Brazil

Executive Summary China: GeoRisk Indicator A new equilibrium between NATO, which now includes Sweden and Finland, and Russia needs to be reestablished before geopolitical risks in Europe subside. Russia aims to inflict a recession on the EU which will revive dormant geopolitical risks embedded in each country. Investors should ignore the apparent drop in China’s geopolitical risk as it could rise further until Xi Jinping consolidates power at the Party Congress this fall. Stay on the sideline on Brazilian, South African, Australian, and Canadian equities despite the commodity bull market, at least until China’s growth stabilizes. Korean risk will rise, albeit by less than Taiwanese risk. The US political cycle ensures that Biden may take further actions against adversaries in Europe, Middle East, and East Asia, putting a floor under global geopolitical risk. Tactical Recommendation Inception Date Return LONG GLOBAL AEROSPACE & DEFENSE / BROAD MARKET EQUITIES 2020-11-27 9.3% Bottom Line: Geopolitical risk will rise in the near term. Stay long gold and global defensive stocks. Feature This month we update our GeoRisk Indicators and make observations about the status of political risk for each territory, and where risks are underrated or overrated by global financial markets. Russia GeoRisk Indicator Our “Original” quantitative measure of Russian political risk – the Russian “geopolitical risk premium” shown in the dotted red line below – has fallen to new lows (Chart 1). One must keep in mind that this geopolitical premium is operating under the assumption of a “free market” but the Russian market in the past few months had been anything but free. The Russian government and central bank had been manipulating the ruble and preventing capital outflows. Hence, Russian assets and any indicator derived from it does not reflect its true risk premium, merely the resolve of its government in the geopolitical struggle. Chart 1Russia: GeoRisk Indicator While the Russia Risk Premium accurately detected the build-up in tensions before the invasion of Ukraine this year, today it gives the misleading impression that Russian geopolitical risk is low. In reality the risk level remains high due to the lack of strategic stability between Russia and the West, particularly the United States, and particularly over the question of NATO enlargement. Our “Old” Russia GeoRisk Indicator remains elevated but has slightly fallen back. This measure failed to detect the rise in risk ahead of this year’s invasion of Ukraine. We predicted the war based on non-market variables, including qualitative analysis. As a result of the failure of our indicator, we devised a “New” Russia GeoRisk Indicator after this year’s invasion, shown as the green line below. This measure provides the most accurate reading. It is pushing the upper limits, which we truncated at 4, as it did during the invasion of Georgia in 2008 and initial invasion of Ukraine in 2014. Related Report  Geopolitical StrategyThird Quarter Geopolitical Outlook: Thunder And Lightning Has Russian geopolitical risk peaked for Europe and the rest of the world? Not until a new strategic equilibrium is established between the US and Russia. That will require a ceasefire in Ukraine and a US-Russia understanding about the role of Finland and Sweden within NATO. However, Hungary is signaling that the EU should impose no further sanctions on Russia. Russia’s cutoff of natural gas exports to Europe will create economic hardship that will start driving change in European governments or policies. A full ban on Russian natural gas may not be implemented in the coming years due to lack of EU unanimity. Still, the EU cannot lift sanctions on Russia because that would enable economic recovery and hence military rehabilitation, which could enable new aggression. Also, Russia will not relinquish the territories it has taken from Ukraine even if President Putin exits the scene. No Russian leader will have the political capital to do that given the sacrifices that Russia has made. Bottom Line: Russia’s management of the ruble is distorting some of our risk indicators. Russia remains un-investable for western investors. Substantial sanction relief will not come until late in the decade, if at all. UK GeoRisk Indicator British political risk is rising, and it may surpass the peaks of the Brexit referendum period in 2016 now that Scotland is pursuing another independence referendum (Chart 2). Chart 2United Kingdom: GeoRisk Indicator New elections are not due until January 25, 2025 and the ruling Conservative Party has every reason to avoid an election over the whole period so that inflation can come down and the economy can recover. But an early election is possible between now and 2025. Prime Minister Boris Johnson has become a liability to his party but he is still a more compelling leader than the alternatives. If Johnson is replaced, then the change of leadership will only temporarily boost the Tories’ public approval. It will ultimately compound the party’s difficulties by dividing the party without resolving the Scottish question.  Regardless, the Tories face stiff headwinds in the coming referendum debate and election, having been in power since 2010 and having suffered a series of major shocks (Brexit, the pandemic, inflation). Bottom Line: The US dollar is not yet peaking against pound sterling, As from a global geopolitical perspective it can go further. Investors should stay cautious about the pound in the short term. But they should prefer the pound to eastern European currencies exposed to Russian instability. Germany GeoRisk Indicator German political risk spiked around the time of the 2021 election and has since subsided, including over the course of the Ukraine war (Chart 3). However, risk will rise again now that Germany has declared that it is under “economic attack” from Russia, which is cutting natural gas in retaliation to Germany’s oil embargo. Chart 3Germany: GeoRisk Indicator This spike in strategic tensions should not be underrated. Germany is entering a new paradigm in which Russian aggression has caused a break with the past policy of Ostpolitik, or economic engagement. Germany will have to devote huge new resources to energy security and national defense and will have to guard against Russia for the foreseeable future. Domestic political risk will also rise as the economy weakens and industrial activity is rationed. Germany does not face a general election until October 26, 2025. Early elections are rare but cannot be ruled out over the next few years. The ruling coalition does not have a solid foundation. It only has a 57% majority in the Bundestag and consists of an ideological mix of parties (a “traffic light” coalition of Social Democrats, Greens, and Free Democrats). Still, Germany’s confrontation with Russia will keep the coalition in power for now. Bottom Line: From a geopolitical point of view, there is not yet a basis for the dollar to peak and roll over against the euro. That is not likely until there is a ceasefire in Ukraine and/or a new NATO-Russia understanding. France GeoRisk Indicator French political risks are lingering at fairly high levels in the wake of the general election and will only partially normalize given the likelihood of European recession and continued tensions around Russia (Chart 4). Chart 4France: GeoRisk Indicator President Emmanuel Macron was re-elected, as expected, but his Renaissance party (previously En Marche) lost its majority and Macron will struggle to win over 39 deputies to gain a majority of 289 seats in the Assembly. He will, however, be able to draw from an overall right-wing ideological majority – especially the Republicans – when it comes to legislative compromises. The election produced some surprises. The right-wing, anti-establishment National Rally of Marine Le Pen, which usually performs poorly in legislative elections, won 89 seats. The left-wing alliance (NUPES) underperformed opinion polls and has not formed a unified bloc within the Assembly. Still, the left will be a powerful force as it will command 151 seats (the sum of the left-wing anti-establishment leader Jean-Luc Mélenchon’s La France Insoumise party and the Communists, Socialists, and Greens). Macron’s key reform – raising the average retirement age from 62 to 65 – will require an ad hoc majority in the Assembly. The Republicans, with 74 seats, can provide the necessary votes. But some members have already refused to side with Macron on this issue. Macron will most likely get support from the populist National Rally on immigration, including measures to make it harder to be naturalized or obtain long-term residence permits, and measures making it easier to expel migrants whose asylum applications have been refused. France will remain hawkish on immigration, but Macron will be able to rein in the populists. On energy and the environment, Macron may be able to cooperate with the Left on climate measures, but ultimately any cooperation will be constrained by the fact that Mélenchon opposes nuclear power. The Republicans and the National Rally will support Macron’s bid to shore up France’s nuclear energy sector. Popular opinion will hold up for France’s energy security in the face of Russian weaponization of natural gas. Macron and Mélenchon will clash on domestic security. Police violence has emerged as a major source of controversy since the Yellow Vest protests. Macron and the Right will protect the police establishment while the Left will favor reforms, notably the concept of “proximity police,” which would entail police officers patrolling in a small area to create stronger, more personal links between the police and the population; officers being under the control of the mayor and prefect; and ultimately most officers not carrying lethal weapons, and the ban of physically dangerous arrest techniques. Grievances over the police as well as racial inequality will likely erupt into significant social unrest in the coming years. As a second-term president without a single-party majority, Macron will increasingly focus on foreign policy. He will aim to become the premier European leader on the world stage. He will seek to revive France’s historic role as a leading diplomatic power and arbiter of Europe. He will strengthen France’s position in the EU and NATO, keep selling arms to the Middle East, and maintain a French military presence in the Sahel. Macron will favor Ukraine’s membership in the EU but also a ceasefire with Russia. He will face a difficult decision on whether to join Israeli and American military action against Iran should the latter reach nuclear breakout capacity and pursue weaponization. Bottom Line: The outperformance of French equities is stretched relative to EMU counterparts. But France will not underperform until the EU’s natural gas crisis begins to subside and a new equilibrium is established with Russia. Italy GeoRisk Indicator Italy is perhaps the weakest link in Europe both economically and strategically (Chart 5). Elections are due by June 2023 but could come earlier as the ruling coalition is showing strains. A change of government would likely compromise the EU’s attempt to maintain a unified front against Russia over the war in Ukraine. Chart 5Italy: GeoRisk Indicator Before the war Italy received 40% of its natural gas from Russia and maintained pragmatic relations with the Putin administration. Now Russia is reducing flows to Italy by 50%, forcing the country into an energy crisis at a time when expected GDP growth had already been downgraded to 2.3% this year and 1.7% in 2023. Meanwhile Italian sovereign bond spreads over German bunds have risen by 64 basis points YTD as a result of the global inflation. The national unity coalition under Prime Minister Mario Draghi came together for two purposes. First, to distribute the EU’s pandemic recovery funds across the country, which amounted to 191.5 billion euros in grants and cheap loans for Italy, 27% of the EU’s total recovery fund and 12% of Italy’s GDP. Second, to elect an establishment politician in the Italian presidency to constrain future populist governments (i.e. re-electing President Sergio Mattarella). Now about 13% of the recovery funds have been distributed in 2021, the economy is slowing, Russia is cutting off energy, and elections are looming. The coalition is no longer stable. Coalition members will jockey for better positioning and pursue their separate interests. The anti-establishment Five Star Movement has already split, with leader Luigi di Maio walking out. Five Star’s popular support has fallen to 12%. The most popular party in the country is now the right-wing, anti-establishment Brothers of Italy, who receive 23% support in polling. Matteo Salvini, leader of the League, another right-wing populist party, has seen its public support fall to 15% and will be looking for opportunities. On the whole, far-right parties command 38% of popular voting intentions, while far-left parties command 17% and centrist parties command 39%. Italy’s elections will favor anti-incumbent parties, especially if the country falls into recession. These parties will be more pragmatic toward Russia and less inclined to expand the EU’s stringent sanctions regime. Implementing a ban on Russian natural gas by 2027 will become more difficult if Italy switches. Italy will be more inclined to push for a ceasefire. A substantial move toward ceasefire will improve investor sentiment, although, again, a durable new strategic equilibrium cannot be established until the US and Russia come to an understanding regarding Finland, Sweden, and NATO enlargement. Bottom Line: Investors should steer clear of Italian government debt and equities until after the next election. Spain GeoRisk Indicator Infighting and power struggles within the People’s Party (PP) have provided temporary relief for the ruling Socialist Worker’s Party (PSOE) and Spanish Prime Minister Pedro Sanchez. However, with Alberto Nunez Feijoo elected as the new leader of PP on April 2, the People’s Party quickly recovered from its setback. It not only retook the first place in the general election polling, but also scored a landslide victory in the Andalusia regional election. Andalusia is the most populous autonomous community in Spain, contributing 17% of the seats in the lower house. The Andalusian regional election was a test run for the parties before next year’s general election. Historically, Andalusia was PSOE’s biggest stronghold, but it was ousted by the center-right People’s Party-Citizens coalition in 2018. Since then, the People’s party has consolidated their presence and popularity in Andalusia. The snap election in June, weeks after Feijoo was elected as the new national party leader, expanded PP’s seats in the regional parliament. It now has an absolute majority in the regional parliament while the Socialists suffered its worst defeat. With the sweeping victory in Andalusia, the People’s Party is well positioned for next year’s general election. In addition, the ruling Socialist Worker’s Party continues to suffer from the stagflationary economic condition. In May, Spain recorded the second highest inflation figure in more than 30 years, slightly below its March number. Furthermore, the recent deadly Melilla incident which resulted in dozens of migrants’ death, also caused some minor setbacks within Sanchez’s ruling coalition. His far-left coalition partner joined the opposition parties in condemning Sanchez for being complacent toward the Moroccan police. The pressure is on the Socialists now, and political risk will rise in the coming months, till after the election (Chart 6). Chart 6Spain: GeoRisk Indicator Bottom Line: Domestic political risk will remain elevated in this polarized country, as elections are due by December 2023 and could come sooner. Populism may return if Europe suffers a recession. Russia aims to inflict a recession on the EU which is negative for cyclical markets like Spain, but Spain benefits from Europe’s turn to liquefied natural gas and has little to fear from Russia. Investors should favor Spanish stocks relative to Italian stocks. Turkey GeoRisk Indicator Turkey faces extreme political and economic instability between now and the general election due by June 2023 (Chart 7). Chart 7Turkey: GeoRisk Indicator Almost any country would see the incumbent ruling party thrown from power under Turkey’s conditions. The ruling Justice and Development Party has been in charge since 2002, the country’s economy has suffered over that period, and today inflation is running at 73% while unemployment stands at 11%. However, President Recep Tayyip Erdoğan is doing everything he can with his recently expanded presidential powers to stay in office. He is making amends with the Gulf Arab states and seeking their economic support. He is also warming relations with Israel, as Turkey seeks to diversify away from Russian gas and Israel/Egypt are potential suppliers. He is doubling down on military distractions across the Middle East and North Africa. And he waged a high-stakes negotiation with the West over Finnish and Swedish accession to NATO. Russian aggression poses a threat to Turkish national interests. Turkey ultimately agreed to Finnish and Swedish membership after a show of Erdoğan strong hands in negotiating with the West over their membership, to show his domestic audience that he is one of the big boys ahead of the election. A risk to this view is that Erdoğan stages military operations against Greek-controlled Cyprus. This would initiate a crisis within NATO and put Finnish and Swedish accession on hold for a longer period. Bottom Line: Investors should not attempt to bottom-feed Turkish lira or stocks and should sell any rallies ahead of the election. A decisive election that removes Erdoğan from power is the best case for Turkish assets, while a decisive Erdoğan victory is second best. Worse scenarios include indecisive outcomes, a contested or stolen election, a constitutional breakdown, or a military coup. China GeoRisk Indicator China’s geopolitical risk is falling and relative equity performance is picking up now that the government has begun easing monetary, fiscal, and regulatory policy to try to secure the economic recovery (Chart 8). Chart 8China: GeoRisk Indicator Easing regulation on Big Tech has spurred a rebound in heavily sold Chinese tech shares, while the Politburo will likely signal a pro-growth turn in policy at its July economic meeting. The worst news of the country’s draconian “Covid Zero” policy is largely priced, while positive news regarding domestic vaccines, vaccine imports, or anti-viral drugs could surprise the market. However, none of these policy signals are reliable until Xi Jinping consolidates power at the twentieth national party congress sometime between September and November (likely October). Chinese stimulus could fail to pick up as much as the market hopes and policy signals could reverse or could continue to contradict themselves. After the party congress, we expect the Xi administration to intensify its efforts to stabilize the economy. The economic work conference in December will release a pro-growth communique. The March legislative session will provide more government support for the economy if needed. However, short-term measures to stabilize growth should not be mistaken for a major reacceleration, as China will continue to struggle with debt-deflation as households and corporations deleverage and the economic model transitions to a post-manufacturing model. Bottom Line: A Santa Claus rally in the fourth quarter, and/or a 2023 rally, is likely, both for offshore and onshore equities. But long-term investors, especially westerners, should steer clear of Chinese assets. China’s reversion to autocracy and confrontation with the United States will ultimately result in tariffs and sanctions and geopolitical crises and will keep risk premiums high. Taiwan GeoRisk Indicator Taiwan’s geopolitical risk has spiked as expected due to confrontation with China. Tensions will remain high through the Taiwanese midterm election on November 26, the Chinese party congress, and the US midterm (Chart 9). But China is not ready to stage a full-scale military conflict over Taiwan yet – that risk will grow over in the later 2020s and 2030s, depending on whether the US and China provide each other with adequate security assurances. Chart 9Taiwan: GeoRisk Indicator Still, Taiwan is the epicenter of global geopolitical risk. China insists that it will be unified with the mainland eventually, by force if not persuasion. China’s potential growth is weakening so it is losing the ability to absorb Taiwan through economic attraction over time. Meanwhile the Taiwanese people do not want to be absorbed – they have developed their own identity and prefer the status quo (or independence) over unification. Taiwan does not have a mutual defense treaty with the United States and yet the US and Taiwan are trying to strengthen their economic and military bonds. This situation is both threatening to China and yet not threatening enough to force China to forswear the military option. At some point China could believe it must assert control over Taiwan before the US increases its military commitment. Meanwhile China, the US, Japan, South Korea, and Europe are all adopting policies to promote semiconductor manufacturing at home, and/or outside Taiwan, so that their industries are not over-reliant on Taiwan. That means Taiwan will lose its comparative advantage over time. Bottom Line: Structurally remain underweight Taiwanese equities. Korea GeoRisk Indicator The newly elected President Yoon reaffirmed the strong military tie between Korea and the US, when he hosted President Biden in Seoul in May. Both Presidents expressed interests in expanding cooperation into new areas like semiconductors, economic security, and stability in the Indo-Pacific region. The new administration is also finding ways to improve relations with Japan, which soured in the past few years over the issue of forced labor during the Japanese occupation of Korea. A way forward is yet to be found, but a new public-private council will be launched on July 4 to seek potential solutions before the supreme court ruling in August which could further damage bilateral ties. President Yoon’s various statements throughout the NATO summit in Madrid on wanting a better relationship with Japan and to resolve historical issues showed this administration’s willingness towards a warming of the relations between the two countries, a departure from the previous administration. On the sideline of the NATO summit, Yoon also engaged with European leaders, dealing Korean defense products, semiconductors, and nuclear technologies, with a receptive European audience eager to bolster their defense, secure supply chain, and diversify energy source. North Korea ramped up its missile tests this year as it tends to do during periods of political transitions in South Korea. It is also rumored to be preparing for another nuclear test. Provocations will continue as the North is responding to the hawkish orientation of the Yoon administration. Investors should expect a rise in geopolitical risk in the peninsular, but on a relative basis, due to its strong alliance network, Korean risk will be lower compared to Taiwan (Chart 10). Korea will benefit from a rebound in China in the near term, but in the long-term, it is a secure source of semiconductors and high-tech exports, as Greater China will be mired in long-term geopolitical instability. Chart 10Korea: GeoRisk Indicator Bottom Line: Overweight South Korean equities relative to emerging markets as a play on Chinese stimulus. Overweight Korea versus Taiwan. Australia GeoRisk Indicator Australia’s Labor Party ultimately obtained a one-seat majority in the House of Representatives following the general election in May (77 seats where 76 are needed). It does not have a majority in the Senate, where it falls 13 seats short of the 39 it needs. It will rely on the Green Party (12 seats) and a few stragglers to piece together ad hoc coalitions to pass legislation. Hence Prime Minister Anthony Albanese’s domestic agenda will be heavily constrained. Pragmatic policies to boost the economy are likely but major tax hikes and energy sector overhauls are unlikely (Chart 11). Chart 11Australia: GeoRisk Indicator Fortunately for Albanese, his government is taking power in the wake of the pandemic, inflation, and Chinese slowdown, so that there is a prospect for the macroeconomic context to improve over his term in office. This could give him a tailwind. But for now he is limited. Like President Biden in the US, Albanese can attempt to reduce tensions with China after Xi Jinping consolidates power. But also like Biden, he will not have a basis for broad and durable re-engagement, since China’s regional ambitions threaten Australian national security over the long run. Global commodity supply constraints give Australia leverage over China. Bottom Line: Stay neutral on Australian currency and equities until global and Chinese growth stabilize. Brazil GeoRisk Indicator It would take a bolt of lightning to prevent former President Lula da Silva from winning re-election in Brazil’s October 2 first round election. Lula is more in line with the median voter than sitting President Jair Bolsonaro. Bolsonaro’s term has been marred with external shocks, following on a decade of recession and malaise. Polls may tighten ahead of the election but Lula is heavily favored. While ideologically to the left, Lula is a known quantity to global investors (Chart 12). However, Bolsonaro may attempt to cling to power, straining the constitutional system and various institutions. A military coup is unlikely but incidents of insubordination cannot be ruled out. Once Lula is inaugurated, a market riot may be necessary to discipline his new administration and ensure that his policies do not stray too far into left-wing populism. Chart 12Brazil: GeoRisk Indicator Brazil’s macroeconomic context is less favorable than it was when Lula first ruled. During the 2000s he rode the wave of Chinese industrialization and a global commodity boom. Today China is slipping into a balance sheet recession and the next wave of industrialization has not yet taken off. Brazil’s public debt dynamics discourage a structural overweight on Brazil within emerging markets. At least Brazil is geopolitically secure – far separated from the conflicts marring Russia, East Europe, China, and East Asia. It also has a decade of bad news behind it that is already priced. Bottom Line: Stay neutral Brazilian assets until global and Chinese growth stabilize and the crisis-prone election season is over. South Africa GeoRisk Indicator South Africa’s economy continues to face major headwinds amid persistent structural issues that have yet to be adequately addressed and resolved by policy makers. The latest bout of severe energy supply cuts by the state-run energy producer, Eskom, serve as a reminder to investors that South Africa’s economy is still dealing with a major issue of generating an uninterrupted supply of electricity. Each day that electricity supply is cut to businesses and households, the local economy stalls. Among other macroeconomic issues such as high unemployment and rising inflation, low-income households which are too the median voter, are facing increasing hardships. The political backdrop is geared toward further increases in political risk going forward (Chart 13). Chart 13South Africa: GeoRisk Indicator Fiscal reform and austerity are underway but won’t last long enough to make a material difference in government finances. The 2024 election is not that far out and the ruling political party, the ANC, will look to quell growing economic pressures to shore up voter support and reinforce its voter base. Fiscal austerity will unwind. Meanwhile, the bull market in global metal prices stands to moderate on weakening global growth, which reduces a tailwind for the rand, South African equities relative to other emerging markets, and government coffers, reducing our reasons for slight optimism on South Africa until global growth stabilizes. Bottom Line: Shift to a neutral stance on South Africa until global and Chinese growth stabilize. Canada GeoRisk Indicator Canadian political risk has spiked since the pandemic (Chart 14). Populist politics can grow over time in Canada, especially if the property sector goes bust. However, the country is geopolitically secure and benefits from proximity to the US economy. Chart 14Canada: GeoRisk Indicator Global commodity supply constraints create opportunities for Canada as governments around the world pursue fiscal programs directed at energy security, national defense, and supply chain resilience. Bottom Line: Stay neutral Canadian currency and equities. While Canada benefits from the high oil price and robust US economy, rising interest rates pose a threat to its high-debt model, while US growth faces disappointments due to Europe’s and China’s troubles.     Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Jesse Anak Kuri Associate Editor jesse.kuri@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Alice Brocheux Research Associate alice.brocheux@bcaresearch.com Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar

Executive Summary Brazil: NPL Provisioning Cycles Explain Bank Share Prices Inflation is well above the central bank’s target. To assert their credibility, monetary authorities have no choice but to extend the rate hiking cycle. Drastic monetary tightening has been and will continue to occur in a context where the level of real economic activity is well below the 2013/14 level. The economy is heading into another recession in H2 this year. Such an economic contraction will weigh on banks and other domestic stocks.  Materials stocks are at risk from a relapse in industrial metal prices while Petrobras is at risk from government intervention. Brazilian equity and credit market valuations are no longer attractive relative to their EM peers. The currency is not cheap either. We find value in 10-year government local currency bonds – currently yielding 12.7% – given that the economy is heading into recession and inflation will likely peak. However, we do advise to hedge the currency risk for now. Recommendation Inception Date Return Equities: Overweight Brazil vs. Emerging Markets  2022-02-08 19.6% Sovereign Credit: Overweight Brazil vs. Emerging Markets 2022-02-08 7.2% Local Currency Government Bonds : Overweight Brazil vs. Emerging Markets 2022-02-08 18.9% Long Brazil Small Caps / Short Brazil Overall Stocks 2022-02-08 1.0% Bottom Line: We recommend that investors reduce their exposure to Brazilian risk assets by downgrading their allocation from overweight to neutral on equities, and local and sovereign fixed income within their respective EM portfolios. Feature We upgraded Brazilian financial markets to overweight versus their EM peers on February 8, and since then the nation’s stocks, local bonds as well as sovereign and corporate credit have outperformed their respective EM benchmarks (Chart 1). Presently, we recommend that EM equity and fixed-income dedicated investors scale down their exposure to Brazil to marketweight. The Central Bank Is In “Overkill” Mode Inflation in Brazil continues to surprise to the upside: headline CPI is 12%, core CPI is 9% and trimmed-mean CPI is 9.5%. All are well above the central bank’s (BCB) target band of 3.5%+/-1.5% (Chart 2, top panel). Further, consumer, business and market participants’ inflation expectations continue to inch higher and are well above the central bank’s target (Chart 2, middle and bottom panels). Chart 1Book Profits On Overweighting Brazil Versus EM Chart 2Brazil: Inflation Is Out Of Control Chart 3Brazil: Economic Activity Is Well Below Its 2013 Level In order to assert its credibility, the central bank has no choice but to extend its tightening cycle. The BCB has already hiked the policy rate by 1075 bps to 12.75%. This has been occurring in a context where the level of real economic activity is well below its 2013/14 level (Chart 3). There are also political motives that will influence the BCB’s hawkish stance in the medium term. As we wrote in the February report, the BCB has a political incentive to bring down inflation toward 5% (the upper range of its target), as it must prove that it is capable of achieving its inflation mandate in order to keep its recently granted independence. With ex-president Luiz Inácio Lula da Silva as the preferred presidential candidate in this year’s election, whose party opposes central bank autonomy and would prefer looser monetary policy, the BCB will continue tightening dramatically this year to reach target inflation. That will allow the central bank to cut rates next year when Lula assumes the presidency and, hence, avoid a major conflict with the government. To read our complete analysis on Brazilian politics and its implications for monetary policy, please access our February 8 report. In addition, fiscal policy will remain tight throughout the year, barring a new round of the cash handout program Auxílio Brasil. All in all, the fiscal thrust will be only mildly positive at 1% of GDP. This means that government spending will not offset dramatic monetary tightening. Bottom Line: Severe monetary tightening is occurring during a period in which the economy has not fully recovered. As a result, Brazil is heading into another recession. Recession Ahead Rising borrowing costs (shown inverted in Chart 4) will curtail bank lending. Further, Brazil’s business cycle has already rolled over, and chances are there will be an outright contraction in the second half of this year: The combined credit and fiscal impulse points to a major relapse in economic activity (Chart 5, top panel). Chart 4Monetary Tightening Will Curtail Bank Lending Chart 5Brazil: Prepare For A Recession In H2 2022   Our proxy for the marginal propensity to consume has plunged, meaning that household spending will continue to contract (Chart 5, middle panel). Consistently, the narrow money (M1) impulse will remain depressed as the BCB tightens monetary policy. This heralds a downbeat growth outlook, including shrinking manufacturing output (Chart 5, bottom panel). Another economic contraction does not bode well for Brazilian equities: Banks will become saddled with non-performing loans (NPLs). As they increase NPL provisions, their profitability will take a hit, and so will bank stocks. Chart 6 illustrates bank share prices correlate with loan provision cycles (provisions are shown inverted). Given that financials make up 25% of the Brazil MSCI index, their drawdown will weigh on the overall index. The bear market in share prices of Chinese materials points to a relapse in Brazilian materials stocks (Chart 7). Chart 6Brazil: NPL Provisioning Cycles Explain Bank Share Prices Chart 7Brazilian Materials: Heed The Message From Chinese Materials   Higher state interventionism in Petrobras will spook investors and damage confidence. The oil producer has a policy of raising domestic fuel prices in accordance with international markets. However, this has led and will lead to backlash from both presidential contenders, Jair Bolsonaro and Lula da Silva. Both candidates have argued for more government control of the oil producer and are not shy about placing loyalists at the head of the board and in the energy ministry in a bid to curb fuel prices and with it please the population. This is negative for Petrobras’ share price. While this sort of policy is expected from Lula, markets have been caught by surprise as the current right-wing government is trying to influence the oil producer as well. As we wrote in July of 2021, we expect Bolsonaro to increase his populist tendencies in order to appeal to poorer households and take support away from Lula’s traditional voter base. Valuations Chart 8Brazilian Equities Have A Neutral Valuation Relative To EM Brazilian financial markets are not undervalued anymore relative to their EM peers: Equities: The cyclically-adjusted P/E ratio for Brazil relative to Emerging Markets is now at a neutral valuation (Chart 8). Currency: The Brazilian real has been a stellar performer this year, to the point that the currency is no longer inexpensive (Chart 9). Investor positioning is presently a risk to the BRL. The aggregate position of leveraged funds and asset managers is now long as of May 10 (Chart 10). Chart 9The BRL Is No Longer Cheap Chart 10Investor Positioning On The BRL Is Net Long     Anecdotal evidence also suggests that Brazilian businesses have been using the rebound in the real to hedge their foreign currency risks. Large corporations have begun purchasing back their foreign currency bonds in anticipation of currency weakness. Further, according to Anbima, the country’s financial markets association, corporate bond sales outside of Brazil have halved compared to 1Q 2021.   We recommended a long BRL/short ZAR trade on February 8 and took a 7.4% profit on April 13. Chart 11Core Inflation Will Drop In H2 2022 Local Rates: Currency weakness risks will weigh on domestic bonds. The relative total return in USD terms of Brazilian domestic bonds versus the EM GBI index has rolled over at its previous high. That said, we find value in 10-year government domestic (local currency) bonds – currently yielding 12.7% – given that the economy is heading into recession and inflation will likely peak (Chart 11). However, we do recommend that investors hedge the currency risk for now. Sovereign and corporate credit: In terms of sovereign and corporate credit (USD bonds), Brazil has outperformed its EM benchmarks substantially in recent months. A pause in outperformance or a relapse is overdue on the back of the recession and exchange rate risks. Investment Recommendations We recommend that investors reduce their exposure to Brazilian risk assets by downgrading their allocation from overweight to neutral on equities and local and sovereign fixed income within their respective EM portfolios. We are also closing our long small caps / short the overall index trade. This trade has produced only a 1% gain since initiation on February 8 this year. Juan Egaña Associate Editor juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes

Executive Summary Macron Still Favored, But Le Pen Cannot Be Ruled Out Macron is still favored to win the French election but Le Pen’s odds are 45%. Le Pen would halt France’s neoliberal structural reforms, paralyze EU policymaking, and help Russia’s leverage in Ukraine. But she would lack legislative support and would not fatally wound the EU or NATO. European political risk will remain high in Germany, Italy, and Spain. Favor UK equities on a relative basis. Financial markets are complacent about Russian geopolitical risk again. Steer clear of eastern European assets. Do not bottom feed in Chinese stocks. China faces social unrest. North Korean geopolitical risk is back. Australia’s election is an opportunity, not a risk. Stay bullish on Latin America. Prefer Brazil over India. Stay negative on Turkey and Pakistan.   Trade Recommendation Inception Date Return TACTICALLY LONG US 10-YEAR TREASURY 2022-04-14   Bottom Line: Go long the US 10-year Treasury on geopolitical risk and near-term peak in inflation. Feature Last year we declared that European political risk had reached a bottom and had nowhere to go but up. Great power rivalry with Russia primarily drove this view but we also argued that our structural theme of populism and nationalism would feed into it. Related Report  Geopolitical StrategyThe Geopolitical Consequences Of The Ukraine War In other words, the triumph of the center-left political establishment in the aftermath of Covid-19 would be temporary. The narrow French presidential race highlights this trend. President Emmanuel Macron is still favored but Marine Le Pen, his far-right, anti-establishment opponent, could pull off an upset victory on April 24. The one thing investors can be sure of is that France’s ability to pursue neoliberal structural reforms will be limited even if Macron wins, since he will lack the mandate he received in 2017. Our GeoRisk Indicators this month suggest that global political trends are feeding into today’s stagflationary macroeconomic context. Market Complacent About Russia Again Global financial markets are becoming complacent about European security once again. Markets have begun to price a slightly lower geopolitical risk for Russia after it withdrew military forces from around Kyiv in an open admission that it failed to overthrow the government. However, western sanctions are rising, not falling, and Russia’s retreat from Kyiv means it will need to be more aggressive in the south and east (Chart 1). Chart 1Russia: GeoRisk Indicator Russia has not achieved its core aim of a militarily neutral Ukraine – so it will escalate the military effort to achieve its aim. Any military failure in the east and south would humiliate the Putin regime and make it more unpredictable and dangerous. The West has doubled down on providing Ukraine with arms and hitting Russia with sanctions (e.g. imposing a ban on Russian coal). Germany prevented an overnight ban on Russian oil and natural gas imports but the EU is diversifying away from Russian energy rapidly. Sanctions that eat away at Russia’s export revenues will force it to take a more aggressive posture now, to achieve a favorable ceasefire before funding runs out. Sweden and Finland are reviewing whether to join NATO, with recommendations due by June. Russia will rattle sabers to underscore its red line against NATO enlargement and will continue to threaten “serious military-political repercussions” if these states try to join. We would guess they would remain neutral as a decision to join NATO could lead to a larger war. Bottom Line: Global equities will remain volatile due to a second phase of the war and potential Russian threats against Ukraine’s backers. European equities and currency, especially in emerging Europe, will suffer a persistent risk premium until a ceasefire is concluded. What If Le Pen Wins In France? By contrast with the war in Ukraine, the French election is a short-term source of political risk. A surprise Le Pen victory would shake up the European political establishment but investors should bear in mind that it would not revolutionize the continent or the world, as Le Pen’s powers would be limited. Unlike President Trump in 2017, she would not take office with her party gaining full control of the legislature. Le Pen rallied into the first round of the election on April 10, garnering 23% of the vote, up from 21% in 2017. This is not a huge increase in support but her odds of winning this time are much better than in 2017 because the country has suffered a series of material shocks to its stability. Voters are less enthusiastic about President Macron and his centrist political platform. Macron, the favorite of the political establishment, received 28% of the first-round vote, up from 24% in 2017. Thus he cannot be said to have disappointed expectations, though he is vulnerable. The euro remains weak against the dollar and unlikely to rally until Russian geopolitical risk and French political risk are decided. The market is not fully pricing French risk as things stand (Chart 2). Chart 2France: GeoRisk Indicator The first-round election results show mixed trends. The political establishment suffered but so did the right-wing parties (Table 1). The main explanation is that left-wing, anti-establishment candidate Jean-Luc Mélenchon beat expectations while the center-right Republicans collapsed. Macron is leading Le Pen by only five percentage points in the second-round opinion polling as we go to press (Chart 3). Macron has maintained this gap throughout the race so far and both candidates are very well known to voters. But Le Pen demonstrated significant momentum in the first round and momentum should never be underestimated. Table 1Results Of France’s First-Round Election​​​​​​ Chart 3French Election: Macron Maintains Lead​​​​​​ Are the polls accurate? Anti-establishment candidates outperformed their polling by 7 percentage points in the first round. Macron, the right-wing candidates, and the pro-establishment candidates all underperformed their March and April polls (Chart 4). Hence investors should expect polls to underrate Le Pen in the second round. Chart 4French Polls Fairly Accurate Versus First-Round Results Given the above points, it is critical to determine which candidate will gather the most support from voters whose first preference got knocked out in the first round. The strength of anti-establishment feeling means that the incumbent is vulnerable while ideological camps may not be as predictable as usual. Mélenchon has asked his voters not to give a single vote to Le Pen but he has not endorsed Macron. About 21% of his supporters say they will vote for Le Pen. Only a little more of them said they would vote for Macron, at 27% (Chart 5). Chart 5To Whom Will Voters Drift? Diagram 1, courtesy of our European Investment Strategy, illustrates that Macron is favored in both scenarios but Le Pen comes within striking distance under certain conservative assumptions about vote switching. Diagram 1Extrapolating France’s First-Round Election To The Second Round Macron’s approval rating has improved since the pandemic. This is unlike the situation in other liberal democracies (Chart 6). Chart 6Macron Handled Pandemic Reasonably Well The pandemic is fading and the economy reviving. Unemployment has fallen from 8.9% to 7.4% over the course of the pandemic. Real wage growth, at 5.8%, is higher than the 3.3% that prevailed when Macron took office in 2017 (Chart 7). Chart 7Real Wages A Boon For Macron But these positives do not rule out a Le Pen surprise. The nation has suffered not one but a series of historic shocks – the pandemic, inflation, and the war in Ukraine. Inflation is rising at 5.1%, pushing the “Misery Index” (inflation plus unemployment) to 12%, higher than when Macron took office, even if lower than the EU average (Chart 8). Chart 8Misery Index The Key Threat To Macron   Le Pen has moderated her populist message and rebranded her party in recent years to better align with the median French voter. She claims that she will not pursue a withdrawal from the European Union or the Euro Area currency union. This puts her on the right side of the one issue that disqualified her from the presidency in the past. Yet French trust in the EU is declining markedly, which suggests that Le Pen is in step with the median voter on wanting greater French autonomy (Chart 9). Le Pen’s well-known sympathy toward Vladimir Putin and Russia is a liability in the context of Russian aggression in Ukraine. Only 35% of French people had a positive opinion of Russia back in 2019, whereas 50% had a favorable view of NATO, and the gap has likely grown as a result of the invasion (Chart 10). However, the historic bout of inflation suggests that economic policy could be the most salient issue for voters rather than foreign policy. Chart 9Le Pen Only Electable Because She Accepted Europe​​​​​ Chart 10Le Pen’s NATO Stance Not Disqualifying ​​​​​ Le Pen’s economic platform is fiscally liberal and protectionist, which will appeal to voters upset over the rising cost of living and pressures of globalization. She wants to cut the income tax and value-added tax, while reversing Macron’s attempt at raising the retirement age and reforming the pension system. France’s tax rates on income, and on gasoline and diesel, are higher than the OECD average. In other words, Macron is running on painful structural reform while Le Pen is running on fiscal largesse. This is another reason to take seriously the risk of a Le Pen victory. What should investors expect if Le Pen pulls off an upset? France’s attempt at neoliberal structural reforms would grind to a halt. While Le Pen may not be able to pass domestic legislation, she would be able to halt the implementation of Macron’s reforms. Productivity and the fiscal outlook would suffer. Le Pen’s ability to change domestic policy will be limited by the National Assembly, which is due for elections from June 12-19. Her party, the National Rally (formerly the Front National), has never won more than 20% of local elections and performed poorly in the 2017 legislative vote. Investors should wait to see the results of the legislative election before drawing any conclusions about Le Pen’s ability to change domestic policy. France’s foreign policy would diverge from Europe’s. If Le Pen takes the presidency, she will put France at odds with Brussels, Berlin, and Washington, in much the same way that President Trump did. She would paralyze European policymaking. Yet Le Pen alone cannot take France out of the EU. The French public’s negative view of the EU is not the same as a majority desire to leave the bloc – and support for the euro currency stands at 69%. Le Pen does not have the support for “Frexit,” French exit from the EU. Moreover European states face immense pressures to work together in the context of global Great Power Rivalry. Independently they are small compared to the US, Russia, and China. Hence the EU will continue to consolidate as a geopolitical entity over the long run. Russia, however, would benefit from Le Pen’s presidency in the context of Ukraine ceasefire talks. EU sanctions efforts would freeze in place. Le Pen could try to take France out of NATO, though she would face extreme opposition from the military and political establishment. If she succeeded on her own executive authority, the result would be a division among NATO’s ranks in the face of Russia. This cannot be ruled out: if the US and Russia are fighting a new Cold War, then it is not unfathomable that France would revert to its Cold War posture of strategic independence. However, while France withdrew from NATO’s integrated military command from 1966-2009, it never withdrew fully from the alliance and was always still implicated in mutual defense. In today’s context, NATO’s deterrent capability would not be much diminished but Le Pen’s administration would be isolated. Russia would be unable to give any material support to France’s economy or national defense. Bottom Line: Macron is still favored for re-election but investors should upgrade Le Pen’s chances to a subjective 45%. If she wins, the euro will suffer a temporary pullback and French government bond spreads will widen over German bunds. The medium-term view on French equities and bonds will depend on her political capability, which depends on the outcome of the legislative election from June 12-19. She will likely be stymied at home and only capable of tinkering with foreign policy. But if she has legislative support, her agenda is fiscally stimulative and would produce a short-term sugar high for French corporate earnings. However, it would be negative for long-term productivity. UK, Italy, Spain: Who Else Faces Populism? Chart 11Rest Of Europe: GeoRisk Indicators Between Russian geopolitical risk and French political risk, other European countries are likely to see their own geopolitical risk premium rise (Chart 11). But these countries have their own domestic political dynamics that contribute to the reemergence of European political risk. Germany’s domestic political risk is relatively low but it faces continued geopolitical risk in the form of Russia tensions, China’s faltering economy, and potentially French populism (Chart 11, top panel). In Italy, the national unity coalition that took shape under Prime Minister Mario Draghi was an expedient undertaken in the face of the pandemic. As the pandemic fades, a backlash will take shape among the large group of voters who oppose the EU and Italian political establishment. The Italian establishment has distributed the EU recovery funds and secured the Italian presidency as a check on future populist governments. But it may not be able to do more than that before the next general election in June 2023, which means that populism will reemerge and increase the political risk premium in Italian assets going forward (Chart 11, second panel). Spain is still a “divided nation” susceptible to a rise in political risk ahead of the general election due by December 10, 2023. However, the conservative People’s Party, the chief opposition party, has suffered from renewed infighting, which gives temporary relief to the ruling Socialist Worker’s Party of Prime Minister Pedro Sanchez. The Russia-Ukraine issue caused some minor divisions within the government but they are not yet leading to any major political crisis, as nationwide pro-Ukraine sentiment is largely unified. The Andalusia regional election, which is expected this November, will be a check point for the People’s Party’s new leadership and a test run for next year’s general election. Andalusia is the most populous autonomous community in Spain, consisting about 17% of the seats in the congress (the lower house). The risk for Sanchez and the Socialists is that the opposition has a strong popular base and this fact combined with the stagflationary backdrop will keep political polarization high and undermine the government’s staying power (Chart 11, third panel). While Prime Minister Boris Johnson has survived the scandal over attending social events during Covid lockdowns, as we expected, nevertheless the Labour Party is starting to make a comeback that will gain momentum ahead of the 2024 general election. Labour is unlikely to embrace fiscal austerity or attempt to reverse Brexit anytime soon. Hence the UK’s inflationary backdrop will persist (Chart 11, fourth panel). Bottom Line: European political risk has bottomed and will rise in the coming months and years, although the EU and Eurozone will survive. We still favor UK equities over developed market equities (excluding the US) because they are heavily tilted toward consumer staples and energy sectors. Stay long GBP-CZK. Favor European defense stocks over tech. Prefer Spanish stocks over Italian. China: Social Unrest More Likely China’s historic confluence of internal and external risks continues – and hence it is too soon for global investors to try to bottom-feed on Chinese investable equities (Chart 12). A tactical opportunity might emerge for non-US investors in 2023 but now is not the right time to buy. Chart 12China: GeoRisk Indicator In domestic politics, the reversion to autocracy under Xi is exacerbating the economic slowdown. True, Beijing is stimulating the economy by means of its traditional monetary and fiscal tools. The latest data show that the total social financing impulse is reviving, primarily on the back of local government bonds (Chart 13). Yet overall social financing is weaker because private sector sentiment remains downbeat. The government is pursuing excessively stringent social restrictions in the face of the pandemic. Beijing is doubling down on “Covid Zero” policy by locking down massive cities such as Shanghai. The restrictions will fail to prevent the virus from spreading. They are likely to engender social unrest, which we flagged as our top “Black Swan” risk this year and is looking more likely. Lockdowns will also obstruct production and global supply chains, pushing up global goods inflation. Meanwhile the property sector continues to slump on the back of weak domestic demand, large debt levels, excess capacity, regulatory scrutiny, and negative sentiment. Consumer borrowing appetite and general animal spirits are weak in the face of the pandemic and repressive political environment (Chart 14). Chart 13China's Stimulus Has Clearly Arrived​​​​​​ Chart 14Yet Chinese Animal Spirits Still Suffering​​​​​​ Hence China will be exporting slow growth and inflation – stagflation – to the rest of the world until after the party congress. At that point President Xi will feel politically secure enough to “let 100 flowers bloom” and try to improve economic sentiment at home and abroad. This will be a temporary phenomenon (as were the original 100 flowers under Chairman Mao) but it will be notable for 2023. In foreign politics, Russia’s attack on Ukraine has accelerated the process of Russo-Chinese alliance formation. This partnership will hasten US containment strategy toward China and impose a much faster economic transition on China as it pursues self-sufficiency. The result will be a revival of US-China tensions. The implications are negative for the rest of Asia Pacific: Taiwanese geopolitical risk will continue rising for reasons we have outlined in previous reports. In addition, Taiwanese equities are finally starting to fall off from the pandemic-induced semiconductor rally (Chart 15). The US and others are also pursuing semiconductor supply security, which will reduce Taiwan’s comparative advantage. Chart 15Taiwan: GeoRisk Indicator South Korea faces paralysis and rising tensions with North Korea. The presidential election on May 9 brought the conservatives back into the Blue House. The conservative People Power Party’s candidate, Yoon Suk-yeol, eked out a narrow victory that leaves him without much political capital. His hands are also tied by the National Assembly, at least for the next two years. He will attempt to reorient South Korean foreign policy toward the US alliance and away from China. He will walk away from the “Moonshine” policy of engagement with North Korea, which yielded no fruit over the past five years. North Korea has responded by threatening a nuclear missile test, restarting intercontinental ballistic missile tests for the first time since 2017, and adopting a more aggressive nuclear deterrence policy in which any South Korean attack will ostensibly be punished by a massive nuclear strike. Tensions on the peninsula are set to rise (Chart 16). Three US aircraft carrier groups are around Japan today, despite the war in Europe (where two are placed), suggesting high threat levels. Chart 16South Korea: GeoRisk Indicator Australia’s elections present opportunity rather than risk. Prime Minister Scott Morrison formally scheduled them for May 21. The Australian Labor Party is leading in public opinion and will perform well. The election threatens a change of parties but not a drastic change in national policy – populist parties are weak. No major improvement in China relations should be expected. Any temporary improvement, as with the Biden administration, will be subject to reversal due to China’s long-term challenge to the liberal international order. Cyclically the Australian dollar and equities stand to benefit from the global commodity upcycle as well as relative geopolitical security due to American security guarantees (Chart 17). Chart 17Australia: GeoRisk Indicator Bottom Line: China’s reversion to autocracy will keep global sentiment negative on Chinese equities until 2023 at earliest. Stay short the renminbi and Taiwanese dollar. Favor the Japanese yen over the Korean won. Favor South Korean over Taiwanese equities. Look favorably on the Australian dollar. Turkey, South Africa, And … Canada Turkish geopolitical risk will remain elevated in the context of a rampant Russia, NATO’s revival and tensions with Russia, the threat of commerce destruction and accidents in the Black Sea region, domestic economic mismanagement, foreign military adventures, and the threat posed to the aging Erdogan regime by the political opposition in the wake of the pandemic and the lead-up to the 2023 elections (Chart 18). Chart 18Turkey: GeoRisk Indicator While we are tactically bullish on South African equities and currency, we expect South African political risk to rise steadily into the 2024 general election. Almost a year has passed since the civil unrest episode of 2021. Covid-19 lockdowns have been lifted and the national state of disaster has ended, which has helped quell social tensions. This is evident in the decline of our South Africa GeoRisk indicator from 2021 highs (Chart 19). While fiscal austerity is under way in South Africa, we have argued that fiscal policy will reverse course in time for the 2024 election. In this year’s fiscal budget, the budget deficit is projected to narrow from -6% to -4.2% over the next two years. Government has increased tax revenue collection through structural reforms that are rooting out corruption and wasteful expenditure. But the ANC will have to tap into government spending to shore up lost support come 2024. Thus South Africa benefits tactically from commodity prices but cyclically the currency is vulnerable. Chart 19South Africa: GeoRisk Indicator Canadian political risk will rise but that should not deter investors from favoring Canadian assets that are not exposed to the property bubble. Prime Minister Justin Trudeau has had a net negative approval rating since early 2021 and his government is losing political capital due to inflation, social unrest, and rising difficulties with housing affordability (Chart 20). While he does not face an election until 2025, the Conservative Party is developing more effective messaging. Chart 20Canada: GeoRisk Indicator India Will Stay Neutral But Lean Toward The West Chart 21Sino-Pak Alliance’s Geopolitical Power Is Thrice That Of India US President Joe Biden has openly expressed his administration’s displeasure regarding India’s response to Russia’s invasion of Ukraine. This has led many to question the strength of Indo-US relations and the direction of India’s geopolitical alignments. To complicate matters, China’s overtures towards India have turned positive lately, leading clients to ask if a realignment in Indo-China relations is nigh. To accurately assess India’s long-term geopolitical propensities, it is important to draw a distinction between ‘cyclical’ and ‘structural’ dynamics that are at play today. Such a distinction yields crystal-clear answers about India’s strategic geopolitical leanings. In specific: Indo-US Relations Will Strengthen On A Strategic Horizon: As the US’s and China’s grand strategies collide, minor and major geopolitical earthquakes are bound to take place in South Asia and the Indo-Pacific. Against this backdrop, India will strategically align with the US to strengthen its hand in the region (Chart 21). While the Russo-Ukrainian war is a major global geopolitical event, for India this is a side-show at best. True, India will retain aspects of its historic good relations with Russia. Yet countering China’s encirclement of India is a far more fundamental concern for India. Since Russia has broken with Europe, and China cannot reject Russia’s alliance, India will gradually align with the US and its allies. India And China Will End Up As A Conflicting Dyad: Strategic conflict between the two Asian powers is likely because China’s naval development and its Eurasian strategy threaten India’s national security and geopolitical imperatives, while India’s alliances are adding to China’s distrust of India. Thus any improvement in Sino-Indian diplomatic relations will be short-lived. The US will constantly provide leeway for India in its attempts to court India as a key player in the containment strategy against China. The US and its allies are the premier maritime powers and upholders of the liberal world order – India serves its national interest better by joining them rather than joining China in a risky attempt to confront the US navy and revolutionize the world order. Indo-Russian Relations Are Bound To Fade In The Long Run: India will lean towards the US over the next few years for reasons of security and economics. But India’s movement into America’s sphere of influence will be slow – and that is by design. India is testing waters with America through networks like the Quadrilateral Dialogue. It sees its historic relationship with Russia as a matter of necessity in the short run and a useful diversification strategy in the long run. True, India will maintain a trading relationship with Russia for defense goods and cheap oil. But this trade will be transactional and is not reason enough for India to join Russia and China in opposing US global leadership. While these factors will mean that Indo-Russian relations are amicable over a cyclical horizon, this relationship is bound to fade over a strategic horizon as China and Russia grow closer and the US pursues its grand strategy of countering China and Russia. Bottom Line: India may appear to be neutral about the Russo-Ukrainian war but India will shed its historical stance of neutrality and veer towards America’s sphere of influence on a strategic timeframe. India is fully aware of its strategic importance to both the American camp and the Russo-Chinese camp. It thus has the luxury of making its leanings explicit after extracting most from both sides. Long Brazil / Short India Brazil’s equity markets have been on a tear. MSCI Brazil has outperformed MSCI EM by 49% in 2022 YTD. Brazil’s markets have done well because Brazil is a commodity exporter and the war in Ukraine has little bearing on faraway Latin America. This rally will have legs although Brazil’s political risks will likely pick back up in advance of the election (Chart 22). The reduction in Brazil’s geopolitical risk so far this year has been driven mainly by the fact that the currency has bounced on the surge in commodity prices. In addition, former President Lula da Silva is the current favorite to win the 2022 presidential elections – Lula is a known quantity and not repugnant to global financial institutions (Chart 23). Chart 22Brazil's Markets Have Benefitted From Rising Commodity Prices Chart 23Brazil: Watch Out For Political Impact Of Commodity Prices Whilst there is no denying that the first-round effects of the Ukraine war have been positive for Brazil, there is a need to watch out for the second-round effects of the war as Latin America’s largest economy heads towards elections. Surging prices will affect two key constituencies in Brazil: consumers and farmers. Consumer price inflation in Brazil has been ascendant and adding to Brazil’s median voter’s economic miseries. Rising inflation will thus undermine President Jair Bolsonaro’s re-election prospects further. The fact that energy prices are a potent polling issue is evinced by the fact that Bolsonaro recently sacked the chief executive of Petrobras (i.e. Brazil’s largest listed company) over rising fuel costs. Furthermore, Brazil is a leading exporter of farm produce and hence also a large importer of fertilizers. Fertilizer prices have surged since the war broke out. This is problematic for Brazil since Russia and Belarus account for a lion’s share of Brazil’s fertilizer imports. Much like inflation in general, the surge in fertilizer prices will affect the elections because some of the regions that support Bolsonaro also happen to be regions whose reliance on agriculture is meaningful (Map 1). They will suffer from higher input prices. Map 1States That Supported Bolso, Could Be Affected By Fertilizer Price Surge Chart 24Long Brazil Financials / Short India Given that Bolsonaro continues to lag Lula on popularity ratings – and given the adverse effect that higher commodity prices will have on Brazil’s voters – we expect Bolsonaro to resort to fiscal populism or attacks on Brazil’s institutions in a last-ditch effort to cling to power. He could even be emboldened by the fact that Sérgio Moro, the former judge and corruption fighter, decided to pull out of the presidential race. This could provide a fillip to Bolso’s popularity. Bottom Line: Brazil currently offers a buying opportunity owing to attractive valuations and high commodity prices. But investors should stay wary of latent political risks in Brazil, which could manifest themselves as presidential elections draw closer. We urge investors to take-on only selective tactical exposure in Brazil for now. Equities appear cheap but political and macro risks abound. To play the rally yet stave off political risk, we suggest a tactical pair trade: Long Brazil Financials / Short India (Chart 24). Whilst we remain constructive on India on a strategic horizon, for the next 12 months we worry about near-term macro and geopolitical headwinds as well as India’s rich valuations. Don’t Buy Into Pakistan’s Government Change Chart 25Pakistan’s Military Is Unusually Influential The newest phase in Pakistan’s endless cycle of political instability has begun. Prime Minister Imran Khan has been ousted. A new coalition government and a new prime minister, Shehbaz Sharif, have assumed power. Prime Minister Sharif’s appointment may make it appear like risks imposed by Pakistan have abated. After all, Sharif is seen as a good administrator and has signaled an interest in mending ties with India. But despite the appearance of a regime change, geopolitical risks imposed by Pakistan remain intact for three sets of reasons: Military Is Still In Charge: Pakistan’s military has been and remains the primary power center in the country (Chart 25). Former Prime Minister Khan’s rise to power was possible owing to the military’s support and he fell for the same reason. Since the military influences the civil administration as well as foreign policy, a lasting improvement in Indo-Pak relations is highly unlikely. Risk Of “Rally Round The Flag” Diversion: General elections are due in Pakistan by October 2023. Sharif is acutely aware of the stiff competition he will face at these elections. His competitors exist outside as well as inside his government. One such contender is Bilawal Bhutto-Zardari of the Pakistan People’s Party (PPP), which is a key coalition partner of the new government that assumed power. Imran Khan himself is still popular and will plot to return to power. Against such a backdrop the newly elected PM is highly unlikely to pursue an improvement in Indo-Pak relations. Such a strategy will adversely affect his popularity and may also upset the military. Hence we highlight the risk of the February 2021 Indo-Pak ceasefire being violated in the run up to Pakistan’s general elections. India’s government has no reason to prevent tensions, given its own political calculations and the benefits of nationalism. Internal Social Instability Poor: Pakistan is young but the country can be likened to a social tinderbox. Many poor youths, a weak economy, and inadequate political valves to release social tensions make for an explosive combination. Pakistan remains a source of geopolitical risk for the South Asian region. Some clients have inquired as to whether the change of government in Pakistan implies closer relations with the United States. The US has less need for Pakistan now that it has withdrawn from Afghanistan. It is focused on countering Russia and China. As such the US has great need of courting India and less need of courting Pakistan. Pakistan will remain China’s ally and will struggle to retain significant US assistance. Bottom Line: We remain strategic sellers of Pakistani equities. Pakistan must contend with high internal social instability, a weak democracy, a weak economy and an unusually influential military. As long as the military remains excessively influential in Pakistan, its foreign policy stance towards India will stay hostile. Yet the military will remain influential because Pakistan exists in a permanent geopolitical competition with India. And until Pakistan’s economy improves structurally and endemically, its alliance with China will stay strong. Investment Takeaways Cyclically go long US 10-year Treasuries. Geopolitical risks are historically high and rising but complacency is returning to markets. Meanwhile inflation is nearing a cyclical peak. Favor US stocks over global. It is too soon to go long euro or European assets, especially emerging Europe. Favor UK equities over developed markets (excluding the US). Stay long GBP-CZK. Favor European defense stocks over European tech. Stay short the Chinese renminbi and Taiwanese dollar. Favor the Japanese yen over the Korean won. Favor South Korean over Taiwanese equities.   Matt Gertken Chief Geopolitical Strategist mattg@bcaresearch.com Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com Jesse Anak Kuri Associate Editor Jesse.Kuri@bcaresearch.com Yushu Ma Research Analyst yushu.ma@bcaresearch.com Guy Russell Senior Analyst GuyR@bcaresearch.com Alice Brocheux Research Associate alice.brocheux@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Regional Geopolitical Risk Matrix Section III: Geopolitical Calendar

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

Special Report

Executive Summary Brazil: Are Political & Macro Risks Priced-In? Presidential elections are due in Brazil on October 2, 2022. While the left-of-center former President Lula da Silva will likely win, the road to his victory will not be as smooth as markets expect. Incumbent President Jair Bolsonaro will make every effort to cling to power, including fiscal populism and attacks on Brazil’s institutions. These moves may roil Brazil’s equity markets as they may provide a fillip to Bolsonaro’s popularity. Bolsonaro’s institutional attacks have triggered down moves in the market before and any fiscal expansion may worry investors as it could prove to be sticky. We urge investors to take-on only selective tactical exposure in Brazil. Equities appear cheap but political and macro risks abound. To play the rally yet stave-off political risk in Brazil, we suggest a tactical pair trade: Long Brazil Financials / Short India. Tactical Recommendation Inception Date Long Brazil Financials / Short India 2022-02-10   Bottom Line: On a tactical timeframe we suggest only selective exposure to Brazil given the latent political and macro risks. On a strategic timeframe, we are neutral on Brazil given that its growth potential coexists with high debt and low proclivity to structural reform. Feature Chart 1Brazil Underperformed Through 2020-21, Is Cheap Today Brazil’s equity markets underperformed relative to emerging markets (EMs) for a second consecutive year in 2021 (Chart 1). But thanks to this correction, Brazilian equities now appear cheap (Chart 1). With Brazil looking cheap, China easing policy, and Lula’s return likely, is now a good time to buy into Brazil? We recommend taking on only selective exposure to Brazil on a tactical horizon for now. Brazil in our view may present a near-term value trap as markets are under-pricing political and economic risks. Lula Set For Phoenix-Like Return Luiz Inácio Lula da Silva (or popularly Lula) of the Worker’s Party (PT) appears all set to reclaim the country’s presidency in the fall of 2022. The main risk that Lula’s presidency may bring is a degree of fiscal expansion. Despite this markets may ultimately welcome his victory at the presidential elections as Lula is in alignment with the median voter, is expected to be better for Brazil’s institutions, will institute a superior pandemic-control strategy, and may also undertake badly needed structural reforms in the early part of his tenure. Despite these points we urge investors to limit exposure to Brazil for now and turn bullish only once the market corrects further. Whilst far-right President Jair Bolsonaro managed to join a political party (i.e., the center-right Liberal Party) late last year, he is yet to secure something more central to winning elections i.e., a high degree of popularity. To boost his low popularity ratings (Chart 2), we expect Bolsonaro to leverage two planks: populism and authoritarianism. These measures will bump up Bolsonaro’s popularity enough to shake up Brazil’s markets with renewed uncertainty, but not enough to win him the presidency. Chart 2Lula Is Ahead But His Lead Has Narrowed Lula is a clear favorite to win. After spending more than a year in jail on corruption charges, Lula is back in the fray and has maintained a lead on Bolsonaro for the first round of polling (Chart 2). Even if a second-round run-off election were to take place, Lula would prevail over Bolsonaro or other key candidates (Chart 3). By contrast, Bolsonaro’s lower popularity means that in a run-off situation he stands a chance only if pitted against center-right candidates like Sergio Moro (his former justice minister) or João Doria (i.e., the center-right Governor of São Paulo) (Chart 4). Chart 3Lula Leads Run-Off Vote Against All Potential Candidates​​​​​​ Chart 4In A Run-Off, Bolso Stands Best Chance Of Winning If Pitted Against Moro​​​​​​ What has driven the swing to the left in Brazil? After the pandemic and some stagflation, Brazil’s median voter’s priorities have changed. In specific: Brazil’s median voter’s top concerns in 2018 were centered around improving law and order (Chart 5). A right-of-center candidate with concrete law-and-order credentials like Bolsonaro was well placed to tap into this public demand. Chart 5In 2018-19, Law And Order Issues Dominated Voters’ Concerns Now, however, Brazil’s voters’ top concerns are focused around improving the economy and controlling the pandemic, where Bolsonaro’s record is dismal (Chart 6). Given this change of priorities, a left-of-center candidate with a solid economic record like Lula is best placed to address voters’ concerns. Lula had the fortune to preside over a global commodity bull market and Brazilian economic boom in the early 2000s (Chart 7). Regarding pandemic control, almost any challenger would be better positioned than Bolsonaro, who initially dismissed Covid-19 as “a little flu” and lacked the will or ability to set up a stable public health policy. Chart 6In 2022, Median Voter Cares Most About Economic Issues, Pandemic-Control​​​​​​ Chart 7Lula’s Presidency Overlapped With An Economic Boom ​​​​​​ A left-of-center candidate like Lula, or even Ciro Gomes (Chart 8), is more in step with the median voter today for two key reasons: Inflation Surge, Few Jobs: Inflation has surged, and the increase is higher than that seen under the previous President Michael Temer (Chart 7). Transportation, food, and housing costs have all taken a toll on voter’s pocketbooks (Chart 9). The cost of electricity has also shot up. For 46% of Brazilian families, expenditure on power and natural gas is eating into more than half of their monthly income, according to Ipec. Chart 8Left-Of-Center Candidates Stand A Better Chance In Brazil In 2022​​​​​​ Chart 9Under Bolso Inflation Has Surged Across Key Categories​​​​ Distinct from inflation, unemployment too has been high under Bolsonaro (Chart 10). Chart 10Unemployment Too Has Surged Under Bolsonaro​​​​​​ Chart 11Brazil’s Per Capita Income Growth Has Lagged That Of Peers​​​​​​ Chart 12Since 2018, Brazil's Economic Miseries Have Grown More Than Those Of Peers Stagnant Incomes: Despite a strong post-pandemic fiscal stimulus, GDP growth in Brazil has been low (Chart 7). In a country that is structurally plagued with high inequalities, the slow growth in Brazil’s per capita income (Chart 11) under a right-wing administration is bound to trigger a leftward shift. It is against this backdrop of rising economic miseries (Chart 12) that Latin America’s largest economy is seeing its ideological pendulum swing leftwards. This phenomenon has played out before too - most notably when Lula first assumed power as the president of Brazil in 2002. Brazil’s GDP growth was low, inflation was high and per capita incomes had almost halved under the presidency of Fernando Henrique Cardoso (or popularly FHC) over 1995-2002. This economic backdrop played a key role in Lula’s landslide win in 2002. Brazil’s political differences are rooted in regional as well as socioeconomic disparities. In the 2018 presidential elections, left-of-center candidates like Fernando Haddad generated greatest traction in the economically backward northeastern region of Brazil. On the other hand, Bolsonaro enjoyed higher traction in the relatively well-off regions in southern and northern Brazil (Maps 1 & 2). Now Bolsonaro has faltered under the pandemic and Lula can reunite the dissatisfied parts of the electorate with his northeastern base. Map 1Brazil’s South, Mid-West And North Supported Bolso In 2018 Map 2Left-Of-Center 2018 Presidential Candidate Haddad Had Greatest Traction In Regions With Low Incomes Bottom Line: The stage appears set for Lula’s return to Brazil’s presidency. But will the road be smooth? We think not. Investors should gird for downside risks that Brazilian markets must contend with as President Bolsonaro fights back. Brace For Bolso’s Fightback The road to Bolsonaro’s likely loss will be paved with market volatility and potentially a correction. Interest rates have surged in Brazil as its central bank combats inflation (Chart 13). Even as BCB’s actions will lend some stability to the Brazilian Real (Chart 13), political events over the course of 2022 will spook foreign investors. Bolsonaro will leverage two planks in a desperate attempt to retain control: Plank #1: Populism Brazil’s financial markets experienced a major correction in the second half of 2021. This was partially driven by the fact that Brazilian legislators approved a rule that allows the government to breach its federal spending cap. Given Bolsonaro’s low popularity ratings today and given that his fiscal stance has been restrained off late, Bolsonaro could well drive another bout of fiscal expansion in the run up to October 2022. Such a move will bump up his popularity but at the same time worry markets given Brazil’s elevated debt levels (Chart 14). Bolsonaro can technically pass these changes in the Brazilian national assembly given that in both houses the government along with the confidence and supply parties has more than 50% of seats. Chart 13Brazil’s Central Bank Has Hiked Rates Aggressively​​​​​​ Chart 14Brazil Is One Of The Most Indebted Emerging Markets Today​​​​​​ Plank #2: Institutional Attacks To rally his supporters, the former army captain could also sow seeds of doubt in Brazil’s judiciary and electoral process. Given the strong support that Bolsonaro enjoys amongst conservatives, he may even mobilize supporters to stage acts of political violence in the run up to the elections. Bolsonaro could make more dramatic attempts to stay in power than former US President Trump, whose rebellion on Capitol Hill did not go as far as it could have gone to attempt to seize power for the outgoing president. Last but not the least, there is a possibility that the Brazilian judiciary presents an unexpected roadblock to Lula’s candidacy. Given the unpredictable path of Brazil’s judicial decisions, investors should be prepared for at least some kind of official impediments to Lula’s rise. Even if Lula is ultimately allowed to run, any ruling that casts doubt on his candidacy or corruption-related track record will upset financial markets. Global financial markets rallied through the Trump rebellion on January 6 last year. But US institutions, however flawed, are more stable than Brazil’s. Brazil only emerged from military dictatorship in 1985. Bolsonaro has fired up elements of the populace that are nostalgic for that period, as we discuss below. Bottom Line: Brazil’s equities look cheap today, but political risks have not fully run their course. President Bolsonaro may launch his fightback soon, which could drive another down-leg in Brazil’s markets. His institutional attacks have triggered down moves before and any potential fiscal expansion that Bolsonaro pursues may worry investors, as this expansion could stick under the subsequent administration. In addition, there is a chance that civil-military relations undergo high strain in the run-up to or immediately after Brazil’s elections. Is A Self-Coup By Bolso Possible? “One uncomfortable fact of the dictatorship is that its most brutal period of repression overlapped with what Milton Friedman called an economic miracle.… Brazil’s economy, nineteenth largest in the world before the coup, grew into the eighth largest. Jobs abounded and the regime then was actually popular.” – Alex Cuadros, Brazillionaires: Wealth, Power, Decadence, and Hope in an American Country (Spiegel & Grau, 2016) It is extremely difficult for President Bolsonaro to win the support of a majority of the electorate. But given his open admiration for Brazil’s dictatorship, is a self-coup possible in 2022? The next nine months will be tumultuous. A coup attempt could occur. However, we allocate a low probability to a successful self-coup because: Bolsonaro’s Popularity Is Too Low: Even dictators need to have some popular appeal. Bolsonaro has lost too much support (Chart 15), he never had full control of any major institutions (including the military), and few institutional players will risk their credibility for his sake. If he somehow clung to power, his subsequent administration would face overwhelming popular resistance. Chart 15Bolsonaro’s Low Approval Ratings - A Liability Bolsonaro’s Economy Is Too Weak: The dictatorship in Brazil managed to hold power for more than two decades partially because this period of authoritarianism was accompanied by a degree of economic well-being. Currently the public is shifting to the left because low growth and high inflation have dented the median voter’s purchasing power. The weak economy would make an authoritarian government unsustainable from the start. Lack Of American Support: Some military personnel may be supportive of a coup and several retired military officers are occupying civilian positions in the Brazilian federal government, thanks to Bolsonaro. So why can’t Brazil slip right back into a military dictatorship led by Bolsonaro, say if the election results are narrow and hotly contested? The coup d'état in Brazil in 1964 was a success to a large extent because this regime-change was supported by America. Back then communism was a threat to the US and Washington was keen to displace left-leaning heads of states in Latin America, such as Brazilian President João Goulart. But America’s strategic concerns have now changed. America today is attempting to coalesce an axis of democracies and the Biden administration has no incentive whatsoever to muddy its credentials by supporting dictatorship in Latin America’s largest country. Even aside from ideology, any such action would encourage fearful governments in the region to seek support from America’s foreign rivals, thus inviting the kind of foreign intervention that the US most wants to prevent in Latin America. The Brazilian Military Has Not Been Suppressed Or Sidelined: History suggests that coups are often triggered by a drop in the military’s importance in a country. However, the military’s power in Brazil has remained meaningful through the twenty-first century. Brazil has maintained steady military spends at around 1.5% of GDP over the last two decades. Thus, top leaders of Brazil’s military have no reason to feel aggrieved or disempowered. Having said that, it is not impossible that an extreme faction of junior officers might try to pull off a fantastical plot, even if they have little hope of succeeding, which is why we highlight that markets can be rudely awakened by the road to Brazil’s election this year. In Turkey in July 2016, an unsuccessful coup attempt caused Turkish equities to decline by 9% over a four-day period. Bottom Line: Investors must gird for the very real possibility of civil-military relations undergoing high degrees of strain in Brazil, particularly if a contested election occurs. While Bolsonaro’s supporters and disaffected elements of the Brazilian military could resist a smooth transition of power away from Bolsonaro, the transition will eventually take place because two powerful constituencies – Brazil’s median voter and America – will not support a coup in Brazil. Will Lula Be Good For Brazil’s Markets? Looking over Bolsonaro’s presidency, from a market-perspective, some policy measures were good, some were bad, and some were downright ugly. In specific: The Good: Pension Reforms And Independent Monetary Policy In Bolsonaro’s first year in power, he delivered pension sector reforms. The law increased the minimum retirement age and also increased workers’ pension contributions thereby resulting in meaningful fiscal savings. Bolsonaro passed a law to formalise the BCB’s autonomy and the BCB has been able to pursue a relatively independent monetary policy. BCB has now lifted the benchmark Selic rate by 725bps over 2021 thereby making it one of the most hawkish central banks amongst EMs (Chart 13). This is in sharp contrast to the situation in EMs like Turkey where the central bank cut rates owing to the influence of a populist head of state. The Bad: Poor Free Market Credentials And Fiscal Expansion In early 2021, President Bolsonaro fired the head of Petrobras (the state-owned energy champion) reportedly for raising fuel prices. Bolsonaro then picked a former army general (with no relevant work experience) to head the company. Although Bolsonaro positioned himself as a supporter of privatization in the run up to his presidency, he failed to follow through. Another area where the far-right leader has disappointed markets is with respect to Brazil’s debt levels. Under his presidency, a constitutional amendment to raise a key government spending cap was passed. Shortly afterwards came the creation of the massive welfare program Auxílio Brasil. Bolsonaro embraced fiscal populism to try to save his presidency after the pandemic. Consequently Brazil’s public debt to GDP ratio ballooned from 86% in 2018 to a peak of 99% in 2020. The Ugly: Poor Pandemic Response And Institutional Attacks The darkest hour of Bolsonaro’s presidency came on September 7, 2021, i.e., Brazil’s Independence Day. During rallies with his supporters, Bolsonaro levelled attacks on the Brazilian judiciary and sowed seeds of doubt in Brazil’s electoral process. More concretely, the greatest failing of the Bolsonaro administration has been its lax response to the pandemic. Bolsonaro delayed preventive measures, and this has meant that Brazil was one of the worst hit major economies of the world. The pandemic has claimed more than 630,000 lives in Brazil i.e., the second highest in the world. In relative terms too, Brazil has experienced a high death rate of about 2,960 per million which is even higher than the US rate of 2,720 per million. President Bolsonaro’s poor handling of the pandemic will cost the President in terms of votes in 2022 as the highest Covid-19-related death rates were seen in Southern Brazil (Map 3) i.e., a region that had voted in large numbers for Bolsonaro in 2018 (see Map 1 above). Map 3The Pandemic Has Had A Devastating Impact In Brazil’s South, Mid-West And North Given this backdrop, a Lula presidency will be welcomed by global financial markets, potentially for three reasons: Superior Pandemic-Control: An administration headed by Lula will bring in a more scientific and cohesive pandemic-control strategy thereby saving lives and benefiting the economy. Alignment With Institutions: Lula will act in alignment with Brazil’s institutions. He stands to benefit from the existing electoral system, the civil bureaucracy, academia, and the media. He may have rougher relations with the judiciary and parts of the military, but he is a known quantity and not likely to attempt to be a Hugo Chavez. Possibility Of Some Structural Reform: Given Brazil’s unstable debt dynamics, and the “lost decade” of economic malaise in the 2010s, there is a chance that Lula could pursue some structural reforms. Lula is more popular than his Worker’s Party, which is still tainted by corruption, so his strength in Congress will not be known until after the election. But Brazilian parties tend to coalesce around the president and Lula has experience in managing the legislative process. The probability of Lula pushing through some bit of structural reform will be the greatest in 2021. Back in 2019, it is worth recounting that only 4% of the Brazilian public supported pension reforms. Despite this Bolsonaro managed the passage of painful pension reforms in 2019 because market pressure forced the parties to cooperate. Faced with inflation and low growth, Lula may be forced to push through some piecemeal structural financial sector and economic reforms. However, if commodity prices and financial markets are cheering his election, he may spend his initial political capital on policies closer to his base of support, which means that a market riot may be necessary to force action on structural reforms. This dynamic will have to be monitored in the aftermath of the election. Assuming Lula does pursue some structural reforms while he has the political capital, and therefore that his first year is positive for financial markets, there is a reason to be positive on Brazil selectively on a tactical basis. However, electoral compulsions could cause Lula to pursue left-wing populism, fiscal expansion, and to resist privatization over the remaining three years of his presidency. Given Brazil’s already elevated debt levels (Chart 14), such a policy tilt would be market negative. It is against this backdrop that we expect a pro-Lula market rally to falter after the initial excitement. Bottom Line: Once the power transition is complete, a relief rally may follow as markets factor in the prospects of institutional stability and possibly a dash of structural reform in the first year of Lula’s presidency. But given Brazil’s elevated inequalities, even a pro-Lula rally will eventually fade as the administration will be constrained to switch back to the old ways and pursue an expansionary fiscal policy when elections loom. Investment Conclusions Brazil Presents A Value Trap, Fraught with Politico-Economic Risks From a strategic perspective, we are neutral on Brazil. A decade of bad news has been priced in but there is not yet a clear and sustainable trajectory to improve the country’s productivity. History suggests that both left-wing and right-wing presidents are often forced to backtrack on structural reforms and resort to cash-handouts in the run up to elections. This tends to add to Brazil’s high debt levels, prevents the domestic growth engine from revving up, and adds to inflation. Low growth and high inflation then set the wheels rolling for another bout of fiscal expansion (Chart 16). Chart 16The Vicious Politico-Economic Cycle That Brazil Is Trapped In Exceptions to this politico-economic cycle occur when a commodity boom is underway or if China, which is Brazil’s key client state, is booming. China today buys a third of Brazil’s exports (Chart 17) and is Brazil’s largest export market. The other reason we remain circumspect about Brazil’s strategic prospects is because of the secular slowdown underway in China. China is not in a position today to recreate the commodity and trade boom that buoyed Lula during his first presidency. China’s policy easing is a tactical boon at best, which can coincide with a Lula relief rally, but afterwards investors will be left with Chinese deleveraging and Brazilian populism. Political Risks Are High, Selective Tactical Exposure Brazil Will Be Optimal We urge investors to buy into Brazilian assets only selectively, even as Brazilian equities appear cheap (Chart 18). Political risks and economic risks such as low growth in GDP and earnings (Chart 19) could contribute to another correction and/or volatility in Brazilian equities. Chart 17China Buys A Third Of Brazil’s Exports​​​​​ ​​​​​Chart 18Brazil: Are Political & Macro Risks Priced-In? Chart 19Brazil's EPS Growth Tracks China's Total Social Financing Growth With A Lag China’s policy easing is an important macro factor playing to Brazil’s benefit. As we highlighted in our “China Geopolitical Outlook 2022,” Beijing is focused on ensuring stability over the next 12 months. But history suggests that Brazil’s corporate earnings respond to a pick-up in China’s total social financing with a lag of more than six months (Chart 19). Thus, even from a purely macro perspective it may make sense to turn bullish on Brazil after the election turmoil concludes. Given that politically sensitive sectors account for an unusually high proportion of Brazil’s market capitalization (Chart 18), and given the political risks in the offing for Brazil, we suggest taking-on selective exposure in Brazil. To play the rally yet mitigate political risks (that can be higher for capital-heavy sectors), we suggest a pair trade: Long Brazil Financials / Short India. 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. India currently trades at a 81% premium to MSCI EM on a forward P-E ratio basis versus its two year average of 56%. A Quick Note On The Nascent EM Rally Investors should gradually look more favorably on emerging markets, but tactical caution is warranted. MSCI EM and MSCI World are down YTD 1.1% and 4.6% respectively. Despite the dip, we are not yet turning bullish on EM as a whole, owing to both geopolitical and macroeconomic factors. Global geopolitical risks in the new year are high. We recently upgraded the odds of Russia re-invading Ukraine from 50% to 75%. Besides EM Europe, we also see high and underrated geopolitical risks in the Middle East in the short run. Both the Russia and Iran conflicts raise a non-negligible risk of energy shocks that undermine global growth. Once these hurdles are cleared, we will turn more positive toward risky assets. Macroeconomically, the current EM rally can be sustained only if China delivers a substantial stimulus, and the US dollar continues to weaken. The former is likely, as we have argued, but the dollar looks to be resilient and it will take several months before China’s credit impulse rebounds. Hence conditions for a sustainable EM rally do not yet exist. Ritika Mankar, CFA Editor/Strategist ritika.mankar@bcaresearch.com   Strategic Themes Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months)

Executive Summary Upgrading Brazil Within An EM Equity Portfolio Brazilian risk assets are cheap and will get a positive impetus from the rising odds of ex-president Lula winning this year's election. As we have argued since July 2021, Lula will adopt pragmatic policies that will appeal to both moderate voters and investors.  Even though the economy is heading into a recession and corporate profits will likely contract in the coming 12 months, we are upgrading our allocation to Brazilian equities and domestic bonds from underweight to overweight relative to their respective EM benchmarks. Structurally, however, the new government will be unable to prevent the public debt-to-GDP ratio from rising. In the long run, odds are that Lula’s government will attempt to “inflate its way out of debt.” Hence, our long-term strategy on Brazil remains intact: long stocks but hedge currency risk. Bottom Line: Upgrade Brazilian equities and fixed income to overweight relative to their EM counterparts. We are also starting a new trade: go long 10-year domestic government bonds in Brazil. Feature In our reports from July 8 and October 26, 2021, we argued that Luiz Inácio Lula da Silva will likely become Brazil’s next president. We contended that this expectation would initially produce a financial market selloff. However, we also stated that investors would, at some point, begin to look through the ongoing economic downturn and begin to price in pragmatic policymaking from a newly elected Lula. These views have by and large played out: Brazilian financial markets sold off and underperformed their EM counterparts dramatically in H2 2021. However, in recent weeks, Brazilian markets have rebounded and have outperformed their EM peers. Could this outperformance be the beginning of a lasting move? We believe it could be, and, hence, for investors with a medium-term horizon, we recommend upgrading Brazilian equities and local bonds to overweight (within their respective EM portfolios) and sovereign credit from neutral to overweight. We are also closing our short BRL/USD trade. The highly probable return of Lula to the presidency later this year implies that investors will likely treat president Bolsonaro as a lame duck. Thereby, markets will be driven more by hints about Lula’s policies than by the current government’s actions. Lula’s current policy proposals and his agenda following the election will be moderate, providing a positive impetus to financial markets. Depressed Valuations And Investor Sentiment Equities: Brazilian stocks are structurally cheap. The cyclically adjusted P/E ratio (CAPE) is well below its historical mean (Chart 1). Relative to emerging markets, Brazilian stocks are also attractive based on this measure (Chart 2). Chart 2Brazilian Stocks Are Also Cheap Relative To EM Chart 1Brazilian Stocks Are Cheap From A Structural Perspective     Additionally, various equity multiples are low both in absolute terms and relative to overall EM (Charts 3 and 4). Chart 3Brazilian Equity Multiples In Absolute Terms Chart 4Brazilian Equity Multiples Relative To EM Further, the equity risk premium – calculated using the earnings yield from the CAPE ratio and forward earnings yield minus Brazilian inflation-adjusted (real) bond yields – is rather high (Chart 5). In addition, analysists’ net EPS revisions have plunged both in absolute terms and relative to overall EM (Chart 6). This entails that a lot of the bad news on the profit outlook for the next 12 months are priced in, at least relative to other EMs. Chart 6Sentiment On Brazilian Stocks Is Downbeat Chart 5The Equity Risk Premium Is High   Overall, we are upgrading Brazilian stocks from underweight to overweight within an EM equity portfolio. Brazilian stocks have massively underperformed their EM peers over the past 12 years. Odds are that Brazil’s equity underperformance is over now. Currency: The BRL on the other hand is not cheap – its valuation is neutral. Chart 7 demonstrates the real’s real effective exchange rate, which shows that the currency is close to its fair value in real trade-weighted terms. However, the risk-reward profile of shorting the real is no longer attractive for the reasons we elaborate on this report. Therefore, we are closing our short in the BRL versus the USD. Concerning positioning, according to data from the US Commodity Futures Trading Commission, leveraged funds are net short the real and asset managers are moderately long (Chart 8, top and middle panels), with the aggregate position being modestly short (Chart 8, bottom panel).  Chart 8Investor Positioning On The BRL Is Net Short Chart 7The BRL Is Not Cheap   Sovereign credit: A stable currency and positive rhetoric from the potential next president entail that sovereign credit risks will stay contained. We recommend EM credit investors to upgrade Brazil from neutral to overweight within an EM credit portfolio. Local bonds: Domestic bond yields offer value. Nominal government bond yields are at 11.5% and inflation-adjusted (real) domestic bond yields are at a record high of 5.5%. With the economy heading into another recession (see below on this), Brazilian local yields are attractive in both nominal and real terms. Any upside in yields will be capped by disappointing growth and falling inflation. A hawkish central bank and a promise of more centrist policies from Lula will also limit any rise in domestic rates and will eventually open the door for a material drop in yields. Critically, in an environment of rising US nominal and real bond yields, Brazil’s super high yields will at least partially shield its financial markets from capital flight. Particularly, foreigners only hold around 10.5% of the domestic bond market. The same measure is much higher in many other EM fixed-income markets. We are therefore upgrading Brazilian domestic bonds from underweight to overweight within an EM local bond portfolio. We also recommend buying 10-year domestic bonds, unhedged. Inflation Is Set To Drop As The Economy Shrinks Inflation in Brazil will roll over. The primary reason is that the economy is entering another recession, the third one in the past eight years. The combined credit and fiscal impulse has fallen substantially, heralding a major downtrend in the economy (Chart 9, top panel). The central bank’s aggressive rate hikes have led to a relapse in the credit cycle and fiscal spending has been pulled back following the large pandemic stimulus. Several segments of the economy have already fallen back into negative territory and our forward-looking indicators are foreshadowing a material contraction in the coming months (Chart 9). The central bank (BCB) will remain hawkish for now even as the economy shrinks. The BCB will not ease until headline and core inflation drop close to the upper band of its target range of 3.5-5%. Monetary authorities will err on the overly hawkish side because many private and public sector wages are linked to the most recent inflation prints. Plus, consumer inflation expectations for 2022 remain above the BCB’s upper range (Chart 10). Chart 9Brazil: The Economy Is Headed Into Recession Chart 10Have Inflation Expectations In Brazil Peaked? Chart 11Brazil: Household Debt Servicing And Credit Origination Monetary authorities’ reluctance to cut interest rates despite a recession entails that domestic demand will undershoot. Worryingly, Brazilian household finances are in poor shape. The top panel of Chart 11show that the household debt-service ratio is at 30%, a very high level, and that individuals have been financing their expenditure with credit to battle inflation. With interest rates having surged, consumer loan delinquencies will balloon, and banks will cut back their lending to both households and businesses. In fact, loan origination to households has relapsed and usually it leads business loan origination (Chart 11, bottom panel). While president Bolsonaro will be tempted to increase fiscal expenditures to boost his approval ratings heading into the election, the BCB will counteract this with even tighter policy, as they have repeatedly stated. Currently, the government’s fiscal stance remains restrained, as shown by a negative fiscal impulse for 2022 (Chart 12). Further, Bolsonaro’s flagship handout program, Auxílio Brasil, stands at just 1% of GDP. On the inflation front, inflation in Brazil has been more supply-driven than demand-induced. In particular, even though headline consumer price inflation now stands at 10%, core inflation measures are much lower. Core CPI is presently 7%, trimmed-mean 7%, and non-tradable 5.4% (Chart 13). They are still above the central bank’s target range but will drop within it in H2 2022. Chart 13Brazil: Will Core Inflation Fall Within The BCB's Target Range? Chart 12Brazil: Fiscal Thrust Is Mildly Negative In 2022   Very tight monetary and fiscal policies as well as another recession will ensure that core consumer price inflation drops significantly, bringing it within the central bank’s target range in H2 2022 (Chart 14). On the flip side, the price to pay for lower inflation will be another period of utter growth contraction.  Chart 14Brazil Core Inflation Will Drop In 2022 Lula 2.0: Economic Policies And Central Bank Reaction The path of the economy and financial markets depends on the interplay between the election, current and future fiscal policy, and the BCB’s policy response. 2022 General Elections Odds are now considerable that ex-president Lula will win the 2022 presidential elections. He continues to massively outperform in voting intentions according to local polling company IPEC (Chart 15). The ex-president’s advantage is so large that he could theoretically win the presidency in the first round, as he would gather the absolute majority of all valid votes (which excludes blank and null votes). Third-way centrist candidates are falling significantly behind Lula and Bolsonaro for a variety of reasons. First, Lula has used pragmatic and reasonable policy statements that appeal to the majority of Brazilians. In doing so, he has largely moved to the center. In particular, Lula has been successfully appealing to moderate voters by forming alliances with centrist figures. For example, he has heavily hinted at selecting center-right icon and former political opponent Geraldo Alckmin as his running mate. Second, corruption has become less of a concern to Brazilians, which is a key policy of many centrist candidates and of former judge Sergio Moro in particular. According to the latest Genial Investimentos/Quaest polls, voters have rated corruption as only the fourth most important issue affecting Brazil (Chart 16). Further, Lula is the preferred candidate to address social issues, the pandemic and most importantly the economy. Chart 15Lula Is Massively Ahead Of The Other Candidates Chart 16Brazilian Voters Are Not Worried About Corruption   All of the above will improve investor sentiment and will likely allow Brazil’s recent outperformance to continue despite major growth disappointments in the next 12 months. For more analysis on these political dynamics, please refer to our reports “Brazil: The Wheels Are Coming Off” and “Can Brazil Break Out Of A Vicious Circle?”  Economic Policies Under Lula 2.0 We believe that, if elected, Lula’s governance and policies will be pragmatic and reasonable, similar to those during his first presidential term (2003-06) rather than with those of his more leftist second term and those of his successor, Dilma Rousseff. Lula now understands that he has to move toward the center if he is to appeal to the majority of the population, boost business confidence and create a positive backdrop for financial markets. To begin, Lula is positioning himself as a center-left politician and is also marginally distancing himself from his leftist Worker’s Party (PT). While Lula remains quite popular throughout the country, the PT remains controversial due to the corruption that was unearthed during Dilma Rousseff’s mandate.  Fiscal policy under Lula will be moderately loose. Lula will negotiate with Congress to abandon the fiscal spending rule that has straightjacketed the government and depressed the economy over the past five years. This implies that efforts to make public debt sustainable will be delayed. In addition, structural reforms might not be enacted or will be passed in a watered-down manner. That being said, given the broad centrist support for Lula, his economic program would not be exclusively dictated by his party. Instead of focusing on cash handouts and state intervention, his government is set to adopt a more centrist approach, such as financing infrastructure and more business-friendly policies than the PT’s core would prefer. All in all, we believe that Lula wants to be remembered as a positive figure in Brazil’s history and not as a politician who was jailed for corruption. Therefore, he will be appealing to moderate voters and separating himself from the PT. Such shifts in policies and allegiance will boost investor sentiment toward Brazil. A Big Unknown: How Will The BCB React To Fiscal Loosening? For Lula’s fiscal loosening to put Brazil on a path of sustainable growth, monetary policy cannot remain as hawkish as it is today. President Bolsonaro signed a bill in 2021 to grant autonomy to the central bank, which entails the government cannot replace the central bank president and other board members. In turn, the current BCB president Roberto Campos Neto has explicitly stated that interest rates must remain elevated to balance deteriorating fiscal accounts. Further, Neto will remain in his post until December 2024, while other board members’ terms expire between 2022 and 2024.  The key question is therefore whether Campos Neto and the monetary policy committee are willing to negotiate with Lula and moderate the BCB’s hawkishness despite fiscal loosening. We believe that an agreement between the government and the central bank is more likely than not. Campos Neto wants to protect the independence of the BCB. If he proves to be too stubborn, Lula (with the support of Congress) could threaten to abolish the central bank’s autonomy. Congress and the general public will be sympathetic to Lula’s position on the need to reduce interest rates substantially. As the economy shrinks and inflation drops toward 5%, the BCB board risks alienating the public and Congress if they remain very hawkish. Lula, on the other hand, will not want to risk alienating moderate voters by siding with the PT and starting off his term by lobbying against the central bank’s independence, especially given the support he has garnered from center-right figures such as Geraldo Alckmin and Fernando Henrique Cardoso. In order to prevent a clash between the government and the BCB, Campos Neto has an incentive to overtighten monetary policy this year, thereby entering 2023 with lower inflation and more scope to cut rates. This would also fall neatly under the central bank’s mandate to keep inflation under target, thereby securing its reputation and its independence.  Consequently, we expect monetary policy to be overly hawkish this year and for the central bank to cut interest rates aggressively in 2023. Financial markets will look through the valley and start pricing lower rates sometime in the coming quarters. Structural Outlook Under Lula 2.0 Despite all the positive momentum that Lula’s presidency and his policies will likely generate in the medium term, they will not likely improve Brazil’s structural outlook meaningfully. Brazil’s public debt has grown to unsustainable levels and Lula will not be able to prevent it from rising further (Chart 17, top panel). With elevated domestic bond yields and a crippling recession, government borrowing costs will exceed nominal GDP growth in the coming months, worsening government debt dynamics (Chart 17, bottom panel). Chart 17Brazil: Public Debt Dynamics Remain Worrisome For a more detailed analysis, please refer to our previous report on what it will take for Brazil to stabilize its public debt to GDP ratio. In short, authorities must either boost nominal GDP growth above borrowing costs and maintain this wide gap over a number of years or the government has to run large and recurring primary surpluses. It is neither economically nor politically feasible to accomplish these feats under any government in Brazil. Chart 18Potential Growth In Brazil Is Unflattering The only way Lula might succeed in stabilizing the public debt-to-GDP ratio is to inflate the public sector out of debt, i.e., run easy fiscal and monetary policies and cap bond yields at low levels, thereby persistently running negative real rates. The victim of this policy mix would be the exchange rate: the real will depreciate significantly. Lula is unlikely to turn to such policies in the first two years of his presidency. Plus, the current BCB governor will not accommodate such aggressive policies. However, odds are that these policies might well make an appearance in the second half of Lula’s presidency, especially when he appoints a new central bank governor in 2025 who will be more open to the idea of capping government bond yields to stabilize public debt dynamics. Barring “inflating out of debt” policies, the only way for Brazil to escape this debt trap is to significantly raise the economy’s potential (real) growth rate. To do this, the country must boost its labor productivity through much needed structural reforms. These include simplifying the tax regime, alleviating labor laws, reducing subsidies and pursuing privatization. Given in Brazil’s working age population growth has fallen below 1%, the only remedy is to boost productivity (Chart 18). Will Lula be able to achieve such a breakthrough in Brazil’s potential growth? We are not holding our breath for now. Investment Recommendations We are upgrading our stance on Brazilian financial markets to overweight even though we believe the economy will be in recession in the next 12 months (Chart 19). The rationale of the upgrade is our belief that investors will start viewing Lula’s presidency as a positive shift for Brazil. This will likely lend support to financial markets that have sold off and offer value as per our discussion above. That said, we are not yet turning bullish on Brazilian equities in absolute term. We are more confident about Brazil outperforming the rest of EM than we are in seeing an imminent sizable rally in the nation’s risk assets. The latter will be driven not only by local dynamics but also by the trajectory of global financial markets. We maintain that EM risk assets and currencies will be weak in absolute terms in the coming months. We are also upgrading Brazilian local currency bonds from underweight to overweight (Chart 20, top panel) and Brazilian credit from neutral to overweight. Chart 20Upgrading Brazil vs. EM Chart 19Is Brazil Set For A New Period Of Outperformance?   In our opinion, local long-term bond yields will be a couple of hundred basis points below the current levels by year-end. Hence, absolute return investors should go long Brazilian 10-year domestic government bonds, currency unhedged. We have a higher conviction on falling yields than on the exchange rate. For the currency, we are closing our short BRL/USD trade (Chart 20, bottom panel), and recommend going long BRL versus ZAR. Chart 21Brazilian Equities: Overweight Small Cap Stocks Within The Overall Market Finally, within the Brazilian equity market, we recommend going long small caps / short the overall index (Chart 21). Odds of lower interest rates down the road and a potential soft spot in commodity prices might create a window of opportunity for small caps to outperform. All in all, given our poor structural view on Brazil, our long-term strategy remains long stocks / short the BRL. This is due to our belief that the government will eventually resort to running loose fiscal and monetary policies to inflate their way out of debt. The result will be strong nominal growth but a depreciating currency. Juan Egaña Research Analyst juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com