Central Europe

Executive Summary Poland: Wages Are Surging Hungary is exhibiting classic signs of an overheating economy –as rising inflation coincides with very strong domestic demand. Yet, authorities are still pursuing very stimulative monetary and fiscal policies. The upcoming appointments of new Czech National Bank (CNB) governor Aleš Michl and three new monetary policy board members entails a dovish shift in monetary policy. Core inflation in Poland will continue to rise due to the unfolding wage-price spiral. The reluctance of policymakers to tighten monetary and fiscal policies substantially in such an environment heralds a weaker currency and higher local bond yields. Continue to underweight Central European equities and local currency bonds relative to their respective EM benchmark. Underweight Central European local currency bonds within European core bond portfolio. Recommendation INITIATION DATE RETURN Receive Czech And Pay Polish 10-Years Swap Rates 2022-03-08 100 BPS Long CZK/Short HUF 2021-06-03 12.4% Short PLN/Long USD 2022-03-02 3.1% Bottom Line: The Hungarian and Polish economies are overheating, yet their monetary and fiscal policies remain accommodative. This is negative for their currencies and local bonds. Even though the incoming leadership of the Czech central bank will cultivate a more dovish stance than the current leadership, Czech macro policies are less stimulative than those in Hungary and Poland. By extension, the Czech currency and local bonds will outperform their Hungarian and Polish counterparts.   Hungary: Classic Overheating Chart 1Hungary Is Overheating The Hungarian economy is exhibiting signs of classic overheating as rising inflation coincides with very strong domestic demand (Chart 1). Yet, authorities are not tightening monetary and fiscal policies meaningfully. The central bank is well behind the inflation curve. Accordingly, the currency will continue to depreciate and local bond yields will rise. The only way to reverse these dynamics is for authorities to tighten monetary or fiscal policies dramatically, which will likely cause a recession. Looking forward, authorities will continue to pursue their pro-growth agenda despite the unfolding wage-price spiral. Inflation is broad-based and will accelerate further. High inflation is not limited to goods. Core, trimmed-mean and service inflation are also very high, in some cases in double digits (Chart 2). Chart 2Hungary: Inflation Is Broad-Based Chart 3Hungary: Wage Growth Is In Double Digits Hungary’s labor market is tight, and wages are surging (Chart 3). Notably, wage growth is in double digits and is well above core inflation. Wage growth will remain robust as the government is set to boost public wages and the private sector is struggling to fill vacant positions. Employment is at an all-time high, and the number of unemployed people is approaching pre-pandemic lows (Chart 4). Strong employment and solid real wage growth will support consumer spending for now.   Despite a major slowdown in the euro area, Hungarian exports will suffer less than those of other EU members. Almost 50% of Hungary’s manufacturing output comes from automotive, food and beverages, as well as industrial electrical equipment sectors. Demand for these sectors remains robust despite a potential drop in demand for consumer goods in the EU.   Despite the central bank raising rates by a cumulative 530 bps since June 2021, real policy rates and real commercial bank lending rates (deflated by core CPI) are at all-time lows, and money and private credit are booming (Chart 5). In brief, the central bank remains behind the inflation curve. The National Bank of Hungary (NBH) has also been the most aggressive central bank in the region in monetization of public debt and corporate debt. There is little evidence to suggest that it is planning to tighten liquidity as a means of reining in inflation. Chart 4Hungary: Labor Market Is Currently Very Tight Chart 5Hungary: Money And Credit Are Booming Chart 6Hungary: Twin Deficit Fiscal policy will remain loose and unorthodox measures will likely persist. Government primary spending has reached 46% of GDP and is unlikely to retrench much. In particular, in response to the EU’s recent €7.2 billion (4.6% of GDP) cut in funding to Hungary, prime minister Orbán has announced spending cuts and tax hikes to prop up government revenues (Chart 6, top panel). The government has imposed “windfall” taxes1 on some firms or industries where profits are excessive from the government’s perspective. The majority of spending cuts (€3 billion or 2% of GDP) will be in public investments. Meanwhile, authorities continue subsidizing household utility bills and raising public wages and pensions. This will keep consumption strong.   A very wide current account and trade deficits are also signs that the economy is overheating (Chart 6, bottom panel). Bottom Line: Super-loose monetary and fiscal policies amid an overheating economy warrant further currency depreciation and higher bond yields.  The Czech Republic: A Policy Shift Coming The recent appointments of Czech National Bank (CNB) governor Aleš Michl and three new monetary policy board members entails a dovish shift in monetary policy. Notably, Aleš Michl, a current board member of the monetary policy committee, has been a strong opponent of the CNB’s hawkish stance alongside current board member Oldřich Dědek. Both men have been the only two of the seven-member  committee to vote against rate hikes in the past eight meetings. In addition, President Zeman recently appointed three new members to the monetary policy committee to replace hawkish members that have reached the end of their terms. These new appointments are likely to be aligned with the forthcoming CNB governor’s dovish approach to monetary policy. Chart 7Czech Output Gap And Core Inflation Altogether, these appointments will result in a major shift in the CNB’s monetary policy board, whereby at least four out of the seven board members will likely vote against further rate hikes after July. Therefore, the CNB policy will undergo a dovish pivot. This will occur at a time when genuine inflation is still high and inflationary pressures are intense: The very large positive output gap heralds persistent inflationary pressures (Chart 7, top panel). Indeed, core and trimmed-mean CPIs are surging, which suggest that inflation is broad-based (Chart 7, bottom panel). Job vacancies exceeding the number of unemployed people entails a very tight labor market (Chart 8). The upshot is rising wages (Chart 9).   Domestic consumption remains robust due to considerable household income gains. Chart 8The Czech Republic: Labor Shortages Are Pervasive Chart 9Wage Growth Is Lower In Czech Than In Hungary And Poland Chart 10Fiscal Policy Is Tightening More In Czech Than In Hungary And Poland On the one hand, a dovish monetary policy shift is negative for the Czech koruna. On the other hand, the country’s fiscal thrust will still be negative this and next year (Chart 10). This is in contrast to Hungary and Poland. Besides, the central bank considers a weak currency to be a risk to its “fulfilment of price stability” and regards the “easing of the monetary conditions” as “inappropriate”. Last month, the CNB board convened in an emergency meeting to announce the selling of foreign exchange reserves to stem volatility in the currency. The Czech Republic has a lot of foreign exchange reserves that could be utilized to stem any large moves in the koruna. Even newly appointed governor Aleš Michl considers a strong koruna to be an important part of his mandate. His recent comments to local media suggest that the CNBs’ intention is to defend the currency against any medium to long-term weakness: “I want a strong koruna based on long-term cash flows to the country and investor interest in the Czechia. The koruna has not strengthened in trend since 2008. Everyone is only evaluating short-term fluctuations, but they do not perceive this significant change. The koruna will only be strong if we have long-term balanced public finances.” Overall, the selling of foreign exchange reserves to defend the currency will tighten monetary conditions and prevent short-term interest rates from falling. Whenever a central bank sells foreign currency, it is forced to purchase local currency which lowers commercial banks’ excess reserves at the central bank. The latter could reduce money origination by commercial banks. While long-term bond yields could rise as the central bank falls behind the inflation curve, the currency will likely be range bound versus the euro for some time. Bottom Line: Even though the central bank is shifting into a dovish mode, it will maintain the policy of a strong currency. Plus, the fiscal policy will be tightening, which is not the case in Hungary and Poland. We reiterate our long CZK / short HUF trade. Poland: Misguided Macro Policy Chart 11Poland: Wages Are Surging Inflation in Poland will continue to rise due to the unfolding wage-price spiral (Chart 11). Besides, the central bank is still behind the inflation curve, and fiscal policy has not tightened substantially. The reluctance of policymakers to tighten monetary and fiscal policies amid the wage-price spiral warrants a weaker currency. Also, a top in domestic bond yields might not be imminent. A buying opportunity in Polish local currency bonds will emerge only when authorities take measures to bring down inflation and when geopolitical tensions between Russia and the west abide. The central bank and government continue to blame inflation on the war in Ukraine, i.e., on supply-side factors rather than excessive domestic demand. Chart 12Poland: Consumer Spending Has Overshot Contrary to policymaker rhetoric, Poland is experiencing an inflationary boom, whereby rising inflation is not only the result of supply-side bottlenecks but is also due to excessive demand. Chart 12 illustrates that retail sales have overshot above a reasonable uptrend trajectory. Critically, the labor market is very tight. As a result, wage growth is skyrocketing both in nominal and real terms. With productivity growth well below wage growth, unit labor costs are accelerating. This will squeeze company profit margins and lead these to hike selling prices to protect profit margins. With such robust income growth, consumers might accept higher prices and the wage-price spiral will likely be sustained. Meantime, fiscal policy will remain accommodative at least throughout early 2023, until the scheduled parliamentary elections take place. The government has provided subsidies on energy and has cut the VAT rate. These programs effectively amount to stimulus for households. Chart 13Poland: Interest Rates Are Very Low/Negative In addition, the central bank will not likely hike rates aggressively. Recent comments by central bank governor Adam Glapinski appear to suggest that the National Bank of Poland (NBP) is likely to pause or slow its rate hikes. Even though the central bank has hiked its policy rate by 590 bps in the past 12 months, real policy and prime lending and mortgage rates as well as government bond yields remain very negative (Chart 13). This signifies that the monetary tightening has been insufficient. Lastly, in the current geopolitical climate, Poland is the most vulnerable among Central European nations to any escalation between Russia and the west. This is due to its extensive border with Ukraine, and due to it being the transit route for arms into Ukraine from the west. Poland has adopted a hard stance on Russia. This makes Poland an easy target for Russian rhetoric. While chances of direct conflict are slim, any further escalation by Russia will make Polish financial markets vulnerable to selloff. Bottom Line: For now, investors should continue to underweight Polish domestic bonds within both EM local currency bonds and core European bond portfolios. Also, we continue to recommend shorting PLN versus the USD. Investment Recommendations The Hungarian and Polish economies are overheating, and their monetary and fiscal policies remain accommodative. This is negative for their currencies and local bonds. Even though the incoming leadership of the Czech central bank will be more dovish than the current leadership, Czech macro policies are less stimulative than those in Hungary and Poland. Hence, the inflation outlook is more benign for the Czech economy than it is in Hungary and Poland. By extension, the Czech currency and local bonds will outperform their Hungarian and Polish counterparts. Chart 14Our Trade: Long CZK / Short HUF In light of this, we recommend the following to investors: Underweight Central European local currency bonds within European core bond portfolio. Keep the long CZK / short HUF trade (Chart 14); Hold onto the short PLN / long USD trade. Maintain the relative rates trade of receiving Czech and paying Polish ten-year rates. This spread has widened by 100 bps since our recommendation on March 8, 2022. Maintain underweight in local bonds and equities for Central Europe relative to their respective EM benchmarks.   Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes 1     A windfall tax is extra tax on profits of a particular company or industry that is deemed to have earned excessive profits.

Executive Summary Loss Of Russian Production Will Lift Brent With German imports of Russian oil close to 10% of its total requirements – following an impressive decline from 35% pre-invasion – we expect the EU to declare an embargo on Russian oil imports this week or next. Smaller states – e.g., Hungary and Slovokia – will be granted embargo waivers; their import volumes will not affect the EU effort. Russia will be forced to shut in ~ 1.6mm b/d of production, rising to 2mm b/d next year (vs. pre-invasion levels). Demand will fall as Brent prices surpass $120/bbl by 2H22, in our revised base case. Prices above $140/bbl are likely if Russia immediately halts EU oil exports. Our revised forecast calls for Brent to average $113/bbl this year, and $122/bbl next year. WTI will trade $3/bbl lower. Per earlier threats, Russia will cut EU natgas exports following the EU embargo. Benchmark euro natgas prices will go back above €225/MWh, and trigger an EU recession. Bottom Line: An EU embargo on Russian oil imports is close. Brent crude will rally above $120/bbl by 2H22, with $140/bbl or higher likely, depending on how quickly Russia reacts to the EU oil embargo. Eurozone natgas will trade above €225/MWh again. We remain long the S&P GSCI index, the COMT ETF, and the XOP and CRAK ETFs to retain exposure to higher prices. We are getting long 1Q23 ICE Brent futures and 4Q22 TTF futures at tonight's close. Feature Related Report  Commodity & Energy StrategyDie Cast By EU: Inflation, Recession Risks Rise The stage is set for the EU to announce an embargo on Russian oil imports this week or next. Odds of an EU embargo being declared sooner rather than later increased, in our view, in the wake of Germany's success in cutting Russian oil imports by more than half in a very short period – from ~ 35% prior to Russia's invasion of Ukraine on 24 February to ~ 12% earlier this month (Chart 1). Further reductions in Russian oil imports we expect from Germany will make it easier for the EU's largest economy to walk away from Russian crude and product imports sooner rather than later.1 Other EU member states already stand with Germany on the issue of an embargo on Russian imports. Those that do not – Hungary and Slovakia, e.g. – do not import Russian oil on a scale that can meaningfully derail EU solidarity on the embargo, which means waivers for these states can be expected to keep the embargo on track. In addition, four of the Five-Eyes states – the US, UK, Australia and Canada – already have imposed embargoes on Russian oil imports. Chart 1EU Energy Import Dependency (2021) Russian Shut-ins Will Tighten Supply The immediate fallout of the EU embargo will be to accelerate the rate at which Russia is forced to shut in production, as increasing volumes of its oil remain stranded on the water looking for a home. We reckon 1mm b/d or so of Russian crude oil output already has been cut. This will continue to increase. Russia will be forced to shut in ~ 1.6mm b/d of crude output this year, rising to 2mm b/d next year (averages vs. pre-invasion levels), in our modelling. This takes Russian oil production down to 8.4mm b/d this year, on average, and 8.0mm b/d next year.2 As more and more Russian crude is shut in, the pipelines carrying Urals and Eastern Siberia-Pacific Ocean (ESPO) crude from the Siberian oil fields to ports will fill, along with inventory in the ports where ships are loaded for export. When storage and pipelines fill, the only alternative Russian producers will have will be to shut in crude and condensate production. While some states obviously will benefit from the increasing availability of Russian crude on offer at 30% discounts or more – e.g., India and China – there is a limit as to how much surplus Russian output they can take in. China, in particular, will not want to jeopardize long-term contracts with key suppliers – e.g., the Kingdom of Saudi Arabia (KSA) – nor will India, which will limit the total volumes both are willing to take from Russia longer term. Security of supply becomes an increasingly important consideration as Russia's oil output continues a long-term decline going forward: Costs were rising prior to Russia's invasion of Ukraine from 2008 to 2019. Falling drilling efficiency and production, were accompanied by rising water cuts – i.e., the amount of water being produced drilling for oil – in Russia's largest fields, which rose to as high as 86%. Shutting production from these older fields will force hard choices as to whether these fields are ever revived.3 Demand Will Be Stressed Shortly after Russia invaded Ukraine, the country's Energy Ministry Alexander Novak warned the EU it would cut off natural gas pipeline supplies being sent to the continent, in retaliation for embargoing oil imports.4 Oil exports of close to 5mm b/d accounted for just under half of Russia's revenue from energy exports last year, with OECD Europe representing half of that amount.5 For Russia, oil exports are far more important than gas exports, which will incline it to immediately cut pipeline flows to Europe as soon as an oil embargo is announced. For the EU, natgas exports from Russia are critical to the economies of its member states (Chart 2). The EU imported ~ 155 bcm of natgas from Russia in 2021, or just over 40% of its total natgas consumption. Germany's share amounted to 45 bcm, or 45% of domestic gas use . If, as we expect, the EU is close to announcing its oil embargo on Russia, an immediate retaliation from Moscow in the form of a cutoff of pipeline exports to the EU most likely will follow. This will throw the EU into a recession, as natgas prices surge. Chart 2Losing Russia's Natgas Will Be Painful For EU Revised Forecast Reflects Falling Russian Output We are revising our Brent forecast and crude oil balances in line with our expectation Russian oil output will decline meaningfully. As noted above, we now expect Russian crude oil output to fall to 8.4mm b/d this year and 8.0mm b/d in 2023. This pushes non-core OPEC 2.0 production – which now includes Russia – lower, as a result (Chart 3). We moved Russia out of the core OPEC 2.0 producer group, given the production declines we expect this year and next, and into the "Other Guys" group. Our base case demand reflects a shift in OECD vs. non-OECD consumption estimates, with the OECD gaining incrementally, while EM demand (via non-OECD consumption) falls incrementally (Chart 4). Chart 3Falling Russia Output Pushes Non-Core OPEC 2.0 Output Lower Chart 4DM Demand Shifts Higher, EM Shifts Lower The lower EM demand growth reflects weaker China oil consumption resulting from the country's zero-COVID policy. In addition, because we expect Russia to act quickly on cutting off EU natgas exports, benchmark TTF natgas prices will move back above €225/MWh. Higher oil and natgas prices in the EU will lead to recession later this year. How quickly this shows up depends on how quickly Russia reacts to an EU oil embargo. In addition, a strong USD – bid higher by global economic uncertainty and safe-haven demand – will pushing the local-currency costs of refined products like gasoline, diesel and jet fuel higher, also will contribute to lower EM demand (Chart 5). Chart 5USD Remains Well Bid In our base case, we expect a tighter market on balance (Chart 6). Oil inventories remain under pressure, owing to falling as Russian output and declines in production outside core OPEC 2.0 and the US (Chart 7). We cannot rule out additional SPR releases from the US or IEA to offset tightening global inventories. Chart 6Global Balances Tighten Chart 7Inventories Draw As Supply Tightens Our forecast for Brent this year has been lifted on the back of a much stronger expectation of an EU oil embargo against Russia. This will result in 2mm b/d of Russian production being shut in by next year, which will not be fully replaced (Table 1). We are lifting our Brent forecast to $110/bbl for 2022, and $115/bbl for next year as a result (Chart 8). Chart 8Loss Of Russian Production Will Lift Brent Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) To Dec23 Investment Implications An EU embargo on Russian oil imports is close at hand, in our view. Brent crude will rally above $120/bbl by 2H22, with $140/bbl or higher possible, depending on Russia's reaction to the EU oil embargo. We expect Brent prices to average $113/bbl this year, and $122/bbl in 2023. WTI will trade $3/bbl lower on average. Eurozone natgas will trade above €225/MWh again and stay at elevated levels, likely moving higher following a Russian cutoff of natgas supplies to the continent. This will throw the EU into recession. We remain long the S&P GSCI index, the COMT ETF, and the XOP and CRAK ETFs to retain exposure to higher prices. We are getting long 1Q23 ICE Brent futures and TTF natgas futures at tonight's close. A word of caution is in order: We are assuming Russia will follow through on its threat to shut off natgas exports to the EU in the event of an embargo against importing its oil is declared. This, we believe, is Russia's red line. If the EU fails to declare an embargo, or if Russia fails to follow through on its threat to cut off gas supplies in the wake of an EU oil embargo of its exports we will have to re-assess our outlook.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Analyst Commodity & Energy Strategy ashwin.shyam@bcaresearch.com Paula Struk Research Associate Commodity & Energy Strategy paula.struk@bcaresearch.com     Commodities Round-Up Energy: Bullish European natural gas inventories are building at a rapid rate, as competition from Asia – typically led by Chinese demand – remains weaker than in previous seasons. EU natgas storage stood at ~446 MWh as of May 16, 2022, the latest available reports indicate (Chart 9). The EU has weathered two extremely difficult winters in 2020-21 and 2021-22. Natgas storage levels were drawn hard to meet space heating demand, which, owing to a winter energy crisis in China at the time, forced European buyers into a competition for liquified natural gas (LNG) during the former period. Following unexpected spring-summer demand in 2021 when cold weather lingered in Europe and wind power generation fell sharply, storage owners again were hard pressed to secure LNG to rebuild storage levels going into this past winter, which caused European TTF natgas prices to soar, as demand surged (Chart 10). With the threat of a cutoff of Russian natgas hanging over the EU, there is a singular focus right now on getting storage as full as possible ahead of next winter. The EU aims to replace two-thirds of Russian gas imports before yearend. Precious Metals: Bullish The Fed has adopted a more hawkish rhetoric, as it acts more aggressively to reduce US inflation. Interest rates have increased from near-zero levels in March to 0.75%, and BCA’s US Bond strategy service expects two more 50 bps rate hikes in June and July. Post July, rate hikes will depend on the Fed’s assessment of inflation, inflation expectations and financial conditions. The Fed faces the risk of either remaining behind the inflation curve or sparking a recession in case it’s either not hawkish enough, or too hawkish. Base Metals: Bullish High power prices in Europe will continue to plague refined base metals production in the continent and keep refined metal prices buoyed. LME Europe aluminum stocks are close to 17-year lows. In China – whose metal smelters were also hit by high power prices in 2021 – aluminum smelting has revived, with the country reportedly producing a record amount of primary aluminum in April. Lockdowns, however, have reduced economic activity, demand for the metal and its domestic price. China has taken advantage of this arbitrage opportunity, sending most of its primary aluminum exports to Europe. This aluminum price spread between the two states has contributed to China’s steady rise in primary aluminum exports this year, after having exported nearly none in 2020 and 2021. Chart 9 Chart 10Dutch Title Transfer Facility Going Down     Footnotes 1     German officials have stated the country will wind down all oil imports from Russia by year end, even if the rest of the EU does not join it in an embargo.  We highly doubt Germany will act alone, given the support an embargo already has received from EU member states.  Please see Germany to Stop Russian Oil Imports Regardless of EU Sanctions, published by bloomberg.com on May 15, 2022. 2     Our expectation for shut-in volumes is lower than the IEA's, which sees Russia being forced to shut in 3mm b/d of production by 2H22.  We continue to monitor this closely via satellite and reporting services and will adjust our estimates as needed.  Obviously, if the IEA is correct oil markets will tighten even more than we expect. 3    Please see "The Future of Russian Oil Production in the Short, Medium, and Long Term," published by the Oxford Institute for Energy Studies in September 2019.  The OIES study notes production in Russia's highest-producing area – the Khanty-Mansi Autonomous (KMA) district – actually fell 15% between 2008-19, even as drilling activity surged 66%.  While output in 2018 rose due to intensified oil recovery (IOR), the OIES noted that the water cut rose sharply in 2018 as well in the KMA district. 4    Please see Russia warns of $300 oil, threatens to cut off European gas if West bans energy imports, published by cnbc.com on March 8, 2022.  The article notes Novak threatened to close the Nord Stream 1 pipeline delivering gas to Germany in retaliation for an EU oil embargo.  Almost three-quarters of Russia's natgas exports were sent to Europe prior to its invasion of Ukraine.  Natgas export revenues accounted for $62 billion of the $242 billion funding Russia's budget last year, while crude oil revenues made up $180 billion (just under 75%). 5    Please see Die Cast By EU: Inflation, Recession Risks Rise, which we published on May 5, 2022.  It is available at ces.bcaresearch.com.   Investment Views and Themes Recommendations Strategic Recommendations Trades Closed in 2022

Executive Summary Polish Central Bank Is Behind Inflation Curve; Czech One is Getting Ahead Curve Amid the current geopolitical crisis, Poland is more vulnerable than other Central European countries due to its extensive border with Ukraine, and because the West is supplying arms to Ukraine via Poland. In our March 2 report, we downgraded Central European stocks and bonds to underweight and recommended shorting the Polish zloty against the US dollar. Poland and the Czech Republic are experiencing genuine inflation.  Czech monetary and fiscal authorities are determined to tackle rising prices, i.e., they will be getting ahead of the inflation curve. In contrast, the Polish central bank and government will err on the side of pro-growth policies rather than tightening policy sufficiently. When authorities fall behind the inflation curve, currencies tend to depreciate and long-term bond yields tend to rise. Recommendation Inception Date Return Receive Czech And Pay Polish 10-Years Swap Rates      March 8, 2022   Pay Czech 10-Years Swap Rates July 23, 2020 257 bps Long CZK/Short HUF June 3, 2021 6.9% Short PLN/Long USD March 2, 2022 4.7% Bottom Line: Such a policy divergence between the Czech Republic and Poland heralds the Czech currency and bonds outperforming their Polish counterparts. We recommend to pay Polish / receive Czech 10-year swap rates, book profits on the position of paying 10-year Czech swap rates and maintain the short PLN/long USD trade. Feature Although risk of a direct Russian military attack on Poland and the Czech Republic are low, we argued in our recent report  from March 2 that their financial markets will remain jittery as the geopolitical conflict escalates in the near term. Nevertheless, the Kremlin does not have the appetite for direct confrontation with NATO. Any attack on a NATO member, such as Poland or other East European countries, would activate Article V of the NATO charter and force the organization to defend its member. Yet, geopolitical risks will likely heighten for now. Having incurred considerable costs already, the Kremlin will not halt its aggressive approach towards NATO. If anything, Russia’s rhetoric and menace will heighten in the coming days and weeks to secure some concessions from the West. Central Europe in general and Poland specifically are on the frontlines of the Russia and NATO confrontation. Poland is potentially vulnerable due to its extensive border with Ukraine and because the West is supplying arms to Ukraine via Poland. That is why in our March 2 report we downgraded Central European stocks and bonds to underweight and recommended shorting the Polish zloty against the US dollar.  Below we provide a macroeconomic analysis of Poland and the Czech Republic and unpack our rationale for the following investment recommendations: Book profits on the position of paying 10-year Czech swap rates. Our view that the Czech central bank will be aggressive, raising rates in the face of rising inflation, has played out well. A new recommendation: Pay Polish / receive Czech 10-year swap rates. Maintain the short PLN/long USD trade. For now, we keep the short HUF/long CZK position. We will update our view on Hungary after the elections later this month. Poland: The Central Bank Is Behind The Curve Chart 1Polish Inflation Has Been Overshooting Poland has been experiencing an inflationary boom – rising inflation is coinciding with strong expansion in real domestic demand and aggregate output (Chart 1). In particular, a wage-price spiral is unfolding alongside a surge in real estate prices. Labor shortages have been mushrooming (Chart 2, top panel). A shrinking working age population suggests that a tight labor market will persist for much longer (Chart 2, middle and bottom panels). Critically, the inflow of Ukrainians fleeing the war should not substantially alter current labor dynamics. Poland’s labor shortages have been primarily in higher skilled employment. While certain services firms could hire immigrants from Ukraine, job vacancies will remain high primarily in middle and higher wage categories. Besides, overall consumer demand will increase in Poland due to an influx of Ukrainians. Notably, the average wage is expanding at a rate of 10% in nominal and 4% in real terms (deflated by core CPI) and unit labor costs are accelerating (Chart 3). Rising unit labor costs will squeeze corporate profit margins and lead companies to hike their selling prices. Chart 2Poland: Labor Shortages Are Rampant Chart 3Poland: Surging Wages And Unit Labor Costs Strong household income growth will sustain robust consumer spending (Chart 4). Vibrant domestic consumption will result in a widening of both the current account and trade deficits. The latter is negative for the currency. Lastly, the prime lending rate and mortgage rates are negative in real terms (Chart 5). This will support demand for credit from households and enterprises. Chart 4Poland: Consumer Spending Is Above Its Trend Chart 5Polish Lending Rates Are Deeply Negative Critically, the central bank of Poland (NPB) has fallen behind the inflation curve. Headline, core and trimmed mean CPI have surged well above the central bank’s target range of 1.5-3.5% (see Chart 1 above). The central bank has been tightening liquidity conditions in the last week or so by intervening in the exchange rate market, i.e., selling foreign exchange reserves to support the zloty. This move is a departure from the plentiful liquidity that the NPB provided over the past two years. First, the central bank injected enormous amounts of liquidity during its quantitative easing that commenced at the start of the pandemic and lasted almost two years. Second, for some time the NBP has been buying the government’s EU funds and providing the latter with local currency. All in all, we believe that the NBP will be treading carefully with its liquidity tightening and will not allow interbank rates to rise much given the geopolitical crisis in the region. In addition, the ruling Law and Justice party (PiS) has been reluctant to withdraw fiscal stimulus ahead of the parliamentary elections in 2023. With geopolitical risks heightened and potential softness in consumer and business sentiment, the government will not tighten fiscal policy much. Table 1Poland's National Polls: Voting Intentions The ruling party’s support has been falling since the last general elections in October 2019. In contrast, the opposing party Civic Coalition, led by former prime minister Donald Tusk, has had a noticeable upsurge of 10 percentage points to 27% support in recent polls from March 1 (Table 1). To increase odds of their election victory, the government will try to secure robust nominal growth going into the election in the latter part of 2023. Overall, fiscal policy will remain largely accommodative. Notably, odds are high that authorities will prolong tax cuts on energy and food prices and could subsidize domestic firms and household energy and food bills through direct transfers. Bottom Line: The Polish economy had been experiencing classic overheating before the geopolitical crisis around Ukraine erupted. A tumble in the exchange rate, surging energy and food prices all herald a further overshoot in consumer price inflation. The central bank and the government will err on the side of pro-growth policies rather than tackling inflation. When authorities fall behind the inflation curve, currencies tend to depreciate and long-term bond yields rise. We recommended shorting the PLN against the USD on March 2 and today we recommend a new fixed-income trade: pay Polish 10-year swap rates and receive Czech 10-year rates. The Czech Republic: The Central Bank Is Getting Ahead Of The Curve Chart 6Czech Inflation Has Been Overshooting In the Czech Republic, our call on the   central bank hiking interest rates sooner and faster than its central European peers has been playing out nicely. The Czech National Bank (CNB) has hiked its policy rate by 425 bps since June 2021. This has produced both higher nominal and real Czech interest rates in relation to those in the Euro Area and Central Europe.  In line with rising Czech rates, the koruna has appreciated versus other regional currencies. For now, the central bank will remain alert to price stability and might continue pushing rates higher as long as consumer price inflation remains above the CNB’s target range of 1-3% (Chart 6). In the meantime, the newly elected Czech government has significantly revised fiscal plans from the previous government to rein in surging inflation. In particular, the new budget involves flat nominal spending in 2022, which will result in government spending contracting in real terms. In turn, the budget deficit is expected to narrow to below 3% of GDP by the end of 2022. Despite tightening monetary and fiscal conditions, Czech inflation will persist for the following reasons: A positive output gap has historically heralded higher inflation (Chart 7). Labor shortages remain acute (Chart 8, top panel). Job vacancies are at all-time highs and the unemployment rate will continue to fall as vacancies are filled by firms (Chart 8, bottom panel). Chart 7The Czech Republic: Output Gap And Inflation Chart 8Czech Labor Shortages Are Acute Chart 9Czech Wages And Unit Labor Costs Competition amongst firms to secure labor will spur wage gains. Increasing unit labor cost amid rising output denotes genuine inflationary pressures (Chart 9).  Retail sales are breaking above the pre-COVID peak supported by robust real wage gains (Chart 9, bottom panel). Bottom Line: The central bank might lift rates further and the government is tightening fiscal policy. Thus, the CNB is getting ahead of the inflation curve. This is positive for the currency, ceteris paribus, and will also cap Czech long-term interest rates even if short rates rise further. Even though Czech financial markets will likely sell off further due to the geopolitical crisis, we expect the Czech koruna and long-term bonds to outperform their counterparts in Poland and Hungary. Investment Recommendations Czech monetary and fiscal authorities are more determined to tackle inflation, i.e., they will be getting ahead of the inflation curve compared to their Polish (and Hungarian) counterparts (Chart 10). Such a policy divergence heralds the following investment strategy: A new fixed-income trade: Pay 10-year Polish swap rates / receive 10-year Czech swap rates. As to the allocation to central Europe, investors should underweight Poland, Czech and Hungarian equities and local currency government bonds within their respective EM benchmark. We initiated the short PLN / long USD trade on March 2. Remain long CZK versus HUF. Take profits on the position of paying Czech 10-year swap rates. 10-year swap rates have risen by 260 basis points since the initiation of this position on July 23, 2020 (Chart 11). Chart 11The Performance Of Our Central European Trades Chart 10Polish Central Bank Is Behind Inflation Curve; Czech One is Getting Ahead Curve   Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes

Highlights Geopolitical risk is trickling back into financial markets. China’s fiscal-and-credit impulse collapsed again. The Global Economic Policy Uncertainty Index is ticking back up after the sharp drop from 2020. All of our proprietary GeoRisk Indicators are elevated or rising. Geopolitical risk often rises during bull markets – the Geopolitical Risk Index can even spike without triggering a bear market or recession. Nevertheless a rise in geopolitical risk is positive for the US dollar, which happens to stand at a critical technical point. The macroeconomic backdrop for the dollar is becoming less bearish given China’s impending slowdown. President Biden’s trip to Europe and summit with Russian President Vladimir Putin will underscore a foreign policy of forming a democratic alliance to confront Russia and China, confirming the secular trend of rising geopolitical risk. Shift to a defensive tactical position. Feature Back in March 2017 we wrote a report, “Donald Trump Is Who We Thought He Was,” in which we reaffirmed our 2016 view that President Trump would succeed in steering the US in the direction of fiscal largesse and trade protectionism. Now it is time for us to do the same with President Biden. Our forecast for Biden rested on the same points: the US would pursue fiscal profligacy and mercantilist trade policy. The recognition of a consistent national policy despite extreme partisan divisions is a testament to the usefulness of macro analysis and the geopolitical method. Trump stole the Democrats’ thunder with his anti-austerity and anti-free trade message. Biden stole it back. It was the median voter in the Rust Belt who was calling the shots all along (after all, Biden would still have won the election without Arizona and Georgia). We did make some qualifications, of course. Biden would maintain a hawkish line on China and Russia but he would reject Trump’s aggressive foreign and trade policy when it came to US allies.1 Biden would restore President Obama’s policy on Iran and immigration but not Russia, where there would be no “diplomatic reset.” And Biden’s fiscal profligacy, unlike Trump’s, would come with tax hikes on corporations and the wealthy … even though they would fall far short of offsetting the new spending. This is what brings us to this week’s report: New developments are confirming this view of the Biden administration. Geopolitical Risk And Bull Markets Chart 1Global Geopolitical Risk And The Dollar In recent weeks Biden has adopted a hawkish policy on China, lowered tensions with Europe, and sought to restore President Obama’s policy of détente with Iran. The jury is still out on relations with Russia – Biden will meet with Putin on June 16 – but we do not expect a 2009-style “reset” that increases engagement. Still, it is too soon to declare a “Biden doctrine” of foreign policy because Biden has not yet faced a major foreign crisis. A major test is coming soon. Biden’s decision to double down on hawkish policy toward China will bring ramifications. His possible deal with Iran faces a range of enemies, including within Iran. His reduction in tensions with Russia is not settled yet. While the specific source and timing of his first major foreign policy crisis is impossible predict, structural tensions are rebuilding. An aggregate of our 13 market-based GeoRisk indicators suggests that global political risk is skyrocketing once again. A sharp spike in the indicator, which is happening now, usually correlates with a dollar rally (Chart 1). This indicator is mean-reverting since it measures the deviation of emerging market currencies, or developed market equity markets, from underlying macroeconomic fundamentals. The implication is positive for the dollar, although the correlation is not always positive. Looking at both the DXY’s level and its rate of change shows periods when the global risk indicator fell yet the dollar stayed strong – and vice versa. The big increase in the indicator over the past week stems mostly from Germany, South Korea, Brazil, and Australia, though all 13 of the indicators are now either elevated or rising, including the China/Taiwan indicators. Some of the increase is due to base effects. As global exports recover, currencies and equities that we monitor are staying weaker than one would expect. This causes the relevant BCA GeoRisk indicator to rise. Base effects from the weak economy in June 2020 will fall out in coming weeks. But the aggregate shows that all of the indicators are either high or rising and, on a country by country level, they are now in established uptrends even aside from base effects. Chart 2Global Policy Uncertainty Revives Meanwhile the global Economic Policy Uncertainty Index is recovering across the world after the drop in uncertainty following the COVID-19 crisis (Chart 2). Policy uncertainty is also linked to the dollar and this indicator shows that it is rising on a secular basis. The Geopolitical Risk Index, maintained by Matteo Iacoviello and a group of academics affiliated with the Policy Uncertainty Index, is also in a secular uptrend, although cyclically it has not recovered from the post-COVID drop-off. It is sensitive to traditional, war-linked geopolitical risk as reported in newspapers. By contrast our proprietary indicators are sensitive to market perceptions of any kind of risk, not just political, both domestic and international. A comparison of the Geopolitical Risk Index with the S&P 500 over the past century shows that a geopolitical crisis may occur at the beginning of a business cycle but it may not be linked with a recession or bear market. Risk can rise, even extravagantly, during economic expansions without causing major pullbacks. But a crisis event certainly can trigger a recession or bear market, particularly if it is tied to the global oil supply, as in the early 1970s, 1980s, and 1990s (Chart 3). Chart 3Secular Rise In Geopolitical Risk Soon To Reassert Itself While geopolitical risk is normally positive for the dollar, the macroeconomic backdrop is negative. The dollar’s attempt to recover earlier this year faltered. This underlying cyclical bearish dollar trend is due to global economic recovery – which will continue – and extravagant American monetary expansion and budget deficits. This is why we have preferred gold – it is a hedge against both geopolitical risk and inflation expectations. Tactically this year we have refrained from betting against the dollar except when building up some safe-haven positions like Japanese yen. Over the medium and long term we expect geopolitical risk to put a floor under the greenback. The bottom line is that the US dollar is at a critical technical crossroads where it could break out or break down. Macro factors suggest a breakdown but the recovery of global policy uncertainty and geopolitical risk suggests the opposite. We remain neutral. A final quantitative indicator of the recovery of geopolitical risk is the performance of global aerospace and defense stocks (Chart 4). Defense shares are rising in absolute and relative terms. Chart 4Another Sign Of Geopolitical Risk: Defense Stocks Outperform As Virus Ebbs And Military Spending Surges Can The WWII Peace Be Prolonged? Qualitative assessments of geopolitical risk are necessary to explain why risk is on a secular upswing – why drops in the quantitative indicators are temporary and the troughs keep getting higher. Great nations are returning to aggressive competition after a period of relative peace and prosperity. Over the past two decades Russia and China took advantage of America’s preoccupations with the Middle East, the financial crisis, and domestic partisanship in order to build up their global influence. The result is a world in which authority is contested. The current crisis is not merely about the end of the post-Cold War international order. It is much scarier than that. It is about the decay of the post-WWII international order and the return of the centuries-long struggle for global supremacy among Great Powers. The US and European political establishments fear the collapse of the WWII settlement in the face of eroding legitimacy at home and rising challenges from abroad. The 1945 peace settlement gave rise to both a Cold War and a diplomatic system, including the United Nations Security Council, for resolving differences among the great powers. It also gave rise to European integration and various institutions of American “liberal hegemony.” It is this system of managing great power struggle, and not the post-Cold War system of American domination, that lies in danger of unraveling. This is evident from the following points: American preeminence only lasted fifteen years, or at best until the 2008 Georgia war and global financial crisis. The US has been an incoherent wild card for at least 13 years now, almost as long as it was said to be the global empire. Russian antagonism with the West never really ended. In retrospect the 1990s were a hiatus rather than a conclusion of this conflict. China’s geopolitical rise has thawed the frozen conflicts in Asia from the 1940s-50s – i.e. the Chinese civil war, the Hong Kong and Taiwan Strait predicaments, the Korean conflict, Japanese pacifism, and regional battles for political influence and territory. Europe’s inward focus and difficulty projecting power have been a constant, as has its tendency to act as a constraint on America. Only now is Europe getting closer to full independence (which helped trigger Brexit). Geopolitical pressures will remain historically elevated for the foreseeable future because the underlying problem is whether great power struggle can be contained and major wars can be prevented. Specifically the question is whether the US can accommodate China’s rise – and whether China can continue to channel its domestic ambitions into productive uses (i.e. not attempts to create a Greater Chinese and then East Asian empire). The Great Recession killed off the “East Asia miracle” phase of China’s growth. Potential GDP is declining, which undermines social stability and threatens the Communist Party’s legitimacy. The renminbi is on a downtrend that began with the Xi Jinping era. The sharp rally during the COVID crisis is over, as both domestic and international pressures are rising again (Chart 5). Chart 5Biden Administration Review Of China Policy: More China Bashing While the data for China’s domestic labor protests is limited in extent, we can use it as a proxy for domestic instability in lieu of official statistics that were tellingly discontinued back in 2005. The slowdown in credit growth and the cyclical sectors of the economy suggest that domestic political risk is underrated in the lead up to the 2022 leadership rotation (Chart 6). Chart 6China's Domestic Political Risk Will Rise Chart 7Steer Clear Of Taiwan Strait The increasing focus on China’s access to key industrial and technological inputs, the tensions over the Taiwan Strait, and the formation of a Russo-Chinese bloc that is excluded from the West all suggest that the risk to global stability is grave and historic. It is reminiscent of the global power struggles of the seventeenth through early twentieth centuries. The outperformance of Taiwanese equities from 2019-20 reflects strong global demand for advanced semiconductors but the global response to this geopolitical bottleneck is to boost production at home and replace Taiwan. Therefore Taiwan’s comparative advantage will erode even as geopolitical risk rises (Chart 7). The drop in geopolitical tensions during COVID-19 is over, as highlighted above. With the US, EU, and other countries launching probes into whether the virus emerged from a laboratory leak in China – contrary to what their publics were told last year – it is likely that a period of national recriminations has begun. There is a substantial risk of nationalism, xenophobia, and jingoism emerging along with new sources of instability. An Alliance Of Democracies The Biden administration’s attempt to restore liberal hegemony across the world requires a period of alliance refurbishment with the Europeans. That is the purpose of his current trip to the UK, Belgium, and Switzerland. But diplomacy only goes so far. The structural factor that has changed is the willingness of the West to utilize government in the economic sphere, i.e. fiscal proactivity. Infrastructure spending and industrial policy, at the service of national security as well as demand-side stimulus, are the order of the day. This revolution in economic policy – a return to Big Government in the West – poses a threat to the authoritarian powers, which have benefited in recent decades by using central strategic planning to take advantage of the West’s democratic and laissez-faire governance. If the West restores a degree of central government – and central coordination via NATO and other institutions – then Beijing and Moscow will face greater pressure on their economies and fewer strategic options. About 16 American allies fall short of the 2% of GDP target for annual defense spending – ranging from Italy to Canada to Germany to Japan. However, recent trends show that defense spending did indeed increase during the Trump administration (Chart 8). Chart 8NATO Boosts Defense Spending The European Union as a whole has added $50 billion to the annual total over the past five years. A discernible rise in defense spending is taking place even in Germany (Chart 9). The same point could be made for Japan, which is significantly boosting defense spending (as a share of output) after decades of saying it would do so without following through. A major reason for the American political establishment’s rejection of President Trump was the risk he posed to the trans-Atlantic alliance. A decline in NATO and US-EU ties would dramatically undermine European security and ultimately American security. Hence Biden is adopting the Trump administration’s hawkish approach to trade with China but winding down the trade war with Europe (Chart 10). Chart 9Europe Spending More On Guns Chart 10US Ends Trade War With Europe? A multilateral deal aimed at setting a floor in global corporate taxes rates is intended to prevent the US and Europe from undercutting each other – and to ensure governments have sufficient funding to maintain social spending and reduce income inequality (Chart 11). Inequality is seen as having vitiated sociopolitical stability and trust in government in the democracies. Chart 11‘Global’ Corporate Tax Deal Shows Return Of Big Government, Attempt To Reduce Inequality In The West Risks To Biden’s Diplomacy It is possible that Biden’s attempt to restore US alliances will go nowhere over the course of his four-year term in office. The Europeans may well remain risk averse despite their initial signals of willingness to work with Biden to tackle China’s and Russia’s challenges to the western system. The Germans flatly rejected both Biden and Trump on the Nord Stream II natural gas pipeline linkage with Russia, which is virtually complete and which strengthens the foundation of Russo-German engagement (more on this below). The US’s lack of international reliability – given the potential of another partisan reversal in four years – makes it very hard for countries to make any sacrifices on behalf of US initiatives. The US’s profound domestic divisions have only slightly abated since the crises of 2020 and could easily flare up again. A major outbreak of domestic instability could distract Biden from the foreign policy game.2 However, American incapacity is a risk, not our base case, over the coming years. We expect the US economic stimulus to stabilize the country enough that the internal political crisis will be contained and the US will continue to play a global role. The “Civil War Lite” has mostly concluded, excepting one or two aftershocks, and the US is entering into a “Reconstruction Lite” era. The implication is negative for China and Russia, as they will now have to confront an America that, if not wholly unified, is at least recovering. Congress’s impending passage of the Innovation and Competition Act – notably through regular legislative order and bipartisan compromise – is case in point. The Senate has already passed this approximately $250 billion smorgasbord of industrial policy, supply chain resilience, and alliance refurbishment. It will allot around $50 billion to the domestic semiconductor industry almost immediately as well as $17 billion to DARPA, $81 billion for federal research and development through the National Science Foundation, which includes $29 billion for education in science, technology, engineering, and mathematics, and other initiatives (Table 1). Table 1Peak Polarization: US Congress Passes Bipartisan ‘Innovation And Competition Act’ To Counter China With the combination of foreign competition, the political establishment’s need to distract from domestic divisions, and the benefit of debt monetization courtesy of the Federal Reserve, the US is likely to achieve some notable successes in pushing back against China and Russia. On the diplomatic front, the US will meet with some success because the European and Asian allies do not wish to see the US embrace nationalism and isolationism. They have their own interests in deterring Russia and China. Lack Of Engagement With Russia Russian leadership has dealt with the country’s structural weaknesses by adopting aggressive foreign policy. At some point either the weaknesses or the foreign policy will create a crisis that will undermine the current regime – after all, Russia has greatly lagged the West in economic development and quality of life (Chart 12). But President Putin has been successful at improving the country’s wealth and status from its miserably low base in the 1990s and this has preserved sociopolitical stability so far. Chart 12Russia's Domestic Political Risk It is debatable whether US policy toward Russia ever really changed under President Trump, but there has certainly not been a change in strategy from Russia. Thus investors should expect US-Russia antagonism to continue after Biden’s summit with Putin even if there is an ostensible improvement. The fundamental purpose of Putin’s strategy has been to salvage the Russian empire after the Soviet collapse, ensure that all world powers recognize Russia’s veto power over major global policies and initiatives, and establish a strong strategic position for the coming decades as Russia’s demographic decline takes its toll. A key component of the strategy has been to increase economic self-sufficiency and reduce exposure to US sanctions. Since the invasion of Ukraine in 2014, Putin has rapidly increased Russia’s foreign exchange reserves so as to buffer against shocks (Chart 13). Chart 13Russia Fortified Against US Sanctions Putin has also reduced Russia’s reliance on the US dollar to about 22% (Chart 14), primarily by substituting the euro and gold. Russia will not be willing or able to purge US dollars from its system entirely but it has been able to limit America’s ability to hurt Russia by constricting access to dollars and the dollar-based global financial architecture. Russian Finance Minister Anton Siluanov highlighted this process ahead of the Biden-Putin summit by declaring that the National Wealth Fund will divest of its remaining $40 billion of its US dollar holdings. Chart 14Russia Diversifies From USD In general this year, Russia is highlighting its various advantages: its resilience against US sanctions, its ability to re-invade Ukraine, its ability to escalate its military presence in Belarus and the Black Sea, and its ability to conduct or condone cyberattacks on vital American food and fuel supplies (Chart 15). Meanwhile the US is suffering from deep political divisions at home and strategic incoherence abroad and these are only starting to be mended by domestic economic stimulus and alliance refurbishment. Chart 15Cyber Security Stocks Recover Europe’s risk-aversion when it comes to strategic confrontation with Russia, and the lack of stability in US-Russia relations, means that investors should not chase Russian currency or financial assets amid the cyclical commodity rally. Investors should also expect risk premiums to remain high in developing European economies relative to their developed counterparts. This is true despite the fact that developed market Europe’s outperformance relative to emerging Europe recently peaked and rolled over. From a technical perspective this outperformance looks to subside but geopolitical tensions can easily escalate in the near term, particularly in advance of the Russian and German elections in September (Chart 16). Chart 16Developed Markets In Europe Will Outperform Emerging Europe Unless Russian Geopolitical Risk Abates Developed Europe trades in line with EUR-RUB and these pair trades all correspond closely to geopolitical tensions with Russia (Chart 17). A notable exception is the UK, whose stock market looks attractive relative to eastern Europe and is much more secure from any geopolitical crisis in this region (Chart 17, bottom panel). The pound is particularly attractive against the Czech koruna, as Russo-Czech tensions have heated up in advance of October’s legislative election there (Chart 18). Chart 17Long UK Versus Eastern Europe Chart 18Long GBP Versus CZK Meanwhile Russia and China have grown closer together out of strategic necessity. Germany’s Election And Stance Toward Russia Germany’s position on Russia is now critical. The decision to complete the Nord Stream II pipeline against American wishes either means that the Biden administration can be safely ignored – since it prizes multilateralism and alliances above all things and is therefore toothless when opposed – or it means that German will aim to compensate the Americans in some other area of strategic concern. Washington is clearly attempting to rally the Germans to its side with regard to putting pressure on China over its trade practices and human rights. This could be the avenue for the US and Germany to tighten their bond despite the new milestone in German-Russia relations. The US may call on Germany to stand up for eastern Europe against Russian aggression but on that front Berlin will continue to disappoint. It has no desire to be drawn into a new Cold War given that the last one resulted in the partition of Germany. The implication is negative for China on one hand and eastern Europe on the other. Germany’s federal election on September 26 will be important because it will determine who will succeed Chancellor Angela Merkel, both in Germany and on the European and global stage. The ruling Christian Democratic Union (CDU) is hoping to ride Merkel’s coattails to another term in charge of the government. But they are likely to rule alongside the Greens, who have surged in opinion polls in recent years. The state election in Saxony-Anhalt over the weekend saw the CDU win 37% of the popular vote, better than any recent result, while Germany’s second major party, the Social Democrats, continued their decline (Table 2). The far-right Alternative for Germany won 21% of the vote, a downshift from 2016, while the Greens won 6% of the vote, a slight improvement from 2016. All parties underperformed opinion polling except the CDU (Chart 19). Table 2Saxony-Anhalt Election Results Chart 19Germany: Conservatives Outperform In Final State Election Before Federal Vote, But Face Challenges Chart 20Germany: Greens Will Outperform in 2021 Vote The implication is still not excellent for the CDU. Saxony-Anhalt is a middling German state, a CDU stronghold, and a state with a popular CDU leader. So it is not representative of the national campaign ahead of September. The latest nationwide opinion polling puts the CDU at around 25% support. They are neck-and-neck with the Greens. The country’s left- and right-leaning ideological blocs are also evenly balanced in opinion polls (Chart 20). A potential concern for the CDU is that the Free Democratic Party is ticking up in national polls, which gives them the potential to steal conservative votes. Betting markets are manifestly underrating the chance that Annalena Baerbock and the Greens take over the chancellorship (Charts 21A and 21B). We still give a subjective 35% chance that the Greens will lead the next German government without the CDU, a 30% that the Greens will lead with the CDU, and a 25% chance that the CDU retains power but forms a coalition with the Greens. A coalition government would moderate the Greens’ ambitious agenda of raising taxes on carbon emissions, wealth, the financial sector, and Big Tech. The CDU has already shifted in a pro-environmental, fiscally proactive direction. Chart 21AGerman Greens Will Recover Chart 21BGerman Greens Still Underrated No matter what the German election will support fiscal spending and European solidarity, which is positive for the euro and regional equities over the next 12 to 24 months. However, the Greens would pursue a more confrontational stance toward Russia, a petro-state whose special relations with the German establishment have impeded the transition to carbon neutrality. Latin America’s Troubles A final aspect of Biden’s agenda deserves some attention: immigration and the Mexican border. Obviously this one of the areas where Biden starkly differs from Trump, unlike on Europe and China, as mentioned above. Vice President Kamala Harris recently came back from a trip to Guatemala and Mexico that received negative media attention. Harris has been put in charge of managing the border crisis, the surge in immigrant arrivals over 2020-21, both to give her some foreign policy experience and to manage the public outcry. Despite telling immigrants explicitly “Do not come,” Harris has no power to deter the influx at a time when the US economy is fired up on historic economic stimulus and the Democratic Party has cut back on all manner of border and immigration enforcement. From a macro perspective the real story is the collapse of political and geopolitical risk in Mexico. From 2016-20 Mexico faced a protectionist onslaught from the Trump administration and then a left-wing supermajority in Congress. But these structural risks have dissipated with the USMCA trade deal and the inability of President Andrés Manuel López Obrador to follow through with anti-market reforms, as we highlighted in reports in October and April. The midterm election deprived the ruling MORENA party of its single-party majority in the Chamber of Deputies, the lower house of the legislature (Chart 22). AMLO is now politically constrained – he will not be able to revive state control over the energy and power sectors. Chart 22Mexican Midterm Election Constrained Left-Wing Populism, Political Risk Chart 23Buy Mexico (And Canada) On US Stimulus American monetary and fiscal stimulus, and the supply-chain shift away from China, also provide tailwinds for Mexico. In short, the Mexican election adds the final piece to one of our key themes stemming from the Biden administration, US populism, and US-China tensions: favor Mexico and Canada (Chart 23). A further implication is that Mexico should outperform Brazil in the equity space. Brazil is closely linked to China’s credit cycle and metals prices, which are slated to turn down as a result of Chinese policy tightening. Mexico is linked to the US economy and oil prices (Chart 24). While our trade stopped out at -5% last week we still favor the underlying view. Brazilian political risk and unsustainable debt dynamics will continue to weigh on the currency and equities until political change is cemented in the 2022 election and the new government is then forced by financial market riots into undertaking structural reforms. Chart 24Brazil's Troubles Not Truly Over - Mexico Will Outperform Elsewhere in Latin America, the rise of a militant left-wing populist to the presidency in a contested election in Peru, and the ongoing social unrest in Colombia and Chile, are less significant than the abrupt slowdown in China’s credit growth (Charts 25A and 25B). According to our COVID-19 Social Stability Index, investors should favor Mexico. Turkey, the Philippines, South Africa, Colombia, and Brazil are the most likely to see substantial social instability according to this ranking system (Table 3). Chart 25AMexico To Outperform Latin America Chart 25BChina’s Slowdown Will Hit South America Table 3Post-COVID Emerging Market Social Unrest Only Just Beginning Investment Takeaways Close long emerging markets relative to developed markets for a loss of 6.8% – this is a strategic trade that we will revisit but it faces challenges in the near term due to China’s slowdown (Chart 26). Go long Mexican equities relative to emerging markets on a strategic time frame. Our long Mexico / short Brazil trade hit the stop loss at 5% but the technical profile and investment thesis are still sound over the short and medium term. Chart 26China Slowdown, Geopolitical Risk Will Weigh On Emerging Markets Chart 27Relative Uncertainty And Safe Havens China’s sharp fiscal-and-credit slowdown suggests that investors should reduce risk exposure, take a defensive tactical positioning, and wait for China’s policy tightening to be priced before buying risky assets. Our geopolitical method suggests the dollar will rise, while macro fundamentals are becoming less dollar-bearish due to China. We are neutral for now and will reassess for our third quarter forecast later this month. If US policy uncertainty falls relative to global uncertainty then the EUR-USD will also fall and safe-haven assets like Swiss bonds will gain a bid (Chart 27). Gold is an excellent haven amid medium-term geopolitical and inflation risks but we recommend closing our long silver trade for a gain of 4.5%. Disfavor emerging Europe relative to developed Europe, where heavy discounts can persist due to geopolitical risk premiums. We will reassess after the Russian Duma election in September. Go long GBP-CZK. Close the Euro “laggards” trade. Go long an equal-weighted basket of euros and US dollars relative to the Chinese renminbi. Short the TWD-USD on a strategic basis. Prefer South Korea to Taiwan – while the semiconductor splurge favors Taiwan, investors should diversify away from the island that lies at the epicenter of global geopolitical risk. Close long defense relative to cyber stocks for a gain of 9.8%. This was a geopolitical “back to work” trade but the cyber rebound is now significant enough to warrant closing this trade.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1 Trump’s policy toward Russia is an excellent example of geopolitical constraints. Despite any personal preferences in favor of closer ties with Russia, Trump and his administration ultimately reaffirmed Article 5 of NATO, authorized the sale of lethal weapons to Ukraine, and deployed US troops to Poland and the Czech Republic. 2 As just one example, given the controversial and contested US election of 2020, it is possible that a major terrorist attack could occur. Neither wing of America’s ideological fringes has a monopoly on fanaticism and violence. Meanwhile foreign powers stand to benefit from US civil strife. A truly disruptive sequence of events in the US in the coming years could lead to greater political instability in the US and a period in which global powers would be able to do what they want without having to deal with Biden’s attempt to regroup with Europe and restore some semblance of a global police force. The US would fall behind in foreign affairs, leaving power vacuums in various regions that would see new sources of political and geopolitical risk crop up. Then the US would struggle to catch up, with another set of destabilizing consequences.

Highlights Even though the National Bank of Hungary is set to hike its policy rate, the pace and magnitude of these rate hikes will be insufficient to contain the inflation outbreak. In the meantime, Czech policymakers – both the central bank and a potentially new government – will be decisive in their actions to tackle rising inflation. Rate hikes amid potential fiscal tightening following the October general elections will support koruna appreciation. To sum up, the Czech koruna will outperform the Hungarian forint. We are initiating a long CZK / short HUF trade while closing our long CZK versus an equal-weighted basket of HUF and PLN position. Feature Chart 1The NBH & CNB Will Soon Embark On Rate Hike Cycles Conditions for central bank rate hike cycles are in place in Hungary and the Czech Republic. With brewing inflationary pressures at work in their economies, Hungarian and Czech authorities are likely to embark on a rate hike cycle in the coming weeks (Chart 1). Yet, Czech authorities are following a more conventional policy mix, which entails a positive outlook for the Czech koruna. By contrast, Hungarian authorities will continue with their populist policy cocktail, with QE and large fiscal spending in the cards. We therefore remain negative on the Hungarian forint outlook for the time being. Sooner than later, the Czech koruna will resume its appreciation versus the Hungarian forint. Hungary: The “Inflation Genie” Is Out Of The Bottle The National Bank of Hungary (NBH) is set to hike its policy rate following spikes in headline and core inflation equal to 5.1% and 3.7%, respectively (Chart 2). A couple of rate hikes will likely happen in the second half of this year as inflation accelerates above the target range of 2-4%. Nevertheless, these rate hikes will be too small to halt the inflation outbreak developing in Hungary. Chart 2Hungary: Inflation Will Ovetshoot In short, the central bank will raise the policy rate but will remain behind the inflation curve. This might support the Hungarian forint in the very near term, but the medium-term outlook is negative for this currency. Significantly, expanding government spending ahead of the 2022 elections and ongoing quantitative easing (QE) from the NBH bodes ill for the exchange rate. The QE program will cap the upside in local bond yields, thus limiting the impact of policy rate hikes on aggregate borrowing costs. Critically, the policy rate and long-term government bond yields in real terms (deflated by core CPI) will remain deeply negative, discouraging private investors, including foreign investors, from buying in (Chart 3). Chart 3Hungary: Real Rates Are At Record Lows Ahead of the 2022 general elections, Prime minister Viktor Orbán and his ruling Fidesz party are tied in national polls with the newly formed opposition front. The opposition alliance was set up to challenge both PM Orbán and the Fidesz party’s decade in power. Their 2019 local elections victory in Budapest raises the possibility of a change in government next year. This threat to Viktor Orbán’s power will force his hand in securing easy fiscal and monetary policies to strive for minimum unemployment and higher nominal income growth and with it maintain popular support. These create conditions for the economy to overheat, and inflation to overshoot: First, the government is increasing spending following a period of already sizable fiscal spending in 2020-21. The 2022 revised budget draft is designed to target key voting groups. In particular, the new spending plan entails tax exemptions for workers under 25, increases in support for families, adds extra pension payments to retirees, and reduces tax burdens on businesses. Second, wage growth is already high at 8% and the government is boosting public sector wages and has increased the minimum wage.  Chart 4Hungary: Labor Market Slack Is Small In addition, the number of unemployed people is smaller than in the past outside recessions (Chart 4). As such, labor shortages will persist. This circumstance is conducive to higher wages, and thereby suggests that inflationary pressures are genuine and will be broad-based. Third, the vaccination campaign led by Hungarian authorities is fairly advanced and comparable to developed economies’ efforts. Unleashed, the pent-up demand for consumer goods & services will help overall consumption to expand quickly in the months ahead. Fourth, the National Bank of Hungary (NBH) will further expand its asset purchases (i.e. QE program) to cap government bond yields, enabling more government borrowing at lower cost and more fiscal spending. Chart 5Hungary Has Been Conducting Large Scale QE Inflationary policies, budding economic overheating and the central bank’s QE bond purchases have greatly reduced the attractiveness of local government bonds. Notably, a lack of foreign portfolio inflows into Hungarian government bonds is already forcing the central bank to absorb a third of local government bond issuance (Chart 5). This trend will likely persist and to cap yields the central bank could be forced to increase the size of its QE program.1 When it happens, the currency market will react negatively, and the forint will experience another downleg. Further, the surge in commercial banks’ excess reserves at the central bank due to the QE program creates conditions for commercial banks to expand their local currency assets. This is inflationary and negative for the exchange rate. Chart 6Hungary: BoP Poses A Risk To The Forint Lastly, a lack of foreign portfolio inflows and no current account surplus do not bode well for the forint (Chart 6). Bottom Line: The central bank’s rate hikes will be timid enabling an inflation overshoot. In short, the central bank will fall behind the inflation curve, leading to low real interest rates and a weaker forint beyond the near term (Chart 3 above). Czech’s Central Bank Is Alert To Inflation Chart 7The Czech Republic: Inflation Is Heading Towards CB's Target Range In the Czech Republic, core and headline consume price inflation are breaking above the upper band of the central bank’s target range (Chart 7). Remarkably, core inflation measures have not declined much in the past year even though the economy experienced a major pandemic-induced slump. As the economy recovers, inflation will rise to new highs. Yet, policymakers are on the alert: fiscal policy is set to become more restrictive following the October elections and the Czech National Bank (CNB) will hike interest rates continuously over the coming months. It is worth noting that Czech policymakers have pursued much more prudent monetary and fiscal policies than Hungarian authorities. The Czech National Bank (CNB) will normalize nominal and real policy rates sooner than its regional and euro area counterparts. In turn, higher Czech real interest rates will support the currency against both the euro and its central European peers: After strong fiscal spending ahead of the October 2021 general elections, fiscal policy will likely become restrictive in Q4 of this year. Czech prime minister Andrej Babis’ slim chances of reelection had pushed his government to expand fiscal spending as a last resort to gather support. Yet, his ANO party is trailing the center-left coalition of the Pirates Party and the STAN coalition in national polls and is closely followed by the center-right SPOLU party. In any outcome a divided parliament likely entails a return to conservative fiscal policy in the years to come.   Chart 8Czech Economy: Job Market Will Heel Rapidly In addition, labor shortages persist. Job vacancies are high and will rise further as the economy reopens and European tourism picks up. Further, the number of unemployed workers to fill these vacancies is going to fall over the coming months (Chart 8). As employment recovers, competition from local firms to secure labor will bid up wages. The recovery in European manufacturing will continue. This will extend the Czech Republic’s manufacturing expansion. Notably, the nation’s manufacturing production output is back to pre-pandemic levels. This is despite weak production volumes out of the car industry, as auto production has been hampered by a global semiconductor shortage. As these shortages ease, auto production will surge, further increasing Czech industrial output. Historically low corporate and consumer real lending rates will help spur credit growth and incentivize consumption. The current account surplus is at record highs at 3.5% of GDP. Positive dynamics within the BoP is positive for the currency. Chart 9The Czech Koruna Is Not Expensive Lastly, the koruna is fairly valued according to its real effective exchange rate based on a unit labor costs measure (Chart 9). Bottom Line: The Czech National Bank will hike interest in response to rising inflation. Czech real rates will move above those in central Europe and the euro area. This will continue to support Czech koruna appreciation. Investment Recommendation Odds are that Czech swap rates will rise faster than those in Hungary reflecting the speed of central bank rate hike cycles. Consequently, the Czech koruna will outperform the Hungarian forint We are initiating a long CZK / short HUF trade. We are closing the long CZK versus an equal-weighted basket of HUF and PLN. This trade has produced a 0.8% gain since its recommendation on November 25. We will discuss the outlook for Poland in the coming weeks. In regard to equities, we continue recommending neutral allocation to central European bourses – Polish, Czech and Hungarian equities – within an EM equity portfolio.   Andrija Vesic Associate Editor andrijav@bcaresearch.com     Footnotes 1In their latest May 25 monetary policy meeting, the NBH stated that it will perform a review of its QE program when purchases amount to HUF 3 trillion. As of May 23, the total stock of purchases amount to HUF 2.23 trillion. In addition, they see government bond purchases as a key tool to smoothing out financial market volatility and avoiding a surge in bond yields.

Chart 1Rates To Rise In Czech Republic, But Will Remain Low In Poland & Hungary Among Central European (CE) currencies, we remain upbeat on the Czech koruna (CZK) due to a relatively hawkish central bank. Meanwhile, the Hungarian forint and Polish zloty are bound to continue underperforming both the CZK and the euro because of their ultra-dovish central banks. In addition to our current strategy of being long the Czech koruna versus the US dollar, we recommend investors to go long CZK against an equal-weighted basket of PLN and HUF. Rising inflation in conjunction with a dovish central bank is bearish for the exchange rate. Yet, rising inflation in tandem with a hawkish central bank is bullish for the currency. While inflation is high in all three central European economies, the Czech central bank is the most hawkish among the three (Chart 1). The Czech National Bank (CNB) has signaled three possible interest rate hikes for next year. As such, among central banks in Central Europe as well as compared with the ECB and the Fed, the CNB is quite hawkish and will be the first to hike rates in this cycle. Such hikes will push Czech real policy rate above zero sooner than in Hungary and Poland. Higher real rates will favor the CZK relative to its CE counterparts, the euro and the US dollar going forward. Central banks’ asset purchases have been much more aggressive in Poland and Hungary than in the Czech Republic (Chart 2). Notably, CNB governor’s recent comments suggest that the CNB will refrain from implementing any asset purchasing programs. Further, broad money supply growth is much more rampant in Hungary and Poland than in the Czech Republic. (Chart 3). Chart 2CB QEs: Tame In Czech Republic But Rampant In Poland & Hungary Chart 3Much Strong Money Growth In Poland And Hungary Than In Czech Republic   Ceteris paribus, these factors favor the CZK over the PLN and HUF. Chart 4 illustrates exchange rate valuations: the HUF is the cheapest currency. However, the CZK offers the best risk-reward when combining valuations with fundamentals. Lastly, 10-year bond yield spreads over German bunds are 170-180 bps in Poland and Czech and 270 bps in Hungary. Taking into account the exchange rate outlook, Czech bonds on a total return basis in common currency, offer a better value and risk/reward profile compared to Polish and Hungarian bonds. Bottom Line: Go long CZK / short PLN and HUF and continue holding the long CZK / short USD position. Also, close the long HUF / short PLN position. The trade has generated a loss of 4.4%. Equities: CE equities relative performance to EM is contingent on the performance of European bank stocks (Chart 5). The basis is that bank stocks represent a large weight in these Central European bourses, namely 25%, 46% and 28% in Poland, Hungary and the Czech Republic, respectively, using the broad Refinitiv Datastream (not MSCI) stock index. Chart 4Currency Valuations Chart 5Remain Neutral On CE Equities Due To Large Bank Sector Weigthing   In the near-term, European banks could outperform given their massive underperformance in recent years. However, the structural case for global and European banks is dismal. Consequently, the large weight in bank stocks will be a drag on central European bourses in the long run. Besides, the visibility on non-performing loans amid the use of credit guarantees during the pandemic is low in Central Europe. All things considered, we continue recommending a neutral allocation to Central European markets within an EM equity portfolio. Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Footnotes

An opportunity to bet on higher longer-term interest rates and on a stronger currency has emerged in the Czech Republic (Chart III-1). Consumer price inflation is above the central bank’s 2% target and will continue to rise, which will necessitate higher interest rates (Chart III-2). The latter will lead to currency appreciation. Chart III-1Pay Rates And Go Long CZK vs. USD Chart III-2Inflation Is Above The CB Bands   The Czech authorities’ strong fiscal and monetary support of the economy amid the COVID recession will keep both labor demand and, thereby, wages supported. In turn, core inflation will likely prove resilient in the near term and will rise over the coming 12-18 months, putting upward pressure on long-term interest rates. First, Prime Minister Andrej Babis is determined to promote a rapid economic recovery, as there are upcoming elections scheduled for next year. In early July, the government approved another spending program that will in part finance infrastructure projects and promote job creation in the non-manufacturing sector. The bill is expected to boost infrastructure spending by 140 billion koruna (or 2.5% of GDP) in 2020, and is part of a multi-decade national investment plan to increase domestic productivity. In particular, the construction sector will benefit from a massive uplift in domestic capex that will go towards upgrading the transport network. This will produce a job boom in the construction industry which should mitigate the employment losses in manufacturing and tourism. Second, shortages continue to persist in the labor market. Our labor shortage proxy is at an all-time high, suggesting that labor shortages will continue to facilitate faster wage growth (Chart III-3). Interestingly, Chart III-4 suggests that overall job vacancies have plateaued but have not dropped. This signifies pent-up demand for labor. Critically, this hiring challenge is likely to make industrial firms reluctant to shed workers amid the transitory pandemic-induced manufacturing downturn. Chart III-3Labor Shortages = Wages Higher Chart III-4JOB VACANCIES ARE HOLDING UP...   Either way, competition for labor in manufacturing and other sectors will keep a firm bid on both wages and unit labor costs in the medium to long term (Chart III-5). Third, low real interest rates will promote domestic credit growth (Chart III-6), helping support final domestic demand which, in turn, will lift inflation. Chart III-5...STRUCTURAL PRESSURE ON LABOR COSTS Chart III-6Low Rates Will Bolster Domestic Demand   Similarly, residential real estate prices and rents will continue to grow at a hefty pace due to low borrowing costs and residential property shortages. Finally, core inflation measures are hovering well above the 2% target and the upper band of 3% (Chart III-2 on page 13). As such, the Czech National Bank (CNB) is likely to hike interest rates sooner rather than later. Critically, inflation is acute across various parts of the economy. Specifically, service price inflation is likely to continue rising in the wake of announced price hikes in public services, such as transport. These are being devised by local authorities to counteract a loss in tax revenue. Altogether, easy fiscal policy (infrastructure spending) will support labor demand, wage growth and final domestic demand, in turn heightening inflationary pressures. Unlike its counterparts in the EU, the CNB is more sensitive to price increases due to the relatively higher starting point of inflation in the Czech economy. As such, the central bank will be the first to hike interest rates among its EU counterparts, tolerating the currency appreciation that will come with it. The basis is Czech domestic demand and income growth will be robust. Investment Recommendation Czech swap rates are currently pricing a rise of only 55 bps in interest rates over the next 10 years. As a result, we recommend investors pay 10-year swap rates (see the top panel of Chart III-1 on page 13). We also recommend going long the Czech koruna versus the US dollar. Unlike the Czech central bank, the US Federal Reserve will keep interest rates very low for too long. In short, the Fed will fall well behind the curve, while the CNB will hike earlier. Rising Czech rates versus US rates favor the koruna against the dollar. This is a structural position that will be held for the next couple of years. It is also consistent with the change in our view on the USD, which has gone from positive to negative in our report from July 9. Andrija Vesic Associate Editor andrijav@bcaresearch.com