferate even in areas that should be the least hospitable – namely, public universities, which are supposed to be beacons of knowledge, science, openness, and critical thinking, but also other public institutions, including the fourth estate. Shay is meticulous with his sources and terminology. He draws on existing academic literature to set the parameters of his subject, defining conspiracy theories as “improbable hypotheses [or] intentional lies … about powerful and sinister groups conspiring to harm good people, often via a secret cabal.” The definition excludes “unwarranted criticism” and “unfair/prejudiced perspectives,” which are harmful but unavoidable. Many prejudices and false beliefs are “still falsifiable in the minds of their adherents,” which is not the case with conspiracy theories, although deep prejudices can obviously be helpful in spreading such theories. Conspiracy theories often depend on “a stunning amount of uniformity of belief and coordination of action without contingencies.” They also rely excessively on pathos, or emotion, in making their arguments, as opposed to logos (reason) and ethos (credibility, authority). Unfortunately there is no absolute, infallible distinction between conspiracy theories and other improbable theories – say, yet-to-be-confirmed theories about conspiracies that actually occurred. Conspiracy theories differ from other theories “in their relationship to facts, evidence, and logic,” which may sound obvious but is very much to the point. Again, “the key difference is the evidence and how it is evaluated.” There is no ready way to refute the fabrications, myths, and political propaganda that people believe without taking the time to assess the claims and their foundations. This requires an open mind and a grim determination to get to the bottom of rival claims about events even when they are extremely morally or politically sensitive, as is often the case with wars, political conflicts, atrocities, and genocides: Reliable historians, journalists, lawyers, and citizens must first approach the question of the cause or the identity of perpetrators and victims of an event or process with an open mind, not prejudiced to either party, and then evaluate the evidence. The diagnosis may be easy but the treatment is not – it takes time, study, and debate, and one’s interlocutors must be willing to be convinced. This problem of convincing others is critical because it is the part that is so often left out of modern political discourse. Conspiracy theories are often hateful and militant, so there is a powerful urge to censor or repress them. Openly debating with conspiracy theorists runs the risk of legitimizing or appearing to legitimize their views, providing them with a public forum, which seems to grant ethos or authority to arguments that are otherwise conspicuously lacking in it. In some countries censorship is legal, almost everywhere when violence is incited. The problem is that the act of suppression can feed the same conspiracy theories, so there is a need, in the appropriate context, to engage with and refute lies and specious arguments. Clients frequently email us to ask our view of the rise of conspiracy theories and what they entail for the global policy backdrop. We associate them with the broader breakdown in authority and decline of public trust in institutions. Shay’s book is an intervention into this topic that clients will find informative and thought-provoking, even if they disagree with the author’s staunchly pro-Israel viewpoint. It is precisely Shay’s ability to discuss and debate extremely contentious matters in a lucid and empirical manner – antisemitism, the history of Zionism, Holocaust denialism, Arab-Israeli relations, the Rwandan genocide, QAnon, the George Floyd protests, various other controversies – that enables him to defend a controversial position he holds passionately, while also demonstrating that passion alone can produce the most false and malicious arguments. As is often the case, the best parts of the book are the most personal – when Shay tells about his father’s sufferings during the Holocaust, and journey from the German concentration camps to New York City, and about Shay’s own experiences scraping enough money together to go to college at Northwestern. These sequences explain why the author felt moved to stage a public intervention against fringe ideological currents, which he shows to have gained more prominence in the university system than one might think. The book is timely, as American voters are increasingly concerned about the handling of identity, inter-group relations, history, education, and ideology in the classroom, resulting in what looks likely to become a new and ugly episode of the culture and education wars. Let us hope that Shay’s standards of intellectual freedom and moral decency prevail.   Matt Gertken, PhD Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1      The downshift in globalization today is even worse than it appears in Chart 10 because several countries have not yet produced the necessary post-pandemic data, artificially reducing the denominator and making the post-pandemic trade rebound appear more prominent than it is in reality. 2     Scott A. Shay, Conspiracy U: A Case Study (New York: Post Hill Press, 2021), 279 pages. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Appendix: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia South Africa Section III: Geopolitical Calendar

Highlights A partial reinvasion of Ukraine cannot be ruled out. The constraints on Russia are not prohibitive, especially amid global energy shortages. On this issue, it is better to be alarmist than complacent. We would put the risk of a partial re-invasion of Ukraine as high as 50/50, albeit with an uncertain time frame over 12-36 months. The negative impact of conflict may not stay contained within Russian and eastern European markets. The US and EU are now threatening major retaliatory sanctions if Russia invades. In response Russia could reduce energy exports, exacerbating global shortages and damaging Europe’s overall economy. Investors should stay short Russian assets and overweight developed European equities over emerging European peers. Stay long gold and GBP-CZK. The dollar will be flat-to-up. Feature Chart 1Ruble Faces More Downside From Geopolitics Geopolitical tensions surrounding Russia remain unresolved and investors should continue to reduce holdings of assets exposed to any renewed conflict in Ukraine and the former Soviet Union. The ruble has dropped off its peaks since early November when strategic tensions revived (Chart 1). Presidents Joe Biden and Vladimir Putin held their second bilateral summit on a secure video link on December 7 to discuss the situation in Ukraine, where Russia has amassed 95,000-120,000 troops on the border in a major show of force. Russia also mustered troops in April and only partially drew them down after the Biden-Putin summit in Geneva where the two sides agreed to hold talks to address differences. The two presidents agreed to hold consultations regarding Ukraine. Putin accused NATO of building up Ukraine’s military and demanded “reliable, legally fixed guarantees excluding the expansion of NATO in the eastern direction and the deployment of offensive strike weapons systems in the states adjacent to Russia.”1 President Putin’s red line against Ukraine joining NATO is well known. Recently he said his red line includes the placement of western military infrastructure or missile systems in Ukraine. Biden refused to accept any limits on NATO membership in keeping with past policy. After the summit National Security Adviser Jake Sullivan said, “I will tell you clearly and directly [Biden] made no such commitments or concessions. He stands by the proposition that countries should be able to freely choose who they associate with.” 2 Biden, who had conferred with the UK, France, Germany, and Italy prior to the call, outlined the coordinated economic sanctions that would be leveled against Russia if it resorted to military force, as well as defense aid that would go to Ukraine and other eastern European countries.  Thus Putin gave an ultimatum and Biden rebuffed it – and yet the two agreed to keep talking. The Russians have since said that they will present proposals to the Americans in less than a week. Talks are better than nothing. But neither side has given concrete indication of a change in position that would de-escalate strategic tensions – instead they have both raised the stakes. Therefore investors should proceed with the strong presumption that tensions will remain elevated or escalate in the coming months. Clearing Away Misconceptions Before going further we should clear away a few misconceptions about the current situation: Ukraine has unique strategic value to Russia. Like Belarus, but unlike Central Asia, Ukraine serves as critical buffer territory protecting Moscow and the Russian core from any would-be invaders. Russia lacks firm geological borders so it protects itself by means of distance and winter. This grand strategy succeeded against King Charles XII of Sweden, Napoleon, and Hitler. The collapse of the Soviet Union left Russia shorn of much of its buffer territory. Ukraine also offers access to the Black Sea. Russia has long striven to gain access to warm-water ports. The loss of control over Ukraine resulted in a loss of access. Russia’s seizure of Crimea in 2014 only partially rectified the situation. Ukraine’s southern coastline around Crimea is the territory at risk today (Map 1). It is Ukraine’s physical existence and unique strategic value – not its democratic leanings or ideological orientation – that ensures perpetual tensions with post-Soviet Russia. Russia has a strategic imperative to reassert control or at least prevent control by foreign powers. Ideological opposition may make things worse but an anti-Russian Ukrainian dictator would also face Russian coercion or aggression, perhaps even more than the current weak democracy. In fact Russia is trying to force Ukraine to revise its constitution and adopt a federal structure so as to grant greater autonomy to separatist regions Donetsk and Luhansk that Russia helped break away in 2014. But Ukraine has not relented to Moscow’s demands of political reform. It is not authoritarianism but a permanent foreclosure of Ukrainian membership in the EU and NATO that Moscow is after. Yet it is highly unlikely that Russia would try to invade and conquer all of Ukraine. Ukraine is the largest country by territory in Europe and has 255,000 active soldiers and 900,000 reserves (contra Russia’s 1 million active and 2 million reserves) who would defend their freedom and sovereignty against an invader.3 Russia would not be able to stage a full-scale invasion with the 175,000 maximum troop buildup that US intelligence is warning about. It would have to mobilize fully, dangerously neglecting other vast dimensions of its national security, and would inevitably get bogged down fighting a vicious insurgency backed by the NATO powers. It would save blood and treasure by paralyzing Ukraine’s politics and preventing it from allying with western militaries, which is what Putin is attempting to do today. Putin uses foreign adventures to strengthen his grip at home but an adventure of this nature would impose such burdens as to threaten his grip at home. A limited re-invasion of Ukraine could yield historic strategic advantages to Russia. Moscow could focus on a partial military incursion that would annex or shore up Donbass, or extend its control from Donbass to the Black Sea, conceivably all the way to the Dnieper river. This pathway would yield Russia maritime access and a buffer space to fortify Crimea. Naval warfare could also yield control of deep-water ports (Yuzhne, Odessa, Mykolaiv, Chornomorsk), control of the mouth of the Dnieper, control of the canal that supplies water to Crimea, and a means of bottling up the Ukrainian navy and preventing foreign maritime assistance. Ukraine would be further weakened and Russia would have a larger beachhead in Ukraine for future pressure tactics. Russia is not bluffing – its military buildup poses a credible threat. If there is anywhere Russia’s threats are credible, it is in taking military action against former Soviet republics like Georgia (2008) and Ukraine (2014) that have pro-western leanings yet lack the collective security of the NATO alliance. At very least, given that Russian forces did deploy in Ukraine in 2014, Russian action in Ukraine cannot be ruled out. The military balance has not changed so significantly in that time and strongly favors Russia (Chart 2). The US has provided around $2.5 billion in military aid to Ukraine since 2014, and has sent lethal weapons including Javelin anti-tank missiles and launchers since 2017-18, including $450 million worth of military aid under the Biden administration (and $300 million just authorized by Congress on December 7). NATO allies have also provided defense aid. This is part of Putin’s complaint but these new arms are not game changers that would prevent Russia from taking military action. Thus if the West rejects Moscow’s core demands, war is likely. This is true even if Russia would prefer to achieve its aims through political and economic rather than military means. Russia does not deem the West’s threat of sanctions as prohibitive of invasion. The West’s sanctions since 2014 have failed to change Russia’s government, strategy, or posture in Ukraine. Yes, European nations joined the US in imposing sanctions. But Germany also pursued the Nord Stream II pipeline as a means of bypassing Ukraine and working directly with Russia to preserve economic engagement and energy security. Former Chancellor Merkel forced the pipeline through despite the objections of eastern Europeans and the United States. The allies also formed the “Normandy Quartet,” excluding the US, to force Ukraine to accept the Minsk agreements on resolving the conflict. Thus the lesson of 2014-21 is not that NATO allies stood shoulder-to-shoulder in defense of Ukraine’s sovereignty and territorial integrity but rather that Germany and the EU, and the EU and the US, have major differences in interests and risk-tolerance in dealing with Russia. Russia does not face, or may think it does not face, a united front among the western powers. A partial reinvasion of Ukraine would bring the western allies together initially but probably not for long. Russia determines the timing of any new military incursion in Ukraine. Winter is not the ideal time to invade Ukraine, though it is possible. Russia could act in spring 2022, as the US has warned, but it could also act in the summer of 2023, the spring of 2024, or other times. From a strategic point of view, Russia has enjoyed a historic window of opportunity since 2001 when the US got bogged down in Afghanistan and Iraq and then the US and the EU got bogged down in economic and financial crisis. Given that the American political establishment is withdrawing from foreign quagmires, reactivating fiscal policy, bulking up the military-industrial complex, and making a dedicated effort to revitalize its global alliances, Russia may believe that its historic window is closing. Russia’s domestic fundamentals are deteriorating over time. Putin could decide it is necessary to seize strategic ground in Ukraine sooner rather than later. Bottom Line: Ukraine offers unique and irreplaceable buffer space and maritime access to Russia. Russia’s military actions in 2014 led to stalemate, such that Russia remains insecure, Ukraine remains defiant, and the West is still entertaining defense cooperation or even NATO membership with Ukraine. Yet the Crimea conflict also revealed a lack of concert among western powers exemplified by Germany’s Nord Stream II pipeline. Today Russia has the military capability to seize another slice of Ukrainian territory. Western retaliatory actions would be painful but may not be deemed prohibitive. Investors cannot rule out a partial re-invasion of Ukraine. Nord Stream Pipeline Is Not The Sole Factor Is Russia not making a show of military force merely to ensure that Nord Stream II pipeline goes into operation? Will Russia not back down if the pipeline is guaranteed? A common view in Washington and the financial industry is that Russia’s military buildup is just a bluff, i.e. Moscow’s aggressive way of demanding that Germany’s new government and the European Union approve Nord Stream. The pipeline finished construction in September but now awaits formal regulatory certification. Approval was originally expected by May 2022 but has now been delayed. The pipeline would carry 55 billion cubic meters of natural gas into Europe, about half of Russia’s current export capacity outside of Ukraine. Ukraine’s total capacity is around 150 billion cubic meters. The pipeline enables Russia and Germany to bypass Ukraine, whose conflicts with Moscow since 2004 have threatened Germany’s energy security. About 18% of EU’s total energy imports come from Russia, whilst this figure is 16% for Germany. That is about 0.5% and 0.2% of EU and German GDP, respectively. Meanwhile Russian energy exports to Germany and the EU make up 0.8% and 5.6% of GDP, respectively (Chart 3). The problem with this reasoning is that the US conceded Nord Stream to Russia over the summer. The US initially raised the threat of sanctions because the pipeline  strengthened Russo-German ties, diminished Ukraine’s leverage, and deprived the US of a chance to sell liquefied natural gas to Europe. But the Biden administration proved unwilling to take this aggressive approach. Secretary of State Anthony Blinken has a long history of arguing that the US should prioritize strong relations with its European allies rather than punitive measures to try to block Russian gas sales. Biden met with outgoing Chancellor Angela Merkel in July and agreed to let Nord Stream go forward. The only proviso was that Russia not “weaponize natural gas,” i.e. withhold supplies for geopolitical purposes, as it has done in the past.4 Before Russia’s military threats, Germany and the EU were expected to certify the pipeline by no later than May 2022 and an earlier certification looked possible because of Europe’s low natural gas supplies. Yet Russia, fresh off parliamentary elections, did precisely what Germany said it was not supposed to do. The pipeline was completed in September and reports of Russian limitations on natural gas supply surfaced in October. Moscow not only weaponized the gas but also mustered its army on the Ukrainian border again. Putin may have feared that the new German government, which officially took office on December 8, would change policy and refuse to certify the pipeline. He also could have feared that the US Congress would pass a Republican-backed provision that would require Biden to impose sanctions that would halt the pipeline. But these explanations are not satisfactory. First, the German government was not likely to halt Nord Stream. Quite the opposite, Berlin has pushed against all opposition to speed the pipeline into action. It only delayed the regulatory approval when Russia did the one thing that Germany had expressly prohibited, which was weaponize natural gas. Second, the US Congress was never likely to pass mandatory sanctions on Nord Stream operators. The Democrats opposed it, as it would have tied Biden’s hands, whereas presidents always retain discretion over foreign policy and national security. Even moderate Republicans opposed the measure, for the same reason. If either of these were the reason for Putin’s latest buildup, then the buildup will probably dissipate in the coming months. Putin also wants to force Ukraine to implement the Minsk agreements. But the Biden administration adopted the Minsk framework in June for the first time, which was a concession to Russia. So the latest military threats are not solely about coercing Europe to approve the pipeline or Ukraine to implement Minsk. Putin is driving at something else. Putin’s Focus On Ukraine And NATO Putin used military pressure on Ukraine’s border to force the US to accept the pipeline and the Minsk agreements. He is now using the same tactic to raise the stakes and demand that the US and its allies permanently rule out NATO membership and defense cooperation with Ukraine. Biden rejected the first demand during the summit, as mentioned. There is no way that the US or NATO will forswear any and all eastward expansion. Even on Ukraine specifically, Biden cannot give Russia a legal guarantee because it would require a 60-seat majority in the Senate (not likely). Any future president would retain prerogative over the matter anyway and Putin knows this. Moreover Ukraine is never going to join NATO. Russia would attack. And NATO members would not be unanimous (as is required for new members) because the collective defense treaty would require them to defend Ukraine. They would be signing up for a war with Russia. Still Biden is unlikely to disavow Ukrainian NATO membership because to do so would be to deny the self-determination of nations, capitulate to Russian coercion, and demoralize the Ukrainians, whom the US hopes will maintain a plucky resistance against Russian domination. It would also demoralize US allies and partners – namely Taiwan, which also lacks a formal defense treaty and would be forced to sue for peace with China in the face of American abandonment. Biden’s refusal to ban Ukraine from NATO is encapsulated in Diagram 1, an exercise in game theory that exemplifies why the risk of war should not be dismissed. Diagram 1Game Theory Suggests Russia Will Keep Applying Military Pressure Biden may give private or executive assurances on Ukraine and NATO but Putin will know that these mean nothing since Biden may be out of office as early as January 2025 and then Putin would have to renegotiate. America is not a credible negotiator because partisanship has resulted in extreme foreign policy vacillations – the next president could revoke the deal. Even after Putin is gone Russia would have to negotiate with the US to prevent the US from arming Ukraine. Hence Moscow may decide to reduce Ukraine and improve Russia’s strategic position by force of arms. This is true even if Biden forswears the NATO option, as Diagram 1 illustrates. Putin’s second demand – that the US not provide offensive weapon systems in countries adjacent to Russia – is more material. This is what the new round of talks will focus on. This new Ukraine line of talks is separate, more urgent and important, than the other bilateral dialogues on the arms race, and cyber-war. US-Russia talks on Iran are also urgent, however, and Russia’s cooperation there may be contingent on US concessions regarding Ukraine. The US may be willing to stop its defense cooperation with Ukraine but not with other allies and partners, however. It is also not clear what Putin will accept. These negotiations will have to be watched. Biden cannot make major concessions with a gun to his head. It is unclear how far the US is willing to concede on defense cooperation with countries around Russia. The US may quietly abandon Ukraine but then it would need to reinforce its other defense relationships. If Putin draws down the troops, and Biden calls a stop to defense aid to Ukraine, then a crisis may be averted. What Could Go Wrong? Economic sanctions under consideration in Washington are significant: the US could freeze bank transactions, expand restrictions on trading Russian sovereign and corporate debt, and lobby Belgium to kick Russia off the SWIFT financial messaging system. However, these sanctions may not be effective in preventing Russia from using military force. Russia has weathered US sanctions since 2014, and the smaller and weaker Iranian economy has weathered maximum pressure sanctions since 2019. Energy producers like Russia and Iran have maximum geopolitical leverage when global energy inventories draw down, as is the case today. Even in the face of Russian military aggression, the Biden administration is vacillating on sanctions targeting Russia’s energy sector that would contribute to global shortages and ultimately raise prices at the pump for voters in a midterm election year.5 Germany’s new government also hesitates to declare unambiguously that it will discontinue the Nord Stream II pipeline if Russia invades Ukraine. True, Germany signaled that the pipeline would be halted. Its energy regulator declared that the pipeline’s ownership must be unbundled, which pushes back the certification date to sometime after May 2022 – this was a geopolitical not a legalistic decision. But construction is completed, the pipeline physically exists, which will vitiate Germany’s commitment to sanctions whenever natural gas shortages occur, as is the case this winter (Chart 4). Shortages will continue to occur and Russia controls a large share of supply. ​​​​​​ It would take a catastrophe to drive Germany to restart coal and nuclear plants, so natural gas will continue to be in demand. Germany does not have liquefied natural gas import capability yet. If Europe imposes crippling sanctions on Russia, Russia could reduce energy supplies and harm Europe’s economy (Chart 5). The Russian economy and society would suffer which is one reason any military action in Ukraine would be limited in scope. Still, Moscow may believe that Germany would restrain the EU, and the EU would restrain the US, thereby preventing sanctions from being fully, uniformly, and durably implemented. Prior to Russia’s aggression, public opinion polls showed that the German public strongly supported Nord Stream. Even a majority of Green Party members supported it despite the fact that the Greens were the most critical of increasing Germany’s dependency on fossil fuels and an authoritarian petro-state. While public approval of the pipeline has surely suffered in the face of Russian aggression, a majority probably still favors the pipeline. Germany has a national consensus in support of engagement with Russia and avoiding a new cold war, given that the original Cold War cut Germany in half. For that reason invasion may only temporarily unite the western powers – it could ultimately drive a wedge between Germany and other EU members, namely in the former Soviet bloc. It would also divide the more risk-averse EU from the US in terms of how to deal with Russia. And it would weaken the Biden administration at a time when it is extremely vulnerable, exacerbating America’s internal divisions. Russian domestic patriotism would rally, at least initially. Note that Russia could miscalculate on this issue and that is one reason for high level of risk. Perhaps the West would prove far more unified and aggressive in its sanctions enforcement than it was after 2014. A falling ruble and rising inflation could cause Russian social unrest. But Russia could misread the situation. Unless the US and Europe escalate the sanctions threat massively to better deter Russia, their lack of concert is another reason for investors not to be complacent about renewed conflict. Bottom Line: The threat of sanctions may prove insufficient to deter renewed Russian aggression against Ukraine. Germany favors engagement with Russia and Europe’s energy dependency on Russia makes it vulnerable to supply disruptions. Russia has leverage given tight global energy markets, Europe’s low natural gas inventories, and US domestic political considerations ahead of the 2022 midterms. Investment Takeaways The point of this report argues that a partial re-invasion of Ukraine cannot be ruled out. Russia has the capability to reinforce de facto control of Donbas, or expand its footprint in southern Ukraine, though not to invade the whole country. The threat of economic sanctions is not yet so overwhelming as to warrant overconfident predictions of de-escalation. In this case it is better to be alarmist than complacent. Russia would want to maintain an element of surprise so the timing of any belligerence is hard to predict. For de-escalation, investors should watch for Russia to withdraw troops from the Ukrainian border, US-Russia consultations to begin promptly and proceed regularly, and for the US and allies to delay or halt defense cooperation and arms transfers to Ukraine. While global investors would quickly become de-sensitized to conflict that is entirely contained in Ukraine, the trans-Atlantic threat of major sanctions now raises the stakes and suggests that global energy shocks could negatively affect the European or global economy in the event of conflict. Any conflict could also spill outside of Ukraine’s borders, as with Malaysian Airlines flight MH17, which was shot down by Russian-backed Ukrainian separatists in July 2014. The Black Sea has seen a dangerous uptick in naval saber-rattling and that strategic situation would become permanently more dangerous if Russia seized more of coastal Ukraine. Russian military integration with Belarus is also a source of insecurity for EU and NATO members. Global financial markets have only started to price the geopolitical risk emanating from Russia. Our Russian GeoRisk Indicator has ticked up (Chart 6). But Russian equity performance relative to broad emerging markets is only arguably underperforming what is implied by Brent crude oil prices. Chart 6Market Slow To React To Ukraine Crisis - Risk To Downside For Russian Assets This relatively muted reaction suggests more downside lies ahead if we are right that strategic tensions will be flat-to-up over the coming months. Sell the RUB-USD on any strength. Stay long GBP-CZK. Tactically short Russian equities versus EM-ex-Asia (Chart 7). They are exposed to further correction as a result of escalating geopolitical risk. Chart 7Russia Falling Off Peaks Of Performance Versus EM-Ex-Asia​​​​​​ Chart 8Developed Europe A Safer Bet Than Emerging Europe Amid Tensions​​​​​​ Stick to long DM Europe versus EM Europe – our main trade this year to capture rising geopolitical risk between Russia and the West (Chart 8).     Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1      President of Russia, "Meeting with US President Joseph Biden," December 7, 2021, kremlin.ru.  2     White House, "Press Briefing by Press Secretary Jen Psaki and National Security Advisor Jake Sullivan, December 7, 2021," whitehouse.gov. 3     Dan Peleschuk, "Ukraine’s military poses a tougher challenge for Russia than in 2014," Politico, April 14, 2021, politico.eu.; see also Gav Don, "LONG READ: Russia looks poised to invade Ukraine, but what would an invasion actually look like?" Intellinews, November 24, 2021, intellinews.com. 4     US Department of State, "Joint Statement of the United States and Germany on Support for Ukraine, European Energy Security, and our Climate Goals," July 21, 2021, state.gov. 5     Kylie Atwood and Natasha Bertrand, "US likely to hold off for now on energy sanctions for Russia, fearing impact on global prices," CNN, December 9, 2021, cnn.com. Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights Our theme for the year, “No Return To Normalcy,” is largely vindicated. Inflation is back! The geopolitical method still points to three long-term strategic themes: multipolarity, hypo-globalization, and populism. All are inflationary in today’s context. Our three key views for 2021 produced two hits and one miss: China sold off, oil prices held up, but the euro fell hard. Our view on Iran is still in flux. COVID-19 proved more relevant for investors than we believed, though we took some risk off the table before the Delta and Omicron variants emerged. Our biggest miss was long Korea / short Taiwan equities. Our geopolitical forecast was spot on but our trade recommendation collapsed. Our biggest hit was long India / short China equities. China’s historic confluence of internal and external risk drove investors to India, the most promising strategic EM play. Feature Every year we conduct a review of the past year’s geopolitical forecasts and investment recommendations. The intention is to hold ourselves to account, prepare for our annual outlook, and improve our analytical framework. Our three key views for 2021 were: 1.  China’s historic confluence of political and geopolitical risk = bearish view of Chinese equities; 2.  The US pivot to Asia runs through Iran = neutral-to-bullish view of oil prices; 3.  Europe wins the US election = bullish view of the euro and European equities. The first view on China was a direct hit. The second view is in flux. The third view was initially right but then turned sour. A crude way of assessing these views would be to look at equity performance relative to long-term trends: China sold off, the UAE rallied, and Europe sold off (Chart 1). Chart 1Three Key Views For 2021: Two Hits, One Miss This is not the whole story. We modified our views over the course of the year as new information came to light. In March we turned neutral on the US dollar, with negative implications for the euro. In June we adjusted our position on Europe overall, arguing that European political risk had bottomed and would rise going forward. In August we adjusted our position on Iran, warning of an imminent crisis due to the Biden administration’s refusal to lift sanctions and Iran’s pursuit of “breakout” uranium enrichment capacity. We stayed bearish on China throughout the year. Going forward, given that a near-term crisis is necessary to determine whether Iran will stay on a diplomatic track, we would short UAE or Saudi equities. We would expect oil to remain volatile given upside risks from geopolitics but downside risks from the new Omicron variant and China’s slowdown. China’s slowdown was also a controlling factor for the Europe view. The energy crisis and showdown with Russia can also get worse before they get better. So we prefer US assets for now and will revisit this issue in our annual strategic outlook due in the coming weeks. Before we get to the worst (and best) calls of the year, we have a few words on our analytical framework in the context of this year’s signal developments. The Geopolitical Method: Lessons From 2021 As with any method rooted in practice, the geopolitical method has many flaws. But it has the advantage of being systematic, empirical, probabilistic, and non-partisan. How do we check ourselves on the thorny problem of partisanship? First, geopolitics requires practicing empathetic analysis, i.e. striving to understand and empathize with the interests of each nation and nation-state when analyzing their behavior. For example: China: China’s ruling party believes it is necessary to have an all-powerful leader to deal with the urgent systemic risks facing the country. We refrain from criticizing single-party rule or China’s human rights record. But we do see compelling evidence that the Communist Party’s shift from consensus rule to personal rule will have a negative impact on governance and relations with the West.1 China obviously rejects foreign diplomatic and military support for Taiwan, which Beijing sees as a renegade province, and hence the odds of a war in the Taiwan Strait are high over the long run. Russia: Russia is threatening its neighbors on multiple fronts not because it is an evil empire but because of its insecurity in the face of the US and NATO, and particularly its opposition to western defense cooperation with Ukraine. Its unproductive domestic economy and vulnerability to social unrest are additional reasons to expect aggression abroad. Second, we take very seriously any complaints of bias we receive from clients. Such complaints are rare, which is encouraging. But we treat all feedback as an opportunity to improve. At the same time, the need to draw clean-cut investment conclusions for all clients will always override the political sensitivities of any subset of clients. Geopolitics is based in the idea that politics is rooted in structural forces like geography and demography, i.e. forces that limit or constrain individual actors and only change at a glacial pace. Geopolitical analysts focus on measurable and material factors rather than ever-changing opinions and ideas. It is impossible for investors today to ignore the global political environment, so the important thing is to analyze it in a cold and clinical manner. To combine this method with global macroeconomic and investment research, one must assess whether and to what extent financial markets have already priced any given policy outcome. The result will be a geopolitically informed macro conclusion, which should yield better decisions about conserving and growing wealth. This is the ideal for which we aim, even though we often fall short. Over the years our method has produced three primary strategic themes: Great Power struggle (multipolarity); hypo-globalization; and domestic populism (Table 1). Table 1Our Major Themes Point To Persistent Inflation Risk The macro impact of these themes will vary with events but in general they point toward a reflationary and inflationary context. They involve a larger role of government in society, new constraints on supply, demand-side stimulus, and budget indiscipline. Bottom Line: Nation-states are mobilizing, which means they will run up against resource constraints. A Return To Normalcy? Or Not? As the year draws to a close, our annual theme is vindicated: “No Return To Normalcy.”  The term “normalcy” comes from President Warren G. Harding’s election campaign in 1920. It was an appeal to an American public that yearned to move on from World War I and the Spanish influenza pandemic. A hundred years later, in December 2020, the emergence of a vaccine for COVID-19 and the election of an orthodox American president (after the unorthodox President Trump) made it look as if 2021 would witness another such return to normalcy. We foresaw this narrative and rejected it. Primarily we rejected it on geopolitical grounds – global policy will not revert to the pre-Trump status quo. We also argued that the pandemic and the gargantuan fiscal relief designed to shield the economy would have lasting consequences. Specifically they would create a more inflationary context. Chart 2No Return To Normalcy In 2021 The most obvious sign that things have not returned to normal in 2021 is the “Misery Index,” the sum of unemployment and headline inflation. Misery Indexes skyrocketed during the crisis and today stand at 10.8% in the US and 11.4% in the EMU, up from 5.2% and 8.1% in 2019, respectively (Chart 2). Unemployment rates are falling but inflation has surged to the highest levels since the 1990s. For investors to be concerned about inflation at the beginning of a new business cycle is unusual and requires explanation. It suggests that inflation will be a persistent problem going forward, as the unemployment rate falls beneath NAIRU and participation rates rise. While we expected inflation, we did not expect the political blowback to come so quickly. President Biden’s approval rating collapsed to 42.2% this fall. Approval of his handling of the economy fell even lower, to 39.6%, below President Trump’s rating at this stage. Consumer confidence has fallen by 15.1% since its post-election peak in June 2021. Republicans are automatically favored to win the House of Representatives in the 2022 midterm elections – but if the economy does not improve they will also win the Senate. Despite Biden’s unpopularity, we argued that his $550 billion bipartisan infrastructure bill and his $1.75 trillion partisan social spending bill would pass Congress. So far this view is on track, with infrastructure signed into law and the Senate looking to vote on the social bill in December (or January). These bills illustrate the strategic themes listed above: the US is reviving public investments in civil and military sectors, reducing global dependencies, and expanding its social safety net. However, large new government spending when the output gap is virtually closed will tend to be inflationary. Russia and China also have high or rising misery indexes, which underscores that political and geopolitical risks will rise rather than fall over the coming 12 months. Unemployment rates are not always reliable in authoritarian states, so the Misery Index is if anything overly optimistic regarding social and economic conditions. China is not immune to social unrest but Russia is particularly at risk. Quality of life and public trust in government have both deteriorated. Inflation will make it worse. Russians remember inflation bitterly from the ruble crisis of 1998. President Putin is already ratcheting up tensions with the West to distract from domestic woes. While we were positioned for higher inflation in 2021, we were too dismissive of the global pandemic. We expected vaccination campaigns to move faster, especially in the US, and we underrated the Delta variant as a driver of financial markets, at least relative to politics. A close look at Treasury yields, oil prices, and airline stocks shows that the evolution of the pandemic marked the key inflection points in the market this year (Chart 3). Chart 3COVID-19 Stayed Relevant In 2021 ... Now Omicron Variant Emerging Bottom Line: Tactically the market impact of the newly discovered Omicron variant of the virus should not be underrated. It is critical to find out if it is more harmful to younger people than Delta and other variants. Cyclically inflation will remain a persistent risk even if it abates somewhat in 2022. Worst Calls Of 2021 We now proceed to our main feature. As always we begin with the worst calls of the year: Chart 4Taiwan Rolled Over ... But Not Against Korea 1.  Long Korea / Short Taiwan. Geopolitical view correct, market view incorrect. US-China conflict is a secular trend and contains elements of all our major themes: Great Power struggle, hypo-globalization, and populism. Taiwan is the epicenter of this conflict and a war is likely over the long run. For 2021 we predicted a 5% chance of war but a 60% chance of a “fourth Taiwan Strait crisis,” i.e. a diplomatic crisis, and our contrarian short of Taiwanese equities was premised on this expectation. Investors are starting to respond to these self-evident geopolitical risks, judging by the TWD-USD exchange rate and the relative performance of Taiwanese equities, which have peaked and are lagging expectations based on global semiconductor stocks. But our choice of South Korean equities as the long end of the pair trade was very unfortunate and the trade is down by 22% (Chart 4). Korea is suffering from a long de-rating process in the face of China’s industrial slowdown and a downgrade to Korean tech sector earnings, as our Emerging Markets Strategy has highlighted. 2.  Short CNY Versus USD And EUR. Geopolitical view correct, market view incorrect. This year we argued that President Biden would be just as hawkish on China as President Trump and would not remove tariffs or export controls. We also argued that the SEC would punish US-listed China stocks and that bilateral relations would not improve despite a likely Biden-Xi summit. These views proved correct. But our neutral view on the dollar and bullish view on the euro betrayed us and the trade has lost 4% so far. The euro collapsed amid its domestic energy crisis and China’s import slowdown (Chart 5). China’s exports boomed while the People’s Bank kept the currency strong to fend off inflation. Chart 5China Tensions Sure, But Don't Fight The People's Bank Chart 6Value Surged Then Fell Back Against Growth Stocks 3.  Long Value Versus Growth. Geopolitical view correct, market view incorrect. We have long favored value over growth stocks, expecting that our strategic themes would lead to more muscular fiscal spending, government intervention in the economy, and a return of inflation. In 2021 we bet that rising inflation expectations and higher bond yields would favor value over growth. This was only one aspect of our larger pro-cyclical view that tech-heavy US equities would underperform their global peers and emerging markets would outpace developed markets. These expectations came true during the first part of the year when exuberance over the “reflation trade” led to a big pop in value (Chart 6). By the second quarter we had pared back our pro-cyclical leanings but we maintained value over growth, ultimately at a loss of 3.75%. The reality nowadays is that value is a byword for low quality, as our colleagues Juan Correa-Ossa and Lucas Laskey have shown. Growth stocks continue to provide investors with innovation and robust earnings amid a lingering pandemic. 4.  Long Aerospace And Defense Stocks. Geopolitical view mixed, market view incorrect. We are perennially bullish on defense stocks given our strategic themes. We expected aerospace and defense stocks to recover as vaccines spread and travel revived. We successfully played the rebound in absolute terms. But the slow pace of vaccination and the emergence of the Delta variant dealt a blow to the sector relative to the broad market. And now comes Omicron. As for defense stocks specifically, investors are downplaying Great Power struggle and worried that government defense budgets will be flat or down. Significant saber-rattling is occurring as expected in the major hotspots – the Taiwan Strait, the Persian Gulf, and Russia’s periphery – but investors do not care about saber-rattling for the sake of saber-rattling. Geopolitical tensions went nowhere so far this year and hence defense stocks floundered relative to the broad market (Chart 7). Still we would be buyers at today’s cheap valuations as we see geopolitical risk rising on a secular basis and the odds of military action are non-negligible in all three of the hotspots just mentioned. 5.  Long Safe Havens. Geopolitical view mixed, market view incorrect. Measured geopolitical risk and policy uncertainty collapsed over the second half of 2020. By early 2021 we expected it to revive on US-China, US-Russia, and US-Iran tensions. As such we expected safe-haven assets to catch a bid, especially having fallen as the global economy reopened. We stayed long gold (up 22.6% since inception, down 5.2% YTD) and at various times bought the Japanese yen and Swiss franc. Some of these trades generated positive returns but in general safe havens remained out of favor (Chart 8). As with defense stocks, we are still constructive on the yen and franc. Chart 7Market Ignored Saber-Rattling 6.  Long Developed Europe / Short Emerging Europe. Geopolitical view correct, market view incorrect. Our pessimistic view of Russia’s relations with the West, and hence of Russian currency and equities, clashed with our positive outlook on oil and commodity prices this year. To play Russian risks we favored developed European equities over their emerging peers (mainly Russian stocks). But emerging Europe has outperformed by 5% since we initiated the trade and other variations on this theme had mixed results (Chart 9). Of course, geopolitical tensions are escalating in eastern Europe we go to press. Chart 8Safe Havens Fell After US Election, Insurrection​​​​​​ Chart 9Refrain From The Russia Rally We do not think investors can afford to ignore the US-Russia conflict, which has escalated over two decades. President Putin has not changed his strategy of building a sphere of influence in the former Soviet Union. The US is internally divided and distracted by a range of challenges, while it continues to lack close coordination with its European allies. Western responses to Russian aggression have failed to change Russia’s cost-benefit analysis. Thus we continue to expect market-negative surprises from Russia, whether that means a seizure of littoral territory in Ukraine, a militarization of the Belarussian border, more disruptive cyber attacks, or some other big surprise. Bottom Line: While our geopolitical forecasts generally hit the mark this year, global financial markets ignored most geopolitical risks other than China. The global recovery, inflation, and the pandemic, vaccines, variants, and social distancing remained the key dynamics. This threw many of our trades off track. However, we are sticking with some of our worst calls this year given the underlying geopolitical and economic forces motivating them beyond a 12-month time frame. Best Calls Of 2021 1.  Long India / Short China. Geopolitical view correct, market view mixed. Our number one view for 2021 was that China would suffer a historic confluence of political and geopolitical risk that would be negative for equities. This view contrasted with our bullish view on India. Prime Minister Narendra Modi had won another single-party majority in the 2019 elections and stood to benefit from the attempts of the US and other democracies to diversify away from China. We favored Indian stocks and local currency bonds – both trades saw a sharp run-up (Chart 10). Unfortunately, we took profits too soon, only netting 12% on the long India / short China equity trade. Some of our other India trades did not go so well. Going forward we expect a tactical reset given India’s tremendous performance this year. 2.  Booking Gains At Peak Biden. Geopolitical view correct, market view correct. We closed several of our reflation trades in the first quarter, when exuberance over vaccines and the Democrat’s election sweep reached extreme levels (Chart 11). We captured a 24% gain on our materials trade and a 37% gain on energy stocks. We turned a 17% profit on our BCA Infrastructure Basket relative trade. We were prompted to close these trades by dangers over Taiwan and Ukraine that soon dissipated. But we also believed that markets were priced for perfection. By the second quarter we had taken some risk off the table, which served us well throughout the middle of the year when the Delta variant struck. While global energy and materials rose to new highs later in the year, the Fed and Omicron interrupted their run. Chart 10Call Of The Year: Long India, Short China 3.  Long Natural Gas On Russia Risks. Geopolitical view correct, market view correct. All year we held the contrarian view that the new Nord Stream II pipeline linking Russia and Germany would become a major geopolitical flashpoint and that it was much less likely to go into operation than consensus held. Chart 11Reflation Trade' Peaked Early, Peaked Again, Then Omicron​​​​​​ We also fully expected Russia to act aggressive in its periphery. In March we argued that while Russia probably would not re-invade Ukraine, long-term risk was substantial (and accordingly a new military standoff began in the fall) We also noted that Russia had other tools to coerce its neighbors. As a result we went long natural gas futures, following our colleagues at Commodity & Energy Strategy. While the trade returned 20%, we took profits before the European energy crisis really took off (Chart 12). 4.  The “Back To War” Trade. Geopolitical view correct, market view correct. Cyber warfare is one of the ways that the Great Powers can compete without engaging in conventional war. We have long been bullish on cyber-security stocks. However, the pandemic created a unique tactical opportunity to initiate a pair trade of long traditional defense stocks / short cyber stocks that returned 10%. It was a geopolitical variation on the “back to work” trades that characterized the revival of economic activity after pandemic lockdowns. Cyber stocks will enjoy a tailwind as long as the pandemic persists and working from home remains a major trend. But over the cyclical time frame defense stocks should rebound relative to their cyber peers, just as physical geopolitical tensions should begin to take on renewed urgency with nations scrambling for territory and resources (Chart 13). Chart 12Hold Onto The Good Ones: Long Natural Gas Chart 13The 'Back To War' Trade Chart 14Rare Earths Revived On Commodity Surge 5.  Long Rare Earth Metals. Geopolitical view correct, market view mixed. We have long maintained that rare earth metals would catch a bid as US-China tensions rose. The pandemic stimulus galvanized a new capex cycle with a focus on strategic goals like supply chain resilience, military-industrial upgrades, and de-carbonization that will boost demand for rare earths. Our trade made a 9% gain, despite difficulties throughout the year arising from our homemade BCA Rare Earth Basket, which proved to be an idiosyncratic instrument. Going forward we will express our view via the benchmark MVIS Rare Earth Index (Chart 14). Bottom Line: Our successful trades hinged on broad geopolitical views: China’s confluence of internal and external risk, Biden’s reflationary agenda, persistent US-Russia conflict, and India’s attractiveness relative to other emerging markets. The change in 2022 is that Biden’s legislative agenda will be spent so the market will shift from American reflation to the Fed and global concerns. If China does not stabilize its economy, more bad news will hit China-related plays and global risk assets. Honorable Mentions: For Better And For Worse Short EM “Strongmen.” Geopolitical view correct, market view mixed. We shorted the currencies of Turkey, Brazil, and the Philippines relative to benchmark EM currencies. Though we closed the trade too early, earning a paltry sum, the political analysis proved correct and the market ultimately responded in a major way (Chart 15). Upcoming elections for these countries in 2022-23 will ensure that their dysfunctional politics remain negative for investors, while other emerging market currencies continue to outperform. Chart 15Short EM 'Strongman' Leaders ¡Viva México! Geopolitical view correct, market view mixed. Mexico benefited from US stimulus, the USMCA trade deal, the West’s economic divorce from China, and the resumption of tourism, immigration, and remittances. In general Latin America stands aloof from the Great Power struggles afflicting emerging markets in Europe and East Asia. But Latin America’s perennial problem with domestic populism and political instability undermines US dollar returns. Mexico looks to be a notable exception. Chart 16¡Viva México! Mexico suffered the biggest opportunity cost from the West’s love affair with China over the past 40 years. Now it stands to gain from the US drive to relocate supply chains, onshore to North America, and diversify from China. Two of our Mexico trades were ill-timed this year, but favoring Mexico over other emerging markets, particularly Brazil, was fundamentally the right call (Chart 16). Bottom Line: Cyclically Mexico is an emerging market with a compelling story based on fundamentals. Tactically disfavor emerging market “strongmen” regimes. Investment Takeaways Our batting average this year was 65%. 2021 will be remembered as a transitional year in which the world tried but did not quite return to normal amid a lingering pandemic. Inflation reemerged as a major concern of consumers, governments, and central banks. Developed markets adopted proactive fiscal policy but global cyclicals faced crosswinds as China resumed its monetary, fiscal, and regulatory tightening campaign. Our bearish call on China was a direct hit. China’s political risks will persist ahead of the twentieth national party congress in fall 2022. Cyclically stay short CNY-USD and TWD-USD. Our worst market call was long Korean / short Taiwanese equities. But the world awoke to Taiwan risk and Taiwanese stocks peaked relative to global equities. Over the long run we think war is likely in the Taiwan Strait. Re-initiate long JPY-KRW as a strategic trade. Our best market call was long Indian / short Chinese equities. Tactically this trade will probably reverse but strategically we maintain the general thesis. The US and Iran failed to rejoin their nuclear deal this year as we originally expected. In August we adjusted our view to expect a short-term Persian Gulf crisis, which in turn will lead either to diplomacy or a new war path. Oil shocks and volatility should be expected over the next 12 months. Tactically go short UAE equities relative to global. European equities and the euro disappointed this year, even though we were right that Scotland would not secede from the UK, that Italian politics would not matter, and that Germany’s election would be an upset but not negative for markets. In March we turned neutral on the US dollar and in June we argued that European political risk had bottomed and would escalate going forward. We remain tactically negative on the euro, though we are cyclically constructive. We still prefer DM Europe over EM Europe due to Russian geopolitical risks. Re-initiate long CAD-RUB and long GBP-CZK as strategic trades. We are waiting for a tactical re-entry point for the following trades: long CHF-USD, CHF-GBP, GBP-EUR, short EM ‘Strongman’ currencies versus EM currencies, long US infrastructure stocks, long European industrials, and long Italian versus Spanish stocks.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1   While autocracy is agreed to be negative for governance indicators, the connection between regime type and economic growth is debatable. Suffice it to say that the determinants of total factor productivity, such as human capital, trade openness, and effectiveness of the legislature, are often difficult to sustain under autocratic or authoritarian regimes. On this point see United Nations Industrial Development Organization, "Determinants of total factor productivity: a literature review," Staff Working Paper 2 (2007). For further discussion, see Carl Henrik Knutsen, "A business case for democracy: regime type, growth, and growth volatility," Democratization 28 (2021), pp 1505-24; Ryan H. Murphy, "Governance and the dimensions of autocracy," Constitutional Political Economy 30 (2019), pp 131-48. For a skeptical view of the relationship, see Adam Przeworski and Fernando Limongi, "Political Regimes and Economic Growth," Journal of Economic Perspectives 7:3 (1993), pp 51-69.   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Highlights Geopolitical conflicts point to energy price spikes and could add to inflation surprises in the near term. However, US fiscal drag and China’s economic slowdown are both disinflationary risks to be aware of.  Specifically, energy-producers like Russia and Iran gain greater leverage amid energy shortages. Europe’s natural gas prices could spike again. Conflict in the Middle East could disrupt oil flows.    President Biden’s $1.75 trillion social spending bill is a litmus test for fiscal fatigue in developed markets. It could fail, and even assuming it passes it will not prevent overall fiscal drag in 2022-23. However, it is inflationary over the long run. China’s slowdown poses the chief disinflationary risk. But we still think policy will ease to avoid an economic crash ahead of the fall 2022 national party congress.  We are closing this year’s long value / short growth trade for a loss of 3.75%. Cyclical sectors ended up being a better way to play the reopening trade. Feature Equity markets rallied in recent weeks despite sharp upward moves in core inflation across the world (Chart 1). Inflation is fast becoming a popular concern and we see geopolitical risks that could drive headline inflation still higher in the short run. We also see underrated disinflationary factors, namely China’s property sector distress and economic slowdown.     Several major developments have occurred in recent weeks that we will cover in this report. Our conclusions: Biden’s domestic agenda will pass but risks are high and macro impact is limited. Congress passed Biden’s infrastructure deal and will probably still pass his signature social spending bill, although inflation is creating pushback. Together these bills have little impact on the budget deficit outlook but they will add to inflationary pressures.  Energy shortages embolden Russia and Iran. Winter weather is unpredictable, the energy crisis may not be over. But investors are underrating Russia’s aggressive posture toward the West. Any conflict with Iran could also cause oil disruptions in the near future. US-China relations may improve but not for long. A bilateral summit between Presidents Joe Biden and Xi Jinping will not reduce tensions for very long, if at all. Climate change cooperation is an insufficient basis to reverse the cold war-style confrontation over the long run. Chart 1Inflation Rattles Policymakers The investment takeaway is that geopolitical tensions could push energy prices still higher in the short term. Iran and Russia need to be monitored. However, China’s economic slowdown will weigh on growth. China poses an underrated disinflationary risk to our views. US Congress: Bellwether For Fiscal Fatigue While inflation is starting to trouble households and voters, investors should bear in mind that the current set of politicians have long aimed to generate an inflation overshoot. They spent the previous decade in fear of deflation, since it generated anti-establishment or populist parties that threatened to disrupt the political system. They quietly built up an institutional consensus around more robust fiscal policy and monetary-fiscal coordination. Now they are seeing that agenda succeed but are facing the first major hurdle in the form of higher prices. They will not simply cut and run. Inflation is accompanied by rising wages, which today’s leaders want to see – almost all of them have promised households a greater share of the fruits of their labor, in keeping with the new, pro-worker, populist zeitgeist. Real wages are growing at 1.1% in the US and 0.9% across the G7 (Chart 2). Even more than central bankers, political leaders are focused on jobs and employment, i.e. voters. Yet the labor market still has considerable slack (Chart 3). Almost all of the major western governments have been politically recapitalized since the pandemic, either through elections or new coalitions. Almost all of them were elected on promises of robust public investment programs to “build back better,” i.e. create jobs, build infrastructure, revitalize industry, and decarbonize the energy economy. Thus while they are concerned about inflation, they will leave that to central banks, as they will be loathe to abandon their grand investment plans.  Chart 2Higher Wages: Real Or Nominal? Still, there will be a breaking point at which inflation forces governments to put their spending plans on hold. The US Congress is the immediate test of whether today’s inflation will trigger fiscal fatigue and force a course correction.      Chart 3Policymakers Fear Populism, Focus On Employment President Biden’s $550 billion infrastructure bill passed Congress last week and will be signed into law around November 15. Now he is worried that his signature $1.75 trillion social spending bill will falter due to inflation fears. He cannot spare a single vote in the Senate (and only three votes in the House of Representatives). Odds that the bill fails are about 35%. Democratic Party leaders will not abandon the cause due to recent inflation prints. They see a once-in-a-generation opportunity to expand the role of government, the social safety net, and the interests of their constituents. If they miss this chance due to inflation that ends up being transitory then they will lose the enthusiastic left wing of the party and suffer a devastating loss in next year’s midterm elections, in which they are already at a disadvantage.   Biden’s social bill is also likely to pass because the budget reconciliation process necessary to pass the bill is the same process needed to raise the national debt limit by December 3. A linkage of the two by party leaders would ensure that both pass … and otherwise Democrats risk self-inflicting a national debt default. The reconciliation bill is more about long-term than short-term inflation risk. The bill does not look to have a substantial impact on the budget outlook: the new spending is partially offset by new taxes and spread out over ten years. The various legislative scenarios look virtually the same in our back-of-the-envelope budget projections (Chart 4). However, given that the output gap is virtually closed, this bill combined with the infrastructure bill will add to inflationary pressures. The fiscal drag will diminish by 2024, not coincidentally the presidential election year 2024, not coincidentally the presidential election year. The deficit is not expected to increase or decrease substantially between 2023 and 2024. From then onward the budget deficit will expand. The increased government demand for goods and services and the increased disposable income for low-earning families will add to inflationary pressures. Other developed markets face a similar situation: inflation is picking up, but big spending has been promised and normalizing budgets will marginally weigh on growth in the next few years (Chart 5). True, growth should hold up since the private economy is rebounding in the wake of the pandemic. But politicians will not be inclined to renege on campaign promises of liberal spending in the face of fiscal drag. The current crop of leaders is primed to make major public investments. This is true of Germany, Japan, Canada, and Italy as well as the United States. It is partly true in France, where fiscal retrenchment has been put on hold given the presidential election in the spring. The effect will be inflationary, especially for the US where populist spending is more extravagant than elsewhere. The long run will depend on structural factors and how much the new investments improve productivity. Bottom Line: A single vote in the US Senate could derail the president’s social spending bill, so the US is now the bellwether for fiscal fatigue in the developed world. Biden is likely to pass the bill, as global fiscal drag is disinflationary over the next 12 months. Yet inflation could stay elevated for other reasons. And this fiscal drag will dissipate later in the business cycle. Russia And Iran Gain Leverage Amid Energy Crunch The global energy price spike arose from a combination of structural factors – namely the pandemic and stimulus. It has abated in recent weeks but will remain a latent problem through the winter season, especially if La Niña makes temperatures unusually cold as expected. Rising energy prices feed into general producer prices, which are being passed onto consumers (Chart 6). They look to be moderating but the weather is unpredictable.   There is another reason that near-term energy prices could spike or stay elevated: geopolitics. Tight global energy supply-demand balances mean that there is little margin of safety if unexpected supply disruptions occur. This gives greater leverage to energy producers, two of which are especially relevant at the moment: Russia and Iran.      Russia’s long-running conflict with the West is heating up on several fronts, as expected. Russia may not have caused the European energy crisis but it is exacerbating shortages by restricting flows of natural gas for political reasons, as it is wont to do (Chart 7). Moscow always maintains plausible deniability but it is currently flexing its energy muscles in several areas: Chart 6Energy Price Depends On Winter ... And Russia/Iran! Ukraine: Russia has avoided filling up and fully utilizing pipelines and storage facilities in Ukraine, where the US is now warning that Russia could stage a large military action in retaliation for Ukrainian drone strikes in the still-simmering Russia-Ukraine war.    Belarus: Russia says it will not increase the gas flow through the major Yamal-Europe natural gas pipeline in 2022 even as Belarus threatens to halt the pipeline’s operation entirely. Belarus, backed by Russia, is locked in a conflict with Poland and the EU over Belarus’s funneling of migrants into their territory (Chart 8). The conflict could lead not only to energy supply disruptions but also to a broader closure of trade and a military standoff.1 Russia has flown two Tu-160 nuclear-armed bombers over Belarus and the border area in a sign of support. Moldova: Russia is withholding natural gas to pressure the new, pro-EU Moldovan government. Russia’s main motive is obvious: it wants Germany and the EU to approve and certify the new Nord Stream II pipeline. Nord Stream II enables Germany and Russia to bypass Ukraine, where pipeline politics raise the risk of shortages and wars. Lame duck German Chancellor Angela Merkel worked with Russia to complete this pipeline before the end of her term, convincing the Biden administration to issue a waiver on congressional sanctions that could have halted its construction. However, two of the parties in the incoming German government, the Greens and the Free Democrats, oppose the pipeline. While these parties may not have been able to stop the pipeline from operating, Russia does not want to take any chances and is trying to force Germany’s and the EU’s hand. The energy crisis makes it more likely that the pipeline will be approved, since the European Commission will have to make its decision during a period when cold weather and shortages will make it politically acceptable to certify the pipeline.2 The decision will further drive a wedge between Germany and eastern EU members, which is what Russia wants. EU natural gas prices will likely subside sometime next year and will probably not derail the economic recovery, according to both our commodity and Europe strategists. A bigger and longer-lasting Russian energy squeeze would emerge if the Nord Stream II pipeline is not certified. This is a low risk at this point but the next six months could bring surprises. More broadly, the West’s conflict with Russia can easily escalate from here. First, President Vladimir Putin faces economic challenges and weak political support. He frequently diverts popular attention by staging aggressive moves abroad. There is no reason to believe his post-2004 strategy of restoring Russia’s sphere of influence in the former Soviet space has changed. High energy prices give him greater leverage even aside from pipeline coercion – so it is not surprising that Russia is moving troops to the Ukraine border again. Growing military support for Belarus, or an expanded conflict in Ukraine, are likely to create a crisis now or later.   Second, the US-Germany agreement to allow Nord Stream II explicitly states that Russia must not weaponize natural gas supply. This statement has had zero effect so far. But when the energy shortage subsides, the EU could pursue retaliatory measures along with the United States. Of course, Russia has been able to weather sanctions. But tensions are already escalating significantly.  After Russia, Iran also gains leverage during times of tight energy supplies. With global oil inventories drawing down, Iran is in the position to inflict “maximum pressure” on the US and its allies, a role reversal from the 2017-20 period in which large inventories enabled the US to impose crippling sanctions on Iran after pulling out of the 2015 nuclear deal (Chart 9). Iran is rapidly advancing on its nuclear program and a new round of diplomatic negotiations may only serve to buy time before it crosses the “breakout” threshold of uranium enrichment capability as early as this month or next. In a recent special report we argued that there is a 40% chance of a crisis over Iran in the Middle East. Such a crisis could ultimately lead to an oil shock in the Persian Gulf or Strait of Hormuz.  Chart 9Now Iran Can Use 'Maximum Pressure' Bottom Line: Russia’s natural gas coercion of Europe could keep European energy prices high through March or May. More broadly Russia’s renewed tensions with the West confirm our view that oil producers gain geopolitical leverage amid the current supply shortages. Iran also gains leverage and its conflict with the US could lead to global oil supply disruptions anytime over the next 12 months. Until Nord Stream II is certified and a new Iranian nuclear agreement is signed, there are two clear sources of potential energy shocks. Moreover in today’s inflationary context there is limited margin of safety for unexpected supply disruptions regardless of source. Xi’s Historical Rewrite China continues to be a major source of risk for the global economy and financial markets in the lead-up to the twentieth national party congress in fall 2022. While Chinese assets have sold off this year, global risk assets are still vulnerable to negative surprises from China.  The five-year political reshuffle in 2022 is more important than usual since President Xi Jinping was originally supposed to step down but will instead stick around as leader for life, like China’s previous strongmen Mao Zedong and Deng Xiaoping.3 Xi’s rejection of term limits became clear in 2017 and is not really news. But Xi will fortify himself and his faction in 2022 against any opposition whatsoever. He is extremely vigilant about any threats that could disrupt this process, whether at home or abroad.  The Communist Party’s sixth plenary session this week highlights both Xi’s success within the Communist Party and the sensitivity of the period. Xi produced a new “historical resolution,” or interpretation of the party’s history, which is only the third such resolution. A few remarks on this historical resolution are pertinent: Mao’s resolution: Chairman Mao wrote the first such resolution in 1945 to lay down his version of the party’s history and solidify his personal control. It is naturally a revolutionary leftist document. Deng’s revision of Mao: General Deng Xiaoping then produced a major revision in 1981, shortly after initiating China’s economic opening and reform. Deng’s interpretation aimed to hold Mao accountable for “gross mistakes” during the Cultural Revolution and yet to recognize the Communist Party’s positive achievements in founding the People’s Republic. His version gave credit to the party and collective leadership rather than Mao’s personal rule. Two 30-year periods: The implication was that the party’s history should be divided into two thirty-year periods: the period of foundations and conflict with Mao as the party’s core and the period of improvement and prosperity with Deng as the core. Jiang’s support of Deng: Deng’s telling came under scrutiny from new leftists in the wake of Tiananmen Square incident in 1989. But General Secretary Jiang Zemin largely held to Deng’s version of the story that the days of reform and opening were a far better example of the party’s leadership because they were so much more stable and prosperous.4 Xi’s reaction to Jiang and Deng: Since coming to power in 2012, Xi Jinping has shown an interest in revising the party’s official interpretation of its own history. The central claim of the revisionists is that China could never have achieved its economic success if not for Mao’s strongman rule. Mao’s rule and the Communist Party’s central control thus regain their centrality to modern China’s story. China’s prosperity owes its existence to these primary political conditions. The two periods cannot be separated.  Xi’s synthesis of Deng and Mao: Now Xi has written himself into that history above all other figures – indeed the communique from the Sixth Plenum mentions Xi more often than Marx, Mao, or Deng (Chart 10). The implication is that Xi is the synthesis of Mao and Deng, as we argued back in 2017 at the end of the nineteenth national party congress. The synthesis consists of a strongman who nevertheless maintains a vibrant economy for strategic ends. What are the practical policy implications of this history lesson? Higher Country Risk: China’s revival of personal rule, as opposed to consensus rule, marks a permanent increase in “country risk” and political risk for investors. Autocratic governments lack institutional guardrails (checks and balances) that prevent drastic policy mistakes. When Xi tries to step down there will probably be a succession crisis. Higher Macroeconomic Risk: China is more likely to get stuck in the “middle-income trap.” Liberal or pro-market economic reform is de-emphasized both in the new historical resolution and in the Xi administration’s broader program. Centralization is already suppressing animal spirits, entrepreneurship, and the private sector.  Higher Geopolitical Risk: The return to autocracy and the withdrawal from economic liberalism also entail a conflict with the United States, which is still the world’s largest economy and most powerful military. The US is not what it once was but it will put pressure on China’s economy and build alliances aimed at strategic containment. Bottom Line: China is trying to escape the middle-income trap, like Taiwan, Japan, and South Korea, but it is trying to do so by means of autocracy, import substitution, and conflict with the United States. These other Asian economies improved productivity by democratizing, embracing globalization, and maintaining a special relationship with the United States. China’s odds of succeeding are low. China will focus on power consolidation through fall 2022 and this will lead to negative surprises for financial markets.    China Slowdown: The Disinflationary Risk While it is very unlikely that Xi will face serious challenges to his rule, strange things can happen at critical junctures. Therefore the regime will be extremely alert for any threats, foreign or domestic, and will ultimately prioritize politics above all other things, which means investors will suffer negative surprises. The lingering pandemic still poses an inflationary risk for the rest of the world while the other main risk is disinflationary:    Inflationary Risk – Zero COVID: The “Covid Zero” policy of attempting to stamp out any trace of the virus will still be relevant at least over the next 12 months (Chart 11). Clampdowns serve a dual purpose since the Xi administration wants to minimize foreign interference and domestic dissent before the party congress. Hence the global economy can suffer more negative supply shocks if ports or factories are closed.  Inflationary Risk – Energy Closures: The government is rationing electricity amid energy shortages to prioritize household heating and essential services. This could hurt factory output over the winter if the weather is bad. Disinflationary Risk – Property Bust: The country is still flirting with overtightening monetary, fiscal, and regulatory policies. Throughout the year we have argued that authorities would avoid overtightening. But China is still very much in a danger zone in which policy mistakes could be made. Recent rumors suggest the government is trying to “correct the overcorrection” of regulatory policy. The government is reportedly mulling measures to relax the curbs on the property sector. We are inclined to agree but there is no sign yet that markets are responding, judging by corporate defaults and the crunch in financial conditions (Chart 12). Chart 12China Has Not Contained Property Turmoil Evergrande, the world’s most indebted property developer, is still hobbling along, but its troubles are not over. There are signs of contagion among other developers, including state-owned enterprises, that cannot meet the government’s “three red lines.” 5 Credit growth has now broken beneath the government’s target range of 12%, though money growth has bounced off the lower 8% limit set for this year (Chart 13). China is dangerously close to overtightening.   China’s economic slowdown has not yet been fully felt in the global economy based on China’s import volumes, which are tightly linked to the combined credit-and-fiscal-spending impulse (Chart 14). The implication is that recent pullbacks in industrial metal prices and commodity indexes will continue. Chart 13China Tries To Avoid Over-Tightening Chart 14China Slowdown Not Yet Fully Felt ​​​​​​​Until China eases policy more substantially, it poses a disinflationary risk and a strong point in favor of the transitory view of global inflation.    It is difficult for China to ease policy – let alone stimulate – when producer prices are so high (see Chart 6 above). The result is a dangerous quandary in which the government’s regulatory crackdowns are triggering a property bust yet the government is prevented from providing the usual policy support as the going gets tough. Asset prices and broader risk sentiment could go into free fall. However, the party has a powerful incentive to prevent a generalized crisis ahead of the party congress. So we are inclined to accept signs that property curbs and other policies will be eased. Bottom Line: The full disinflationary impact of China’s financial turmoil and economic slowdown has yet to be felt globally.     Biden-Xi Summit Not A Game Changer As long as inflation prevents robust monetary and fiscal easing, Beijing is incentivized to improve sentiment in other ways. One way is to back away from the regulatory crackdown in other sectors, such as Big Tech. The other is to improve relations with the United States. A stabilization of US ties would be useful before the party congress since President Xi would prefer not to have the US interfering in China’s internal affairs during such a critical hour. No surprise that China is showing signs of trying to stabilize the relationship.   The US is apparently reciprocating. Presidents Biden and Xi also agreed to hold a virtual bilateral summit next week, which could lead to a new series of talks. The US Trade Representative also plans to restart trade negotiations. The plan is to enforce the Phase One trade deal, issue waivers for tariffs that hurt US companies, and pursue new talks over outstanding structural disputes. The Phase One trade deal has fallen far short of its goals in general but on the energy front it is doing well. China will continue importing US commodities amid global shortages (Chart 15). The summit alone will have a limited impact. Biden had a summit with Putin earlier this year but relations could deteriorate tomorrow over cyber-attacks, Ukraine, or Belarus. However, there is some basis for the US and China to cooperate next year: Iran. Xi is consolidating power at home in 2022 and probably wants to use negotiations to keep the Americans at bay. Biden is pivoting to foreign policy in 2022, since Congress will not get anything done, and will primarily focus on halting Iran’s nuclear program. If China assists the US with Iran, then there is a basis for a reduction in tensions. The problem is not only Iran itself but also that China will not jump to enforce sanctions on Iran amid energy shortages. And China is not about to make sweeping structural economic concessions to the US as the Xi administration doubles down on state-guided industrial policy. Meanwhile the US is pursuing a long-term policy of strategic containment and Biden will not want to be seen as appeasing China ahead of midterm elections, especially given Xi’s reversion to autocracy. What about cooperation on climate change? The US and China also delivered a surprise joint statement at the United Nations climate change conference in Scotland (COP26), confirming the widely held expectation that climate policy is an area of engagement. These powers and Europe have a strategic interest in reducing dependency on Middle Eastern oil (Chart 16). Climate talks will begin in the first half of next year. However, climate cooperation is not significant enough alone to outweigh the deeper conflicts between the US and China. Moreover climate policy itself is somewhat antagonistic, as the EU and US are looking at applying “carbon adjustment fees” to carbon-intensive imports, e.g. iron and steel exports from China and other high-polluting producers (Chart 17). While the EU and US are not on the same page yet, and these carbon tariffs are far from implementation, the emergence of green protectionism does not bode well for US-China relations even aside from their fundamental political and military disputes. Bottom Line: Some short-term stabilization of US-China relations is possible but not guaranteed. Markets will cheer if it happens but the effect will be fleeting. Chinese assets are still extremely vulnerable to political and geopolitical risks.   Investment Takeaways Gold can still go higher. Financial markets are pricing higher inflation and weak real rates. Gold has been our chief trade to prepare both for higher inflation and geopolitical risk. We are closing our long value / growth equity trade for a loss of 3.75%. We are maintaining our long DM Europe / short EM Europe trade. This trade has performed poorly due to the rally in energy prices and hence Russian equities. But while energy prices may overshoot in the near term, investors will flee Russian equities as geopolitical risks materialize. We are maintaining our long Korea / short Taiwan trade despite its being deeply in the red. This trade is valid over a strategic or long-term time horizon, in which a major geopolitical crisis and/or war is likely. Our expectation that China will ease policy to stabilize the economy ahead of fall 2022 should support Korean equities.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com       Footnotes 1     Over the past year President Alexander Lukashenko’s repression of domestic unrest prompted the EU to impose sanctions. Lukashenko responded by organizing an immigration scheme in which Middle Eastern migrants are flown into Belarus and funneled into the EU via Poland. The EU is threatening to expand sanctions while Belarus is threatening to cut off the Yamal-Europe pipeline amid Europe’s energy crisis. See Pavel Felgenhauer, “Belarus as Latest Front in Acute East-West Standoff,” Jamestown Foundation, November 11, 2021, Jamestown.org. 2     Both Germany and the EU must approve of Nord Stream II for it to enter into operation. The German Federal Network Agency has until January 8, 2022 to certify the project. The Economy Ministry has already given the green light. Then the European Commission has two-to-four months to respond. The EU is supposed to consider whether the pipeline meets the EU’s requirement that gas transport be “unbundled” or separated from gas production and sales. This is a higher hurdle but Germany’s clout will be felt. Hence final approval could come by March 8 or May 8, 2022. The energy crisis will put pressure for an early certification but the EU Commission may take the full time to pretend that it is not being blackmailed. See Joseph Nasr and Christoph Steitz, “Certifying Nord Stream 2 poses no threat to gas supply to EU – Germany,” Reuters, October 26, 2021, reuters.com. 3    Xi is not serving for an “unprecedented third term,” as the mainstream media keeps reporting. China’s top office is not constant nor were term limits ever firmly established. Each leader’s reign should be measured by their effective control rather than technical terms in office. Mao reigned for 27 years (1949-76), Deng for 14 years or more (1978-92), Jiang Zemin for 10 years (1992-2002), and Hu Jintao for 10 years (2002-2012).  4    See Joseph Fewsmith, “Mao’s Shadow” Hoover Institution, China Leadership Monitor 43 (2014), and “The 19th Party Congress: Ringing In Xi Jinping’s New Age,” Hoover Institution, China Leadership Monitor 55 (2018), hoover.org.  5    Liability-to-asset ratios less than 70%, debt-to-equity less than 100%, and cash-to-short-term-debt ratios of more than 1.0x.   Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Open Trades & Positions 

Highlights Short-term inflation risk will escalate further if politics causes new supply disruptions. Long-term inflation risk is significant as well. There is a distinct risk of a geopolitical crisis in the Middle East that would push up energy prices: the US’s unfinished business with Iran. The primary disinflationary risk is China’s property sector distress. However, Beijing will strive to maintain stability prior to the twentieth national party congress in fall 2022. South Asian geopolitical risks are rising. The Indo-Pakistani ceasefire is likely to break down, while Afghani terrorism will rebound. Book gains on our emerging market currency short targeting “strongman” regimes. Feature Investors are underrating the risk of a global oil shock. This was our geopolitical takeaway from the BCA Conference this year. Investors are focused on the risk of inflation and stagflation, always with reference to the 1970s. The sharp increase in energy prices due to the Arab Oil Embargo of 1973 and the Iranian Revolution of 1979 are universally cited as aggravating factors of stagflation at that time. But these events are also given as critical differences between the situation in the 1970s and today. Unfortunately, there could be similarities. From a strictly geopolitical perspective, the risk of a conflict in the Middle East is significant both in the near term and over the coming year or so. The risk stems from the US’s unfinished business with Iran. More broadly, any supply disruption would have an outsized impact as global energy inventories decline. OPEC’s spare capacity at present can cover a 5 million barrel shock (Chart 1). In this week’s report we also provide tactical updates on China, Russia, and India. Geopolitics And The 1970s Inflation Chart 2Wage-Price Spiral, Stagflation In 1970s Fundamentally the stagflation of the 1970s occurred because global policymakers engendered a spiral of higher wages and higher prices. The wage-price spiral was exacerbated by a falling dollar, after President Nixon abandoned the gold standard, and a commodity price surge (Chart 2). Monetary policy clearly played a role. It was too easy for too long, with broad money supply consistently rising relative to nominal GDP (Chart 3). Central banks including the Federal Reserve were focused exclusively on employment. Policymakers saw the primary risk to the institution’s credibility as recession and unemployment, not inflation. Fear of the Great Depression lurked under the surface. Fiscal policy also played a role. The size of the US budget deficit at this time is often exaggerated but there is no question that they were growing and contributed to the bout of inflation and spike in bond yields (Chart 4). The reason was not only President Johnson’s large social spending program, known as the “Great Society.” It was also Johnson’s war – the Vietnam war. Chart 3Central Banks Focused On Employment, Not Prices, In 1970s On top of this heady mix of inflationary variables came geopolitics. The Yom Kippur war in 1973 prompted Arab states to impose an embargo on Israel’s supporters in the West. The Arab embargo cut off 8% of global oil demand at the time. Oil prices skyrocketed, precipitating a deep recession (Chart 5). Chart 4Johnson's 'Great Society' And Vietnam War Spending The embargo came to a halt in spring of 1974 after Israeli forces withdrew to the east of the Suez Canal. The oil shock exacerbated the underlying inflationary wave that continued throughout the decade. The Iranian revolution triggered another oil shock in 1979, bringing the rise in general prices to their peak in the early 1980s, at which point policymakers intervened decisively. Chart 5Arab Oil Embargo And Iranian Revolution There is an analogy with today’s global policy mix. Fear of the Great Recession and deflation rules within policymaking circles, albeit less so among the general public. The Fed and the European Central Bank have adjusted their strategies to pursue an average inflation target and “maximum employment.” Chart 6Wage-Price Spiral Today?​​​​​​ The Biden administration is reviving big government with a framework agreement of around $1.2 trillion in new deficit spending on infrastructure, green energy, and social programs likely to pass Congress before year’s end. In short, the macro and policy backdrop are changing in a way that is reminiscent of the 1970s despite various structural differences between the two periods. It is too early to declare that a wage-price spiral has developed but core inflation is rising and investors are right to be concerned about the direction and potential for inflation surprises down the road (Chart 6). These trends would not be nearly as concerning if they were not occurring in the context of a shift in public opinion in favor of government versus markets, labor versus capital, onshoring versus offshoring, and protectionism versus free trade. Investors should note that the last policy sea change (in the opposite direction) lasted roughly 30-40 years. The global savings glut – shown here as the combined current account balances of the world’s major economies – has begun to decline, implying that a major deflationary force might be subsiding. Asian exporters apparently have substantial pricing power, as witnessed by rising export prices, although they have yet to break above the secular downtrend of the post-2008 period (Chart 7). Chart 7Hypo-Globalization Is Inflationary A commodity price surge is also underway, of course, though it is so far manageable. The US and EU economies are less energy-intensive than in the 1970s and there is considerable buffer between today’s high prices and an economic recession (Chart 8). Chart 8Wage-Price Spiral Today? The problem is that there is a diminishing margin of safety. Furthermore, a crisis in the Middle East is not far-fetched, as there is a concrete and distinct reason for worrying about one: the US’s unresolved collision course with Iran. A crisis in the Persian Gulf would greatly exacerbate today’s energy shortages. Iran: The Risk Of An Oil Shock Iran now says it will rejoin diplomatic talks over its nuclear program in late November. This development was expected, and is important, but it masks the urgent and dangerous trajectory of events that could blow up any day now. It is emphatically not an “all clear” sign for geopolitical risk in the Persian Gulf. The US is hinting, merely hinting, that it is willing to use military force to prevent Iran from going nuclear. The Iranians doubt US appetite for war and have every reason to think that nuclear status will guarantee them regime survival. Thus the Iranians are incentivized to use diplomacy as a screen while pursuing nuclear weaponization – unless the US and Israel make a convincing display of military strength to force Iran back to genuine diplomacy. A convincing display is hard to do. A secret war is taking place, of sabotage and cyber-attacks. On October 26 a cyber-attack disrupted Iranian gas stations. But even attacks on nuclear scientists and facilities have not dissuaded the Iranians from making progress on their nuclear program yet. Iran does not want to be attacked but it knows that a ground invasion is virtually impossible and air strikes alone have a poor record of winning wars. The Iranians have achieved 60% highly enriched uranium and are expected to achieve nuclear breakout capacity – the ability to make a nuclear device – sometime between now and December (Table 1). The IAEA no longer has any visibility in Iran. The regime’s verified production of uranium metal can only be used for the construction of a warhead. Recent technical progress may be irreversible, according to the Institute for Science and International Security.1 If that is true then the upcoming round of diplomatic negotiations is already doomed. Table 1Iran’s Compliance With Nuclear Deal And Time Until Breakout (Oct 2021) American policymakers seem overconfident in the face of this clear nuclear proliferation risk. This is strange given that North Korea successfully manipulated them over the past three decades and now has an arsenal of 40-50 nuclear weapons. The consensus goes as follows: Regime instability: Americans emphasize that the Iranian regime is unstable, lacks genuine support, and faces a large and restive youth population. This is all true. Indeed Iran is one of the most likely candidates for major regime instability in the wake of the COVID-19 shock. Chart 9AIran's Economy Sees Inflation Spike ...​​​​​​ Chart 9B... Yet Some Green Shoots Are Rising However, popular protest has not had any effect on the regime over the past 12 years. Today the economy is improving and illicit oil revenues are rising (Chart 9). A new nationalist government is in charge that has far greater support than the discredited reformist faction that failed on both the economic and foreign policy fronts (Chart 10). The sophisticated idea that achieving nuclear breakout will somehow weaken the regime is wishful thinking.  If it provokes US and/or Israeli air strikes, it will most likely see the people rally around the flag and convince the next generation to adopt the revolutionary cause.2 If it does not provoke a war, then the regime’s strategic wisdom will be confirmed. American military and economic superiority: Americans tend to think that Iran will back down in the face of the US’s and Israel’s overwhelming military and economic superiority. It is true that a massive show of force – combined with the sale of specialized weaponry to Israel to enable a successful strike against extremely hardened nuclear facilities – could force Iran to pause its nuclear quest and go back to negotiations. Yet the US’s awesome display of military power in both Iraq and Afghanistan ended in ignominy and have not deterred Iran, just next door, after 20 years. Nor have American economic sanctions, including “maximum pressure” sanctions since 2019. The US is starkly divided, very few people view Iran as a major threat, and there is an aversion to wars in the Middle East (Chart 11). The Iranians could be forgiven for doubting that the US has the appetite to enforce its demands. ​​​​​​ ​​​​​​ In short the US is attempting to turn its strategic focus to China and Asia Pacific, which creates a power vacuum in the Middle East that Iran may attempt to fill. Meanwhile global supply and demand balances for energy are tight, with shortages popping up around the world, giving Iran greater leverage. From an investment point of view, a crisis is likely in the near term regardless of what happens afterwards. A crisis is necessary to force the US and Iran to return to a durable nuclear deal like in 2015. Otherwise Iran will reach nuclear breakout and an even bigger crisis will erupt, potentially forcing the US and Israel (or Israel alone) to take military action. Diplomatic efforts will need to have some quick and substantial victories in the coming months to convince us that the countries have moved off their collision course. A conflict with Iran will not necessarily go to the extreme of Iran shutting down the Strait of Hormuz and cutting off 21% of the world’s oil and 26% of liquefied natural gas (Chart 12). If that happens a global recession is unavoidable. It would more likely involve lesser conflicts, at least initially, such as “Tanker War 2.0” in the Persian Gulf.3 Or it could involve a flare-up of the ongoing proxy war by missile and drone strikes, such as with the Abqaiq attack in 2019 that knocked 5.7 million barrels per day offline overnight. The impact on oil markets will depend on the nature and magnitude of the event. What are the odds of a military conflict? In past reports we have demonstrated that there is a 40% chance of conflict with Iran. The country’s nuclear program is at a critical juncture. The longer the world goes without a diplomatic track to defuse tensions, the more investors should brace for negative surprises. Bottom Line: There is a clear and present danger of a geopolitical oil shock. The implication is that oil and LNG prices could spike in the coming zero-to-12 months. The implication would be a dramatic “up then down” movement in global energy prices. Inflation expectations should benefit from simmering tensions but a full-blown war would cause an extreme price spike and global recession. China: The Return Of The Authoritative Person Another reason that today’s inflation risk could last longer than expected is that China’s government is likely to backpedal from overtightening monetary, fiscal, and regulatory policy. If this is true then China will secure its economic recovery, the global recovery will continue, commodity prices will stay elevated, and the inflation expectations and bond yields will recover. If it is not true then investors will start talking about disinflation and deflation again soon. We are not bullish on Chinese assets – far from it. We see China entering a property-induced debt-deflation crisis over the long run. But over the 2021-22 period we have argued that China would pull back from the brink of overtightening. Our GeoRisk Indicator for China highlights how policy risk remains elevated (see Appendix). So far our assessment appears largely accurate. The government has quietly intervened to prevent the troubled developer Evergrande from suffering a Lehman-style collapse. The long-delayed imposition of a nationwide property tax is once again being diluted into a few regional trial balloons. Alibaba founder Jack Ma, whom the government disappeared last year, has reappeared in public view, which implies that Beijing recognizes that its crackdown on Big Tech could cause long-term damage to innovation. At this critical juncture, a mysterious “authoritative” commentator has returned to the scene after five years of silence. Widely believed to be Vice Premier Liu He, a Politburo member and Xi Jinping confidante on economic affairs, the authoritative person argues in a recent editorial that China will stick with its current economic policies.4 However, the message was not entirely hawkish. Table 2 highlights the key arguments – China is not oblivious to the risk of a policy mistake. Table 2Messages From China’s ‘Authoritative Person’ On Economic Policy (2021) Readers will recall that a similar “authoritative Person” first appeared in the People’s Daily in May 2016. At that time, the Chinese government had just relented in the face of economic instability and stimulated the economy. It saw a 3.5% of GDP increase in fiscal spending and a 10.0% of GDP increase in the credit impulse from the trough in 2015 to the peak in 2016. The authoritative person was explaining that the intention to reform would persist despite the relapse into debt-fueled growth. So one must wonder today whether the authoritative person is emerging because Beijing is sticking to its guns (consensus view) or rather because it is gradually being forced to relax policy by the manifest risk of financial instability. To be fair, a recent announcement on government special purpose bonds does not indicate major fiscal easing. If local governments accelerate their issuance of new special purpose bonds to meet their quota for the year then they are still not dramatically increasing the fiscal support for the economy. But this announcement could protect against downside growth risks. The first quarter of 2022 will be the true test of whether China will remain hawkish. Going forward there are two significant dangers as we see it. The first is that policymakers prove ideological rather than pragmatic. An autocratic government could get so wrapped up in its populist campaign to restrain high housing costs that it refuses to slacken policies enough and causes a crash. The second danger is that inflation stays higher for longer, preventing authorities from easing policy even when they know they need to do so to stabilize growth. The second danger is the bigger of the two risks. As for the first risk, ideology will take a backseat to necessity. Xi Jinping needs to secure key promotions for his faction in the top positions of the Communist Party at the twentieth national party congress in 2022. He cannot be sure to succeed if the economy is in free fall. A self-induced crash would be a very peculiar way of trying to solidify one’s stature as leader for life at the critical hour. Similarly China cannot maintain a long-term great power competition with the United States if it deliberately triggers property deflation and financial turmoil. It can and will continue modernizing and upgrading its military, e.g. developing hypersonic missiles, even if it faces financial turmoil. But it will have a much greater chance of neutralizing US regional allies and creating a regional buffer space if its economic growth is stable. Ultimately China cannot prevent financial instability, economic distress, and political risk from rising in the coming years. There will be a reckoning for its vast imbalances, as with all countries. It could be that this reckoning will upset the Xi administration’s best-laid plans for 2022. But before that happens we expect policy to ease. A policy mistake today would mean that very negative economic outcomes will arrive precisely in time to affect sociopolitical stability ahead of the party congress next fall. We will keep betting against that. Bottom Line: China’s “authoritative” media commentator shows that policymakers are not as hawkish as the consensus holds. The main takeaway is that policymakers will adjust the intensity of their reform efforts to maintain stability. This is standard Chinese policymaking and it is more important than usual ahead of the political rotation in 2022. Otherwise global inflation risk will quickly give way to deflation risk as defaults among China’s property developers spread and morph into broader financial and economic instability. Indo-Pakistani Ceasefire: A Breakdown Is Nigh India and Pakistan agreed to a ceasefire along the line of control in February 2021. While the agreement has held up so far, a breakdown is probably around the corner. It was never likely to last for long. Over the short run, the ceasefire made sense for both countries: COVID-19 Risks: The first wave of the pandemic had abated but COVID-19-related risks loomed large. India had administered less than 15 million vaccine doses back then and Pakistan only 100,000. Dangerous Transitions Were Underway: With America’s withdrawal from Afghanistan in the works, Pakistan was fully focused on its western border. India was pre-occupied with its eastern front, where skirmishes with Chinese troops forced it to redirect some of its military focus. As we now head towards the end of 2021, these constraints are no longer binding. COVID-19 Risks Under Control: The vaccination campaign in India and Pakistan has gathered pace. More than 50% of India’s population and 30% of Pakistan’s have been given at least one dose. Pakistan’s Ducks Are Lined-up In Afghanistan: America’s withdrawal from Afghanistan has been completed. Afghanistan is under Taliban’s control and Pakistan has a better hold over the affairs of its western neighbor. One constraint remains: India and China remain embroiled in border disputes. Conciliatory talks between their military commanders broke down a fortnight ago. Winter makes it nearly impossible to undertake significant operations in the Himalayas but a failure of coordination today could set up a conflict either immediately or in the spring. While India may see greater value in maintaining the ceasefire than Pakistan, India has elections due in key northern states in 2022. India’s northern states harbor even less favorable views of Pakistan than the rest of India. Hence any small event could trigger a disproportionate response from India. Bottom Line: While it is impossible to predict the timing, a breakdown in the Indo-Pakistani ceasefire may materialize in 2022 or sooner. Depending on the exact nature of any conflict, a geopolitically induced selloff in Indian equities could create a much-needed consolidation of this year’s rally and ultimately a buying opportunity. Russia, Global Terrorism, And Great Power Relations Part of Putin’s strategy of rebuilding the Russian empire involves ensuring that Russia has a seat at the table for every major negotiation in Eurasia. Now that the US has withdrawn forces from Afghanistan, Russia is pursuing a greater role there. Most recently Russia hosted delegations from China, Pakistan, India, and the Taliban. India too is planning to host a national security advisor-level conference next month to discuss the Afghanistan situation. Do these conferences matter for global investors? Not directly. But regional developments can give insight into the strategies of the great powers in a world that is witnessing a secular rise in geopolitical risk. China, Russia, and India have skin in the game when it comes to Afghanistan’s future. This is because all three powers have much to lose if Afghanistan becomes a large-scale incubator for terrorists who can infiltrate Russia through Central Asia, China through Xinjiang, or India through Pakistan. Hence all three regional powers will be constrained to stay involved in the affairs of Afghanistan. Terrorism-related risks in South Asia have been capped over the last decade due to the American war (Chart 13). The US withdrawal will lead to the activation of latent terrorist activity. This poses risks specifically for India, which has a history of being targeted by Afghani terrorist groups. And yet, while China and Russia saw the Afghan vacuum coming and have been engaging with Taliban from the get-go, India only recently began engaging with Taliban. The evolution of Afghanistan under the Taliban will also influence the risk of terrorism for the rest of the world. In the wake of the global pandemic and recession, social misery and regime failures in areas with large youth populations will continue to combine with modern communications technology to create a revival of terrorist threats (Chart 14). American officials recently warned of the potential for transnational attacks based in Afghanistan to strike the homeland within six months. That risk may be exaggerated today but it is real over the long run, especially as US intelligence turns its strategic focus toward states and away from non-state actors. India, Europe, and other targets are probably even more vulnerable than the United States. If Russia and China succeed in shaping the new Afghanistan’s leadership then the focus of militant proxies will be directed elsewhere. Beyond terrorism, if Russia and China coordinate closely over Afghanistan then India may be left in the cold. This would reinforce recent trends in which a tightening Russo-Chinese partnership hastens India’s shift away from neutrality and toward favoring the US and the West in strategic matters. If these trends continue to the point of alliance formation, then they increase the risk that any conflicts between two powers will implicate others. Bottom Line: Afghanistan is now a regional barometer of multilateral cooperation on counterterrorism, the exclusivity of Russo-Chinese cooperation, and India’s strategic isolation or alignment with the West. Investment Takeaways It is too soon to play down inflation risks. We share the BCA House View that they will subside next year as pandemic effects wane. But we also see clear near-term risks to this view. In the short run (zero to 12 months), a distinct risk of a Middle Eastern geopolitical crisis looms. A gradual escalation of tensions is inflationary whereas a sharp spike in conflict would push energy prices into punitive territory and kill global demand. Over the next 12 months, China’s economic and financial instability will also elicit policy easing or fiscal stimulus as necessary to preserve stability, as highlighted by the regime’s mouthpiece. Obviously stimulus will not be utilized if the economic recovery is stable, given elevated producer prices. In a future report we will show that Russia is willing and able to manipulate natural gas prices to increase its bargaining leverage over Europe. This dynamic, combined with the risk of cold winter weather exacerbating shortages, suggests that the worst is not yet over. Geopolitical conflict with Russia will resume over the long run. Stay long gold as a hedge against both inflation and geopolitical crises involving Iran, Taiwan/China, and Russia. Maintain “value” plays as a cheap hedge against inflation. Book a profit of 2.5% on our short trade for currencies of emerging market “strongmen,” Turkey, Brazil, and the Philippines. Our view is still negative on these economies. Stay long cyber-security stocks. Over the long run, inflation risk must be monitored. We expect significant inflation risk to persist as a result of a generational change in global policy in favor of government and labor over business and capital. But the US is maintaining easy immigration policy and boosting productivity-enhancing investments. Meanwhile China’s secular slowdown is disinflationary. The dollar may remain resilient in the face of persistently high geopolitical risk. The jury is still out.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1      David Albright and Sarah Burkhard, "Iran’s Recent, Irreversible Nuclear Advances," Institute for Science and International Security, September 22, 2021, isis-online.org. 2     Ray Takeyh, "The Bomb Will Backfire On Iran," Foreign Affairs, October 18, 2021, foreignaffairs.com. 3     See Aaron Stein and Afshon Ostovar, "Tanker War 2.0: Iranian Strategy In The Gulf," Foreign Policy Research Institute, August 10, 2021, fpri.org. 4     "Ten Questions About China’s Economy," Xinhua, October 24, 2021, news.cn.     Section II: Appendix: GeoRisk Indicator China Russia United Kingdom Germany France Italy Canada Spain Taiwan Korea Turkey Brazil Australia South Africa Section III: Geopolitical Calendar

Special Report

Highlights As US and China’s grand strategies collide, expect major and minor geopolitical earthquakes whose epicenter will now lie in South Asia and the Indian Ocean basin. Another tectonic change will drive South Asia’s emergence as a new geopolitical battle ground - South Asia is now heavily weaponized. All key players operating in this theater are nuclear powers. South Asia’s democratic traditions are well-known but notable institutional and social fault lines exist. These could trigger major geopolitical events in Afghanistan, Pakistan and in pockets of India too. We are bullish on India strategically but bearish tactically. Dangerous transitions are underway to India’s east and west. Within India, key elections are approaching, and it is possible that growth may disappoint. For reasons of geopolitics, we are strategically bullish on Bangladesh but strategically bearish on Pakistan and Sri Lanka. We are booking gains of 9% on our long rare earths basket and 1% on our long GBP-CZK trade. Feature Over the 1900s, East Asia and the Middle East emerged as two key geopolitical focal points on the world map. Global hegemons flexed their muscles and clashed in these two theaters. Meanwhile South Asia was a geopolitical backstage at best. The majority of South Asia was a British colony until the second half of the twentieth century. After WWII it struggled with the difficulties of independence and mostly missed out on the prosperity of East Asia and the Pacific. But will the twenty-first century be any different? Absolutely so. We expect the current century to be marked by major and minor geopolitical earthquakes in which South Asia and the Indian Ocean basin will play a major part. This seismic change is likely to be the result of several tectonic forces: Population: A quarter of the world’s people live in South Asia today and this share will keep growing for the next four decades. India will be the most populous country in the world by 2027 and will account for about a fifth of global population. Supply: China’s growth model has left it heavily dependent on imports of raw materials from abroad. It is clashing with the West over markets and supply chains. Beijing is building supply lines overland while developing a navy to try to secure its maritime interests. These interests increasingly overlap with India’s, creating economic competition and security concerns over vital sea lines of communication. Access: Whilst the Himalayas and Tibetan plateau have historically prevented China from expanding its influence in South Asia, China’s alliance with Pakistan is strengthening. Physical channels like the China Pakistan Economic Corridor (CPEC), and other linkages under the Belt and Road Initiative, now provide China a foot in the South Asian door like never before (Map 1). Weapons: The second half of the twentieth century saw China, India, and Pakistan acquire nuclear arms. Consequently, South Asia today is one of the most weaponized geographies globally (Map 1). Map 1South Asia To Emerge As A Key Geopolitical Theater In The 21st Century With the South Asian economy ever developing, and US-China confrontation here to stay, we expect China to make its presence felt in South Asia over the coming decades. The US’s recent withdrawal from Afghanistan, and the failure of democratization in Myanmar, are but two symptoms of a grand strategic change by which China seeks to prevent US encirclement and Indo-American cooperation develops to counter China. Throw in the abiding interests of all these powers in the Middle East and it becomes clear that South Asia and the Indian Ocean basin writ large will become increasingly important over the coming decades. The Lay Of The Land - India Is The Center Of Gravity Chart 1South Asia Managed Rare Feat Of ‘Steady’ Growth South Asia stands out amongst developing regions of the world for its large and young population. In recent decades, South Asia has also managed to grow its economy steadily, surpassing Sub-Saharan Africa and rivaling the Middle East (Chart 1). While South Asia’s growth rates have not been as miraculous as East Asia post World War II, its growth engine has managed to hum slowly but surely. India and Bangladesh have been the star performers on the economic growth front (Chart 2). Despite decent growth rates, the South Asian region is characterized by very low per capita incomes due to large population. On per capita incomes, Sri Lanka leads whilst Pakistan finds itself at the other end of the spectrum (Chart 3). Chart 2India And Bangladesh Have Been Star Performers Chart 3Per Capita Incomes In South Asia Have Grown, But Remain Low Chart 4India Accounts For About 80% Of South Asia’s GDP South Asia constitutes eight nations. However only four are material from an investment perspective: India, Pakistan, Sri Lanka, and Bangladesh. India is the center of gravity as it offers the most liquid scrips and accounts for 80% of the region’s GDP (Chart 4). In addition: India accounts for 101 of the 110 companies from South Asia listed on MSCI’s equity indices. MSCI India’s market capitalization is about $1 trillion. In fact, India’s equity market could soon become larger than that of the UK and join the world’s top-five club.1 The combined market cap of MSCI Bangladesh, Sri Lanka, and Pakistan amounts to only about $6 billion. Liquidity is a constraint that investors must contend with whilst investing in these three countries in South Asia. Pakistan is the home of 220 million – set to grow to 300 million by 2040. It lags its neighbors on economic growth and governance but has nuclear weapons and a 650,000-strong military. Bottom Line: India is the center of gravity for the regional economy and financial markets in South Asia. Sri Lanka and Bangladesh are small but are developing. Pakistan is the laggard, but is militarily strong, which raises political and geopolitical risks. South Asia: Major Consumer, Minor Producer Chart 5Manufacturing Capabilities Of South Asian Economies Are Weak South Asia’s defining economic characteristic is that it is a major consumer. This feature contrasts with the region’s East Asian cousins, which worked up economic miracles based on their manufacturing capabilities. South Asia’s appetite to consume is partly driven by population and partly driven by the fact that this region’s economies have an unusually underdeveloped manufacturing base (Chart 5). It’s no surprise that all countries in South Asia (with the sole exception of Afghanistan) are set to have a current account deficit over the next five years (Charts 6A and 6B). Chart 6ASouth Asian Economies Tend To Be Net Importers Chart 6BSouth Asian Economies Tend To Be Net Importers India is set to become the third largest global importer of goods and services (after the US and UK) over the next five years. Its rise as a large client state of the world will be both a blessing and a curse, as increased business leverage will coincide with geopolitical insecurity. Structurally, Sino-Indian tensions are rising and growing bilateral trade will not be enough to prevent them. Meanwhile dependency on the volatile Middle East is a geopolitical vulnerability. Either way, India and its region become more important to the rest of the world over time. Whilst the structure of South Asia’s economy is relatively rudimentary, it is worth noting that Bangladesh and Sri Lanka present an exception. Bangladesh has embarked on a path of manufacturing-oriented development via labor-intensive production. Sri Lanka has a well-developed services sector (Chart 7). In particular: Bangladesh: Within South Asia, Bangladesh’s manufacturing sector stands out as being better developed than regional peers. More than 95% of Bangladesh’s exports are manufactured goods –a level that is comparable to China (Chart 8). China’s share in the global apparel and footwear market has been systematically declining and Bangladesh is one of the countries that has benefited most from this shift. Bangladesh’s share in global apparel and footwear exports to the US as well as EU has been rising steadily and today stands at 4.5% and 13% respectively.2 Chart 7Bangladesh’s And Sri Lanka’s Economies Are Relatively Modern Chart 8Bangladesh Has The Most Developed Exports Franchise In South Asia Sri Lanka: Whilst Sri Lanka social complexities are lower and per capita incomes are higher as compared to peers in South Asia, its transition from a long civil war to a focus on economic development recently suffered a body blow, first owing to terrorist attacks in 2019 and then owing to the pandemic. The economic predicament was then worsened by its government’s hasty transition to organic farming which hit domestic food production. Geopolitically it is worth noting that China is one of the largest lenders to Sri Lanka. Whilst Sri Lanka’s central bank may be able to convince markets of the nation’s ability to meet debt obligations for now, its foreign exchange reserves position remains precarious and public debt levels remain high. Sri Lanka’s vulnerable finances are likely to only increase Sri Lanka’s reliance on capital-rich China. Despite Democracy, South Asia Has Political Tinderboxes Another factor that sets South Asia apart from developing regions like Africa, the Middle East, and Central Asia is the region’s democratic moorings. India and Sri Lanka lead the region on this front, although the last decade may have seen minor setbacks to the quality of democracy in both countries (Chart 9). Pockets of South Asia are socially and politically unstable, characterized by religious or communal strife, terrorist activity, and even the occasional coup d'état. Risk Of Social Conflict Most Elevated In Pakistan And Afghanistan India’s demographic dividend is real, but its benefits should not be overstated. For instance, India’s northern region is a demographic tinderbox. It is younger than the rest of the country, yet per capita incomes are lower, youth underemployment is higher, and society is more heterogeneous. The rise of nationalism in India is an important consequence and could engender potential social unrest. Chart 9India’s Democracy Strongest, But May Have Had Some Setbacks Chart 10South Asia Is Young And Will Age Slowly   Chart 11Social Complexities Are High In Afghanistan & Pakistan A similar problem confronts South Asia as a whole. Pakistan and Afghanistan are younger than India by a wide margin (Chart 10). But both countries are economically backward and have either poor or non-existent democratic traditions. Lots of poor youths and inadequate political valves to release social tensions make for an explosive combination. These countries are highly vulnerable to social conflict that could cause political instability at home or across the region via terrorism (Chart 11). The Gatsby Effect Most Prominent In Pakistan While various regions struggle with inequality, South Asia has less of a problem that way (Chart 12). However South Asia is characterized by very low levels of social mobility as compared to peer regions. This can partially be attributed to two centuries of colonial rule as well as to endemic traditions of social stratification. Chart 12Gatsby Effect: Social Mobility Is Lowest In Pakistan Within South Asia it is worth noting that social mobility is the lowest in Pakistan and highest in Sri Lanka. Chart 13Military’s Influence Most Elevated In Pakistan And Nepal Too Military Influential In Pakistan (And Nepal) Events that transpired over January 2020 in the US showed that even the oldest constitutional democracy in the world is not immune to a breakdown of civil-military relations. South Asia has seen the occasional coup d'état, one reason for the political tinderboxes highlighted above. Obviously, Myanmar is the worst – it saw its nascent democratization snuffed out just last year. But other countries in the region could also struggle to maintain civilian order in the coming decades. The military’s influence is outsized in Pakistan as well as Nepal (Chart 13). India maintains high levels of defense spending but has a strong tradition of civilian control (Chart 14). Chart 14Pakistan’s Military Budget Is Most Generous, India A Close Second South Asia: A New Global Battle Ground Historically global hegemons have sought to assert their dominance by staking claim over coastal regions in Europe and Asia. Over the past two centuries Asia has emerged as a geopolitical theater second only to Europe. Naval and coastal conflicts have emerged from the rise of Japan (the Russo-Japanese War) and the Cold War (the Korean War & the Vietnam War). Today the rise of China is the destabilizing factor. The “frozen conflicts” of the Cold War are thawing in Taiwan, South Korea, and elsewhere. China is pursuing territorial disputes around its entire periphery, including notably in the East and South China Seas but also South Asia. Meanwhile the US, fearful of China, is struggling to strike a deal with Iran and shift its focus from the Middle East to reviving its Pacific strategic presence. A budding US-China competition is creating conditions for a new cold war or a series of “proxy battles” in Asia. Over the next few decades, we expect disputes to continue. But the focal points are likely to cover South Asia too. In specific, landlocked regions in South Asia are likely to see rising tensions in the twenty-first century (Map 2). Also as mentioned above, China’s naval expansion and the US’s attempt to form a “quadrilateral” alliance with India, Japan, and Australia will generate tensions and potentially conflict. European allies are also becoming more active in Asia as a result of US alliances as well as owing to Europe’s independent need for secure supply lines. Map 2China’s Interest In Landlocked Regions Of South Asia Is Rising While border clashes between India and China will ebb and flow, Indo-Chinese confrontations along India’s eastern border will become a structural theme. Arguably, Sino-Indian rivalries pre-date the twenty-first century. But in a world in which the Asian giants are increasingly economically and technologically developed, Sino-Indian confrontations are likely to persist and result in major geopolitical events. Consider: China is adopting nationalism and an assertive foreign policy to cope with rising socioeconomic pressures on the Communist Party as potential GDP growth slows. China is developing a navy as well as a stronger alliance with Pakistan, which includes greater lines of communication. North India is a key constituency for the political party in power in India today (i.e., the Bhartiya Janata Party or BJP) and this geography harbors especially unfavorable views of Pakistan (Chart 15). Thus, there is a risk that the India of today could respond far more decisively or aggressively to threats or even minor disputes. More broadly, nationalism is rising in India as well as China. India is shedding its historical stance of neutrality and aligning with the US, which fuels China’s distrust (Chart 16). Chart 15Northern India Views Pakistan Even More Unfavorably Than Rest Of India Chart 16India Has Aligned With The QUAD To Counter The Sino-Pak Alliance Turning attention to India’s western border, clashes between India and Pakistan relating to landlocked areas in Kashmir will also be a recurring theme. Whilst India currently has a ceasefire agreement in place with Pakistan, peace between the two countries cannot possibly be expected to last. This is mainly because: Kashmir: Core problems between the two countries, like India’s control over Kashmir and Pakistan’s use of militant proxies, remain unaddressed. India’s unexpected decision in 2019 to abrogate article 370 of the Indian constitution has reinforced Pakistan’s attention on Kashmir. Sino-Pak Alliance: Pakistan accounted for 38% of China’s arms exports over 2016-20. Pakistan accounts for the lion’s share of Chinese investments made in South Asia (Chart 17). Sino-India rivalries will spill into the Indo-Pak relationship (and vice versa). Revival Of Taliban: The US withdrawal from Afghanistan has revived Taliban rule in that country. Taliban’s rise will resuscitate a range of dormant terrorist movements in Afghanistan as well as in Pakistan. India has a long history of being targeted. South Asia today is very different from what it looked like for most of the post-WWII era: it is heavily weaponized. India, Pakistan, and China became nuclear powers in the second half of the twentieth century and have been steadily building their nuclear stockpiles ever since (Chart 18). North Korea’s growing arsenal is theoretically able to target India, while Iran (more friendly toward India) may also obtain nuclear weapons. Chart 17China And Pakistan: Joined At The Hip? Chart 18South Asia: The New Epicenter For Nuclear Activity While nuclear arms create a powerful incentive for nations to avoid total war, they can also create unmitigated fear and uncertainty during incidents of major strategic tension. This is especially true when countries have not yet worked out a mode of living with each other, as with the US and USSR in the early days of the Cold War. Investment Takeaways For investors with an investment horizon exceeding 12 months, we highlight that India presents a long-term buying opportunity for two key reasons: China’s Internal And External Troubles Will Benefit India: As long as US and China do not reengage in a major way, global corporations will fall under pressure to diversify from China and the US will pursue closer relations with India. China faces an array of challenges across its periphery, whereas India need only focus on the South Asian sphere. India Is Rising As A Global Consumer: As long as a major Middle East war and oil shock is avoided (not a negligible risk), India should see more benefits than costs from its growing importance as a client of the world. However, over the next 12 months we worry that India is priced for perfection. India currently trades at a punchy premium relative to emerging markets (Table 1) at a time of when both geopolitical and macroeconomic headwinds are at play. In particular: Table 1We Are Bearish On India Tactically, But Bullish On India & Bangladesh Strategically Major Transitions Are Dangerous: Recent developments in South Asia have added to geopolitical risks for India. The assumption of power by Taliban in Afghanistan will activate latent terrorist forces that could target India. Pakistan’s chronic instability combined with the change of power in Afghanistan could set off an escalation in Indo-Pakistani tensions, sooner rather than later. On India’s eastern front, China’s need to distract its population from a souring economy could trigger a clash between China and India. Down south, China’s rising influence over crisis-hit Sri Lanka is notable and could potentially engender security risks for India. Chart 19Politics Can Trump Economics In Run Up To General Elections Growth Slowing, Elections Approaching: We worry that India’s growth engine may throw up a downside surprise over the next 12 months owing to poor jobs growth and poor investment growth. History suggests that politics often trumps economics in the run up to general elections (Chart 19). Hence there is a real risk that policy decisions will be voter-friendly but not market-friendly over 2022. As both India and Pakistan are gearing up for elections in the coming years, major military showdown or saber rattling should not be ruled out. Both countries may engineer a rally around the flag effect to bump up their pandemic-battered approval. Tension with China may escalate as Xi Jinping extends his term in power next year and seeks to enforce red lines in China’s eastern and western borders. Globally what are the key geopolitical factors that could lead to India’s underperformance in the short run? We highlight a checklist here: China Stimulates: The near-term clash between markets and policymakers in China should eventually give way to meaningful fiscal stimulus by Chinese authorities. This buoys China as well as emerging markets that depend on China for their growth. However, even if China flounders, India may not continue to outperform. The correlation between MSCI India and China equities has been positive. Fed Tightens Quickly: A faster-than-expected taper and tightening guidance could cause those emerging markets that are richly priced like India to correct. A Crisis Over Iran’s Nuclear Program: If the US is unable to return to diplomacy, tensions in the Middle East will rise and stoke oil prices. This will affect India adversely, given global price pressures and India’s high dependence on oil imports. Conversely, if these developments fail to materialize then that would lower our conviction regarding India’s underperformance in the short run. In summary, we are bullish India strategically but bearish tactically. As regards the three other investable markets in South Asia: We are bearish on Pakistan and Sri Lanka on a strategic time horizon. Whilst both nations’ rising alignment with China could be an advantage ceteris paribus, ironically their deteriorating finances are driving their proximity to capital-rich China (Chart 20). To boot, Sri Lanka’s ability to pay its way out of its economic crisis on its own steam is worsening. This is evident from its rising debt to GDP ratio (Chart 21). Chart 20Pakistan And Sri Lanka Running Low On Reserves Pakistan faces elevated risks of internal social conflict, must deal with a rapidly changing external environment, has a weak democracy and an unusually influential military. Sri Lanka’s social risks are low, but its economic crisis appears likely to persist. The fact that both markets have been characterized by a high degree of volatility in earnings in the recent past implies that even a cyclical “Buy” case for either of these markets is fraught with risks (Table 1). The outlook for Bangladesh is better. Exports account for 15% of GDP and the US and Europe account for around 70% of its exports. Strong fiscal stimulus in these developed markets should augur well for this frontier market. Additionally, Bangladesh is characterized by moderate social risks, reasonably strong democracy scores and low levels of influence from the military. Its healthy public finances (Chart 21) and the fact that it shares no border with China creates the potential to leverage a symbiotic relationship with China. Chart 21Sri Lanka’s Debt Now Exceeds Its GDP But there is a catch. Bangladesh as a market has a low market cap and hence offers low levels of liquidity (Table 1). We thus urge investors to avoid making cyclical investment calls on this South Asian market. However, from a long-term perspective we highlight our strategic bullish view on Bangladesh given supportive geopolitical factors. Watch out for an upcoming report from our Emerging Markets Strategy team, that will delve into the macroeconomic aspects of Bangladesh.   Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Footnotes 1 Abhishek Vishnoi and Swetha Gopinath, "India's stock market on track to overtake UK in terms of m-cap: Report" Business Standard, October 2021. 2 Arianna Rossi, Christian Viegelahn, and David Williams, "The post-COVID-19 garment industry in Asia" Research Brief, International Labour Organization, July 2021. Open Trades & Positions